Barons Partner Fund Commentary on FAST, CYH, CXO, SCHW, AL, NLSN, KKR
Baron Partners Fund had 15.3% of its total investments in businesses that were greater than 3 times leveraged debt to EBITDA, our definition of a leveraged business. The Fund held 84.7% of its total investments in more conservatively capitalized businesses. During the period, 33.9% of total investments were in stocks having a beta greater than 1.2, i.e., they were 1.2 times as volatile as the market. Our less volatile stocks represented 66.1% of total investments.We believe our higher quality, appropriately financed businesses are well positioned to outperform over the coming years. Of course, there can be no assurance that will be the case.
Linda Martinson, Baron Funds Chairman, has written about and shown you charts demonstrating how closely the performance of individual stocks have been correlated during the past five years, regardless of individual businesses' disparate fundamentals. We think this is due to increased popularity of ETFs, which has homogenized valuations, and investor concerns that have made investors value companies similarly during this period. Since we believe that the businesses in which we have invested have more favorable prospects than most and are now valued similarly to average businesses, we believe that the prospects for Baron Partners Fund's investments are unusually favorable.This is because if they are valued like other companies and our businesses grow faster, their share prices should outperform. If our businesses continue to outperform, we think it is likely they will be accorded premium valuations.We'll see. Of course, there can be no assurance that this will happen.
Shares of the leading industrial supplies distributor, Fastenal Co. (FAST), rose as demand from manufacturing and commercial construction clients improved. Sales across the company's 2,500 branches have accelerated in 2011, culminating in a 23% increase during April and May. This strength is indicative of a growing rebound in factory production as well as stronger pricing and market-share gains for this exceptional service provider from out of the downturn. Although the recovery appears fragile, manufacturers are beginning to cautiously ramp up production, add back shifts and rehire furloughed workers. Fastenal has been converting this renewed demand into faster profit growth, the result of strong leverage on occupancy and overhead. (Matt Weiss).
Windy City Investments Holdings LLC (Nuveen Investments) is a privately held investment management firm. Its valuation rose 29.2% in the quarter. Assets under management have increased to $206 billion as a result of strong performance at subsidiary managers Windslow and Tradewinds.While Windslow's products are relatively low fee, Windslow produces high margins due to a limited investment staff. Windy City's municipal-bond business has also improved recently.We believe stability in the muni products should allow an IPO to occur in approximately a year if current conditions remain intact. (Michael Baron).
Shares of Intuitive Surgical, Inc. outperformed in the June quarter. Intuitive Surgical manufactures and markets the da Vinci robotic surgical system. Procedure growth exceeded Wall Street's expectations, driven by strong growth of emerging procedures such as thoracic, otolaryngological and colorectal. Systems sales also exceeded Wall Street's expectations. We continue to have strong conviction in the investment thesis. (Neal Kaufman).
Shares of hospital operator Community Health Systems, Inc. (CYH) fell 35.8% in the quarter. Community withdrew its bid to acquire Tenet Healthcare.We thought Tenet would have been an attractive acquisition for Community due to our view that it has significant operational and purchasing synergies. We believe Community is the better run business. However, during Community's efforts to acquire Tenet, the target company aggressively defended itself against an unwanted takeover which, if it took place, would have meant Tenet's management would have lost their jobs. Tenet claimed Community engaged in improper emergency room billing and admit practices. These allegations resulted in a government investigation that resulted in Community's stock falling sharply. We think Community is significantly undervalued relative to the replacement costs of its 19,000 hospital beds and current $1.9 billion annual cash flow. We have known Community's management a long time and are confident in their integrity. As a result, we think if this investigation determines there have been improper billing practices in certain of their hospitals, we think they will be considered inadvertent, their business will be fined and it will again become prosperous and fast growing. We also believe Community provides an important service to the nonurban communities that it serves. (Susan Robbins)
Concho Resources, Inc. (CXO) is an independent energy exploration & production company that is primarily focused on operations in the Permian Basin in West Texas and Southeast New Mexico. The company has continued to be one of the fastest-growing producers among its peers, and we expect it to continue to be a leader given the depth and quality of its inventory. Concho shares suffered during the quarter from the sharp decline in oil prices and an apparent rotation out of energy shares by investors following a prolonged period of sector outperformance. We continue to hold Concho shares and believe the company's valuation does not adequately reflect its strong development prospects and current net asset value. (Jamie Stone).
Shares of broker Charles Schwab Corp. (SCHW) fell 8.5%. Schwab underperformed as online trading activity declined and it became increasingly unlikely that the Fed would raise interest rates soon, which has negative implications for Schwab's currently depressed interest income.We believe interest income eventually will increase and, more importantly, that Schwab's solid business model and strategy will enable it to gain share in the brokerage space, both for retail and institutional clients. (Rob Susman)
Air Lease Corp. (AL) purchases commercial aircraft to lease to airlines around the world. Steve Udvar-Hazy (CEO), previously headed International Lease Finance Corp., the largest aircraft lessor in the world. He co-founded the aircraft leasing business in 1973. AL is a growth company, with an initial order book to acquire $6.8 billion worth of aircraft over the next seven years. Recently at the Paris Air Show, AL announced future commitments worth an estimated $5 billion. Management estimates its fleet will grow from 49 aircraft currently to 100 by year end and to 300 by 2015. It will then possess one of the largest, most modern, fuel efficient fleets in the world. Demand for air travel has consistently grown in terms of number of aircraft and passenger traffic over the last 40 years. And now, airlines are leasing more aircraft; 35% of commercial jets in service trending to 50% over the next 5-10 years. Importantly, with proceeds from its IPO and a private placement, AL does not see an immediate need to tap equity markets to finance its growth. (David Goldsmith)
The Fund added to its investment in Nielsen Holdings NV (NLSN) during the second quarter. Nielsen supplies its customers with critical information and analytics about "what consumers watch" and "what consumers buy." Nielsen's "Watch" business is the de facto standard for measuring television audiences in the US.The company is leveraging its expertise to generate ratings for online and mobile campaigns. Nielsen's "Buy" business builds a real-time global database of retail transactional measurement data. Nielsen is actively expanding its coverage into developing markets to provide its clients with insight into a vast population of emerging middle class consumers.
