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Ron Baron's Second Quarter Letter

August 23, 2012 | About:
Holly LaFon

Holly LaFon

277 followers
Nearly four years ago, in the days immediately following investment bank Lehman Brothers' demise, stock markets around the world fell sharply. Bank lending was "frozen" and commerce had visibly slowed. We made an even greater effort than usual to speak to and visit executives of businesses in which Baron mutual funds had invested. Nearly all told us they were planning large employee layoffs and significant reductions in capital spending. Late Thursday afternoon, September 18, 2008, three days after the Lehman bankruptcy, Treasury Secretary Hank Paulson and Fed Chairman Ben Bernanke convened a "closed door" meeting with a group of U.S. Senators and Representatives. The group met in the office of then House Speaker Nancy Pelosi. The assembled Congressmen included leaders from both parties. Senator Evan Bayh was a member of that group.

Last spring, I attended the Milken Global Conference in California. Senator Bayh described there what happened in the 2008 Paulson-Bernanke meeting that he characterized as "terrifying." Senator Bayh was attempting to provide context to Milken conference attendees to help them understand the rationale for the Dodd-Frank financial regulations.

As Senator Bayh recounted, after the Congressional leaders had been seated in Speaker Pelosi's office, Secretary Paulson called the meeting to order. The Secretary then asked everyone in the room to please listen closely to what Chairman Bernanke had to say. He turned to Bernanke and quietly said, "Ben, please tell the Congressmen what has happened."

The normally understated Bernanke spoke softly. "I have studied the Great Depression and its causes for my entire adult life. That Depression may have started because of a stock market crash. What hit the general economy, however, was the disruption of credit it caused. Average citizens were unable to borrow money to do anything. To buy a home, to start a business, to stock the shelves of their stores. Credit has the ability to build a modern economy. Lack of credit has the ability to destroy it. Swiftly and absolutely. If we do not act boldly, and immediately, we will replay the Depression of the 1930s, only this time it will be much worse. Within 24-48 hours, we will have a complete meltdown of our financial system. Our most important financial institutions will collapse. Thousands of businesses will go bankrupt. Millions of people will lose their jobs. If we don't act now, we won't have an economy on Monday."

Chairman Bernanke then paused. The Senators and Representatives sat in stunned silence. They had never heard such a grim assessment of our nation's financial prospects. After a few more minutes, the Congressmen began to ask,"What do we need to do? We sure can't allow that to happen." Senator Bayh then described to the Milken conference how TARP was created to purchase illiquid debt from financial institutions so banks would again be able to make loans. The intent of Congress was to "unclog" credit pipes by providing banks with liquidity.

"Do you have any idea about the sentiment of our constituents for this bank 'bailout?'" Senator Bayh asked. "It was 15,000 to one AGAINST!" he said, answering his own question. "Sure glad I sent in my 'yes' opinion," someone in the audience remarked, trying to be funny. The Senator noted that the group in Speaker Pelosi's office displayed rare political courage. They agreed to work together and do what was necessary to resolve that crisis…regardless of party affiliations and partisan dogma, and regardless of how unpopular TARP was with their constituents. However, when the crisis ended, they all agreed, they would create legislation they believed would prevent its recurrence. Hence, Dodd Frank.

The above story is relevant today since conditions prevailing in southern European "periphery" nations have parallels to what happened in America four years ago.

European banks now own investments in illiquid sovereign debt that are material relative to their book equities.Those sovereign investments have fallen in value "marked to market." The decline in value of sovereign debt has impaired periphery banks' abilities to make loans without requiring assistance by governments to recapitalize their balance sheets. This is analogous to circumstances in America in 2008. Our banks then held substantial investments in sub-prime mortgages that had fallen significantly in value and were material relative to banks' equity. That impaired their ability to make commercial loans without our government's assistance.

The flawed construct of the euro, a single currency without a single government, does not permit European governments to have independent fiscal and monetary policies. This means they are unable to stimulate their economies and "print money" to recapitalize their banks. In fact, during this crisis, periphery nations have cut their budgets and raised taxes attempting to reduce indebtedness as a condition for aid from Germany and others. However, as a result, the economies of those nations have gotten worse and interest rates have increased significantly. Unemployment in the southern European nations has soared to 20-25% of their workforces! This is just as Bernanke prophesized would happen in the United States if our Congress and Federal Reserve had not acted in September 2008.

Contrary to what has taken place in the southern European "periphery," governments around the world able to conduct unconstrained monetary and fiscal policies are presently able to borrow for almost no cost! Fiscal stimulus from budget deficits and monetary stimulus from "printing money" have created an environment that has enabled United States' banks to be recapitalized and businesses and consumers to continue to deleverage while countering deflationary pressures.

