Baron Growth Fund Commentary on SUG, CYH, DMND, CHH, ZIP, MMS
During the June quarter, Baron Growth Fund’s 0.52% gain was slightly better than that of the benchmark index against which we compare this Fund’s performance. That index, the Russell 2000 Growth, fell 0.59% in the quarter. The S&P 500 Index, which measures the performance of 500 larger companies that comprise about 75% of total United States’ equity value, gained 0.10% in the period.
The businesses in which Baron Growth Fund has invested have grown faster than those in its benchmark index during the past five years. Regardless, the Fund’s performance has slightly underperformed its benchmark’s results for the past five years. However, over the long term and since the Fund’s inception its performance has been significantly better than both its benchmark and the broad market. We have met our goal of exceeding our benchmark’s performance by 300-500 basis points per year on average over the long term. This means, in investment parlance, Baron Growth Fund has provided “alpha” of more than 700 basis points per year excess returns compared to our benchmark over the period. The Fund’s long-term investments in well managed, appropriately financed, competitively advantaged, fast growing small growth companies have also produced those returns with less volatility than the market. Again, using professional investor parlance, it has done so with less risk, i.e. less “beta,” on average with 0.67 percent of the market’s volatility. This is past performance and there can be no assurance that the Fund will continue to achieve its goal.
Linda Martinson, Baron Funds' Chairman, wrote in her December quarterly "Letter from Linda" about how closely correlated the performance of individual stocks' performance has been during the past five years. This is regardless of their fundamentals, i.e., earnings, cash flow, balance sheets, managements and growth prospects. We think this may be partly due to increased popularity of ETFs, which has caused valuations to become homogenized. Businesses have also become more similarly valued because investors are afraid that businesses’ growth prospects have become less certain. JP Morgan’s chief strategist recently remarked that “active managers” have added little value during the past five years since stock prices have become so correlated.
We believe the businesses in which we have invested have more favorable prospects than most businesses. Since they are now valued similarly to average businesses, the prospects for Baron Growth Fund’s investments seem to us unusually favorable. This is because if our businesses are valued similarly to average businesses and ours grow faster, are better managed, have stronger balance sheets and have important competitive advantages, their stocks should again outperform. If the more conservatively capitalized, less leveraged, smaller, consistently growing businesses in whose stocks Baron Growth Fund has invested continue to outperform reflecting their businesses’ favorable prospects, we think they will likely again be accorded premium valuations. Thus, we have two chances to outperform...faster growth, higher multiple. We’ll see. Of course, there can be no assurance that we will be successful. Since Baron Growth Fund’s inception, although it has significantly outperformed its benchmark index over the long term, about 38% of the time, the benchmark index has outperformed the Fund during certain three month periods.
During the past few months, investors have once again become focused on risk. This followed earthquakes, a tsunami and nuclear plant tragedies in Japan that have not only caused human suffering but disrupted economic growth in Japan and in America. Also helping create an unsettled financial environment were the violent Arab Spring in the Middle East, where other nations obtained a large portion of their carbon energy; highly publicized financial crises in Europe; and the failure of politicians to reach an agreement to reduce entitlement spending and raise America’s debt ceiling for the 76th time since 1960! As a result of economic uncertainty caused by these disruptive developments, less leveraged, less volatile and more consistently growing businesses have again begun to outperform, while cyclical and leveraged businesses, in general, are not performing as well. Baron Growth Fund had what we believe was a moderate 16.60% of its portfolio on average invested in businesses that use leverage greater than three times EBITDA. It also had 27.61% of its portfolio on average invested in businesses that are more than 1.2 times as volatile as the market.
