Dear Baron Growth Fund Shareholder:
Performance
During a period marked by increased volatility, U.S. stock markets ended the fourth quarter higher. Baron Growth Fund rose 7.23% over the period to finish the year up 4.40%. These results trailed the Russell 2000 Growth Index, the small cap benchmark against which the Fund competes, by 283 basis points for the quarter and 120 basis points for the year. Despite small caps having strong fourth quarter results, the Russell 2000 Growth trailed its larger-cap S&P 500 Index counterpart by approximately 800 basis points in 2014. This represents the largest annual spread for small growth versus large growth since 1998.
We believe there were principally two reasons for this. The first was a “rotation” of interest into larger companies whose stocks lagged the prior year. In 2013, for example, small caps had outperformed large cap stocks by roughly 1,000 basis points. The second is that large cap stocks represent a perceived ‘flight to safety’ that, we believe, reflects investor fear. This cyclical behavior is a well-established pattern.We are confident that stocks of smaller, faster growing companies will once again return to favor – and that the results of the fourth quarter may signal that inflection point is approaching. In addition, in the wake of underperforming small cap stocks in 2014, during which many small cap businesses experienced strong growth, we believe these companies now offer unusually attractive value.
Table I.
Performance (Retail Shares)
Annualized for periods ended December 31, 2014
| Russell Baron Growth Fund | 2000 Growth Index | S&P 500 Index | |
| Three Months | 7.23% | 10.06% | 4.93% |
| One Year | 4.40% | 5.60% | 13.69% |
| Three Years | 18.91% | 20.14% | 20.41% |
| Five Years | 16.12% | 16.80% | 15.45% |
| Ten Years | 8.41% | 8.54% | 7.67% |
| Fifteen Years | 8.77% | 4.34% | 4.24% |
| Since Inception (December 31,1994) | 13.70% | 7.83% | 9.85% |
The freefall in oil prices dominated the business headlines during the fourth quarter. The price of crude oil dropped to $53 per barrel as of year-end, down almost 50% from its June high and at the lowest level since May 2009. As a result, energy related stocks were among the worst performers during the quarter and the year. Energy investments do not represent a large percentage of either this Fund’s or our Firm’s investments.
In our view, the steep decline in oil prices will prove to be a substantial net positive for the U.S. economy and non-energy-related U.S. stocks. The approximate 50% decline in oil prices saves our economy roughly $360 billion per year, or more than 2% of GDP. In addition, the amount of oil being produced domestically has almost doubled to nine million barrels/day today vs. five million barrels/day in 2005, which means we need to import less energy.This is good news for the U.S. trade deficit – and the domestic economy. Money not spent on oil and gas can be spent elsewhere. Energy- intensive manufacturers and other businesses will have lower energy costs, resulting in higher cash flows. Consumers, of course, will have more disposable income to spend on goods and services.
The quarter was marked by generally positive economic reports that support our view that the U.S. economy is strengthening, helped by record low interest rates, falling energy prices, falling trade and budget deficits and improvements in job growth. During the quarter, consumer confidence rose and was evident in robust auto sales and improved housing data.
While we do not try to predict short-term“macro”developments or current events, we believe conditions remain favorable for the economy and stocks. This is based on our view that U.S. economic growth is accelerating and stocks remain attractively valued, trading around 16x earnings, in-line with 100-year average P/E multiples.
Baron Growth Fund does not change its investment approach because we believe certain types of stocks will be in or out of favor in the short term.We invest for the long term in businesses with, in our view, large growth opportunities, sustainable competitive advantages and talented, visionary managements. Following the 2014 underperformance of small cap growth stocks, we believe Baron Growth Fund’s portfolio is unusually well- positioned. Over the long term, the Fund has outperformed its benchmark by approximately 600 basis points per year on average since inception on December 31, 1994. It has also outperformed the large cap S&P 500 Index by approximately 400 basis points per year over the same timeframe. Over 20 years, Baron Growth Fund has earned an average compound annual return of 13.70%.This compares to 7.83% for the Russell 2000 Growth Index and 9.85% for the S&P 500 Index.
