U.S. stocks had an excellent 2013
Results for U.S. stock markets were exceptionally strong during 2013. Stock markets continued their more than four year advance from the financial panic lows reached in March 2009. The backdrop for this advance was an improving economy, less than median stock prices based on historic valuations and, inexpensive credit increasingly available through a healed banking system. We believe U.S. stock markets were helped meaningfully by the U.S. Federal Reserve Bank's LSAP, large scale asset purchase program, more commonly called "quantitative easing." The stated purpose of the bank's strategy is to encourage businesses to invest to grow and create jobs. By keeping interest rates low and creating inflation, the Fed's LSAP is also intended to help our businesses and citizens continue to deleverage. During 2013, stocks advanced on average about 30% from the prior year. Stocks of smaller and mid cap companies often increased in price more than 40%! Further, U.S. stocks' closing prices at year end 2013 exceeded peak prices they achieved in October 2007 by about 35%, as measured by the S&P 500.
Baron mutual funds also achieved strong results during 2013. On December 31, Baron Funds' share prices were about 30-55% above their prior peak prices achieved in fall 2007. Please see individual Baron mutual fund letters for precise performance results. During 2013, the largest and oldest Baron mutual funds achieved results that approximated or slightly trailed their small cap and mid cap benchmarks. Baron Asset Fund ($2.8 billion) gained 38.88%; Baron Growth Fund ($8.3 billion) gained 38.32%; Baron Small Cap Fund ($5.8 billion) gained 37.77%; Baron Opportunity ($495 million) gained 37.55%; and Baron Partners Fund ($1.5 billion) gained 47.63%. These results were achieved with long-term investment allocations to sectors that were significantly different than their benchmarks. Our investment results were achieved with underallocation to the best performing sector, Health Care, which had the best performing, but volatile, subsector, biotechnology. Biotech stocks last year often achieved gains of 50-100%! We had de minimis investments in biotech businesses because, to date, we have found the success of biotech businesses too difficult to forecast.
Baron Funds is continuing to invest for the long term in well managed, competitively advantaged, consistently growing businesses. We also think it is notable that the best performing stocks last year were often smaller fast growing businesses with modest or volatile earnings. This is in stark contrast to the businesses in which Baron Funds has invested the vast majority of assets entrusted to us. The businesses in which we have invested in general had substantial earnings and annual standard deviations of those earnings that were on average half that of our benchmarks.
Young Baron mutual funds outperform
We were especially pleased with the results of our newer mutual funds in 2013. We believe the performance of these funds shows that our research intense, investment strategy of "investing in people" and "investing for the long term" is applicable to more than small and mid-cap growth companies. Baron Real Estate Fund ($1 billion) was the number one performing real estate fund for the last two calendar years.* In 2013, it increased in value 27.12%. The appropriate benchmark real estate index gained 17.44% while the MSCI U.S. REIT Index was up 1.3%. The Baron Emerging Markets Fund ($376 million) is now three years old. It too has been a top decile performer since its inception.** During 2013, Baron Emerging Markets Fund gained 14.71%. This compared to a 0.10% gain for its benchmark index.We were also pleased with the results of Baron Fifth Avenue Growth Fund ($93 million). We had not been successful outperforming this Fund's benchmark index consistently since its formation in 2004 until we hired Alex Umansky as its portfolio manager in the fourth quarter of 2011. We had been attempting to recruit him for almost two years before that. Although we believed we were "recruiting" him, Alex told our annual conference attendees in 2012 that he felt like "Linda and Ron were stalking me" for two years. Regardless, in the two full years that Alex has managed this large cap growth fund, he has beaten its benchmark by more than 400 basis points per year, no mean feat. In 2013, Baron Fifth Avenue Growth Fund gained 35.44%, the S&P 500 by 32.39%. In its second year of operation, Baron Energy and Resources Fund ($33 million), run by Jamie Stone, our Energy analyst with 20 years analytic experience in financial markets and oilfields around the world, gained 25.32%. This compares to a gain of 16.49% for its benchmark. In the third quarter of 2013, we also launched Baron Discovery Fund ($11 million). This Fund is managed by two very talented, ten-year veteran Baron Funds' analysts, Laird Bieger and Randy Gwirtzman. Baron Discovery Fund invests principally in smaller businesses not yet mature enough for either Baron Growth Fund or Baron Small Cap Fund. Baron Discovery Fund is off to a good start. It increased in value 16.70% per share in the fourth quarter, significantly outpacing its small cap benchmark which gained 8.17% in the period.
