Baron Funds Second Quarter Commentary

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Sep 02, 2011
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“What the heck is going on, Ron? Wynn’s Las Vegas business is really strong. It’s the same thing for the rest of this town. If the economy is getting weaker, we don’t see it. Why is the market down 600 points today?” Matt Maddox, Chief Financial Officer, Wynn Resorts. August 9, 2011.

“Wynn’s occupancies are better. So are rates. Our convention business is also picking up. If you want to get a room in Las Vegas in September or October you can’t,” Matt went on when he called me in early August, recounting information announced on Wynn’s earnings call. Baron Funds believes hotel and travel business’ trends are usually accurate coincident indicators of our economy’s health. This is because corporate and leisure travel is a discretionary expenditure that does well in good times and can be easily postponed amidst economic uncertainty. From late July through early August, before we printed this letter, the stock market fell 17% before beginning to stabilize. This was despite currently strong business trends throughout the bellwether travel and leisure industry and strength evident in many other industries.

The stock market correction initially took place amid concerns that America’s economic recovery from the Great Recession of ‘08-’09 was “stalling” in large part due to lack of confidence in our politicians. The widespread impression of a dysfunctional government was reinforced when Congress and the President were unable to agree for several months to “raise our debt ceiling.” The debt ceiling debate had seemed noncontroversial since that limit had been raised more than 70 times in the past fifty years. How can this government create what JP Morgan’s Jamie Dimon calls “coherent and consistent policies” to encourage private businesses to invest and create jobs, we all wondered, if they can’t even agree whether the government should pay its bills when they are due? This became even more worrisome because unemployment is a troubling 9.2% of our workforce and incipient signs of social unrest have recently been evident in disparate places like Philadelphia and Wisconsin.

The August 2011 U.S. stock market decline was reminiscent of the dramatic collapse our markets experienced in Fall 2008 that is still so fresh in everyone’s minds. The decline in our markets three years ago was precipitated by the bankruptcy of Lehman Brothers and lasted for five months. It was caused by fears of contagion due to financial counterparty risk in a highly leveraged economy. The 2008-09 “water torture crash” and economic free fall was ended, in our opinion, by courageous actions of Federal Reserve Chairman Ben Bernanke, Treasury Secretary Henry Paulson, Congress and President Bush working together. Soon after President Obama’s inauguration in 2009, he, too, helped our economy begin its recovery by supporting Federal Reserve Chairman Bernanke and by promulgating unconventional government policies like rescuing our automobile manufacturers and banks. We think the President’s efforts saved jobs and industries and provided us with a solid foundation for growth. In our opinion, had he not done so, future historians would likely be writing about The Second Great Depression rather than the Great Depression of the 1930s.

The President then spent what seemed like his entire first year trying to pass Obamacare, his universal healthcare program. President Obama’s healthcare efforts necessarily left him less time to persuade legislators to develop and to get our nation to accept what many believe were needed programs for job creating, infrastructure projects that could have put many unemployed construction workers back to work. The August 2011 market decline was precipitated by the failure of the Congress and the President to agree in a timely manner to “raise the debt limit.” As a result of the highly partisan debate between the parties, one independent credit rating agency ultimately downgraded our country’s credit rating. The agency gave as a reason continued ideological “debate” and their belief that it remained unlikely that our Congress and President would be able to reach agreement to reduce government spending. Since entitlements are unaffordable as they exist, in our opinion, spending must be reduced if these programs are to survive.

The disagreements between Republicans and Democrats created a crisis of confidence among investors.

Comparisons between Fall 2008 and Summer 2011. Summer ’11 is not Fall ’08. Also negatively impacting U.S. stock markets during August 2011, is a European banking and political crisis with parallels to the “sub prime” crisis experienced here three years ago. We assume that banks in Europe will ultimately be recapitalized with government assistance similar to what happened in America. If unmanaged, the consequential damage to their economies would be unacceptable.