The company's proprietary data, unique analytical capabilities, and pristine brand serve as extremely high barriers to entry. Nielsen data is deeply integrated into its clients' businesses, providing Nielsen with high retention rates and pricing power. The company generates strong operating leverage given the high fixed costs involved in collecting and processing billions of transactions monthly. Finally, Nielsen generates robust free cash flow given the modest capital investments required to run its business. (Neal Rosenberg)
Kohlberg, Kravis and Roberts & Co. L.P. (KKR) is an alternative asset manager with over $60 billion in assets under management. Over the past few years, a host of alternative asset managers have sought the public markets as a way to monetize a portion of the founders' stakes, transition ownership and responsibilities to the next generation of executives and institutionalize a business that had previously been viewed as not multigenerational. However, it has been a tumultuous few years for the majority of alternative asset managers since these initial public offerings. Private equity firms in particular were hard hit as the economy cratered and their business plans were left vulnerable with an absence of liquid credit markets.We believe, however, that KKR is well positioned emerging from the financial crisis to take share from industry competitors and successfully monetize prior investments.
Undoubtedly, KKR has seen significant prior investment success. Surprisingly, the company has maintained a very limited group of core investors. That client base is now growing as KKR is more aggressively marketing not only the firm's strong investment performance, but also its global infrastructure that can source and secure deals without the assistance of banks or other private equity firms. Over the past few years, the number of marketing professionals at KKR has grown many multiples.We anticipate the assets under management to grow significantly as more institutions seek the higher average rate of returns offered by private equity to compensate for the lackluster performance achieved recently in other financial markets. These clients prefer to form deeper relationships with top tier private equity firms like KKR rather than spreading their investments amongst many smaller players. And while KKR is relatively a large firm in the industry, it still only controls approximately 5% of the overall private equity market. Additionally, we believe KKR will be successful in broadening its alternative investment skill set to include public equity and fixed income products that should substantially raise the company's assets under management.
KKR has approximately $9 in book value per share.We believe that the $550 million in anticipated 2011 management fees should carry a 35% operating margin. We value this steady earnings stream similarly to other traditional asset managers and believe it is worth approximately $3.50 to the equity holders. However, we feel that the upside in the stock will be achieved from the company's lucrative carried interest, 60% of which is paid to shareholders. Under the current $60 billion in assets under management, we believe the after tax economic net income could be close to $1 per share. Applying a 15x multiple to these earnings would result in a significantly undervalued stock at today's price. (Michael Baron)
Baron Partners Fund top 10 holdings represented 67.5% of the Fund's net assets on June 30, 2011. This compares to approximately 27% of assets in the top 10 of our diversified funds. This strategy involves greater company specific risk than a diversified strategy.We expect, as a result, to achieve higher returns than the benchmark index over the long term. From the Fund's inception more than 19 years ago, as well as during the past 15 years, 10 years and since its conversion to an open ended mutual fund more than eight years ago, as you can see from Table I, that has been the case. We obviously cannot guarantee that will continue to be so.
Baron Partners Fund invests in businesses regardless of their market capitalizations. The median market capitalization of stocks held at June 30, 2011 was $5.46 billion.Although we obviously do not manage the Fund to achieve this result, the median market capitalization for the Russell MidCap Growth index was $4.93 billion! The weighted market capitalization for the Fund on June 30, 2011 was $7.39 billion compared to $8.40 billion for the benchmark.Approximately 29.4% of Baron Partners Fund's total investments at June 30 were invested in large cap companies; 58.6% were invested in mid-cap companies; and 9.6% were invested in small cap businesses.
The Fund may use what we consider moderate portfolio leverage from time to time. It is especially likely to do so at points in time when we believe prospects for businesses are quite favorable and stock prices of those businesses do not reflect those prospects. As of June 30, 2011, Baron Partners Fund had 125.3% of its net assets invested in securities. This is at the high end of the range of leverage we can employ.
Thank you for investing in Baron Partners Fund.
Thank you for joining us as fellow shareholders in Baron Partners Fund.We believe the growth prospects for the businesses in which Baron Partners Fund has invested are favorable and improving. Since, in our opinion, the share prices of our businesses do not reflect their prospects, we believe their stock prospects remain favorable. Of course, there can be no guarantees this will be the case.
We are continuing to work hard to justify your confidence and trust in our stewardship of your family’s hard-earned savings.We also remain dedicated to continuing to provide you with the information I would like to have about your investments in Baron Partners Fund if our roles were reversed.This is so you will be able to make an informed decision about whether this Fund remains an appropriate investment for you and your family. Thank you again for your long-term support.