During the quarter, the Fund’s investments within the Information Technology (IT), Materials, and Consumer Staples sectors were the largest contributors to favorable relative performance. Strength in IT was largely attributable to the outperformance of MAXIMUS, Inc. (MMS) and SS&C Technologies, Inc. (SSNC), which were also the Fund’s two largest contributors to absolute performance. Other sector contributors were FactSet Research Systems, Inc. (FDS), a provider of financial information to the investment community, and two Internet software & services holdings, CoStar Group, Inc. (CSGP) and Benefitfocus, Inc (BNFT).
Within Materials, the Fund’s lower exposure to this lagging sector and outperformance of CaesarStone Sdot-Yam Ltd. (CSTE) aided relative results. Shares of CaesarStone, a leading manufacturer of engineered quartz surfaces used for kitchen and bathroom countertops, increased by double digits after the company reported impressive quarterly results and raised their 2014 guidance for the third consecutive quarter.
Within Consumer Staples, the outperformance of United Natural Foods, Inc. (UNFI) the largest distributor of natural and organic products, and The Boston Beer Company, Inc. (SAM), the largest craft brewer in the U.S., added the most value to absolute returns. Shares of Boston Beer were up sharply after reporting quarterly results with sales growth in excess of 25%.
The Fund’s investments within the Health Care, Consumer Discretionary, and Industrials sectors were the largest detractors from relative performance. Within Health Care, the Fund’s meaningfully lower exposure to biotechnology stocks, which rose 22% within the index, and underperformance of Community Health Systems, Inc. (CYH), detracted the most from relative results. Community Health’s shares stalled in the quarter as investors grew more cautious after the Republicans swept Congress and the U.S. Supreme Court surprisingly decided to hear a case brought by critics of the Affordable Care Act.
Many of the Fund’s Consumer Discretionary investments underperformed, led by its largest sector holding, Under Armour, Inc. (UA), which gave back some gains after rising significantly earlier in the year as the company continued to demonstrate strong brand momentum and robust 30% sales growth across all categories. Other consumer-centric detractors included a small investment in DreamWorks Animation SKG, Inc. (DWA), a leading developer, producer, and marketer of animated films, TV shows, and home entertainment, and Manchester United plc (MANU), an English Premier League professional sports team. Shares of DreamWorks lagged due to disappointing feature film results, while shares of Manchester United were down following a secondary offering. We remain optimistic about Manchester United over the long term.
Finally, weakness in Industrials was mainly due to the underperformance of Genesee & Wyoming, Inc. (GWR), a leading short-line railroad, and Colfax Corp. (CFX), an industrial machinery company focused on infrastructure. Shares of Genesee & Wyoming declined in the quarter due to its commodity- related exposure, particularly in Australia, and rail congestion issues across the U.S. rail network, both of which we believe will be temporary. Shares of Colfax fell after the company reported weaker-than-expected quarterly earnings.
During the quarter, we took advantage of market volatility and added opportunistically to several new and existing investments that had fallen sharply in price. In 2014, Baron Growth Fund had invested nearly $440 million in eight new companies with average market caps of $1.5 billion. In 2014, the Fund also added approximately $290 million to existing holdings with average market caps of $1.8 billion and reduced positions with average market caps over $5 billion. Those larger businesses had been very successful investments and had been owned for several years by the Fund.
These transactions are illustrative of our strategy. Baron Growth Fund invests in small cap businesses under $2.5 billion in size with significant competitive advantages that possess large addressable market opportunities. We monitor their progress closely as they become mid cap stocks. We sell them after they’ve become larger, successful companies and reinvest the proceeds in small cap growth businesses.
We try to explain the reasons certain stocks outperformed or underperformed during the period in the “Top Contributors” and “Top Detractors” section that follows. In many instances, we regard gains and losses in the short term as random. We continue to believe all the growth businesses in which we have invested could double in size within five years. Importantly, we believe these investments possess stronger fundamental and quality characteristics than the companies that comprise the benchmark. Baron Growth Fund’s investments consist primarily of companies with higher profit margins, more favorable returns on capital, and much lower earnings volatility than the securities in the benchmark against which we compete. We believe these characteristics should offer investors significant excess returns over time, although we obviously cannot guarantee that.