Outlook.
U.S. economic growth is accelerating.
U.S. home prices increased throughout the year and gained 14% from year ago levels in December! Homes for sale declined and homes under construction increased. Domestic energy supplies have increased significantly due to shale exploitation, while energy consumption per unit of GDP growth is falling. We also think it is positive that the federal government's deficit has fallen from $1.4 trillion four years ago to $680 billion, 4.1% of GDP, in 2013, and is projected by some to fall to $600 billion, 3.3% of GDP, in 2014 and $475 billion, 2.7% of GDP, in 2015. The Federal Reserve announced its intention to reduce its monthly bond purchases. This has caused consternation among some investors. We believe the Fed is able to "taper" its bond purchases because our economy is finally beginning to grow more rapidly. We think this is a positive development.
A shortage of stocks?
16 years ago there were more than 8,800 publicly owned stocks in the United States. In 2012, as a result of mergers and acquisitions and less hospitable equity markets, there were only about 4,100. Remarkably, the Wilshire 5000 Index now consists of only 3,678 stocks.We think fewer stocks to buy, after $550 billion left equity mutual funds from 2008-2012 in order to invest $1 trillion in bonds, is not a formula for lower stock prices. Especially with an improving economy and less than median stock price valuations. That is exactly what happened in 2013 when stock mutual fund flows increased significantly and the stock market increased even more. We think our strength is in finding and investing in great growth companies, not in forecasting stock markets.
Don't tell Ford Mustang owners there is no inflation.
The foundation for economic growth in the United States and around the globe strengthened as central banks in other countries, most notably Japan, have followed the lead of United States' Federal Reserve. As result of "money printing" and low interest rates, deleveraging of global economies continues and currencies continue to depreciate. Interest rates that remain below the rate of inflation make debt less burdensome to service and allow "deleveraging." This means that outstanding debt, while continuing to increase in absolute terms, is growing relatively more slowly than our economy and becoming a smaller percentage of U.S. GDP.
We think the annual rate of inflation is already far higher than our government's estimate of 2%. Governments here and elsewhere are incentivized to understate inflation. If inflation were higher, it would mean higher cost of living adjustments to government workers' wages. It would also cause interest rates to increase more rapidly and make outstanding indebtedness more expensive to service. We think inflation is closer to 4% than 2% as has been the case since President Kennedy was elected in 1960. U.S. GDP in 1960 was $523 billion. It reached an estimated $16.9 trillion in 2013. That is about 7.6% higher than $15.7 trillion in 2012! The difference between the 2-2.5% growth we all read about and the 7.6% actually achieved we think of as inflation...which for the past 54 years, has been about 4% per year.
A recent story in the Sunday New York Times "Automobiles" section features a headline story about the "new" Ford Mustang, which we believe is relevant to the inflation topic. The two door, Mustang sports car was first introduced on March 13, 1964 during my junior year in college. Unlike many other things, its looks have changed little since. The Mustang was an enormous success, selling 686,000 cars in its first year! Its price in 1964 was $2,368. The Mustang's current price, 50 years after its "IPO," is nearly $18,000. The CAGR for $2,368 to reach $18,000 over 50 years is 4.14% per year. That is almost exactly the 4% number that we have been considering as the rate of inflation per year for both the past 50 years and the past 100 years. It is the "plug" number between 2-2.5% annual "real" growth of our country's GDP and its nominal annual growth during the past century of 6.8% per year. Try it yourself with nearly anything else...except the cost of computers and communications which continue to inexorably decline. Stock prices have closely tracked GDP growth for the past 54 years and for the past century as well. Stock prices have averaged 6.6% annual compounded growth per year during that period. They have also provided dividends of approximately 3% per year. We believe investments in growing businesses through ownership of their publicly traded stocks provides protection over the long term against depreciation of currencies.
