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.
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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, as well as in reproductive and genetic health. (Neal Kaufman)
Baron Opportunity Fund: Guidewire Software
Shares of Guidewire Software rose in the fourth quarter, helped by strong financial performance and continued wins at Tier 1 insurers. Guidewire is the gold standard of property & casualty core systems vendors, as evidenced by near-perfect retention rates, growing installed base, and accelerating adoption of its complete product suite. We believe that the company is in the early innings of a core system replacement cycle, and that it is dramatically expanding its addressable market through persistent innovation. (Neal Rosenberg)
Baron Opportunity Fund: Oasis Petroleum
Oasis Petroleum is one of the largest exploration and production companies in the Williston Basin Bakken shale oil play. Falling oil prices pressured shares in the fourth quarter, as reduced cash flow forecasts led Oasis to curtail investment spending and reduce its growth outlook. Oasis’s financial flexibility is also an investor concern. We believe Oasis has ample financial flexibility but shares remain levered to oil price changes, as economics in the Williston basin become increasingly marginal. We chose to exit our position. (Jamie Stone)
Baron Opportunity Fund: Golar LNG
Golar LNG is engaged in transportation, re-gasification and liquefaction of liquified natural gas (LNG). Golar has been developing a gas liquefaction project in Cameroon. Declining oil prices have made LNG less attractive in the near-term and reduced the upside from selling LNG as a substitute for crude oil. Concerns around Golar losing money from selling LNG at current spot prices or even canceling the project, in our view, created a buying opportunity because we believe this project represents a good long-term investment opportunity for Golar. (Gilad Shany)
Baron Opportunity Fund: Twitter
Twitter is not just an online social network, but a real-time global broadcasting platform that offers an unparalleled variety of content. Despite this, Twitter has been struggling with slower-than-expected user growth, which has caused its shares to lag. The company has acknowledged the need to make the service easier to adopt for new users and to find, and engage with content, for all users. Towards that end, the company has re-shuffled its product development team and recently conducted a detailed analyst day, where management set out the vast opportunity in front of Twitter and its plans for improving the service and growing its user base. While it might take some time for these efforts to gain traction, we continue to believe that Twitter is a unique asset still in the early stages of its evolution. (Ashim Mehra)
Baron Opportunity Fund: Netflix
Netflix is the leading global on-demand video service, with over 50 million subscribers in the U.S. and abroad. Shares declined in the fourth quarter as third quarter domestic subscriber additions came in below expectations. While quarterly fluctuations in net additions have occurred in the past and may continue going forward, we believe Netflix continues to differentiate its service and remains on track towards achieving 50 million U.S. subscribers and over 100 million subscribers in international markets. (Ashim Mehra)
Baron Opportunity Fund: Concho Resources
Concho Resources is an independent exploration and production 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. We increased our Concho position during the period. (Jamie Stone)
Baron Opportunity Fund: Portfolio Structure
Baron Opportunity Fund had $397.3 million of assets under management as of December 31, 2014. The Fund had investments in 50 securities. The top 10 positions accounted for 35.1% of total investments. The median market cap of the Fund was $5.4 billion at the end of the quarter.
As detailed above, we focus on investing the Fund’s assets in themes and individual businesses that we believe will experience significant secular growth rates. As a result, the Fund’s sector weights are an output of our process, not an input. Not surprisingly, most of our investments are in those industry sectors more typically associated with growth. At quarter end, 70.8% of the portfolio was invested in the Consumer Discretionary and Information Technology sectors. We also have meaningful investments across the Health Care and Industrials sectors. In thinking about diversification, we pay little attention to sector weights as defined by GICS, instead focusing on the fundamental business drivers and end market exposures for our investments.
We re-established a position in cloud computing pioneer, Salesforce.com, during the quarter. Salesforce is the world’s largest pure-play cloud software company, led by a visionary and inspiring CEO in Marc Benioff. The company offers leading cloud applications for salesforce automation, customer service, performance management and marketing, as well as an application development and hosting platform (known as platform-as-a-service, or PaaS). Salesforce serves a vast addressable market, and we see a path towards $10 billion of annual run rate revenues based on the company’s current set of products. Secular adoption of cloud computing has tipped, in our view, but remains a small part of overall software spending. Salesforce is highly innovative and has steadily added to its portfolio of clouds through both acquisitions and organic development. Most recently, the company launched Wave, its analytics cloud, further expanding its addressable market. Salesforce is becoming an increasingly strategic vendor to clients, leading to more senior relationships, greater adoption and growing deal sizes. Most Salesforce products are sold on a subscription basis, leading to strong visibility. Retention rates are currently in the high 80s% range, but have been trending steadily upward as management actively focuses on attrition. We expect the company to be able to achieve 30% EBITDA margins and strong FCF generation as growth slows.