Although we compare Baron Growth Fund’s performance to the Russell 2000 Growth Index, we pick stocks, we invest in growth businesses for the long term, and we do not try to mimic that index with the composition of our portfolio.There will be times when highly leveraged businesses, technology stocks, or other businesses in which we have modest investments may comprise significant weightings in that or other indexes. If these groups outperform during those periods, it will obviously be difficult for our Fund to outperform its benchmark index during the three months when that is the case. In the second quarter, as is normally the case for us since we are stockpickers, not index investors, the average weightings of Baron Growth Fund’s investments were far different than those in the Russell 2000 Growth Index. We consider Baron Growth Fund appropriately diversified with 105 investments allocated principally among seven GICS categories: Energy (11.6%), Information Technology (14.1%), Consumer Staples (5.3%), Industrials (11.6%), Financials (11.2%), Health Care (13.8%) and Consumer Discretionary (22.3%). During the quarter, the Fund had about twice the percentage of its assets allocated to principally domestic energy businesses as the benchmark Russell 2000 Growth Index.
The 11.6% of the Fund’s portfolio representing Energy businesses performed significantly better than the 5.6% of the Index allocated to Energy investments. Our Energy stocks gained 7.01% during the period compared to a loss of 8.82% for the Index’ Energy investments. Energy stocks in the benchmark were negatively impacted in the period by falling energy prices. Natural gas pipeline Southern Union (SUG) increased 55.82% during the period when it became the subject of a takeover offer bidding war. Southern Union had been investing in a natural gas pipeline from Texas to the Florida Panhandle for the past two years.That pipeline had recently been completed on time and on budget. With appropriate financing in place, the pipeline about to become operational and its capacity largely sold out, this investment will soon contribute to Southern Union’s earnings.
We think the story behind Baron Growth Fund’s long term investment in Southern Union is illustrative of many of our other successful fund investments. We had invested in Metromobile, a cellular telephone company founded by its entrepreneurial Chairman, George Lindemann, in the late 1980s and early 1990s. Metromobile had been the parent of Southern Union. Before Metromobile was acquired by Bell Atlantic in 1992, George spun out Southern Union to Metromobile’s shareholders. George and his family were the largest investors in Metromobile and, as a result, became the largest investors in Southern Union. At the time, we believed the opportunity for domestic, inexpensive, less polluting and plentiful natural gas to replace oil as fuel in America was substantial. We also believed George could successfully operate and grow a highly regulated business. After researching Southern Union, Baron Growth Fund began to purchase its shares in 1995. Between 1995 and 1999, we bought 1.6 million shares of Southern Union’s stock between $5 and $15 per share. When the market crashed in the Fall of 2008, Southern Union’s shares fell sharply from mid $20s per share. We purchased an additional 2.0 million shares at an average price of $14.74. During this quarter, following the completion of its Florida Panhandle interstate pipeline, Southern Union received a takeover offer from Energy Transfer Equity, L.P. (ETE) at $33 per share. This offer was soon topped by an offer from Williams Energy at $39 per share. This was followed by a $40 bid by Energy Transfer, followed by a $44 bid from Williams, followed by a $44.25 bid, part cash, part stock by Energy Transfer. Energy Transfer Equity, L.P. is a business founded by Kelcy Warren, a self-made, highlyregarded executive. Kelcy’s wealth is virtually entirely in his investment in Energy Transfer. The acquisition of Southern Union by Energy Transfer, in our opinion, will enhance the value of his business, making the stock portion of that takeover offer tax advantaged and ultimately more valuable than cash. Although we typically like to bet on executives like Kelcy and George for the long term, in this case, Baron Growth Fund sold its shares in Southern Union for an average price of $41.57 per share. This is since Baron Growth Fund is a small cap growth fund and only purchases stocks when their market capitalizations are below $2.5 billion. When businesses' market capitalizations exceed $10 billion, they are reduced and the proceeds recycled into businesses with market capitalizations below $2.5 billion. The market capitalization of Energy Transfer Equity, L.P. following its acquisition of Southern Union will exceed $14 billion.
