Dear Baron Real Estate Fund shareholder:
The generally unimpeded six-year broad-based appreciation in the stock market, most real estate securities, and the Baron Real Estate Fund (the “Fund”) hit a speed bump in the third quarter. The onslaught of negative news items contributed to disappointing performance for most stocks. Concerns included uncertainty over China’s economic growth prospects and its effect on emerging markets, the surprise devaluation of the yuan, persistently weak oil and commodity prices, uncertainty over the timing of the first Federal Reserve rate hike, and stretched valuations for certain segments of the market.
The S&P 500 Index declined 6.44% from June 30, 2015 through September 30, 2015, its worst quarterly performance in four years, since the third quarter of 2011 when the S&P 500 declined 13.87%. The Baron Real Estate Fund was not immune to the overall market correction, and we are disappointed in the third quarter performance (see performance table below). As we finalize this third quarter letter, the Fund is off to a strong start in the fourth quarter, and has increased by 7.68% (Institutional Shares) from September 30, 2015 through October 23, 2015.
In our shareholder letters, we strive to bring you under the tent so that you are fully informed of our current views. We have devoted considerable time reflecting on the first nine months of 2015, our observations regarding the stock market, and the various segments of the real estate market.
In this letter, we will address various items that may be “top of mind,” including our perspective on the outlook for the stock market, the Fund, commercial real estate, the housing market, interest rates, and valuations. We will also opine on a number of real estate categories and companies that comprise the Fund, including REITs, hotels and cruise lines, homebuilders and land developers, building product/services companies, real estate services companies, senior housing operators, tower operators, casinos and gaming operators, and real estate operating companies.
Q. What is your outlook for the overall market, real estate, and the Fund?
A. Although we recognize that in the months ahead, there may be periods of market weakness, we continue to maintain our view that the prospects for the stock market, real estate, and the Fund are promising. We believe various factors should contribute to attractive returns in the future. We encourage you to read the “Portfolio Structure” section presented later in this letter. We also urge you to review our perspective on the outlook for the broader market, real estate, and several other “top of mind” topics that can be found in the “Outlook” section at the end of this letter.
During the most recent quarter, the following holdings were the top contributors to performance:
Equinix, Inc., an owner and operator of data centers, remains a top holding of the Fund. The company continues to report strong business results amid diminishing competition, and improving demand for its hard-to-replicate data center assets. It recently announced an agreement to acquire Telecity, a European data center company, for $3.6 billion. We are optimistic about this transaction because we think it should result in increased revenue opportunities, cost savings, tax advantages, geographic diversification, and new data capacity. In our opinion, the company should continue to generate strong cash flow growth and the shares remain attractively valued.
Strategic Hotels & Resorts, Inc., a hotel REIT, owns one of the highest quality luxury hotel portfolios in the U.S. In the most recent quarter, Strategic Hotels announced that it has entered into a definitive agreement to be acquired by Blackstone Real Estate.
A few of what we consider to be the Fund’s “best-in-class” REITs continued to report strong business results and held up well despite the recent market turmoil. They include AvalonBay Communities, Inc., that owns and operates what we believe is one of the newest and highest quality apartment portfolios in the U.S., and Simon Property Group, Inc., the world’s largest and best managed retail mall and outlets operator.
Home Depot, Inc. also held up well in the most recent quarter as the company continued to report strong business results and encouraging business prospects.
In the most recent quarter, the shares of CaesarStone Sdot-Yam Ltd., the leading global manufacturer of high quality engineered quartz surfaces used primarily as countertops in residential kitchens, declined significantly from a peak of approximately $70 per share to $30. During this period, the Fund sold a portion of its holdings at an average price of $57 per share and subsequently reacquired shares at $33 per share, a price that we believe represents considerable value. We remain bullish about the prospects for the shares and the company.
In our opinion, the shares of CaesarStone were impacted by three key factors:
First, its second quarter U.S. sales growth of 20%, while strong, did fall short of expectations of 30%. This occurred following the company’s recent increase of its manufacturing capacity to meet the surging demand for its quartz products. This lower growth quarter was likely due to factors that included customer budgeting shortfalls, delays in distributor orders, customer bottlenecks, and some moderation in single-family home construction. Importantly, we believe that despite its more moderate 20% growth, demand for quartz and CaesarStone products specifically will remain strong. Furthermore, management believes that growth in the U.S. in the second half of 2015 may be greater than 20%.
Second, a small hedge fund issued a negative report on the company. In our opinion, the allegations cited in the report (that include claims of cost inflation, misrepresentations regarding quartz content, market share losses, and financial reporting inaccuracies) are irresponsible, inaccurate, and misleading. The management of CaesarStone published a response that refutes all claims in the hedge fund report and is considering legal action against the hedge fund.
Third, in the most recent quarter, two Board members resigned. We have discussed this with management and are comfortable that the reasons for the two resignations did not include concerns about corporate governance, the management team, or strategy. Further, the company also issued a press release that states that the two resignations did not reflect differences of opinion as it relates to the company’s business, accounting or public disclosures, or any concerns about alleged wrongdoing.
What is our current view of CaesarStone? We remain optimistic about the company’s long-term prospects. CaesarStone’s quartz products continue to take market share from other materials such as granite, marble, and laminate because it offers superior scratch, stain, and heat resistance as well as a wider array of design options. Quartz penetration in the U.S. is estimated at only 8% versus a much deeper penetration rate in the company’s other geographic markets (Israel 86%, Australia nearly 40%, Canada 18%). Our sense is that quartz penetration will continue to accelerate, and its modest 8% U.S. penetration underscores the potential opportunity for CaesarStone to grow sales over time. The company has zero debt. We believe CaesarStone continues to be a high-growth way to participate in the residential construction, repair and remodeling market.
