DEAR BARON ASSET FUND SHAREHOLDER:
PERFORMANCE
During the quarter ended June 30, 2016, equity markets increased before falling suddenly on June 24th, when British voters unexpectedly voted in favor of leaving the European Union, the so-called Brexit. After digesting the likely implications of Brexit, U.S. investors appeared to change their view, and the markets rose sharply during the last few days of June and through early-July. Baron Asset Fund (the “Fund”) Retail Shares gained 2.74% and the Institutional Shares gained 2.79%; the Russell Midcap Growth Index gained 1.56%, and the S&P 500 Index gained 2.46%.
As discussed below, the investments that had the most significant positive impact on performance included fast-growing companies in the Information Technology (IT, Financial) sector that reported strong earnings and were perceived to be relatively immune from potential macroeconomic disruption. These included Gartner, Inc., which provides its clients research and analysis of the IT sector, Zillow Group, Inc., an Internet-based company that provides information and sales leads for the residential real estate market, and Guidewire Software, Inc., which provides mission critical software to the insurance industry. Similar dynamics applied to the Health Care sector, where companies like IDEXX Laboratories, Inc., a veterinary diagnostic firm, Bio-Techne Corporation, a manufacturer of proteins for life sciences research, and West Pharmaceutical Services, Inc., a drug packaging manufacturer, also performed well. Companies in the Financials sector that benefited from lower and/or volatile interest rates also did well, including Equinix, Inc., a REIT that owns and operates data centers, and MarketAxess Holdings Inc., an electronic trading platform for fixed income instruments.
The worst performers included companies in the Financials sector that would be disadvantaged by the persistence of low interest rates, such as brokerage firm The Charles Schwab Corp. In addition, in the aftermath of Brexit, companies with significant exposure to Europe were disproportionately impacted. These included real estate services firm CBRE Group, Inc., and Industrials sector companies, including Westinghouse Air Brake Technologies Corporation, which manufactures components for railcars, and WABCO Holdings Inc., which manufactures components for heavy trucks. Illumina, Inc., a DNA sequencing company, fell after reporting weak quarterly sales, particularly in Europe.
Shares of IDEXX Laboratories, Inc. (IDXX, Financial), the leading provider of testing and diagnostics to veterinarians, gained after the company reported another quarter of strong financial results. We continue to believe that IDEXX’s business trends are improving and that its competitive position is becoming increasingly unassailable. The company’s placements of new diagnostic instruments in veterinary hospitals grew by almost 25% in its recent quarter. We expect this to be a key driver of future growth because these instruments require the ongoing purchase of high-margin consumables to perform in-clinic tests. In addition, the company’s network of domestic testing laboratories continued to grow at more than twice the rate of its main competitor. We believe that these trends, coupled with the revenue contributions from its new proprietary tests, has potential for better revenue and earnings growth during the next few years.
Shares of Gartner, Inc. (IT, Financial), the largest provider of syndicated research and analysis on the IT sector, gained after the company reported financial results significantly ahead of expectations. Revenues were impressive across the company’s three divisions, and there was notable growth in its core research subscriptions. We believe that various forward-looking metrics in this highly-recurring business continue to look strong. Contract value growth and sales productivity trends are approaching levels sufficient to drive margin expansion, customer retention rates are at all-time highs, and the company has significant financial flexibility. We continue to believe that Gartner will generate accelerating top-line growth, significant growth in earnings and free cash flow, and persistent return of capital.
Zillow Group, Inc. (ZG, Financial) is the leading Internet-based company focused on the residential real estate market. Zillow owns various websites, including Trulia, that contain information about homes for sale, and real estate brokerages and agents advertise on these sites to attract potential clients. We believe that an increasing number of home buyers will begin their home searches online, and Zillow will be an important beneficiary of this trend. The company’s shares gained meaningfully after it reported sharply improved results and offered encouraging guidance for the remainder of the year. In addition, the company reached a favorable legal settlement with its largest competitor, which removed an overhang on its shares.