| “Yesterday” Clinton Years 1992-2000 Internet Bubble 12/31/99 P/E 33x | “The Long and Winding Road” Bush Years 2000-2008 9/11; Iraq; Afghanistan; Housing Bubble; Financial Panic | “Here Comes the Sun” Obama Years 2008-2014 Recovery P/E 16.2x | “Any Time at All” | |
| Annualized Returns | Inception 12/31/94 to 12/31/99 | 12/31/99 to 12/31/08 | 12/31/08 to 12/31/14 | Inception 12/31/94 to 12/31/14 |
| Baron Growth Fund | 29.90% | 2.46% | 18.96% | 13.70% |
| Russell 2000 Growth Index | 18.99% | –4.71% | 19.57% | 7.83% |
| S&P 500 Index | 28.56% | –3.60% | 17.22% | 9.85% |
Table II.
Top contributors to performance for the quarter ended December 31, 2014
| Year Acquired | Market Cap When Acquired (billions) | Quarter End Market Cap (billions) | Total Return | Percent Impact | |
| MAXIMUS, Inc. | 2011 | $1.2 | $3.6 | 36.78% | 0.59% |
| SS&C Technologies, Inc. | 2010 | 1.0 | 5.1 | 33.60 | 0.58 |
| United Natural Foods, Inc. | 2011 | 1.8 | 3.9 | 25.81 | 0.49 |
| ITC Holdings Corp. | 2005 | 0.8 | 6.3 | 13.95 | 0.46 |
| FactSet Research Systems, Inc. | 2006 | 2.5 | 5.9 | 16.14 | 0.42 |
Shares of MAXIMUS, Inc. (MMS), a provider of outsourced government health and human services in the U.S., U.K. and Australia, rose in the fourth quarter. Investors were buoyed by management’s roadmap for meaningful earnings acceleration in 2016.They were also pleased with 2015 visibility; MAXIMUS will enter the year with almost 100% of its midpoint revenue guidance in backlog or option renewals. We believe this is a well positioned and well run, strong cash generative company. (Susan Robbins)
After almost doubling in 2013, shares of financial technology vendor SS&C Technologies Holdings, Inc. (SSNC) rallied in the fourth quarter. We expect continued improvement in SS&Cs revenue trends over the next few quarters due to positive secular trends in fund administration, improving end markets, and recognition of deferred revenue. We are excited by the recent acquisition of DST Global Solutions, and expect additional accretive acquisitions of fund administrators and bolt-on technologies by the company. (Neal Rosenberg)
United Natural Foods, Inc. (UNFI), the largest distributor of natural, organic, and specialty products to North American supermarkets, delivered another quarter of strong, better-than-expected results that helped push shares to new highs. Sales were up 24% over 2013, boosted by double-digit organic growth and meaningful contribution from a large, recent acquisition that we believe has the potential to double the company’s addressable market opportunity in gourmet perishable foods. (Matt Weiss)
ITC Holdings Corp. (ITC) is the nation’s largest independent transmission company. ITC shares rose in the fourth quarter in the context of the general strong performance of utilities. We believe ITC has robust prospects for growth and will be able to continue to execute on its growth strategy and concurrent five-year capital plan. The primary drivers for transmission investment – reliability and connection of new electricity generation (including renewables) – remain intact and we believe ITC is well positioned to benefit from these trends. (Rebecca Ellin)
Shares of market data vendor FactSet Research Systems, Inc. (FDS) increased again in the fourth quarter, as the company’s organic growth rate accelerated and its customer and seat count additions exceeded expectations. We believe FactSet will continue to take share across all markets, generate strong cash flow, and return it aggressively to shareholders. While end market conditions have been challenging since 2008, we see meaningful acceleration in FactSet’s buy side customer base and improving conditions on the sell side, which should be an added tailwind to growth. (Neal Rosenberg)
Table III.
