Dear Baron Small Cap Fund Shareholder:
Stocks rebounded in the fourth quarter of 2015, from the big sell-off in the prior quarter, as confidence in the strengths of large economies picked up. The Baron Small Cap Fund (the “Fund”) gained 4.09% (Institutional Shares) in the quarter. This is in line with the Russell 2000 Growth Index, which was up 4.32%, but trailed the S&P 500 Index, which was up 7.04%, as large-cap stocks continued to outperform smaller ones. For the year, the Fund lost 5.01%, while the Russell 2000 Growth Index was down 1.38% and the S&P 500 Index was up 1.38%.
Stocks rallied about 9% during October and November as economic reports showed renewed strength, especially jobs growth, and leading indicators in Europe and Asia improved. The small-cap market reverted to its form of earlier in the year, as biotech/pharma and high growth tech stocks led the bounce. The Federal Reserve raised the fed funds rate in midDecember, the first increase since 2006. The increase was expected and generally applauded by the investment community on the rationale that monetary policy was “normalizing” with the economy in good stead. The Fed indicated that gradual increases in the fed funds rate were to be expected if economic activity continued to expand and inflation started to perk up. Against this backdrop, we continued to do what we do – find special small-cap growth companies, the fundamentals of which remain strong in the face of a volatile market.
Acuity Brands, Inc., the leading U.S. provider of lighting solutions, continues to grow strongly, benefiting from the secular demand for more energy efficiency and the rapid adoption of LED lighting, which now accounts for more than half its business. Volumes grew 17% in the quarter, margins expanded, and earnings were up 29% for the third quarter. During the quarter, Acuity announced the acquisition of Juno Lighting Group, a large player in the lighting industry that they have coveted for years. Their products fit well with Acuity’s offerings and the deal is nicely accretive, even before the revenue synergies we expect will be achieved. We are excited about Acuity’s focus on selling solutions, not just luminaires, and we believe the company has potential to grow earnings rapidly.
Shares of Waste Connections, Inc., a leading solid waste company focused on secondary markets in the U.S., rose as the company reported industry leading organic growth of about 5%. The company expects 7% EBITDA growth for 2016, despite weakness in its oil exploration and production waste business, which weighed heavily on results and the stock in 2015. The company supplemented organic growth with significant acquisitions. Its deals were straight down the fairway. It bought leading fully integrated providers of solid waste services, with nice growth prospects at accretive multiples. The company has also been using its free cash flow to repurchase its stock, as they have for years. We continue to admire the company’s management and execution, and we appreciate the visibility and steady growth of its business in these uncertain times.
On Assignment, Inc., a leading provider of IT staffing solutions, reported accelerated growth and beat expectations, which led to stock gains. Organic revenues grew 13% in the quarter, which were sharply ahead of earlier, choppy trends, driven by continued strong mid-market demand and the company’s ability to deliver more job candidates due to management’s decision to ramp up its hiring of recruiters last winter. Management guided to continued strong growth, citing good demand for top workers and the expectation of further productivity from the recently hired staff. The company is also benefiting from its recent acquisition of Creative Circle, a leading staffing agency focused on digital advertising and marketing markets, which was highly accretive and a terrific strategic fit. Though the stock has risen, it still trades at a modest multiple of calendar year 2016 estimated adjusted earnings, so it continues to be a large position in our portfolio.
Berry Plastics Group, Inc., a leading North American plastic packaging company, finished its fiscal year posting cash flow better than Street expectations and guided to continued strong cash generation. Berry completed its transformative acquisition of Avintiv, which makes non-woven materials for health and hygiene markets. We believe the deal will add to the company’s growth rate, wisely diversifies the business mix and offers notable synergies with respect to both costs and revenues. Though we were a bit confused at first by the deal, we see its merit and respect management’s integration skills based on its track record of success with previous significant acquisitions.
Other stocks in the portfolio which contributed less to performance but rose over 20% in the quarter include: INC Research Holdings, Inc., Sarana Menara Nusantara Tbk PT, The Spectranetics Corporation, and our MLPs (Columbia Pipeline Partners, LP, PBF Logistics LP, Westlake Chemical Partners LP, Phillips 66 Partners LP and Western Refining Logistics, LP).
Shares of United Natural Foods, Inc., the leading distributor of natural foods, fell in the quarter after reporting disappointing results and the loss of a key conventional supermarket customer. Organic growth has decelerated from over 10% to 7% in the latest quarter, as Whole Foods, its largest customer has experienced greater competition and slower comps, as private label natural and organic foods, which UNFI doesn’t distribute, gain share; and as new outlets, which UNFI doesn’t service, carry more of the products. The loss of Safeway as a customer will reduce revenues by about 5% and create some unexpected capacity utilization issues. We reduced our position, but still remain owners, as we believe in the long-term growth prospects for the natural/organic segment, are enthused about the company’s focus on adding fresh foods to its offerings, and believe additive acquisitions and customer wins are on the horizon. The stock now trades at 13 times earnings and under 8 times cash flow, and we think it is well oversold.
Flotek Industries supplies a proprietary product called CNF to oil and gas companies that helps boost shale well productivity. Though drilling activity is way down this year, CNF sales are rising because of how much value it provides in well optimization. During the quarter, the stock fell on an assertion by short-sellers that the company had inflated claims of the product’s efficacy, which we suspect will prove false. We believe that fundamentals will win out and that earnings could grow substantially in time. However, declining oil prices continue to pressure drilling and sentiment towards all energy stocks is terrible.