Shares of Equinix, Inc. (EQIX, Financial), a REIT that owns and operates a global network of data centers, increased on continued strong demand for its outsourcing services, largely driven by its clients’ accelerating adoption of cloud-based computing solutions. In addition, the data center industry has continued to consolidate, and new supply has been kept in check. Together, these trends have created a strong growth and pricing environment that has benefited all players. In addition, Equinix completed its acquisition of European data center company Telecity on terms we believe to be favorable. Finally, the continued low interest rate environment benefited dividend paying REITs.
Shares of property and casualty insurance software vendor Guidewire Software, Inc. (GWRE, Financial) increased as the company continued to capture an increasing share of its target market. Guidewire enjoys near-perfect client retention rates, a growing installed base of users, and accelerating adoption of its product offerings. We believe that insurers are in the early stages of replacing the core software systems needed to run their businesses, and Guidewire continues to expand its addressable market through persistent product innovation. In addition, in April, Accenture plc sold a majority stake in Duck Creek, the largest direct Guidewire competitor, and extended its relationship with Guidewire. We believe this will lead to improved pricing and better client win rates for Guidewire.
Shares of DNA sequencing company Illumina, Inc. fell after reporting results that missed Wall Street expectations. In addition, the company lowered its forecast for the remainder of 2016 because of weak sales of its HiSeq instrument line and a lower overall sales forecast for Europe. Management believes the issues are short term, fixable, and unrelated to fundamental market demand. We continue to believe that Illumina has a long runway for growth driven by the increased adoption of DNA sequencing in clinical markets such as cancer screening, diagnosis, and treatment.
Shares of The Charles Schwab Corp. (SCHW, Financial), the brokerage firm, fell meaningfully during the last week of June in response to fallout from the Brexit vote. In the aftermath of Brexit, U.S. interest rates fell yet again to their lowest levels in modern history. Low interest rates have negative implications for several of Schwab’s revenue streams, most notably the profitable management fees it must waive on its clients’ investments in money market funds. Despite the difficult macroeconomic environment, we believe that the company continues to increase its relative market share. When interest rates eventually return to higher levels, we believe that Schwab’s earnings have the potential to improve significantly.
Shares of SS&C Technologies Holdings, Inc. (SSNC, Financial), a vendor of various financial technologies, detracted from performance. We attribute the decline to concerns that lackluster hedge fund performance will impact SS&C’s growth. We believe a low single-digit percentage of the company’s revenue is directly correlated to equity markets, far less than investors fear. We believe the company will continue to generate attractive revenue growth through market share gains, cross-sales of its expanded services portfolio into the installed customer base of Advent (a company it recently acquired), and new product introductions.
CBRE Group, Inc. (CBG, Financial) is a commercial real estate services firm with leading market positions in all of its major businesses – leasing, investment sales, outsourcing, and real estate investment management. The company’s shares fell on concerns that the commercial real estate cycle might be nearing its peak. These fears were exacerbated in the aftermath of the Brexit vote. In addition, CBRE has a significant presence in the United Kingdom and, by extension, exposure to the depreciating British Pound. We believe the outlook for commercial real estate remains attractive, and we also believe that CBRE’s increased reliance on recurring revenue businesses should make the company less susceptible to shifts in the real estate market.
Westinghouse Air Brake Technologies Corporation (“Wabtec”) (WAB, Financial) is the leading manufacturer of safety and productivity products for railroads. Its shares fell because of uncertainty around the strength of its rail customers, as the global industrial economy slowed, coupled with the potential impact of Brexit. Wabtec generates about half its revenues outside the U.S., resulting in stiff foreign currency headwinds. We believe the company should be able to grow its mass transit business even in this tougher environment. In addition, we are excited about the potential benefits of its pending acquisition of its largest European competitor.