Although the stock market has changed little in price during the past 12 years, Baron Growth Fund obviously has achieved good returns in this investment. More takeover offers for our businesses seem likely, in our opinion. This is since we believe stock prices are significantly undervaluing businesses. Among other long-term investments that were either subject to takeover offers this year or in which interest has been publicly expressed by acquirers are Ralcorp (RAH), J. Crew (JCG) and GenProbe (GPRO).
The Fund’s 13.8% portfolio allocation to Health Care investments underperformed the benchmark’s 19.6% Health Care allocation. The Fund’s Health Care investments fell 2.19% in the period. This compared to a 3.52% gain for the allocation to Health Care stocks in the benchmark index. The Fund’s disappointing Health Care performance was the result of its investment in regional hospital provider Community Health Systems (CYH). Community’s shares fell 35.8% in the period. This decline followed Community’s effort to acquire Tenet Healthcare, a larger but, in our opinion, not especially well run business. This underperforming business offered Community opportunity to improve Tenet’s results significantly. Tenet’s defense against the unwanted takeover when management would obviously lose their jobs was to accuse Community of irregular billing for emergency room services. Community Healthcare stock fell sharply when government regulators began an investigation of those practices. Community is now selling for about five times its current cash flow and for a significant discount to its more than $700,000 replacement cost per hospital bed. We have known Community’s management for many years and have confidence in their integrity. We continue to believe that Community’s operating margins can improve significantly, as it continues to add doctors to its hospitals and achieve purchase synergies for the hospitals it has acquired.We also assume that regulators will conclude their investigation of this business over some reasonable time period, and the company may then be subjected to some sanction or fine, and Community’s stock will at that time again reflect its asset value, earnings and growth prospects.
Other index weightings did not have an unusual impact on our results in the period.
The second calendar quarter was characterized by several important “macro” trends. Health Care already represents 17% of our country’s economy. This compares to other developed nations whose health care costs approximate 10-11%. The Obamacare universal health care mandate will probably increase our nation’s health care expenses to nearly 20% of GDP. As a result, businesses like AMERIGROUP (AGP) that provide managed care with better outcomes at lower cost outperformed in this period. Health Care businesses that are reimbursed or paid for their services by government often underperformed, since, although businesses are performing well, federal and state governments must reduce expenses. The same goes for industrial businesses which rely upon governments to fund infrastructure projects. Consumer Discretionary businesses underperformed in the period due to concern among investors that our economic recovery is slowing.
Diamond Foods, Inc. (DMND), a manufacturer and distributor of snack products, experienced a 37.0% increase in its share price.This followed its announced acquisition of Pringles from Procter & Gamble. We believe Diamond is likely to increase Pringles distribution; could likely add exciting new products; and has important cost synergies with its existing snack businesses. New information was recently released that disclosed improved fundamentals and growing profitability at the acquired company. Additionally, legacy brands have been performing well, and the company's planned 50% expansion of its Kettle product manufacturing capacity should permit, in our view, accelerated growth in the eastern U.S. over the next few years. As the depth of products grows, we expect Diamond Foods will gain additional distribution points and improved terms from retailers. (Michael Baron).