Top detractors from performance for the quarter ended December 31, 2014
| Year Acquired | Market Cap When Acquired (billions) | Quarter End Market Cap or Market Cap When Sold (billions) | Total Return | Percent Impact | |
| Targa Resources Corp. | 2010 | $0.9 | $4.5 | –21.67% | –0.46% |
| Atlas Energy, L.P. | 2014 | 2.2 | 1.6 | –27.01 | –0.31 |
| Helmerich & Payne, Inc. | 2006 | 2.4 | 7.3 | –30.27 | –0.30 |
| SM Energy Co. | 2009 | 2.1 | 2.6 | –52.08 | –0.23 |
| Core Laboratories N.V. | 2006 | 1.2 | 5.3 | –17.59 | –0.20 |
Targa Resources Corp. (TRGP) is the general partner of Targa Resources Partners, a midstream energy MLP. Falling oil prices drove down shares in the fourth quarter. In October, Targa announced the acquisition of assets from Atlas Energy, L.P. Investors became concerned aboutTarga’s commodity exposure (30% of cash flows) as crude and liquids prices collapsed, and the acquisition increasesTarga’s exposure to these price moves. We continue to believe in Targa’s ability to find and execute on profitable growth opportunities. (Jamie Stone)
Atlas Energy, L.P. (ATLS) is the general partner of midstream energy MLP Atlas Pipeline Partners, L.P. and exploration and production MLP Atlas Resource Partners. Shares of Atlas fell in the fourth quarter as oil prices declined to the lowest level in five years. Atlas has exposure to oil price movements through commodity-linked contracts in its midstream operation and direct exposure in its exploration and production MLP. Investors expected cash flow generation atAtlas’s MLPs to decline and therefore put the distribution per unit at risk. (Jamie Stone)
Helmerich & Payne, Inc. (HP) is the leading land drilling contractor in the U.S. Shares fell in the fourth quarter on investor disappointment over fiscal fourth quarter earnings and pessimism about the outlook for U.S. land drilling given the plunge in oil prices. We believe Helmerich is in a relatively better position to weather this downturn due to strong contract backlog, built-in fleet growth from existing contracts, and a bullet-proof balance sheet. We think the long-term trends of rig fleet renewal and Helmerich’s competitive advantages will re-emerge when oil prices stabilize. (Jamie Stone)
SM Energy Co. (SM) is an independent E&P company with operations that are primarily focused on shale oil fields in South Texas and North Dakota. The company’s shares fell by 50% during the quarter amid the rout in oil and gas prices. Despite the fact that SM has one of the stronger balance sheets in the sector and that changes in its well completion practices are yielding higher per well productivity and returns, the shares seemed to succumb to a tsunami of selling in the quarter.We sold our investment position.
Core Laboratories N.V. (CLB) is a technology-focused oilfield services and equipment company with the majority of its revenues generated outside the U.S. Shares came under pressure in the fourth quarter due to worse- than-expected third quarter operating results and fourth quarter guidance and rising concerns about the impact that lower oil prices would have on future customer capital investment. Lower oil prices are resulting in reduced earnings expectations for Core as drilling and completion activity is expected to fall sharply in 2015. (Jamie Stone)
Recent Purchases
Table IV.
Top net purchases for the quarter ended December 31, 2014
| Year Acquired | Market Cap When Acquired (billions) | Quarter End Market Cap (billions) | Amount Purchased (millions) | |
| AO World plc | 2014 | $2.0 | $1.8 | $23.4 |
| Benefitfocus, Inc. | 2013 | 1.3 | 0.8 | 22.7 |
| BRP, Inc. | 2013 | 2.2 | 2.5 | 16.4 |
| Lumber Liquidators Holdings, Inc. | 2010 | 0.6 | 1.8 | 13.0 |
| Badger Daylighting Ltd. | 2014 | 1.3 | 0.8 | 10.0 |
In the quarter, we increased our position in AO World plc (LSE:AO.). AO World is the UK’s leading online retailer of major domestic appliances. The company has more than 10% share of the overall UK market and sets itself apart from its competitors through its proprietary software, optimized supply chain, and stellar customer service. We believe AO is positioned to benefit over the next several years from a secular move to online buying, combined with the company’s comparable pricing, better selection and outstanding customer service. We believe the company will be successful in growing its share of the UK market, expanding into the larger German market, and entering new Western European markets. (Ashim Mehra)
