Dear Baron Focused Growth Fund Shareholder:
Performance
Baron Focused Growth Fund increased 4.51% during the fourth quarter while the Russell 2500 Growth Index, the benchmark against which we compare Fund performance, increased 7.49%.The S&P 500 Index, which measures the performance of large cap companies, gained 4.93% in the quarter.
Results for 2014 were also disappointing. The Fund increased 2.35% during this period while the Russell 2500 Growth Index increased 7.05%. The S&P 500 Index also outperformed the Fund, as investors favored large cap stocks for much of 2014. That index rose 13.69% in the year. The median market capitalization for Baron Focused Growth Fund’s portfolio is $5.91 billion. The median market capitalization for the Russell 2500 Growth Index is $1.22 billion and the median market capitalization for the S&P 500 is $19.01 billion.
Table I.
Performance (Retail Shares)”
Annualized for periods ended December 31, 2014
| Baron Focused Growth Fund | Russell 2500 Growth Index | S&P 500 Index | |
| Three Months | 4.51% | 7.49% | 4.93% |
| One Year | 2.35% | 7.05% | 13.69% |
| Three Years | 14.26% | 20.47% | 20.41% |
| Five Years | 12.98% | 17.27% | 15.45% |
| Ten Years | 8.63% | 9.37% | 7.67% |
| Fifteen Years | 7.92% | 5.32% | 4.24% |
| Since Inception (May 31,1996) | 11.50% | 7.59% | 8.22% |
The market experienced increased volatility in the fourth quarter. The plummeting price of oil dominated business headlines. Oil prices, which had been more than $100 per barrel over the summer, ended the year near $50. This raised concerns that the job growth created by domestic oil exploration and production firms will stall and stifle the still-recovering economy. Slow growth in Europe and a crumbling Russian ruble exacerbated investor concerns about global economic health. The market ended the period higher, although investors once again steered clear of risk in favor of more stable, slower growing firms. Companies with lower leverage outperformed as did companies with lower earnings growth and lower volatility.
Domestically, generally positive economic reports supported the view that the U.S. economy is accelerating, outpacing much of the rest of the developed world. Unemployment was down, average hourly wages increased, and consumer confidence rose. Higher-than-expected automobile sales and construction spending bolstered the recovery narrative. Interest rates remained low, allowing companies to grow by financing expansion with inexpensive capital. We believe the economy will continue to improve. The drop in energy prices is reducing the burden on consumers. With about 19 million barrels of oil consumed per day in the United States, the decline is equivalent to about $200 billion in annual savings for the domestic economy!
The Fund is positioned to take advantage of the following overarching themes. Consumer-oriented companies that we believe will benefit from the anticipated increase in consumer disposable income represent over 40% of the Fund. Lower fuel costs should encourage consumers to purchase more expensive cars at CarMax, Inc (KMX). Reduced transportation costs could benefit hotel and lodging companies such as Vail Resorts, Inc. (MTN) and Hyatt Hotels Corp (H). Lower unemployment could benefit retail companies like Dick’s Sporting Goods, Inc. (DKS), as more shoppers will have steady incomes. Low interest rates could help companies that benefit from a transactional environment, like real estate data provider CoStar Group, Inc. (CSGP), which helps clients with acquisition-related due diligence activities; and Church & Dwight Co., Inc. (CHD), in possible acquisitions of consumer product companies that could benefit from its production and distribution network. The improving economy and rising stock market over the past few years could result in renewed interest in investing and benefit firms such as FactSet Research Systems, Inc. (FDS), a data provider for institutional investors.