Shares of Ralcorp Holdings, a manufacturer of private-label foods and branded cereal products, gained 25.2% for the period held after reporting that its cereal business had strong top-line growth and its branded food business drove increases in profitability.There has been speculation that the company could be a target of a takeover by a competitor or a private-equity firm. After an unsolicited $82 per share takeover bid by ConAgra was rejected, we sold our shares at an average price of $88 per share in the quarter.We began to purchase shares in Ralcorp in 2001 at $16 per share. (Michael Baron)
Shares of Choice Hotels International, Inc. (CHH), the largest franchisor of moderately priced hotels in the United States, declined 13.7% in the period. This was due to continued lackluster unit growth of its U.S. franchise system.With credit markets for new construction still tight, Choice used a portion of its excess cash to provide "seed" money to franchisees to incentivize unit growth of an interesting new hotel concept. Choice is well positioned to add more hotel conversions, leaving chains that are seeking to move their systems upscale and improve their service consistency. We believe that projected low unit additions to U.S. hotels for the next several years as a result of greater project equity required by banks bode well for Choice. Choice has significant opportunities for expansion in Europe and Asia as well as in America. Its reservation system is also producing demand for rooms not available in its system that could be monetized. Although investors apparently would have preferred that the company return excess cash to shareholders, when the economy rebounds and financing markets improve, we expect Choice to generate significant, growing and valuable recurring revenue. (David Baron)
Anhanguera Educacional Participacoes SA is the leading post-secondary education company in Brazil, operating both campus-based and distance-learning programs. Shares of Anhanguera retreated during the quarter as fears relating to the potential impact of rising wage and rent inflation weighed on performance. We are not particularly concerned about this short-term issue, as we believe the Company can manage costs and tuition pricing to reach its intermediate and long-term profitability goals. We remain attracted to the Brazilian private education sector, which is the primary means by which workers can become qualified for substantially higher value-added careers. (Michael Kass).
We initiated a position in CFR Pharmaceuticals, a leading Latin American pharmaceutical company, which held its initial public offering in May. The company’s origins date back to 1922 when the founder, Nicolas Weinstein Rudoy, emigrated from the Galicia region of Poland and opened a drug store in Santiago, Chile. The current CEO, Alejandro Weinstein Manieu, is the grandson of the founder.The Weinstein family continues to own 76% of the company. Emerging markets are expected to represent a significant source of growth for the pharmaceutical industry driven by rising GDP, an aging population, improved life expectancy, and the growth of the middle-class.We think CFR is well positioned to grow based on the company’s leading position in its markets; large specialized salesforce; relationships with regulators, physicians and customers; established manufacturing infrastructure; and reputation for producing high quality products. We also think the company will utilize the proceeds from the IPO to make value-creating acquisitions in select emerging markets. (Neal Kaufman)
Zipcar, Inc. (ZIP) operates the world’s leading car sharing network with over 600,000 members and 8,000 vehicles. The company came public in April after a successful IPO “roadshow.” Founded in 2000, Zipcar offers “cars as a service,” providing members a convenient and cost-effective alternative to car ownership. Members enjoy the flexibility of renting a specific car for a specific period of time, as brief as one hour, without the accompanying carrying costs, including insurance, parking, fuel and maintenance, which are all included. The reservation process employs user-friendly technology and is more convenient than traditional car-rental services, as vehicles are clustered in metro locations, offering greater access and choice for urban dwellers. Zipcar operates in 14 U.S. cities and more than 200 college campuses. We believe they possess compelling expansion opportunities to additional U.S. markets as well as internationally, specifically Western Europe, where the potential for vehicle sharing is large.We believe that the company’s young, web-savvy member base is also a sought-after demographic, where ancillary revenue opportunities such as advertising and mobile couponing remain untapped. (Matt Weiss)
Maximus, Inc. (MMS) is a leading provider of government health and human services program management and consulting. We expect Maximus to generate significant earnings growth over the next several years with the growing privatization of government services. In the U.S., Maximus is the largest provider of outsourced Medicaid enrollment, touching more than 50% of program participants. Maximus will be a direct beneficiary of Medicaid expansion required under health care reform, which should double the number of Americans in the program by 2019. In the interim, states are aggressively turning to managed care to lower costs. Around 27% of Maximus’ revenues are international, where Maximus provides welfare to work services, another area, we believe, with strong growth potential. Maximus boasts more than 20% return on invested capital, $10 per share in cash, no debt, and a fiscal 2011 expected cash flow of $75 — $95 million, which supports an active share repurchase program. 97% of fiscal 2011 revenue was in backlog as of start of the fiscal year. The company’s pipeline of business is a robust $1.6 billion. (Susan Robbins)