stock prices remain attractively valued on a historic basis relative to businesses’ current earnings, their growth prospects and their “reproduction costs.” How long do we expect this to last? That is uncertain. What does seem certain is that values of growth stocks, whose businesses are growing, present unusual opportunities for investment at a time when interest rates have never been lower; corporate balance sheets rarely stronger; and trillions of dollars in cash are on the sidelines awaiting opportunities “when the coast is clear” or are invested instead “for safety” in low yielding debt instruments. We agree with Chuck
Schwab that “staying broadly diversified and firmly in the game remains the key to long-term financial security.” Chuck recently remarked that “this is the most violent period I’ve ever seen. Most people remain very concerned. For good reasons, of course.” Which is why we agree with Chuck that the values of equities in general are so enticing and why we remain so optimistic regarding the long-term
prospects for our investments. Of course, underlying this view is our optimism that our children and their children will have a higher standard of living than we do…just as ours is much better than our parents and their parents.
Baron funds invest in growth companies at reasonable price. They identify secular trends and typically stay with their picks for a long time, taking full advantage of the value created during the growth cycle.
In the letter, Ron Baron compared the current time with the 1976 to 1982, the best time during his career to invest in growth stocks:
Is it any wonder that individual investors’ confidence has been shaken and that stock prices are as cheap as they are, offering what we believe to be significant opportunity? The period from 1976 through 1982 was the best time during my investment career to invest in growth stocks. That was when President Jimmy Carter, whom many regard as the worst President of modern times, presided for four years. The economy struggled and short term interest rates briefly exceeded 18%! Our economy is recovering more slowly and creating fewer private sector jobs than we would all like. Short term interest rates, however, are zero not 18% and trillions of dollars are on the sidelines awaiting a safe time to invest. As a result, we think we again have an opportunity to invest in growth businesses at cheap prices just as we did during the late 1970s and early 1980s. The benefits we believe will come during the next several years when The Great Reflation, which like day follows night, will follow The Great Recession.
The advances in our living standards during the past century, and especially those of the last thirty years have been enabled by technology. Cell phones, productivity enhancing software, the Internet and, most recently, the iPhone, will continue to transform our society and our old line businesses. We think our living standards will continue to improve in the years ahead as the many problems our society faces regarding energy, healthcare, education and the environment are addressed. We believe businesses able to solve those problems will have considerable growth opportunities.
One of the funds that Ron Baron manages himself is Baron Growth Fund. For the fund, Ron Baron wrote a separate letter. He and his team commented on several holdings that did not perform too well during the quarter:
On Devry and Strayer Education
The stock prices of high quality providers of postsecondary education DeVry and Strayer Education, serving around 90,000 and 56,000 primarily working adult students, respectively, declined in the second quarter despite continuing to report strong enrollment trends and solid operating fundamentals. Investors have sold shares of for profit education companies across the board, concerned about heightened regulatory risk as well as in anticipation of slowing growth during an economic recovery. We believe that regulatory concerns, while real, have been overdone, and that these stocks should recover with more clarity on the Department of Education’s final disposition of Gainful Employment, later this summer. We believe that DeVry and Strayer, whose students are often minority and economically disadvantaged, will
benefit from tighter regulation as questionable and inappropriate practices of less reputable schools will hopefully be eliminated, giving more credibility to survivors whose businesses we expect will be more highly valued by investors. (Susan Robbins)
MSCI shares fell during the quarter, as declines in global equity markets weighed on the value of ETF assets linked to MSCI indexes. MSCI’s multiple contracted also due to concerns over the health of international economies. MSCI, as the de facto standard for measuring international equity returns, is perceived to have high correlation with the performance of global markets. We continue to believe that MSCI’s long-term secular drivers remain intact, including increased demand for exposure to non-U.S. stock markets, growing interest in passively managed investment products, and the need for investment managers to use more sophisticated analytical tools to standardize operations, measure risk, and improve disclosure. The stock has rebounded in July following strong second quarter results, which included record quarterly sales and improved retention rates. We continue to be excited about the company’s recent acquisition of RiskMetrics, which we believe will bolster MSCI’s position in the multi-asset class analytics market, provide significant cost synergies, and enable the company to accelerate its research and development efforts while expanding margins.(Neal Rosenberg)
On J. Crew
J. Crew, an apparel retailer, had negative performance in the quarter. Some of this was profit taking as the company’s stock had risen almost 40% over the last year or so. The company’s fundamentals have continued to be strong and we believe the company’s product is still resonating with customers. We like the long-term story at J. Crew.