| “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 05/31/96 to 12/31/99 | 12/31/99 to 12/31/08 | 12/31/08 to 12/31/14 | Inception 05/31/96 to 12/31/14 |
| Baron Focused Growth Fund | 27.87% | 2.72% | 16.21% | 11.50% |
| Russell 2500 Growth Index | 17.60% | –3.99% | 21.02% | 7.59% |
| 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 | |
| CarMax, Inc. | 2011 | $5.7 | $14.3 | 43.31% | 1.63% |
| CoStar Group, Inc. | 2014 | 6.2 | 5.9 | 18.12 | 1.05 |
| FactSet Research Systems, Inc. | 2008 | 2.5 | 5.9 | 16.14 | 0.81 |
| ITC Holdings Corp. | 2008 | 2.2 | 6.3 | 13.88 | 0.62 |
| CaesarStone Sdot-Yam Ltd. | 2013 | 1.5 | 2.1 | 16.53 | 0.53 |
Shares of CarMax, Inc. (KMX), 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), 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)
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)
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)
CaesarStone Sdot-Yam Ltd. (CSTE) saw its stock price rise in the fourth quarter. CaesarStone is a leading global manufacturer of quartz surfaces for kitchens and bathrooms. Performance was driven by a strong earnings beat for the third quarter and management’s rosy outlook, as earnings growth continues to accelerate from successful new product launches and quartz market share gains vs. other countertop materials, such as granite and marble. (David Kirshenbaum)
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 | |
| Tesla Motors Inc. | 2014 | $31.2 | $27.9 | –8.68% | –0.70% |
| Colfax Corp. | 2012 | 2.4 | 6.4 | –9.55 | –0.63 |
| Helmerich & Payne, Inc. | 2007 | 3.7 | 8.4 | -19.98 | –0.58 |
| The Carlyle Group | 2012 | 0.9 | 1.9 | -9.29 | –0.39 |
| Pinnacle Entertainment, Inc. | 2013 | 1.1 | 1.4 | –11.77 | –0.39 |
After performing better than the market for most of 2014, shares of electric vehicle (EV) company Tesla Motors Inc. (TSLA) declined in the fourth quarter as lower oil prices reduce the near-term appeal of its cars. The company also delayed 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 global industrial machinery company Colfax Corp. (CFX) fell in the fourth quarter on reports of weaker-than-expected third quarter earnings and below-consensus 2015 guidance. Shares also declined as the market rotated out of companies such as Colfax with exposure to falling oil and gas pricing, slowing international markets, and headwinds from foreign exchange exposure. We believe Colfax will use its proven business system to improve operations of acquired companies, which we believe will generate substantial shareholder value over time. (Rebecca Ellin)
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 reemerge when oil prices stabilize. (Jamie Stone)
Shares of alternative asset manager The Carlyle Group (CG) decreased 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)
Shares of Pinnacle Entertainment, Inc. (PNK), a regional casino company, declined in the fourth quarter after the company announced it would start the process of converting to a REIT and spinning off its real estate assets. Investors grew cautious ahead of a proposed equity offering that Pinnacle is planning for mid-2015 to help reduce its debt. The Fund exited its position in Pinnacle. (David Baron)
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) | |
| Tesla Motors Inc. | 2014 | $31.2 | $27.9 | $9.5 |
| Financial Engines, Inc. | 2014 | 1.8 | 1.9 | 3.3 |
| TerraForm Power, Inc. | 2014 | 3.2 | 3.1 | 3.3 |
| Benefitfocus, Inc. | 2014 | 0.7 | 0.8 | 2.4 |
| The Carlyle Group | 2014 | 0.9 | 1.9 | 1.0 |
During the quarter, we bought additional shares of Tesla Motors Inc. (TSLA), the company with the mission to revolutionize and electrify the auto industry. Limited opportunities exist in one’s lifetime to witness tectonic shifts in the making, and we believe Tesla is driving one of these shifts. We want to take the back seat of this car and enjoy the ride. Since the last time we wrote about Tesla, Audi announced plans to invest $2 billion in electric vehicles (EVs), GM announced a new all-electric car, and Mercedes presented an autonomous car that may be electric. The same traditional car manufacturers who have been resisting the adoption of EVs are slowly changing their tune, and there is no doubt that Tesla had a leading role in this shift. We believe Tesla’s technology leadership, excellent talent pool and first mover advantage will allow it to take a substantial market share in the new electrifying era of the car industry and create the next mega auto brand. (Gilad Shany)
Shares of Financial Engines, Inc. (FNGN), a service provider to defined contribution plans and individual investors, have declined by approximately 50% from their peak in early 2014.The Fund took advantage of low share prices to add to the position it established in the previous quarter. The stock remained weak in the fourth quarter following an unexpected management change. The new CEO has substantial operating and marketing experience, and has worked for Financial Engines since 2001. Accordingly, we think this change could be a positive and our long-term investment premise still holds. Financial Engines is the dominant player in a $5 trillion defined contribution retirement market. The company currently has contracts encompassing approximately $1 trillion in plan assets and manages over $100 billion. We believe there is significant potential to increase both figures through increased sales to plan sponsors, improved marketing to plan participants and broadened product offerings. Additionally, we believe the company can eventually use its expertise to service the IRA and defined benefit market, each with an additional $5 trillion in assets. We believe Financial Engines’ essential advice offering and plan connectivity advantage should result in significant client growth and a profitable recurring revenue stream. (Michael Baron)
During the quarter, we re-initiated a position in TerraForm Power, Inc. (TERP), a dividend growth-oriented company formed to own and operate contracted clean power generation assets acquired from parent company SunEdison, the third largest worldwide solar energy developer. The company is a part of a new class of investments, known as a “yieldcos,” which are similar to traditional energy master limited partnerships. These “yieldco” businesses are comprised of long-lived assets contracted with creditworthy counterparties, stable cash flows, favorable tax attributes, and predictable growth driven by assets “dropped down” by the parent company due to the yieldco’s lower cost of capital. During the quarter, the companies announced a transformational acquisition to acquire First Wind for $2.4 billion, which serves to diversify the platform into wind energy as well as accelerate its growth. With 24% CAGR in dividend per share now expected through 2019, we think TerraForm is an attractive total return investment in the rapidly growing global renewable energy sector. (Rebecca Ellin)
Portfolio Structure
The objective of Baron Focused Growth Fund is to double its value per share within five years. Our strategy to accomplish this goal is to invest for the long term principally in a non-diversified portfolio of what we believe are appropriately capitalized, well-managed, small and mid-cap businesses at attractive prices. We attempt to create a portfolio of less than thirty securities diversified by GICS sectors that will be approximately 80% as volatile as the market. These businesses are identified by our firm’s proprietary research.