Baron Capital Group is a research business. When turmoil exists in markets, we think it is our job to continue to diligently research businesses as we always have to take advantage of that turmoil. In Fall 2008, immediately after Lehman failed, we called and visited as many executives of businesses in which we had invested or were considering investing as we could. We were startled to hear that significant declines in sales were taking place magnitudes larger than any we had ever heard about. One executive after another then told us they were sharply curtailing capital expenditures and were reducing fixed operating costs and workforce by either firing workers or reducing their pay. The very negative business trends in Fall 2008 were accompanied by “frozen” financial markets with businesses unable to borrow to sustain their operations. It didn’t take great analytic ability to understand that our economy was on the precipice of a much worse recession than any I had witnessed during my entire career, which began in 1970.

There is not an inkling the same thing is now occurring. U.S. banks have since been recapitalized with significant additional equity; new financial regulation, while limiting bank profitability, should also limit risk in their businesses; thanks to Fed Chairman Bernanke, money is widely available and inexpensive; growth businesses are trying to hire more qualified employees (in Silicon Valley, for example, “We’re hiring” signs abound), and earnings of 74% of the businesses in which Baron Funds is a shareholder earned more than expected in the most recent period. There is no sign yet of significant diminution in future results. My friend Peter Lynch used to say that markets forecast “nine of the past five recessions.” Hopefully, this will be another of those instances when markets got it wrong. Finally, stocks are really cheap. The S&P 500 Index has increased a total of only 6.4% over the entire past twelve years! Earnings during that period have more than doubled! This means valuations are about half what they were twelve years ago. Stocks now also yield more than ten year Treasury bonds. This has been a rare event during the past fifty years.

So why has there been a selling frenzy, a near “panic,” during the past two weeks? We think it is partly due to computer trading, especially “high frequency trading,” that has enabled and perhaps even caused such a “panic” to occur. (We wrote about this topic in our June 30, 2010 quarterly letter.) When the stock market “crashed” in October 1929, an event many believe brought on the Great Depression, 16 million shares traded. The exchange was not automated and had to remain open all night to catch up with the paper work for trades that took place earlier in the day. In the 1960s, when stock trading on the New York Stock Exchange regularly exceeded 10 million shares per day, the exchange was able to open only half-days during the week and needed to close Fridays to catch up with paperwork. When the market “crashed” once again in October 1987, 600 million shares traded on a newly automated exchange. Obviously not a problem with paperwork any longer. With high frequency trading now representing more than 70% of daily exchange volumes and encompassing what the SEC calls “momentum ignition” end of day trading and “order anticipation” trading, volumes on the day stocks fell 600 points was an astounding 9.7 billion shares! So, high frequency trading allows investors to “panic” and buy and sell at inopportune times, in our opinion, when events like European sovereign debt issues and disagreements between politicians become front page news and scare individual investors who watch television programs like “Markets in Turmoil.”

Can our politicians ever again govern and legislate effectively? They have before.We assume they will again. President Franklin Roosevelt, a Democrat, feared a resumption of the Depression and social unrest following World War II if soldiers returned home and were unable to find jobs. President Roosevelt believed that the construction of an interstate highway system could be a partial solution to that problem and would create jobs for the unemployed. President Eisenhower, a Republican, when he returned from Germany after leading our troops in that War, recognized that construction of an interstate highway system would not only provide jobs for returning soldiers but would be an important component of a national defense system. With Eisenhower’s strong support, the Federal Interstate Highway Act of 1956 was enacted. It passed Congress on June 26, 1956 by a vote of 89-1!!! To ensure that cooperative, effective government could happen again, Starbucks’ CEO Howard Schultz recently suggested in a New York Times Op- Ed that individuals should go on strike when politicians ask for contributions until the legislators begin to work and play effectively together. We couldn’t agree more with the concept.

“A courageous act is made without weighing its popularity or unpopularity. It relies solely on the belief that it is the right thing to do.” United States Senator Edmund G. Ross. 1868.

