Ron Baron's Baron Partners Fund Fourth Quarter 2014 Commentary

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Mar 20, 2015
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Baron Partners Fund advanced 5.33% during the fourth quarter of 2014. The Russell Midcap Growth Index, the benchmark against which we compare the performance of this Fund, advanced 5.84% in the period. Baron Partners Fund outperformed the S&P 500 Index, which measures the performance of large cap companies, by 40 basis points in the period. For the full year 2014, the Fund underperformed its benchmark by 164 basis points and the S&P 500 Index by 343 basis points.

Although it underperformed in 2014, the Fund has outperformed both its benchmark index and the S&P 500 Index on an annualized basis in all relevant periods other than this year since its conversion from a partnership to a mutual fund on April 30, 2003, as well as over the last 3 years, 5 years, 10 years, 15 years, 20 years, and since its inception on January 31, 1992. The businesses in which the Fund has invested have grown significantly this year. Since the Fund’s shares have not kept pace, we believe the Fund is well positioned to outperform, although we obviously can’t guarantee it.

In the December quarter, the U.S. stock market rose despite a sharp decline in Energy stocks. Oil prices, which fell more than 40% in the fourth quarter due to weakening global demand and rising output, plunged after Saudi Arabia’s decision not to cut production. The price of crude oil dropped to $53 per barrel, down almost 50% from its June high and the lowest level since May 2009. We think the decline in oil prices is a positive for the U.S. economy and non-energy-related U.S. stocks. This is because energyintensive manufacturers will have lower energy costs, resulting in higher cash flow, and consumers will have higher disposable income to spend on goods and services.

In the December quarter, the U.S. stock market rose despite a sharp decline in Energy stocks. Oil prices, which fell more than 40% in the fourth quarter due to weakening global demand and rising output, plunged after Saudi Arabia’s decision not to cut production. The price of crude oil dropped to $53 per barrel, down almost 50% from its June high and the lowest level since May 2009. We think the decline in oil prices is a positive for the U.S.

During the quarter, the Fund’s Energy investments fell along with the sector. In addition, shares of Tesla Motors Inc. declined due to a perception that the decline in oil prices would negatively impact future sales. We took advantage of the weakness in Tesla shares and added to our position. We also took advantage of weakness in other growth stocks. We initiated a position in Zillow, Inc., which operates an online real estate information marketplace, and added to positions in CoStar Group, Inc., FactSet Research Systems, Inc. and Air Lease Corp.

The Fund’s investments within the Information Technology and Utilities sectors were the largest contributors to positive relative performance, while investments in the Financials, Energy, and Consumer Discretionary sectors were the largest detractors. Of the Fund’s average gross assets, 45.90% produced double digit returns and 34.11% advanced by single digits. We try to explain the reasons certain stocks outperformed or underperformed during the period in the “Top Contributors” and “Top Detractors” sections. In many instances, we regard gains and losses in the short term as random. We continue to believe all the businesses in which we have invested have the potential to double in size in four to five years. As a result, we believe stocks that have recently underperformed will achieve above average returns and contribute positively to the Fund’s performance in coming quarters, although we cannot guarantee this.

Managing risk is a key part of our investment process. We manage risk from a company perspective by investing in businesses that we believe are conservatively financed with high barriers to entry. Our proprietary research regarding business’ long-term growth opportunities, competitive advantages, management teams and risks determines how much we allocate to individual securities. We invest in different industries that are affected differently in the short term by unpredictable events. This is to achieve a portfolio of investments with risks that are not correlated. This is part of our effort to reduce the volatility of a non-diversified portfolio. Further, the underlying businesses in which the Fund has invested historically have less volatile earnings than its benchmark index.

In 2014, large cap “value” stocks significantly outperformed small cap growth stocks. We believe that the barrage of negative news from abroad was an important reason for the flight to safety in 2014. Our approach is to invest for the long term. We do not try to predict short-term “macro” developments or shift our investment approach because certain types of stocks are in or out of favor.

Although economic data from other regions around the world (Europe, China) has not been robust, U.S. economic data continues to show broad signs of strength, including gains in housing prices, starts and existing sales; increased industrial production; strong auto sales; rising consumer confidence; and lower unemployment claims. Interest rates remain at historically low levels.

Our outlook for stocks remains favorable. In our opinion, stocks remain attractively valued, trading at 16.2 times earnings, approximating their median valuation for the past century, while business activity is accelerating. Historically, stocks have provided protection against inflation, as well as better returns than other asset classes. We think that will continue to be the case, but we can’t guarantee it.

