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 Partner Fund. The fund typically invests in mid cap companies but does not limit itself in that space. The fund has not have much luck in terms of performance lately, as Ron Baron put it in a separate letter for the fund:
During the nearly eighteen and a half years since the Fund’s founding on January 31, 1992, Baron Partners Fund’s focused portfolio of long term investments, principally in mid-sized growth companies, has outperformed the Russell Midcap Growth index by approximately 406 basis points per year. It has outperformed its competitive benchmark index by 515 basis points per year for the past ten years and by 302 basis points per year since its conversion to a mutual fund from a partnership about seven years ago on April 30, 2003. During the past five years, however, Baron Partners Fund has underperformed the Russell MidCap Growth index by approximately 109 basis points per year.
In the letter, he and his team commented on the stocks that did not behave very well during the past quarter:
Shares of Charles Schwab declined in the second quarter as the sovereign debt crisis in Greece caused a consensus view to develop that the U.S. government would raise the Fed Funds rate later than had previously been thought. The continuation of the low interest rate environment is negative for Schwab’s near-term earnings. About one-third of the company’s revenues are derived from the net interest spread the company earns on cash in customers’ bank and brokerage accounts. This net interest spread is correlated with government interest rates, and therefore is currently at a depressed level. Also, Schwab has chosen to rebate the management fees it would otherwise earn on money market funds that due to the low Fed Funds rate currently yield very little. When the Fed Funds rate rises to a level more consistent with historical averages, Schwab’s revenues and earnings should increase dramatically. We are reassured that the Schwab franchise remains strong, as the company continues to receive solid net asset inflows from its customers, in spite of the current high unemployment environment in which some customers have less money to save and invest. (Katherine Harman)
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)
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)
FactSet Systems shares fell 8.4% in the second quarter as declines in equity markets caused the stock’s multiple to contract. Despite the stock’s decline, the company reported improved financial results during the quarter, helped by improving end markets and continued market share gains. The company booked $11 million of new subscription value and growth accelerated to over 5.0% from about 1.9%. We believe that FactSet is benefitting from improved spending on market data systems, market share gains due to its superior product offerings, and the launch of proprietary content that offers the same or better functionality as third party vendors at a much more compelling price. Finally, the company is continuing to roll out its next-generation platform, which is designed to widen the company’s technological edge, lower barriers to adoption, and increase utilization, all of which are positive for retention and revenue growth. (Neal Rosenberg)
Eaton Vance, an asset manager with over $176 billion under management, had a stock price decline of approximately 17% in the quarter. Over the short term, the company’s revenue is contingent on the performance of the financial markets. As investors feared that the global economy had not sufficiently emerged from the financial recession, these markets dropped in the latest period. In addition, expenses remained high as the company continued to incent its sales force to improve asset flows. This high compensation expense pressured the company’s profit margin.
The company’s closed end mutual fundmfranchise and growing institutional business in our view offer long term opportunity. (Michael Baron)
Vail Resorts is the largest operator of ski resorts in North America. Its share price declined 13% in the quarter. Investors evidenced increased concerns regarding closings of the company’s real estate projects in Breckenridge and Vail due to a continuing tight financing market and little improvement in housing nationwide. In addition, lower than expected spring sales of its season passes also caused concern among investors for the upcoming 2010/2011 ski season. Realtors in Vail have indicated that Vail real estate closings are occurring more often than either the brokerage firms or Vail initially expected. Vail’s stock is priced at 7.5 times current year cash flow, much lower than most other lodging and resort businesses.
We believe that once the company completes its real estate development projects this September, this unique company should generate significant free cash flow that could soon eliminate virtually all that company’s debt. This is most unusual for a real estate or resort business. (David Baron)
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, in our view, should provide Community an attractive pool of acquisition targets. (Susan Robbins)
Ritchie Bros. Auctioneers’ shares lagged in the second quarter as the company’s gross auction proceeds (GAP) growth continued to be restrained by unfavorable market conditions. Equipment consignments to Ritchie’s Internet auctions have been negatively impacted by low interest rates, uncertainty over near-term pricing trends, uncertainty as to when construction volumes will begin to pick up, and low pressure from banks pursuing delinquencies. We believe these conditions are temporary, and although we have yet to identify material signs of a market recovery, we believe Ritchie has significantly increased its market share of used construction equipment sales during the downturn. Over the long term, we believe that Ritchie has an open-ended growth opportunity in that core used equipment market. This is because, although it has the leading share of market, it remains less than 10%, and its value proposition is quite large. Ritchie’s Internet auctions get both buyers and sellers a better price. (Neal Rosenberg)
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)
Read the complete Ron Baron 2Q10 letter here
Check out Ron Baron’s complete equity holdings here
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