AECOM is the largest design and engineering firm in the world. The company specializes in the planning phases of critical infrastructure projects tied to transportation and water resource end markets. These include high speed rail initiatives, suspension bridges, complex subway systems to waterway needs such as dams, levees, treatment facilities and hydropower plants. Since its IPO in 2007, the company has grown its sales and profits at a very rapid pace, owing to the acute need for modern, upgraded infrastructure worldwide, as well as significant funding for their projects at federal and local government levels. The stock has come under pressure, more recently, as investors perceive global stimulus programs as ineffective and unsustainable. AECOM’s results, however, present a different picture. We are encouraged by the company’s continued double digit earnings growth and view its international exposure (52% of sales) as a competitive advantage. In the emerging markets it serves, such as China and India, the company is performing well. Furthermore, AECOM has a robust and growing backlog that represents almost two years of future work. Finally, the company possesses balance sheet strength which it intends to use to help grow and leverage its leading platform. (Matt Weiss)
Ralcorp is a manufacturer of private label food and the Post brand cereal. We believe Ralcorp shares were under pressure this quarter as a result of extensive promotional activity undertaken by major cereal producers. Cereal is a core category for Ralcorp generating almost half of the company’s revenues. While disappointing, we believe much of the bad news regarding cereal is behind us. Key cereal producers have indicated a desire to cut back on promotions and we believe a more rational pricing environment will return, which should be beneficial for Ralcorp. Additionally, we believe the recent announcement to acquire AIPC will provide another leg of growth for Ralcorp. AIPC is a leading producer of private label pasta with $600 million sales and over 20% EBITDA margin. We believe pasta is an attractive category to add to Ralcorp’s private label portfolio. Pasta resonates with today’s value conscious consumers as a healthy and cost effective meal solution and has latent potential for innovation with higher price, higher margin offerings such as gluten free, whole wheat and organic. Ralcorp intends to finance this acquisition with all debt. It believes AIPC should be $0.50 accretive to earnings per share on a pro-forma basis and expects to be debt free within 5 years.(Kyuhey August)
Despite receiving approval to close its Switch & Data acquisition in February, which had been weighing on the shares for months, Equinix shares ultimately traded down in the second quarter, due to weakening currencies and then concerns about a double dip recession. Equinix has some exposure to the euro and the British pound, but we believe that the impact in terms of translated financials is modest. Meanwhile, end-demand for the company’s data centers has remained robust, and the company is on track to continue to fill its available capacity, while adding new capacity as needed around the world. Management continues to be disciplined in reinvesting its excess cash flow, targeting expansions that drive attractive returns on investment, while the base business continues to be characterized by a high degree of recurring revenue. (Rich Rosenstein)
On Penn National Gaming
Shares of Penn National Gaming, a casino company with 19 facilities in 15 jurisdictions, declined during the quarter, as investors worried that a double dip recession in the U.S. would cause gambling revenue in the company’s properties to decline. In addition, investors apparently remained concerned about the Gulf Coast oil spill’s impact on visitation to the Penn’s properties in Biloxi and Bay St. Louis. Those two properties together comprise 5% of the company’s cash flow. Penn’s management has not seen any deterioration in gaming play or traffic at those casinos and has said that revenue trends remain in line with its expectations. Penn has one of the best development pipelines in its industry. This includes expansion projects in Maryland, West Virginia, Pennsylvania, Kansas and Ohio over the next few years. We believe the company also has one of the best balance sheets in its industry, which should enable Penn to finance these projects. We think the Penn’s balance sheet and project pipeline are not valued properly by investors. We believe that its current multiple of approximately 7.5 times cash flow doesn’t give enough weight to the company’s potential to increase its cash flow by more than 40% in the next three years, while reducing its debt by about a third. (David Baron)
On Community Health Systems
We know of no fundamental reason for the decline in the stock price of Community Health Systems, which operates 122 hospitals, the majority of which are sole providers, in mostly rural and suburban markets in the U.S. The stock performed well with the passage of healthcare reform, as investors realized that the expansion of healthcare coverage to around 32 million uninsured Americans will meaningfully increase demand for hospital services and reduce bad debt, which currently runs around 12% of Community’s revenue. Despite first quarter results which beat consensus expectations, nervousness around near term economically sensitive volume trends and what we believe are overblown concerns about Medicaid reimbursement levels, representing less than 10% of Community’s revenue, may have contributed to a sell-off. Community’s business model is to acquire struggling not for profit hospitals and improve their operations by upgrading facilities, adding services, recruiting doctors and controlling costs. Recessionary pressures as well as the challenges smaller less sophisticated hospitals will have adapting to the demands of healthcare reform should, in our view, provide Community an attractive pool of acquisition targets.(Susan Robbins)
On Choice Hotels
Choice Hotels’ shares declined on investors’ concerns that a prolonged domestic economic recovery may lead to lower revenue growth as well as a further decline in new franchise contracts. We believe Choice’s fee based franchise business of “value” priced hotels is among the most attractive in its industry. The company’s reservation system provides substantial unmet demand in U.S. markets or segments in which it is not yet represented. Further, the company which has about a 10% share of the four million hotel rooms in the United States, has a significant opportunity to grow its franchise units abroad. Europe is a current opportunity for conversions with just 30% of hotels on the continent branded compared to 70% in the States. India and China offer longer term new build opportunities for franchisees. India has fewer hotel rooms in its nation of 1.2 billion with its 140,000 rooms than exist at present in Orlando. (David Baron)
Read the complete Ron Baron 2Q10 letter here
Check out Ron Baron’s complete equity holdings here
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About the author:
My name is Ben C. and I am 2nd year MBA candidate at the Anderson School of Business at the University of California- Los Angeles. I have a BS in Economics from the Wharton School of Business at the University of Pennsylvania. Before coming to Anderson I worked as a generalist equity research analyst for Right Wall Capital, a long-short equity hedge fund located in New York City. Prior to working at Right Wall I worked as an analyst at Blue Ram Capital, another long-short equity hedge fund located in Rye Brook, NY. This past summer, I worked for West Coast Asset Management as a research analyst. West Coast, which was co-founded by Kinko’s founder Paul Orfalea, is run by well-known value investors Lance Helfert and Atticus Lowe.