We think the businesses in which Baron Focused Growth Fund has invested have the potential to double in size within approximately five years and double again over the subsequent five years. We think these well-managed businesses have sustainable competitive advantages and strong, long-term growth opportunities. Considering current stock price valuations, we believe we have the opportunity to meet our performance goals during the next decade, although there is no guarantee that we will do so.
As of December 31, 2014, Baron Focused Growth Fund held 24 investments. The median market capitalization of those small and mid-sized growth companies was $5.91 billion. Compared to its benchmark, the Fund’s investments have higher profitability (as exhibited through greater operating margin, EBITDA margin and Net margin).They also exhibit better internal returns (higher return on invested capital and return on equity). And they are more conservatively financed (lower debt to market capitalization ratio) and more consistent (lower standard deviation of earnings growth and lower beta). We find these metrics important in limiting risk for a focused portfolio.
Interestingly, the Fund’s holdings lag on a free cash flow margin (cash flow from operations minus capital expenditures). This metric is often cited as crucial for today’s investors who value the company’s ability to return cash to shareholders through dividends and/ or buybacks. While we do not intend to denigrate the importance of cash generation, we often prefer the Fund’s holdings reinvest in their businesses to increase growth. We intend to be long- term owners of businesses that can double in value over the next four to five years. Without making such capital reinvestments in their business, firms stand little chance of fulfilling ambitious growth plans. The Fund is investing in companies like Hyatt Hotels, which is investing approximately $300 million annually to improve its properties and attain increased occupancy and room rates; Manchester United, which has increased its capital spending on player acquisitions to improve its on-field product; and Tesla Motors, which is focusing its capital spend on more than doubling its short-term production capacity and building a $5 billion plant for battery packaging and cell manufacturing. While these investments result in lower free cash flow margin today, we believe they are positioning their companies for future growth. We believe investing in companies with strong current financial positions that are improving their product to attack a large opportunity gives the Fund the best chance to achieve its long-term return goals.
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 | |
| Tesla Motors Inc. | 2014 | $31.2 | $27.9. | $14.5 | 7.4% |
| Hyatt Hotels Corp. | 2009 | 4.2 | 9.1 | 14.5 | 7.4 |
| CoStar Group, Inc. | 2014 | 6.2 | 5.9 | 12.9 | 6.6 |
| Vail Resorts, Inc. | 2013 | 2.3 | 3.3 | 12.4 | 6.4 |
| FactSet Research Systems, Inc. | 2008 | 2.5 | 5.9 | 10.6 | 5.4 |
| CarMax, Inc. | 2011 | 5.7 | 14.3 | 10.0 | 5.1 |
| Colfax Corp. | 2012 | 2.4 | 6.4 | 9.3 | 4.7 |
| Manchester United plc | 2012 | 2.3 | 2.6 | 8.7 | 4.5 |
| Choice Hotels International, Inc. | 2010 | 1.9 | 3.3 | 8.4 | 4.3 |
| Iridium Communications, Inc. | 2014 | 0.6 | 0.9 | 8.1 | 4.2 |
Thank you for investing in Baron Focused Growth Fund.
We are continuing to work hard to justify your confidence and trust in our stewardship of your family’s hard-earned savings. We are also continuing to try to provide you with information I would like to have if our roles were reversed. This is so you can make an informed judgment about whether Baron Focused Growth Fund remains an appropriate investment for your family.
Respectfully,
Ronald Baron
CEO and Portfolio Manager
January 22, 2015