Stocks are at median values for the past century, they should be higher
Interest rates and nominal inflation are important determinants of stock multiples. At current interest rate levels and reported inflation rates, stock multiples should mathematically be meaningfully above the 15.4 times median valuations of U.S. markets for the past one hundred years. Multiples now approximate median valuations. The price to earnings multiple has generally ranged from 10-20. It would not be surprising to us to see the multiple on 2014 earnings increase above the median valuation for the past century. Coupled with expected U.S. GDP growth, that could produce an increase in stock prices of 15-20% during 2014.
Businesses are beginning to increase their investment programs...a positive
Higher taxes, which no one obviously wants to pay; unusually low interest rates; and depreciation of our currency encourage businesses to invest in job creating enterprises not just repurchase stock, increase dividends and cut costs. It also makes good business sense due to high taxes to invest pretax dollars to penalize current earnings to build a larger business in the future...and create good paying jobs in the process.
Cities that invest in themselves are just like businesses that invest in themselves. The greater the investment when short-term paybacks are not the purpose, the greater the likelihood others will find that business or city with improved infrastructure an attractive entity in which to invest. When Michael Bloomberg became Mayor of New York 12 years ago, one of first questions he asked was what could bring his city to its knees? He was told his city could not survive in the very short term without an assured supply of potable water. The Mayor quickly determined that New York City's water supply with its century old aqueducts in disrepair made his city unacceptably vulnerable. Although there was no short-term political gain to be obtained from a long-term and expensive investment in aqueducts, Mayor Bloomberg made significant investments to repair those century old aqueducts. Just like his administration caused so many investments in education, cr ime prev ention and health that.
have made New York City an attractive place for businesses to operate, tourists to visit and most of its citizens to live.
Opportunities abound
There are so many opportunities. When I was young in the 1950s, our nation built its interstate highway system. Beneficiaries were not only obvious ones like transportation and cement manufacturers, but fast food restaurants like McDonald's, destination resorts like Disney World and motels like Holiday Inns. Just like the effort to land a man on the moon in the 1960s resulted in opportunities for technology, communications and the Internet. Similarly with health care today. Health care service providers that have a demonstrable value proposition that can enable health care providers to offer better outcomes at lower costs will be beneficiaries of significant increases in government spending for health care resulting from the "Affordable Healthcare Act." We think there remain tremendous growth opportunities for providers of technology and users of the Internet. Energy is another obvious source of ideas in which to invest for growth. An extraordinary opportunity now exists to exploit enormous shale energy reserves and to develop infrastructure to transport and refine these resources. Baron Funds is researching and investing in businesses that we think have the opportunity to become much larger enterprises. We are finding exceptional opportunities in health care services; technology; and energy among other industries.
The indexes are unmanaged. The MSCI US REIT Index is a free float-adjusted market capitalization index that measures the performance of all equity REITs in the US equity market, except for specialty equity REITs that do not generate a majority of their revenue and income from real estate rental an d leasing operations. Baron Real Estate Fund's benchmark is the MSCI USA IMI Extended Real Estate Index Net which is a custom index calculated by MSCI for, and as requested by, BAMCO, Inc. The index includes real estate and real estate-related GICS classification securities. MSCI makes no express or implied warranties or representations an d shall have no liability whatsoever with respect to any MSCI data contained herein. The MSCI data may not be further redistributed or used as a basis for other indices or any se curities or financial products. This report is not approved, reviewed or produced by MSCI. Baron Fifth Avenue Growth Fund's benchmark is the S&P 500 Index which measures the performance of 500 widely held large-cap U.S. companies. Baron Emerging Markets Fund's benchmark is the MSCI EM (Emerging Markets) IMI Growth Index Net USD which is a free float-adjusted market capitalization indexes designed to measure equity market performance of large-, mid- and small-cap securities in the emerging markets and which screens for growth-style securities. Baron Energy and Resources Fund's benchmark is the Standard & Poor's (S&P) North American Natural Resources Sector Index which is a modified capitalization-weighted equity index of U.S.- traded natural resources-related stocks, including mining, energy, paper and forest products, and plantation owning companies. Baron Discovery Fund's, benchmark is the Russell 2000® Growth Index which measures the performance of small-sized U.S. companies that are classified as growth. The indexes and the Funds include reinvestment of interest, capital gains and dividends, which positively impact the performance results.