The Fund added to its position in Benefitfocus, Inc. (BNFT), a leading provider of cloud-based benefits software. The company offers an integrated suite of solutions to help customers shop, enroll, manage, and exchange benefits information. Benefits are presented in a user-friendly manner that allows insured individuals and their dependents to access all their benefits in one place. The company is experiencing accelerating demand, driven by the Affordable Care Act and a shift towards defined contribution benefits, which requires the enhanced insight and consumer experience offered by modern software applications. We believe that Benefitfocus serves an addressable market more than 100 times larger than its current business, which should allow the company to compound revenue at more than 30% annually. (Neal Rosenberg)
In the quarter, we increased our position in power sports vehicle company BRP, Inc (TSX:DOO). We believe the recent decline in the stock is an opportunity and current difficulties involving Russian sales, poor weather and a slight delay in moving manufacturing to Mexico should create easy comparisons for FY 2016 (end January 2016) and stronger sentiment in the stock. We believe the company’s strategy has not changed and it continues to innovate and introduce new product while lowering costs. While this strategy will take another two years before full implementation, it should set the stage for growth of revenue, earnings and cash flow and create an even stronger company. Its balance sheet remains strong and management has indicated it will look at the initiation of possible dividends. (David Baron)
Portfolio Structure and Strategy
Baron Growth Fund owns 89 stocks. The top 10 holdings comprise approximately 28% of the Fund. We believe this diversified Fund offers investors potentially better than market returns with less “risk” than the market. We define “risk” as volatility. The Fund’s “beta,” i.e. volatility, since inception is 0.68. Our strategy to achieve this is to invest for the long term in a diversified portfolio of appropriately capitalized, well-managed, growing, small cap businesses at attractive prices. The Fund’s average portfolio turnover for the past three years is 10.5%. This means the Fund has an average holding period for its investments of over nine years. This contrasts sharply with the average small cap mutual fund which typically “turns over” its portfolio every eight months. We invest in companies with market capitalizations of $2.5 billion or less that we believe have the potential to double in size within four to five years. We believe that a portfolio of investments diversified among several industries all of which are dependent upon different, non-correlated fundamentals will likely reduce portfolio volatility. In addition, many of the companies in which the Fund invests have significant recurring revenue, which makes earnings for companies in which we have invested less volatile than the Russell 2000 Growth Index.We find all these businesses through our dedicated research effort. Our holdings are, in our view, well-managed businesses with significant barriers to competitive threats. These barriers provide our companies with pricing power. Most of our companies produce significant cash flows, which are often reinvested in their businesses to increase their revenues and margins over the long term. We believe the Fund has an opportunity to meet its objectives, although there is no guarantee that it will do so.
Table V.
Top 10 holdings as of December 31, 2014
| Year Acquired | Market Cap When Acquired (billions) | Quarter End Market Cap (billions) | Amount (millions) | Percent of Net Assets | |
| ITC Holdings Corp. | 2005 | $0.8 | $6.3 | $265.8 | 3.3% |
| Under Armour, Inc. | 2005 | 1.0 | 14.5 | 261.4 | 3.2 |
| The Middleby Corp. | 2011 | 1.6 | 5.7 | 252.7 | 3.1 |
| Gartner, Inc. | 2007 | 2.3 | 7.4 | 237.9 | 2.9 |
| Arch Capital Group Ltd. | 2002 | 0.4 | 7.6 | 233.4 | 2.9 |
| FactSet Research Systems, Inc. | 2006 | 2.5 | 5.9 | 225.2 | 2.8 |
| Dick’s Sporting Goods, Inc. | 2004 | 1.4 | 5.9 | 198.6 | 2.5 |
| Vail Resorts, Inc. | 1997 | 0.2 | 3.3 | 188.2 | 2.3 |
| CoStar Group, Inc. | 2004 | 0.7 | 5.9 | 183.6 | 2.3 |
| SS&C Technologies, Inc. | 2010 | 1.0 | 5.1 | 180.6 | 2.2 |
Thank you for investing in Baron Growth Fund.
Thank you for joining us as fellow shareholders in Baron Growth Fund. We believe the growth prospects for the businesses in which Baron Growth Fund has invested continue to be favorable.
We continue to work hard to justify your confidence and trust in our stewardship of your family’s hard-earned savings. We will also continue to provide you with information that I would like to have if our roles were reversed. This is so you will be able to make an informed judgment about whether Baron Growth Fund remains an appropriate and attractive investment for your family.
Respectfully,
Ronald Baron
CEO and Portfolio Manager
January 22, 2015