Shares of CarMax, Inc. (KMX, Financial), the nation’s largest used car retailer, rose sharply during the fourth quarter after reporting strong results, highlighted by accelerating sales and earnings growth. Demand for the company’s high quality, late model vehicle inventory has remained strong and coincides with resurgent new car sales and an attractive financing environment. In addition, shares have been buoyed recently by the announcement of a large share repurchase program that we believe will be significantly accretive to earnings over the next several years. (Matt Weiss)

Shares of CoStar Group, Inc. (CSGP, Financial), the leading provider of information and marketing services to the commercial real estate industry, contributed to performance in the fourth quarter. We attribute this to continued robust financial performance, early synergy generation from the acquisition of Apartments.com, and better relative performance from higher multiple growth stocks over the ownership period. Ongoing investments in R&D and a doubling of the sales force will, in our view, help increase customer penetration, while the acquisition of Apartments.com extends CoStar’s reach into multi-family lead generation. (Neal Rosenberg)

ITC Holdings Corp. (ITC, Financial) 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 IDEXX Laboratories, Inc. (IDXX, Financial), a leader in veterinary diagnostics, rose in the fourth quarter on better-than-expected earnings and progress on moving to a direct distribution model in the U.S. IDEXX’s fundamentals continue to improve, with organic growth in its core business reaching 12% in the most recently reported quarter. We believe organic revenue growth at current levels is sustainable due to recent innovations in IDEXX’s portfolio of diagnostic products, instruments, data management tools, and geographic expansion. (Rebecca Ellin)

Shares of market data vendor FactSet Research Systems, Inc. (FDS, Financial) 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)

Concho Resources, Inc. (CXO, Financial) is an independent E&P company focused on the Permian Basin in West Texas and New Mexico. Concho shares fell in the fourth quarter amid the rout in oil prices. While Concho is executing on its drilling programs and seeing improving well results and widening prospects within its asset base, the impact of lower prices on cash flows is diminishing near-term growth forecasts and raising concerns about the future value of its inventory. We see the current environment as an opportunity for Concho to add high quality assets at attractive prices. (Jamie Stone)

Helmerich & Payne, Inc. (HP, Financial) 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 reemerge when oil prices stabilize. (Jamie Stone)

After performing better than the market for most of 2014, shares of electric vehicle (EV) company Tesla Motors Inc. (TSLA, Financial) declined in the fourth quarter because traders believe lower oil prices reduce the near-term appeal of its cars. The company also delayed by three months the launch of its next model (“X”) to the second half of 2015. While we view the pursuit of a perfect product pre-launch as a positive, it points to the execution risk in a new category like EVs. We believe Tesla is an attractive long-term investment given its talent pool, technology leadership, first mover advantage, scale, and brand. (Gilad Shany)

Shares of alternative asset manager The Carlyle Group (CG, Financial) fell in the fourth quarter. The company continues to perform in accordance with our investment thesis, and assets under management remained largely flat in a challenging year. However, lower investment realizations resulted in a lower dividend payout, and lower performance fees resulted in a sharp drop in distributable earnings. Its hedge fund business also performed poorly. On a positive note, Carlyle has increased its diversification and is in an improved position to stabilize distributable earnings. (Michael Baron)

Mobileye N.V. (MBLY, Financial) is a software and systems designer of camera-based advanced driver assistance systems. Mobileye’s systems serve to help reduce the number of car accidents, and, over time, we believe will play into the transition into autonomous driving. After Mobileye’s IPO in the third quarter, the stock more than doubled. We believe some traders viewed this appreciation as an opportunity to take profits, which created selling pressure in the fourth quarter. (Gilad Shany)

Air Lease Corp. (AL, Financial) leases commercial aircraft to airlines around the world. Air Lease owns 221 planes, with 372 new planes worth about $29 billion on order. This is in anticipation of increased demand from U.S. and European airlines for more fuel-efficient models to replace their aging fleets, and the need for more lift in emerging markets. Aircraft demand remains strong, led by passenger traffic growth (up 5.8% through November 2014) and healthy customer profit margins. Revenues (+24% through the third quarter of 2014) and EPS (+41%) are growing as its fleet builds. Air Lease has greater than 65% of leases placed through 2016, providing predictable cash flows, and a well-capitalized balance sheet to generate a long “runway” of profitable growth. We believe Air Lease is trading cheaply compared to its potential earnings power. (David Goldsmith)

We initiated a position in Zillow Inc. (Z, Financial) in the quarter. Zillow is the leading online real estate site in the U.S., offering information on homes for sale and rent, in addition to the Zillow Mortgage Marketplace. The company also owns and operates Street Easy, the leading real estate site for New York City. Zillow continues to invest in its brand as the leader in an $8 billion real estate advertising market. The company is merging with number two player Trulia, pending FTC approval. With the transition to online and mobile, we believe Zillow is well positioned to grow meaningfully from the 4% share it has today, and will generate meaningfully more revenue, cash flow, and shareholder value over the next several years. (Ashim Mehra)