The principle of putting what is right for the country ahead of partisan politics is well illustrated in the story of Edmund G. Ross, a little known Civil War-era Senator from Kansas. In 1955, Senator John F. Kennedy highlighted Ross’ courageous actions in his Pulitzer Prize winning book, Profiles in Courage. Senator Ross, a Republican, cast the deciding vote that ended an impeachment trial against President Andrew Johnson, a Democrat. Ross’ vote helped our country avoid a Constitutional crisis.

In 1868, following the conclusion of our Civil War, there was strong disagreement among members of Congress about how to re-integrate the Confederate states into the war torn union. President Andrew Johnson, a Democrat, believed a conciliatory approach would help heal the nation. That was the intention of President Abraham Lincoln before he was assassinated. Republicans then in control of the Senate, however, sought to enforce a punishing military dictatorship in the South. As the impeachment trial of the President began, it became clear Johnson's detractors in the Senate had no intention of giving him a fair trial. Although he was no fan of the President, Senator Ross believed the President's conduct did not justify charges under the Constitutional standard of "high crimes and misdemeanors" and voted to acquit. Neither he nor any other Republican who voted to exonerate the President was re-elected to the Senate. Further, when Ross returned to his home in Kansas, he suffered ostracism, death threats, vilification and poverty. Ross was ultimately vindicated for his views on the Constitution by the Supreme Court and the subject of praise by the press and the public later in his life!

Today our nation is once again torn by competing and highly politicized and partisan opinions. Rather than attempting to compromise to find solutions to our nation's problems, our politicians dogmatically attack each other. "When I attempt to convince individuals in business to agree with me, I romance them. I send their wives flowers on their birthdays. I invite them to play golf. When politicians in Washington try to convince members of the opposition party to agree with them, they first hit them in the head with a two by four," New York City Mayor Michael Bloomberg remarked to me this summer.

When Senator Barack Obama ran for President in 2008, he did so proclaiming, "We have never been just a collection of Red States and Blue States…We have been and always will be the United States of America." America has so many opportunities to create jobs by investing in our country's neglected infrastructure; by using less foreign energy; by improving our environment; by providing better education for our citizens; by improving our healthcare services; and by fairly limiting entitlements.We could pay for all this by reforming our tax code; by ending our participation in foreign wars; and by more efficiently operating our government. We remain hopeful that Senators and Congressmen will put aside partisan interests and focus on all our interests.

"If I had been you, I would have done business with Walmart and I would have invested in Walmart's stock." Robert Baker. Chairman and CEO. National Realty and Development Corporation. Summer 2011.

Robert Baker is a good friend of mine. Bob is a shopping center developer who has developed and owns for National Realty and Development Corporation (NRDC), his privately held, family business, more than 22 million square feet of regional shopping centers. A recent article in The Sunday New York Times Business section featured Robert and his son Richard. The Times' article described the successful acquisitions of department store chain Lord and Taylor and Canadian retailer, The Hudson's Bay Company, a business founded in 1670, led by the Bakers and their partner Bill Mack, with whom I am also friendly. Both businesses had substantial real estate interests, which is what attracted Bob and his partners. I thought the article was really interesting and prompted a conversation between Bob and me about his family's shopping malls.

Walmart is an important anchor tenant for many NRDC malls.When I asked Bob about NRDC's relationship with the Bentonville, Arkansas retailer, he described how it began. Many years ago, Bob noticed that Walmart, a retailer with which he was only vaguely familiar at the time, acquired by the assignment of two leases, two stores from one of NRDC's mall tenants. Those two stores produced retail revenues of $4 million per year each in the year prior to their acquisition. In Walmart's first year operating those stores as NRDC's tenant, sales in each of the acquired stores exceeded $20 million! In the second year, to avoid "percentage rent" payments to NRDC, Walmart built two new stores across the street.