Shares of The Container Store, the leading retailer of storage and organization products, fell over concerns about sales progression and profitability. The company is rolling out TCS Closets, a compelling and unique offering of custom closets, which seems to be getting good traction and offsetting negative sales trends with other products. However, expenses are rising because of costs to develop the initiatives and offer free shipping, so earnings are below expectations. Retail sales in general are weak, and the stocks of most retailers and consumer product companies were under pressure in the quarter. We trimmed our position.
Cepheid, a provider of equipment for molecular diagnostic tests, reduced guidance for sales in 2015 and operating margins for the next couple of years, so the stock fell. While we believe the company’s technology and reach is unique, and that its long-term opportunity is large, we are disappointed with the pace of the company’s development, which raises questions of the company’s competitive position and management’s ability to execute. We decided to exit the position.
Our stocks that fell over 20% in the quarter were: Iconix Brand Group Inc., Targa Resources Corp. and SFX Entertainment, Inc.
Portfolio Structure
As of December 31, 2015, the Fund had $4.1 billion under management. We continued to reduce the number of positions in the Fund during the quarter and ended the year with 79 stocks held. The portfolio is also more concentrated, with the top 10 stocks now comprising 32.8% of the Fund’s assets.
Our largest positions continued to perform very well. For the quarter, the top 10 returned 10.7% and contributed 3.0% to the Fund’s return, and the top 20 (which makes up 50.6% of the Fund’s assets in total) returned 9.2% and contributed 4.1%. For the year, the totals are top 10 up 21.6% (contributing 4.9%) and top 20 up 19.8% (contributing 6.9%).
Our performance was penalized in 2015 by the fact that many of our smaller positions suffered large percentage losses, offsetting the gains of our top positions. Our response is to run a tighter portfolio going forward and to have a lower threshold of pain, especially with our smaller and less seasoned positions.
We believe in our approach –– to be long-term investors in what we believe are special small-growth companies, that have big opportunities, competitive advantages and barriers to competition, and are managed by entrepreneurial owner/operators that we respect and trust. We hold 17 stocks in the portfolio that have more than tripled since we first invested in them. The holding periods for the stocks range from 3 to 12 years, and the straight average annualized return is 32%. These stocks comprise about one third of the portfolio assets. We hold another 16 stocks that have more than doubled since we bought them. Those make up about another quarter of the Fund and have straight average annualized returns of 35%. This is a testament to our strategy.
We pay close attention to these “big winners” to make sure that the businesses can continue to grow and still offer considerable upside to justify holding them, or to right-size the positions based on shorter-term performance of the business and the stocks.
We search for new stocks that we believe can be our next winners, primarily companies that exhibit the same characteristics of our previous successes.
Though we know we are compared to an index, we don’t try to mimic it or worry too much if we are not in line with it. The companies we favor are a small subset of the index, a collection of what we believe are high quality, well-managed growth businesses across many industries; companies we understand well and feel comfortable underwriting their future prospects; stocks that are reasonably valued and offer nice upside through future organic growth, which is often supplemented by strategic and accretive acquisitions and/or use of free cash flow to enhance shareholder value. Often there is an upward bias in trading multiples to add to returns.
Recent Activity
During the quarter, we sold out of 13 names in their entirety in our efforts to tighten up the Fund. Many of the sales had to do with the continuing declines in energy and commodity prices, which we believed would continue to weigh on the prospects of the company. Stocks negatively affected include: Clean Harbors, Inc., Genesee & Wyoming, Inc., Targa Resources Corp. and Phillips 66 Partners LP.
We also trimmed our positions in long-term winners as their stocks performed well. Some of this was to raise capital for other purchases and some was done with market cap in consideration, as is our Fund’s policy. Positions reduced include: Equinix, Inc., Berry Plastics Group, Inc., ACI Worldwide, Inc. and FleetCor Technologies, Inc.
Outlook
Fear has gripped the market as the new year starts and stocks have suffered heavy losses. The major concerns are declining growth in China and the continued fall in the price of oil, which just broke $30 per barrel. Both are feared to be harbingers of slower global growth, with the potential contagion effect on our domestic economic climate.
There are a litany of other concerns as well – rate increases by the Fed, deterioration in the credit markets, Chinese currency devaluation, upcoming U.S. presidential elections, increased geopolitical flare-ups and terrorism activity and concern about deflation.All are adding to the general market angst.
However, the U.S. economy is performing well. Jobs reports continue to be robust. Production in drilling and capital spending by energy companies and the softness in the industrial sector, which is hurt by the strong dollar and softness in key export markets, is being offset by expansion in the service sectors. We believe we are entering a soft patch for the economy, but we do not expect a recession. And, we are hopeful that foreign economies will perform better, as they benefit from significant stimulus in the pipeline, as global central banks have been easing for over a year.
Stocks have sold off to levels where we deem them very attractive. There have been multiple compressions in highly valued stocks as many of last year’s leaders have been hit the hardest. Companies whose growth has been challenged by the tough macroeconomic environment continue to be out of favor and trade lower. Also, we note that after two years of relative underperformance, small-cap stocks now trade in line with their normal 5% premium to large caps, at 16 times 2016 estimates.
This is a tough environment. People are freaking out. We’re not. As mentioned above, we are aware of the challenges, but we have faith in our process and believe over the long term that it will be rewarded. We continue to favor companies that we believe are able to continue to grow despite the headwinds. We think our portfolio of small to mid-sized quality growth companies is well positioned. A key will be if earnings come in as we expect.
Thanks for investing in the Baron Small Cap Fund.