We believe that virtually all governments ultimately either default and restructure their sovereign debts or devalue their currencies.We think that will ultimately take place in the European periphery. "In the end they print money." Most "investors" remain concerned about the euro, European economies, the looming "fiscal cliff" in our economy (less spending, higher taxes), a slower than usual economic recovery in our nation due to deleveraging that will likely take several more years to complete, Syria, Iran,"earnings" in the current quarter and the impact on food prices of the drought in our Midwest. As a consequence, they continue to withdraw money from equity mutual funds and sell stocks.

"I don't own any stocks. I only own gold and short term Treasury securities. Read my book!" That was what a former OMB Budget Director told me at a recent dinner party.

Regardless of that individual's strongly felt opinions, we think stocks are attractive because they are historically cheap; their underlying businesses have strong balance sheets; and, we believe, the growth of their businesses should exceed the continued devaluation of the dollar due to inflation. With highly liquid balance sheets, readily available credit and credit costs the lowest in the history of the United States, businesses can avail themselves of many growth opportunities. One of the clearest is that America, with its vast reserves of shale oil and gas, has become the world's lowest cost energy producer. We can become the world's largest energy producer if we have the political will to do so. There are many other growth opportunities for businesses as well that come from solutions to problems that have not been addressed for many years. Of course, the reasons stocks are so cheap are because there are well advertised political and economic uncertainties. Watch CNBC's Squawk Box any morning or read any newspaper to see what I mean. Investors, as a result, are spending their time trying to assess likely outcomes of what is unpredictable so they can avoid losing money rather than doing research on businesses so they can make money!

We think long-term investments in stocks will continue to offset rising costs for tuition, cars, clothes, food, gasoline, wages, rents, maintenance and, yes, even houses. This is as they have for the past 30 years since the founding of our business in 1982; for the 54 years since the Eisenhower recession in 1958; and, in fact, for the 195 years since the founding of the New York Stock and Bond Exchange in 1817, which made it convenient to invest in stocks in this country. We think inflation during coming decades is unlikely to be less than in recent and long past decades.

We think of "money" as a medium of exchange. It enables commerce. It is not a store of value. Stocks have increased in value 12 fold in the past 30 years since the founding of Baron Capital in 1982, 8.6% per year. They have increased 31 times since the Eisenhower recession in 1958, 6.6% per year.We think stocks will likely increase significantly during the next 30 years as well. 10 times in 30 years represents a little more than three doubles, about 7.9% per year, in line with historic norms. Dividends, at present about 2% per year, would add to those returns.

"Bet on billionaires." Will Danoff. Portfolio Manager. Fidelity Contra Fund. 2012.

Will is a friend. In addition to being a great portfolio manager and securities analyst, in my opinion, he is a perceptive, smart, very nice, optimistic guy.Will likes to "bet on billionaires." He believes that, in addition to a certain amount of good luck and an immeasurable amount of hard work, a talent is necessary for one to build a business that can achieve sustained, unusual financial success. His "bet on billionaires" simply means he wants to invest with successful, entrepreneurial individuals who he thinks will likely figure out how to do it again. It goes unsaid that he tries to invest with people whom he trusts and who he believes will treat him as a partner, not as what Warren Buffett refers to as a "patsy."

Will's "bet on billionaires" remark made me think about our version of that refrain, "We invest in people, not just buildings." People, in our opinion and in the opinions of many other successful business executives, are what distinguish one business from another.

Tom Pritzker is one of those guys in whom we have invested. I have known Tom for more than 37 years! It seems like we met at O'Hare Airport yesterday. Tom is now Chairman of Hyatt Hotels Corp., a business his dad, Jay, founded in its current structure and that we regard as unusually well managed. Baron Funds is a large shareholder in Hyatt Hotels. Tom is an even larger shareholder than we are and has recently bought more. Tom agrees with our philosophy about investing in people. So did his dad.

As an aside, Jay introduced me to Steve Wynn in 1980. This was after I mentioned to him that I had become interested in investing in the casino gaming industry. Jay told me that if I wanted to invest in casinos, I needed to meet Steve and study his business, The Golden Nugget. "He is the most talented executive in that industry. If you want to invest in gaming, you will probably do better investing with him than with anyone else." Jay's advice made our shareholders more than $800 million in profits during the past 10 years.We invested $135 million in Steve's new company,Wynn Resorts, in 2001, which allowed us to make such a large profit during such a difficult period. Our firm had previously invested successfully with Steve for more than 30 years. When I began my career, I obviously learned from Jay that investing really is all about people! Tom and I were recently speaking about investment opportunities. Tom remarked that he "had never seen a business plan that worked as expected." Since times are uncertain, Tom wants people in whom he has invested to be flexible in their management style and outlook and whom he thinks can navigate turbulent times. Tom thinks investing is about a lot more than math. It's about investing in people who against the odds figure out how to build a business…which is not such an easy thing to do.