Richard Baker, Robert's son, soon afterwards joined the family business. Richard knew that Walmart was an exceptional retailer. The data on two stores Walmart had operated in NRDC malls for a year confirmed that opinion. Richard had thought for quite a while that Walmart could be a great anchor tenant for many of NRDC's eastern seaboard malls. When Richard read that Walmart was beginning to expand on the east coast, he began to pester his dad to visit that company in Bentonville, Arkansas. When Robert and Richard finally made the trip, their meeting was memorable. As Bob recalls, they were asked to wait for a lengthy period in "a sparsely furnished room with a pay telephone on the wall and without even water to drink." That meeting, however, was the beginning of a long and profitable relationship for the Baker family's regional malls and Walmart. NRDC is now Walmart's largest landlord on the east coast. In our conversation about his business, Bob summed up what he thought was the difference between his business and ours.' "If I were you and I had seen what a terrific retailer Walmart was, I would not only have done business with Walmart. I would have bought their stock!"

In an investment climate obsessed with short term, macro, "risk on-risk off," news oriented trading, like whether or not Congress would raise the debt ceiling, we continue to invest as we always have. For the long term in businesses that have significant growth opportunities…that have unusual and sustainable competitive advantages…that have strong balance sheets…and, as importantly…that we think are exceptionally well managed. Bob was right. Had we been privy to the results Walmart stores produced in NRDC's malls, we certainly would have studied Walmart closely as a possible investment. Almost as certainly, we would have purchased Walmart's stock.

That would have been just like so many experiences and observations that have led to profitable investments for Baron Funds. We invested in Charles Schwab in 1992 after Baron Asset Fund, our first mutual fund, began to grow rapidly once we were admitted to Schwab's Mutual Fund Marketplace "platform." Schwab's platform revolutionized mutual fund distribution. We invested in Wynn Resorts in 2001 and 2002. We had studied the prospects for gaming in Macau, China several years before Steve Wynn obtained a license to operate a property in that jurisdiction. Since we had been investing with Steve since 1980 and thought we understood why his hotels earned more in their rooms, games, retail and restaurants than any others, it was a pretty easy decision to invest in this business after he was awarded a license to operate a casino in Macau.

We met Max Messmer when he was President of Dole Foods in the late 1980’s and Dole was our firm’s largest investment. This made it easy for us to follow him to Robert Half and five years later begin to invest in that business. Robert Half provides temporary accountants for which we believed there would be significant demand.

We quickly understood the opportunity for the Polo Ralph Lauren brand in America and abroad in 1998 when we invested in Ralph Lauren’s business. We thought then and still do that Ralph was a merchandising genius and a genuinely nice guy.

When I met Jay Pritzker in the mid 1970s, he quickly became one of my favorite executives. I use this phrase cautiously since there are so many executives of businesses in which we invest whom I regard highly. Regardless, my impression of Jay made it easy for us to invest in Hyatt Hotels Corporation when he was building hotels with really cool atriums at airports for businessmen. Until then, there were few airport hotels and businessmen had to drive to center city and often stay overnight to attend a meeting.

There have been so many stories like this during my career. Furthermore, when we find businesses with great opportunities, we often have an opportunity to invest at attractive prices. This is because growth businesses generally penalize current profits to make their businesses significantly larger over the long term.

The postscript to these stories also comes from Bob Baker. “It’s not surprising to me that your firm has been a successful investor. Last winter, we were at a charity cocktail party together. You met Herb Pardes, Chairman of New York Presbyterian Hospital. ‘Let’s get together for lunch,’ you suggested to him. ‘I want to talk about healthcare. I’d also like you to speak to my office about your views on Obamacare and its impact on hospitals.’ What you meant is that you want to listen to what he has to say about healthcare. You always listen to successful, smart people. That’s one way you get ideas and test them.” Linda Martinson, our Firm’s President and Chief Operating Officer, and the Chairman of Baron Funds, explores a number of other reasons we choose to invest in businesses in her Letter from Linda that follows.

20th Annual Baron Investment Conference. Metropolitan Opera House. New York City. November 4, 2011.

