Baron Opportunity Fund commentary for the fourth quarter ended December 31, 2014.

Baron Opportunity Fund had a modest fourth quarter, gaining 3.56%, but trailing both the Russell Midcap Growth Index, which rose 5.84%, and the large-cap S&P 500 Index, which increased 4.93%.

Baron Opportunity Fund: Review & Outlook

As I’ve written in past letters, 2014 was a challenging year for the Baron Opportunity Fund. Performance was not up to our (and my) historical standards. When the market turned in mid-March, we were a top decile fund against our peer group for the prior 5- and 10-year periods (according to Morningstar data).* But the Fund trailed the market averages materially last year. As I detailed throughout the year, the market environment presented a significant headwind to the Fund’s consistent strategy of investing in high growth, innovative businesses, and, with the clarity of 20/20 hindsight, we made some missteps of our own. For those investors who continue to place their trust in us, I want to personally thank you for your support and patience. It is our aim to prove 2014 the anomaly I believe it was.

Baron Opportunity Fund: What happened last year?

Beginning in mid-March – triggered by the Federal Reserve meeting (remember the “dot charts”) and Janet Yellen’s first post meeting press conference as Federal Reserve Chairwoman, which raised the spectre that the Fed would increase interest rates sooner and more rapidly than previously expected – the market abruptly adopted a strong “risk-off” posture. The next six weeks saw a severe sell-off in growth stocks, led by many of the high-growth sectors in which the Fund is heavily invested (Internet, cloud computing, social media, bio-technology, cyber-security). Market sentiment swung back-and-forth a few times over the ensuing months – gyrating in step with the latest Fed statement; world events such as the Ukraine conflict, Ebola and ISIS; and, to end the year, the sharp decline in oil prices – but the risk-off stance persisted by and large. The secular growth stocks we invest in trailed the market, with high-growth Internet and software stocks lagging significantly (the S&P Internet Index finished down slightly on the year). Instead, the market was led by stocks exhibiting high current earnings or cash flow yields or high dividend yields, as well as cyclical beneficiaries. Smaller company stocks trailed large cap stocks by the widest margin in 16 years.

While challenging for fundamental growth investors, this type of behavior is actually quite logical in periods when uncertainty and low risk dominate. Most of the value in a low-growth business is in the near term – current earnings, cash flows and dividends. For the innovative businesses we invest in, however, most of the value will come in the out years. Such companies invest today to capitalize on large opportunities and to erect competitive moats. This tends to push profits and cash flows into the future – but, critically, in our opinion, serves to maximize the net present value of cash flows, the key determinant of value for any business. But, in a risk-off market, investors view the future as uncertain. They seek the safety of earnings now. They ignore, for the moment, questions of long-term value creation.

So, in light of 2014 performance, why do we remain confident in our strategy? For a start, as alluded to in my last letter, we think reversion to the mean is an inescapable law of the market. Fundamental as gravity. What’s in favor today will be out of favor tomorrow – and vice versa. I cannot predict when the turn will occur. But I believe it inevitably will.

Yet this merely addresses market trading behavior, not whether our strategy itself is sound. The real basis for our conviction is far more fundamental. As our investors know, the Fund invests in a diversified portfolio of innovative, highgrowth businesses. We focus on businesses and industry segments whose growth is being driven by disruptive innovation and where significant changes – i.e., generational shifts – are occurring. We believe innovation provides the foundation for businesses to generate long-term secular (as opposed to cyclical) growth in revenues and profits. Moreover, we view innovation as critical to creating significant and durable competitive advantages, a factor we at Baron consider to be a key component of long-term value creation. History teaches us that new winners emerge during periods of generational or paradigm shifts – think ABC, NBC and CBS during the TV age or Microsoft and Intel during the PC era. We believe such winners will be able to build deep and wide moats that will give them potentially decades of durable competitive advantages. We seek to invest in these winners.

To conclude, in our view, none of the issues impacting the market in 2014 had anything to do with or will have any long-term impact on the innovation themes we focus on or the long-term drivers for the businesses in which we have invested. And with another year of strong growth and lagging stock prices, we believe many of our high-growth businesses are now attractively valued on a growth-adjusted basis and, more importantly, against our longterm projections of earnings and cash flow. Our independent research underlies our conviction that the fundamentals of our companies are solid, and that the secular themes in which we are investing are not just intact but more powerful than ever. We remain confident that these industry themes will provide the fuel to drive much of the world’s economic growth for years to come.

Baron Opportunity Fund: CarMax

Shares of CarMax, 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)

Baron Opportunity Fund: Gartner

Shares of information technology research firm Gartner performed well in the fourth quarter, driven by strong financial results, accelerating contract value in its core research business, and continued share repurchases. Gartner’s earnings exceeded expectations, helped by sustained growth in its research segment and better-than-expected performance in its consulting and events segments. Growth in research contract value, the company’s key long-term value driver, improved to 14%, and we believe will continue to accelerate over the next several quarters. (Neal Rosenberg)

Baron Opportunity Fund: Red Hat

Red Hat is the world’s largest open source software provider. Red Hat’s recurring revenue business model, with high renewal rates and ongoing market share gains, support a stable and profitably growing business. Shares moved higher in the fourth quarter over investor excitement around several large deals, share gains and accelerated growth rates. (Gilad Shany)

Baron Opportunity Fund: Illumina

Shares of Illumina, the leader in next generation DNA sequencing instruments and consumables, rose in the fourth quarter. The company reported revenue growth of 35% year over year in the third quarter, well ahead of expectations, and increased revenue and earnings guidance for the year. We believe Illumina holds an effective monopoly on DNA sequencing at a time when demand is accelerating, as DNA sequencing is increasingly being used in cancer diagnosis and treatment,

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