1 year ago

Baron Funds



Baron Small Cap Fund Early in 2017, Gartner announced the acquisition of CEB, in a cash and stock deal valued at $3.3 billion, by far the largest acquisition Gartner has ever undertaken. Though a major undertaking, which does introduce some execution risk, we view the acquisition favorably. CEB sees it as a highly complementary business, teaching best practices to executives in other corporate functions, that we believe Gartner can run more successfully. Plus it is significantly accretive. Gene Hall was hired by Gartner as its CEO a dozen years ago. Though the franchise and the product were established, the business was poorly managed and struggling. Under Gene’s leadership that ship was righted and the value of the enterprise has risen from $600 million to over $9.0 billion (much to the benefit of Baron Small Cap Fund shareholders). Gene views this opportunity as reminiscent, and he and his team are enthused to undertake another turnaround, which if successful will add much shareholder value. On Assignment, Inc., the provider of temporary staffing to the technology and digital/creative industries, rose after the election. Sentiment about the industry benefited from both hopes of faster growth and belief there will be less “offshoring” of jobs, which is a competitive source of labor. On Assignment has been the fastest growing staffer for the last few years and reported double-digit organic growth in the third quarter, which contrasted greatly with other industry players. We believe its superior growth is still a testament to the focus on specialized verticals and on tremendous execution. We also greatly admire the capital allocation skills of senior management. Though the stock has rebounded, it still trades at a modest multiple of expected earnings, which we would expect to accelerate if employment picks up. Cognex Corp., the leading provider of machine vision products used in factory automation, reported very strong results–revenues up 37% and income up over 100%–driven by large orders from the consumer electronics industry. Other verticals such as logistics, automotive, and robotics grew nicely as well. Cognex reiterated its goal to grow organically at 20% per year, as machine vision technology makes more and more inroads in existing and new manufacturing and distribution processes. Cognex announced some small technology acquisitions, but still has a huge cash horde in the bank (over $700 million) to support bigger deals or stock buybacks in the future. Summit Materials, Inc. is a vertically integrated provider of construction materials (e.g., aggregate, cement and concrete) and services. Summit reported good results for the most recent quarter, and the stock caught a bid as Trump discussed the potential for $1 trillion in infrastructure spending, which certainly would be a boon for the industry if implemented. Our bullish thesis is based on a business acceleration driven by the recent passage of federal and state highway construction bills, our belief that the trading multiple of the stock would increase to be more in line with some larger industry comps, and our expectation that the company will continue with its thoughtful and accretive acquisition program to build the company into a larger entity with a less leveraged capital structure. Other stocks that rose over 20% in the quarter and contributed to our returns include Industrials Univar Inc. and RBC Bearings Incorporated; Materials company Ferroglobe PLC; Financials Moelis & Company and Financial Engines, Inc.; and consumer companies The Cheesecake Factory, Inc. and The Chefs’ Warehouse, Inc. Table III. Top detractors from performance for the quarter ended December 31, 2016 Percent Impact DexCom, Inc. –0.70% FleetCor Technologies, Inc. –0.51 Guidewire Software, Inc. –0.51 The Ultimate Software Group, Inc. –0.44 Acuity Brands, Inc. –0.43 Our underperformers this quarter were primarily companies whose nearterm results missed Street expectations. DexCom, Inc. sells a continuous glucose monitoring device (CGM) for people with insulin-dependent diabetes. The stock fell in the quarter and has been down year-to-date over concerns about the upcoming launch of competitive products in the U.S. and Europe, and fear that growth in 2017 will moderate somewhat. We purchased our shares in DexCom four years ago, after they launched their revolutionary S4 product. We believe CGM is a life-altering technology, that DexCom is the clear leader in the field with the most accurate sensors and best delivery system, and that the penetration of the product will grow from a couple of hundred thousand users in the U.S. to millions worldwide in time. We believe that EBITDA can grow from $65 million in 2016 to over $500 million in 2020…if so, the enterprise will be valued at over $10 billion in three years, double its year end