The Fund took advantage of market volatility to add to its position in market data vendor FactSet Research Systems, Inc. We believe FactSet is serving less than 5% of its addressable market. Through investments in new product development and sales resources, the company is expanding beyond its roots in equity security and portfolio analysis to address new workflows and users, notably in fixed income, wealth management, risk management, and data feeds. We believe FactSet will take share across all of its markets, given its best-in-class product offering, a unique array of portfolio analysis capabilities, and industry-leading customer service. FactSet has an outstanding financial model, with 95% retention rates, high margins, and strong cash flow generation, which is returned to shareholders through aggressive share repurchases and a growing dividend. (Neal Rosenberg)

Investment Strategy

We invest for the long term in a non-diversified portfolio of competitively advantaged, well-managed, growing businesses at what we think are attractive prices. Often, we have opportunities to purchase stocks of businesses we have researched extensively and that we believe are mispriced or have fallen in price due to what we perceive to be temporary issues. For example, in the December quarter, the Fund took advantage of a decline in the shares of FactSet Research Systems, Inc., a long-time holding in the Fund, when shares fell due to overall market weakness. We also added opportunistically to our positions in Tesla Motors Inc., CoStar Group, Inc., and Air Lease Corp. We believe these are all well-established, appropriately capitalized, growing companies, with strong positions in markets with stable demand for their products and services. The Fund may use leverage to invest in stable and wellcapitalized growth companies, with the goal of enhancing its investment returns.

Another common theme for Baron Partners Fund’s investments is one of businesses investing for growth, often at the expense of short-term profits. These businesses are investing in order to become much larger, more profitable businesses in the future. Virtually all the businesses in which we have invested are making such capital commitments. Verisk Analytics, Inc.’s startup investments in health care and real estate data services; CarMax, Inc.’s line of new stores coupled with efforts to grow sales in existing stores; and Hyatt Hotels Corp.’s investment in hotel renovations and improved guest services, as well as its ongoing expansion in Asia; are noteworthy in this regard. As long-term investors who hold stocks for an average of about five years, we expect to benefit from these expenditures. In contrast, most other mid-cap mutual funds are more trading oriented, turning over their entire portfolios on average every nine months. Since these funds, in general, will not care about or benefit from such long-term, strategic investments by businesses, they accord them little or no value. This allows us to invest in these companies at prices we feel are especially attractive.

Baron Partners Fund also has significant investments in growing “C” corporations like Vail Resorts, Inc., and ITC Holdings Corp., whose shares we believe are especially undervalued when compared to similar businesses structured as REITs or master limited partnerships. The Fund’s investments in alternative investment money manager The Carlyle Group, and financial intermediary The Charles Schwab Corp., are benefiting from strong performance of equities since the Financial Panic of 2008-09.

Portfolio Structure

The Fund’s non-diversified portfolio is currently invested in 27 businesses, principally mid-cap companies. As of December 31, the weighted average market capitalization of the Fund’s portfolio investments was $10.96 billion, compared with $13.92 billion for the benchmark. The Fund currently has significantly larger investments in Consumer Discretionary, Financials, and Utilities sectors than the Russell Midcap Growth Index. The Fund’s investments in Energy, Health Care and Information Technology are weighted less than the index. The Fund does not have investments in Materials, Telecommunication Services, Consumer Staples, or biotechnology businesses. Biotech businesses performed strongly in 2013 and 2014, often increasing in price 50-100%. The Fund, to date, has avoided significant investments in businesses with volatile earnings or when it believes it is not apparent whether or not a business will be successful. We are not attempting to mirror any index with the Fund’s portfolio.

We think the businesses in which the Fund has invested have the potential to double in size within four to five years. We think because of the competitive advantages of those businesses, it would take many years or cost a lot of money, and, therefore, not be economically feasible, for new entrants to compete against them. We think these barriers enable our companies to generate strong returns on capital and provide them with the ability to grow consistently over the long term.

Thank you for investing in Baron Partners Fund.

Thank you for joining us as fellow shareholders in Baron Partners Fund. We believe the growth prospects for the businesses in which Baron Partners Fund has invested are favorable and improving. Since, in our opinion, the share prices of our businesses do not reflect their prospects, we believe they remain attractive. Of course, there can be no guarantee this will be the case.

We are continuing to work hard to justify your confidence and trust in our stewardship of your family’s hard-earned savings. We also remain dedicated to continuing to provide you with the information I would like to have about your investments in Baron Partners Fund if our roles were reversed. This is so you will be able to make an informed decision about whether this Fund remains an appropriate investment for you and your family.

Respectfully,
Ronald Baron

CEO and Portfolio Manager

January 22, 2015