PORTFOLIO STRUCTURE
At June 30, 2016, Baron Asset Fund held 55 positions. The Fund’s 10 largest holdings represented 40.1% of assets, and the 20 largest represented 63.3% of assets. The Fund’s largest weighting was the Health Care sector at 24.8% of assets. This sector includes life sciences companies, health care equipment and supplies companies, and health care technology companies. The Fund held 23.6% of its assets in the Information Technology sector, which includes investments in software companies, IT consulting firms, and data processing firms. The Fund held 21.4% of its assets in the Financials sector, which includes investments in insurance companies, investment brokers, and specialized finance firms. The Fund also had significant weightings in Industrials at 13.2% of assets and Consumer Discretionary at 11.6% of assets.
We initiated a position in Teleflex, Inc. (TFX, Financial), a medical device company that over the past five years has been transformed, under CEO Benson Smith’s leadership, from a diversified industrial company into a pure-play medical device company through a series of divestitures and acquisitions. Today, the company sells products used by hospitals and health care providers for critical care applications and surgical procedures. The company’s products include, among others, catheters that provide vascular access for delivery of intravenous medications, laryngeal masks for delivery of anesthesia, and surgical instruments used for minimally invasive surgery. The company’s products are used in procedures for treatment of acute or life-threatening illnesses and are therefore less susceptible to being cut during an economic downturn.
We think the company has a solid base business that should be able to grow in the mid-single digits on an organic basis driven by volume growth, new product introductions, and to a lesser extent pricing. In addition, we think the company has the potential to accelerate its organic growth through several interesting new product opportunities, including, among others, the Percuvance Surgical System, a surgical instrument for use in minimally invasive procedures. Percuvance requires a smaller incision site than traditional laparoscopic surgery, while maintaining the equivalent rigidity and strength of laparoscopic instruments. Percuvance has the potential to reduce patient trauma and minimize scarring. The company plans to pursue a full market release of the product in the third quarter of 2016. We think the product has widespread application and well over $100 million of revenue potential over the long term.
In addition, the company has several non-revenue dependent margin expansion initiatives in place, including manufacturing plant consolidation, acquisitions of distributors, and material substitution. New product launches at higher margins should also drive margin expansion. We think the combination of organic growth and margin expansion should drive low double-digit earnings growth, with potential for faster earnings growth if new products accelerate the revenue growth rate or management executes accretive acquisitions.
We sold our position in longtime holding Airgas, Inc., as the company was acquired, at what we believed to be an attractive price, by the French gas producer Air Liquide SA. We sold our position in Perrigo Co. Plc, as we grew more concerned that the political pressure on drug manufacturers to limit pricing increases, initially stemming from the controversy surrounding the practices of Valeant Pharmaceuticals International, Inc., would negatively impact Perrigo’s business. We reduced our stake in Mobileye N.V., a leader in advanced driver assistance systems for automobiles, as its valuation increased. We reduced our stake in health care software firm athenahealth, Inc. after management changes occurred at the company. We reduced our stake in Quintiles Transnational Holdings, Inc. after the contract research organization announced a merger with IMS Health Holdings, Inc., a health care data and technology company.
OUTLOOK
Despite the near-term uncertainty created by various global events, most notably Brexit, we continue to believe that high-quality, mid-sized growth stocks represent an attractive long-term investment opportunity. During the past 30 years, mid-cap growth stocks, as a category, have outperformed small-cap and large-cap growth stocks. We believe that this trend will continue.
The U.S. economy continues to rank among the world’s healthiest, and its equity market multiples are within the range of their long-term averages. Although interest rates declined again during the quarter, perhaps the most prevalent concern among equity investors is uncertainty about what will happen to stocks when interest rates finally begin to increase. We believe that equity markets often perform well during a rising rate environment. Separately, employment and housing trends continue to improve, and energy prices still remain meaningfully below recent levels. We think that our portfolio of what we believe are well-managed, competitively advantaged, fast growing companies will continue to perform well in this environment, although we cannot guarantee that they will.
Thank you for investing in Baron Asset Fund.
Our entire Firm and our research department, in particular, are committed to justifying your ongoing confidence and support. I remain a significant investor in the Fund alongside you.
Sincerely,
Andrew Peck
Portfolio Manager
July 19, 2016