level. We are not preoccupied with catalysts or when we will make our returns (and we have quadrupled our money on the investment so far). We are focused on whether the business will develop as expected and its competitive advantage, which we believe is still intact. Early in 2017, Medicare announced the DexCom’s CGM will be covered and reimbursed as a replacement for finger sticks. This reimbursement comes more than a year earlier than expected and expands the total addressable market materially. The stock has risen some 40% on the announcement. We feel our process of looking at companies with a longer-term perspective and not being obsessed with trying to predict near-term stock action was rewarded in this case. FleetCor Technologies, Inc., a leading provider of payment processing and information management services to the global fleet industry, reported weaker-than-expected third quarter results. Some growth initiatives were delayed such that organic growth is now expected to be 8% instead of 10%. Also, fuel prices declined and foreign exchange translations were largerthan-expected headwinds. Later in the quarter, FleetCor lost its contract to serve Chevron to WEX, which is also a holding of the Fund. We still like FleetCor and believe that organic growth will return to a double-digit pace and they will benefit from recent smart acquisitions, and that they can execute deals in the future. We also believe the trading multiple of the stock is depressed and likely to expand in time. Guidewire Software, Inc., the property and casualty insurance software vendor, announced strong operating results and a significant strategic acquisition of the leading seller of software to smaller insurers during the quarter, but still its stock declined. Guidewire’s reported results are being penalized for its development of a new cloud deployed digital engagement platform, and accounting for the acquisition will be messy. Though the stock trades at a hefty valuation of near-term (understated) earnings, we continue to view this as one of our favorite long-term ideas. We think the company’s EBITDA can grow 10-fold from its $100 million level to $1 billion in time and the company can be worth $20 billion plus versus its current $3.5 billion enterprise value. From these pages to God’s ears… The Ultimate Software Group, Inc., the vendor of cloud-based payroll and human capital software, fell in the quarter after Oracle acquired its selling partner Netsuite, putting in question their ongoing relationship. Also, the probable repeal of the Affordable Care Act (“ACA”) might put a damper on future growth as the ACA provided a tailwind in 2016. Ultimate reported strong results year-to-date with recurring revenue growth accelerating to over 25% and EBIT margins beating estimates. The stock trades at a lofty valuation of present EBITDA, but we foresee continued strong revenue growth and margin expansion, and we think we still can make strong returns going forward. Other stocks that fell over 15% in the quarter and hurt performance were Diplomat Pharmacy, Inc., Flotek Industries, Inc., Party City Holdco Inc., and Brookdale Senior Living, Inc. 30

December 31, 2016 Baron Small Cap Fund Portfolio Structure As of December 31, 2016, the Fund had $3.3 billion under management and was invested in 70 common stocks. The top 10 positions represented 35.8% of the Fund at the end of the quarter. Table IV. Top 10 holdings as of December 31, 2016 Year Acquired Quarter End Investment Value (millions) Percent of Net Assets Gartner, Inc. 2007 $161.7 5.0% TransDigm Group, Inc. 2006 155.6 4.8 Bright Horizons Family Solutions, Inc. 2013 129.5 4.0 Waste Connections, Inc. 2016 117.9 3.6 IDEXX Laboratories, Inc. 2008 117.3 3.6 The Ultimate Software Group, Inc. 2008 114.9 3.5 Acuity Brands, Inc. 2011 103.9 3.2 On Assignment, Inc. 2012 91.6 2.8 SBA Communications Corp. 2004 87.8 2.7 Gaming and Leisure Properties, Inc. 2013 84.2 2.6 The Fund’s characteristics are as explained in prior notes–high quality businesses, with strong management teams, growing nicely and reasonably priced, in our opinion. The portfolio is packed with long-term winners and spiced up with new additions that are in keeping with our small cap mandate. We remain overweight in Industrials and underweight in IT and Financials, as has been the case for some time. This is a reflection of our bottom-up process, not a statement of which sectors we believe will be best near term…because we don’t focus on that so much, believing stock selection and long-term investing drives our performance. Recent Activity During the quarter we bought into two new investments of significance, Camping World Holdings, Inc. and Liberty Expedia Holdings, Inc., and built out some other positions. Table V. Top net purchases for the quarter ended December 31, 2016 Year Acquired Quarter End Market Cap (billions) Amount Purchased (millions) Camping World Holdings, Inc. 2016 $2.8 $22.6 Liberty Expedia Holdings, Inc. 2016 2.3 21.4 SiteOne Landscape Supply, Inc. 2016 1.4 14.1 Univar Inc. 2016 3.9 5.7 Zoe’s Kitchen, Inc. 2016 0.5 5.4 We invested in SiteOne Landscape Supply, Inc., the largest and only national wholesale distributor of landscape supplies, when it came public in May 2016 and filled out our position this last quarter. The company distributes a range of irrigation, fertilizer, landscapes, and nursery products to contractors throughout the U.S., who maintain residential lawns and gardens as well as commercial spaces and golf courses. Customers view SiteOne as a critical business partner for its broad product offerings, technical expertise, sharp prices, network of local stores, and delivery capabilities…as a one-stop shop for all their needs. The landscape supply industry is large ($16 billion), highly fragmented, with positive underlying market trends and tailwinds favoring outdoor living and water and energy efficiency. SiteOne was created in 2014 when a private equity firm acquired the landscape business of John Deere. New management was brought in who had the necessary skill set and vision (who we think are great), and a plan was hatched to develop a national brand, instill commercial and operational initiatives and accelerate acquisitions to consolidate the industry. So far, so good on all counts. And, we believe we are still in the early innings of development. SiteOne presently does about $1.6 billion in revenues, or has about 10% market share. We believe that the company can ultimately have between 30% to 50% share, as do other leading niche distributors, of a growing sector. We expect mid single-digit organic growth, as they exploit their scale and continue to develop local marketing plans. We foresee significant margin opportunities with operating income, growing from 7% to over 10% in time as operational and commercial initiatives take hold. And we expect significant acquisitions, which create a lot of value in that they are highly accretive, synergistic, and will strengthen the platform. SiteOne has an enterprise value now of about $2 billion, and we foresee an entity worth about $3 to $5 billion plus in time. Camping World Holdings, Inc. owns the largest recreational vehicle (RV) retailer in America, selling RVs and related products through 120 locations and also Good Sam, which provides services to RV and outdoor lifestyle enthusiasts. Camping World dealerships sold about 12% of all new RVs last year. Good Sam has 2.5 million RV customers in its database and has a membership club that offers roadside assistance, extended warranties, finance and insurance, and other services to RV owners and outdoor lifestyle aficionados. The company came public in October 2016 and we bought a position for the Fund. Camping World was formed via the merger of the retail chain and Good Sam in 1997, followed by the combination with Freedom Heads, a large RV chain in 2003. The company is managed by a long-tenured team, led by Marcus Lemonis, who is also a well-known television personality. Under his leadership, the company has succeeded in consolidating the industry and is now eight times larger than the next largest competitor. The company has significant advantages of scale which results in volume purchase discounts from manufacturers and better terms from lenders and insurance providers. They offer buyers better deals and make higher profits than their competitors. The company has grown its footprint through greenfield startups and through aggressive M&A efforts, often buying struggling dealerships, at less than four times trailing cash flow. Camping World has been very successful growing the profits of acquired dealers after purchase, making those acquisitions even more additive. The company hopes to expand its footprint threefold over time to 400 dealerships. Though the industry is cyclical, less in the towables segment that Camping World favors, the recurring Good Sam and Partners Service portions of its business account for 60% of profits. We believe the Good Sam business is special. It sells club memberships and service on a subscription basis at very high margins, and we expect nice growth as they further penetrate the customer base. Management has also made clear its desire to extend Good Sam to offer ancillary leisure categories, which we believe would be a positive development. The stock has performed nicely since the IPO and trades 10 times our estimate for this year’s EBITDA, which embeds modest estimates for acquisitions (though the company has been very active so far, probably a precursor). We think cash flows will grow double digits going forward, that free cash flow will be used to make acquisitions and reduce debt, and that the equity will continue to appreciate. 31