Tom said, for example, that as a result of the present turmoil in Europe, it may now be possible for Hyatt's executives to obtain additional hotel management agreements on that continent. In normal times, it would not be possible to do that. "The best locations were taken 500 years ago!" he remarked as he described the competitive advantages of such properties. Of course, the best way to obtain operating agreements for exceptional properties is to demonstrate to property ownership that in turbulent times your management company will perform. We believe Hyatt's operating philosophy, culture, reputation, balance sheet and PEOPLE are as outstanding and long-term oriented as the property owners they seek to represent.

Jim Carlson, Chairman and CEO, AMERIGROUP Corp. (AGP), is an especially relevant example of the impact an exceptional manager can have on his or her business. In the first week of July, AMERIGROUP announced it would be acquired by WellPoint, Inc. for $92 per share. At the time of this acquisition, Baron Capital on behalf of our clients owned 3.5 million shares of AMERIGROUP, a Medicaid managed care business. Included in that amount are 2.3 million shares purchased by Baron Growth Fund principally between 2002 and 2003 for an average price of $16.76 per share. The growth opportunity for AMERIGROUP's business was substantial when we invested. However, until Jim Carlson, an experienced health care executive, became its Chairman and CEO five years ago, the company made several missteps.At the time Jim assumed control, we had earned only a modest profit on our Amerigroup investment. During the first year that Jim became the business' senior executive, AMERIGROUP's managed Medicaid business reported annual revenues of $1.3 billion. We estimate AMERIGROUP's revenues will reach $9 billion in 2012.We think its revenues could double again in four or five years.

When I called Jim after the company announced it would be acquired by WellPoint to thank him for making our investors so much money, he thanked me! He told me that it was delightful to have us as shareholders for the past five years. "You can't manage a business to satisfy an investor who wants to 'make a trade,'" he said. "It is unusual in my experience for investors to take an interest in the long-term vision of a management team and the executives themselves, understand the opportunities and competitive advantages of a business and make a long-term commitment to that business and its management.Your support made it easier for us to achieve our goals."We are looking forward to investing in Jim's next venture.

Baron Capital wins Institutional Investor's Third Annual Investment Management Award for Top Mid-Cap Growth Manager during 2011.

Baron Capital Group invests on behalf of its clients in growth businesses across all market capitalizations. About half our firm's assets under management, the largest percentage of assets entrusted to us by our clients, are invested in mid-cap growth companies. Many of these companies were purchased when their market capitalizations were less than $2.5 billion, our definition of a small-cap business. Linda discusses in her "Letter from Linda" that follows mine the Baron Capital investment process that focuses upon investing for the long term in growing businesses.We invest for the long term so that Baron Funds shareholders and Baron Capital Group clients can benefit from the growth of businesses our firm has researched carefully and, hopefully, invested in wisely. Our portfolios "turn over" on average every six or seven years, an eternity for "computer driven model trading," hedge funds and plain old mutual fund traders. It is obvious that our process is different than most. So are our returns, as you can see from Baron Funds' performance illustrated in the line graphs that follow Linda's letter.

According to the Institutional Investor web site, the Institutional Investor 3rd Annual U.S. Investment Management Awards recognize U.S. institutional investors whose "innovative strategies and fiduciary savvy have resulted in impressive returns." These investors "stood out in the eyes of the investor community for their exceptional performance, risk management and services. Baron Capital Management is the Mid-Cap Growth Equity Winner." The award was given based upon many performance metrics. Our firm was chosen based upon responses to "questionnaires sent to over 1,000 endowments, foundations, pension funds, and other institutions." Among the characteristics those polled were asked to judge were process discipline, risk management, distinctiveness of style, reputation of the firm and long term performance.1We are proud to have received this award.

Baron Investment Conference 2012. October 12, 2012. Metropolitan Opera House. New York City.