After many years of conducting research on developments in the solar energy field but not identifying an appropriate long-term investment vehicle, we initiated positions in SunEdison, Inc. and its yield-co subsidiary, TerraForm Power, Inc., taking advantage of the decline in solar stocks in sympathy with the fall in oil prices to build positions at price levels we found attractive. SunEdison is one of the world’s largest developers of solar energy projects and, in our view, one of the most diverse in terms of technology, end market exposure and geography. SunPower development projects span the utility, commercial and industrial, and residential markets. And its project portfolio and pipeline is truly global in nature. The company is currently far along in transforming its business model from one based on “building and selling” solar projects to one focused on “building and owning” these projects. We believe this transformation will enable the company to roughly triple the retained value of each solar project. With solar energy accounting for less than 1% of global electricity production, we believe the opportunity ahead for SunEdison is vast. The solar energy market is growing rapidly as prices have come down – due to both overcapacity for solar modules and technological innovation – and solar is achieving “grid parity” in many parts of the world with coal and natural gas.
We re-invested in Amazon during the quarter, taking advantage of the fall in Amazon’s stock price as investor sentiment on the company turned increasingly negative. Amazon is the world’s largest online retailer, as well as a pioneer and leader in cloud computing services. The company is still led by founder Jeff Bezos, who remains laser focused on creating longterm shareholder value, not one quarter’s worth of Wall Street earnings. While many see Amazon as an online retailer (or, more recently, as a cloud computing company), we think Amazon differentiates through the scale, uniqueness and innovativeness of its infrastructure – warehouses, logistics software and delivery networks in its retail business and data centers, computers and software in its cloud computing business. And while many investors criticize Amazon for its high levels of spending, we believe Amazon is prudently investing to establish insurmountable infrastructure advantages across its businesses that will be very difficult and very expensive for its competitors to replicate. In our way of thinking, what Amazon has done, and is doing, is akin to laying the tracks for the 18th Century railroads – expensive to build, but, once built, provide the basis for dominant market share and strong returns for many years. Amazon’s “tracks” enable it to offer differentiated customer propositions across both of its businesses – superior user experience, vast selection, everyday low prices, free shipping and next- and even same-day delivery in its retail business; and security, scale, flexibility and low prices in its cloud computing business. Amazon’s addressable markets remain very large, with Amazon having less than 2% share of total US retail (and far lower on a global basis) and with cloud computing still in its infancy. As the negative sentiment continued to build around Amazon’s investment spending, we saw the opportunity to invest at what we believed were attractive prices for its two businesses, particularly given our view of the long-term revenue and cash flow potential of Amazon’s unique platform. As stated above, we increased our position in Concho Resources, Inc. as oil prices fell during the quarter.
We sold Concur Technologies, Inc. after it agreed to be acquired by SAP. We trimmed our Illumina, Inc. and Gartner, Inc., positions – two of our top three holdings, which were strong stocks in 2014. We sold IHS, Inc. and Fossil Group, Inc. to fund other investments.
Thank you for your support and for trusting us with your assets. We look forward to updating you in future letters.
Michael A. Lippert
January 22, 2015
Investors should consider the investment objectives, risks, and charges and expenses of the investment carefully before investing. The prospectus and summary prospectus contains this and other information about the Funds. You may obtain them from its distributor, Baron Capital, Inc., by calling 1-800-99BARON or visiting www.BaronFunds.com. Please read them carefully before investing. The Adviser believes that there is more potential for capital appreciation in securities of high growth businesses benefiting from innovation through development of pioneering, transformative or technologically advanced products or services, but there also is more risk. Companies propelled by innovation, including technological advances and new business models, may present the risk of rapid change and product obsolescence and their successes may be difficult to predict for the long term. Securities issued by medium sized companies may be thinly traded and may be more difficult to sell during market downturns. The Fund may not achieve its objectives. Portfolio holdings are subject to change. Current and future portfolio holdings are subject to risk. The discussions of the companies herein are not intended as advice to any person regarding the advisability of investing in any particular security. The views expressed in this report reflect those of the respective portfolio managers only through the end of the period stated in this report. The portfolio manager’s views are not intended as recommendations or investment advice to any person reading this report and are subject to change at any time based on market and other conditions and Baron has no obligation to update them. This report does not constitute an offer to sell or a solicitation of any offer to buy securities of Baron Opportunity Fund by anyone in any jurisdiction where it would be unlawful under the laws of that jurisdiction to make such offer or solicitation.