The idea behind our annual investment conferences is to give Baron Funds’ shareholders and our Firm’s private clients an opportunity to meet the managements of several businesses in which their hardearned savings have been invested.We ask managements to outline the prospects for their businesses and to “tell their stories,” to tell how they became Ralph Lauren, Chuck Schwab, Leo Melamed, Steve Wynn, Tom Pritzker and so many other individuals we believe are incredibly talented, hardworking, ethical, inspiring but perhaps not as well known. We then give our investors an opportunity to ask those executives unscripted questions…no holds barred…in front of literally thousands of their fellow shareholders and dozens of press reporters and other media. We also give you an opportunity to hear from several Baron Funds’ executives and portfolio managers, including me, and question us in the same way…unscripted and no holds barred.

Baron Investment Conferences are intended to allow you to judge for yourselves the talent and directness of individual executives of our portfolio companies as well as of Baron analysts, portfolio managers and executives. We hope this glimpse into “our world” will help you judge whether we remain true to our objective of “investing in people, not just buildings.” Our plan is to allow you to “kick the tires” of your investments in Baron Funds every year to determine whether our funds remain an attractive and suitable investment for you and your family. In essence, this is what we do every day on your behalf with our investment research as well as in the management of our business as we seek to recruit, train and retain the most talented, hard working and ethical managers, analysts and executives to oversee and manage your savings. In our efforts to provide even more transparency into our process than our shareholder letters and media interviews provide, for one day each year our conferences give you an opportunity “to walk in our shoes…to see what we see…and hear what we hear.”

Our first conference in 1992 in New York City’s Harmonie Club had 78 attendees. They were mostly family and close friends whom I had asked to “do me a favor” to fill the room so I “wouldn’t be embarrassed.” Our event has moved several times since to accommodate increased Baron Funds’ shareholder interest. This year we will again host our event at Lincoln Center’s Metropolitan Opera House. We again expect more than 4,000 attendees to include individual shareholders from across America. Attendees represent a cross section of doctors, lawyers, engineers, teachers, doormen and waiters as well as financial advisors, consultants, family offices, plan sponsors and other institutional investors.

We long ago replaced Beatlemania at breaks and lunch with surprise lunchtime entertainment like Diana Ross, John Mellencamp, Sheryl Crow, Faith Hill, Lionel Ritchie, Belushi and Ackroyd’s Blues Brothers, Jessica Simpson, Bernadette Peters and The Jersey Boys. We’ve also added surprise entertainment later in the day that has included Jon Bon Jovi, Jerry Seinfeld, Rod Stewart, Bette Midler, Sir Elton John, Billy Crystal, Stevie Wonder, Cher, Paul Simon, Neil Diamond and Billy Joel. This is to thank you for your interest and for taking time from your busy schedules to spend the day with us. This year we are also making an effort to let you spend a little more time with our analysts, managers and executives.

What hasn’t changed? The annual Baron Investment Conference continues to be at our expense not yours. We’ve also continued to do our best to find executives to speak with you whom we think provide interesting case studies of so many who run the companies in which Baron Funds has invested.We hope you’ll be able to attend our annual meeting this Fall.We’re all looking forward to seeing you November 4.

Thank you for investing in Baron Funds.

Thank you for joining us as fellow shareholders in Baron Funds. We believe the growth prospects for the well managed, competitively advantaged and appropriately financed businesses in which Baron Funds has invested are favorable. Volatile markets in recent months have created uncertainty among investors causing many to be afraid to invest. These developments have made stocks, in our judgment, quite cheap which should offer investment opportunity and limit investment risk. We are continuing to work hard to justify your confidence and trust in our stewardship of your family’s hard-earned savings.

Thank you again for your long term support.

We are especially thankful for the confidence you have expressed in us in such unusual times.

Respectfully,

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Ronald Baron

CEO and Chief Investment Officer

August 24, 2011

P.S. Linda Martinson, Baron Funds Chairman, has written about the “competitive advantage” of many Baron Funds’ investments in her “Letter from Linda” that follows. We believe sustainable competitive advantage is one of the most important characteristics of businesses in which Baron Funds has invested that has allowed our Funds to outperform over the long term. We hope you will find this discussion interesting.