We hope you will be able to help us celebrate the thirtieth anniversary of Baron Capital Group and the twenty-fifth anniversary of Baron Funds at our 21st annual investment conference on October 12th. Our speakers in the morning as usual are executives of businesses in which our firm has significant investments on behalf of our shareholders. This year's speakers include David Rubenstein, co-founder, co-CEO, The Carlyle Group, a large private equity firm; Steven Spinner, President and CEO, United Natural Foods, Inc., a large distributor of organic and natural foods; Rob Katz, Chairman and CEO,Vail Resorts, Inc., the largest owner and operator of ski resorts in North America; Frank Coyne, Chairman and CEO, Verisk Analytics, Inc., the leading data analytics provider to property and casualty insurers; and Kevin Plank, founder, Chairman and CEO of Under Armour, Inc., a leading provider of branded, high quality apparel, shoes and accessories that help athletes improve their performance.

We think David Rubenstein is an especially timely choice this year. This is since one candidate for President of the United States this fall is the founder of a private equity firm and few Americans appear to know anything about private equity firms. David should be able to explain to us exactly how such a firm operates and what it is that the founder of a private equity firm does.With regard to our other speakers, we hope you will keep in mind when listening to them both the growth opportunities of their businesses and what is unique about those businesses that limits competitive threats. Competitive advantage provides businesses with unusual "pricing power" and enables them to grow faster and remain unusually profitable. When listening to and then questioning our speakers…and portfolio managers, Linda and me after lunch…we expect you to judge all of us as well…no questions are off limits…so that you will be able to determine whether Baron Funds remains a suitable and attractive investment for your families' hard earned savings. Of course, as we always tell our guests, we hope you will regard this day as one to "kick the tires" of your investments in Baron Funds.

Finally. The entertainment. As usual, we think it will be very cool. Also as usual, it will be at our expense, not yours. Also as usual, it will be a surprise. Both at lunch and at the end of the day. No, we can't tell you who it is. Only Linda and I know for sure. Linda because she signs the contracts. Me because I choose it and figure out how to pay for it.

We hope we'll see you October 12. But, for those of you who can't attend this year, in addition to watching by webcast from the Baron Funds website (excluding entertainment), you can get a sense of our meeting by watching CNBC's Squawk Box that morning from 6 AM to 8:30 AM New York time. Becky Quick and I will interview David Rubenstein, co-founder and co- CEO, The Carlyle Group; Tom Pritzker, Chairman, Hyatt Hotels Corp.; Kevin Plank, Chairman and CEO, Under Armour, Inc.; Chuck Schwab, Chairman, The Charles Schwab Corp.; Steve Wynn, Chairman and CEO, Wynn Resorts Ltd.; and George Lindemann, Chairman and CEO, Southern Union Co.. Most of these executives have already made Baron Funds lots of money. We expect David and Tom to make us lots more.

Respectfully,

Ronald Baron

CEO and Chief Investment Officer

Baron Funds

August 3, 2012


Rating: 3.0/5 (13 votes)

Comments

Cornelius Chan
Cornelius Chan - 2 years ago
I want to ask a question about the following paragraph, answers appreciated:

"...we think stocks are attractive because they are historically cheap; their underlying businesses have strong balance sheets; and, we believe, the growth of their businesses should exceed the continued devaluation of the dollar due to inflation."

How can stocks be cheap when the Dow is at 13,000+?

Don't you think it would be wiser to wait for a pullback in the Dow before claiming "stocks are cheap"?

Yes, some stocks are cheap - the beaten down ones due to a flaw here or a flaw there that the market is pricing in. But to say stocks are cheap? Arrogant, fat and lazy IMO.
Adib Motiwala
Adib Motiwala - 2 years ago
I would not call Ron Baron that. He surely knows a thing or two about investing given his long term track record and experience investing for decades. I am not sure he meant the entire market or few stocks.... He is a stock picker and buys for long term. He may be comparing to other asset classes and also historically such that with dividend yields for the entire market > 10 year treasury yields ( does not happen too often).....
Cornelius Chan
Cornelius Chan - 2 years ago
Adib,

Thanks for some insights.

I want to clarify what I mean when I say arrogant fat and lazy. What I am referring to is the practice of money managers who don't wait until a stock is really cheap to say it is cheap, but say it is cheap relative to other things like the return on bonds. So what ends up happening is these guys say a stock at 3X book value is cheap when those of us who like to buy undervalued stocks at low prices call it cheap only approaching 1X book value or some such figure.

Regarding past performance, there is nothing like gurufocus' stats on how money managers did in the '08/09 market to reveal excellence in investing. It is something like five or six (going from memory) money managers who did not lose money during this period and these are the guys on my guru list that I track: including Donald Yacktman, Bruce Berkowitz, David Einhorn, David Tepper and Howard Marks. Chances are if these guys say a stock is cheap, it is really cheap in of itself not relative to bonds or zero percent interest rates.

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