We believe CaesarStone’s shares are attractively valued at only 12.2 times our 2016 estimate of $2.78 earnings per share. At only 14 times our 2017 earnings per share estimate of $3.36 (20% earnings growth), the shares would reach $47 per share in the next 12 to 18 months versus a current price of $34 per share or 40% upside.
Following a 35% increase in 2014, the shares of Brookdale Senior Living, Inc., the largest and most comprehensive owner-operator of senior housing in the U.S., declined significantly due to lowered earnings guidance (for two straight quarters), its slower-than-expected merger integration with Emeritus Corp., management leadership changes, and a pickup in senior housing construction activity. Following the second quarter, the Fund has been steadily decreasing its investment in Brookdale and currently
maintains only a modest position in the company. We do, however, view the recent price decline as overdone and believe the shares have now become attractively valued. We remain optimistic about Brookdale’s long-term prospects, and we will continue to monitor its business and performance.
In the third quarter, the shares of Diamond Resorts International, Inc., a global leader in the hospitality and vacation ownership industry, declined due to some concerns regarding the potential for increased competition from Airbnb and regulatory changes that could negatively impact the timeshare industry’s consumer lending practices. However, we recently met with management and believe these issues are overstated and should not result in a material financial impact.
We remain optimistic about the prospects for Diamond Resorts due to its strong growth potential, solid balance sheet (its low net debt level approximates estimated cash flow), extremely favorable valuation (less than 4.5 times 2016 estimated cash flow!), and its strong estimated free cash flow generation of approximately $250 million (15% free cash flow yield) that could be used for acquisitions, dividends, stock buybacks, or debt repayment. Finally, in our opinion, management’s interests are aligned with ours due to their significant ownership stake in the company.
The shares of Hilton Worldwide Holdings, Inc., the largest hotel company in the world, declined in the third quarter alongside most hotel stocks. Factors that weighed on hotel shares include concerns about a global economic slowdown, fears about competition and pricing pressure from Airbnb, and weaker-than-expected financial results and forecasts from several other companies (although not from Hilton). We recently met with Hilton management, and we continue to believe the company’s long-term prospects remain attractive.
Hilton has been generating industry leading growth and gains in market share. In addition to its solid business results, we believe there are several catalysts that could propel the shares higher, including a possible REIT conversion of its company-owned real estate, the spin-out of its timeshare business, the initiation of a dividend policy and stock buyback plan, Hilton’s inclusion in the S&P 500 Index, and an upgrade of its debt rating to investment grade. We are confident that management is focused on methods and initiatives to unlock shareholder value.
At its current share price of $23, Hilton is priced at what we believe is a compelling value of less than 10 times 2016 estimated cash flow. It has been our experience that buying high-quality hotel companies such as Hilton at less than 10 times cash flow has been prudent, and it usually results in strong returns, although there is no guarantee that this will be the case. We have continued to buy stock at recent prices and remain optimistic about the company’s long-term prospects.
Portfolio Structure
Q: What are your current thoughts regarding the various real estate categories that comprise the Fund?
A: In addition to our investments in REITs, we differentiate the Fund by investing in nine additional non-REIT real estate categories, as listed below. We believe that our broader approach to investing in real estate should produce better results over the long term.
At September 30, the Fund maintained 43 positions. Our 10 largest holdings comprised 35.2% of the Fund, with an average position size of 3.5%, and our 20 largest holdings accounted for 60.2% of the Fund, with an average position size of 3.0%.
Following the third quarter decline in the broad market and most real estate-related companies, we generally believe that real estate valuations have now become more attractive and business prospects remain solid. Our thoughts on The Baron Real Estate Fund’s 10 real estate category allocations are as follows:
Hotels & Leisure (22.7%) (Includes Hotels (9.0%), Timeshare/Leisure (7.1%) and Cruise Lines (6.6%)):
Hotels (9.0%): In the first nine months of 2015, shares of most hotel companies declined due to concerns over the possibility of increased inventory and pricing pressure from new competitors such as Airbnb, fears of a global economic slowdown, difficult year-over-year growth comparisons, concerns that the lodging cycle might be nearing an end, and weaker than expected financial results and business forecasts by several companies.
While we continue to closely monitor industry conditions, we maintain that the prospects for our investments in hotels are attractive amid expectations of solid demand, generally low supply forecasts, company-specific initiatives that may unlock shareholder value, the growing likelihood of mergers & acquisition activity (Strategic Hotels & Resorts, Inc., one of the Fund’s top holdings, recently agreed to be sold to Blackstone Real Estate), and attractive valuations that, in our opinion, reflect low investor expectations and more than anticipate many of the aforementioned possible challenges.
Timeshare/Leisure (7.1%): We also remain optimistic about our timeshare investments, Wyndham Worldwide Corp. and Diamond Resorts International, Inc. Following strong share price performance the last few years, the stocks of both companies have declined in 2015 due to concerns regarding the potential for increased competition (Airbnb) and regulatory changes that could negatively impact the timeshare industry’s consumer lending practices. We recently discussed these issues with both management teams and believe the worries are overstated and should not result in any material financial impact for the foreseeable future. We remain optimistic about the prospects for both companies due to solid growth potential, quality balance sheets, extremely favorable valuations, and strong estimated free cash flow generation that could be used for acquisitions, dividends, stock buybacks, or debt repayment. Finally, we believe the interests of both management teams are aligned with ours due to their significant ownership stake in their companies.
Cruise Lines (6.6%): We are optimistic about the prospects for the Fund’s investments in our cruise line companies (“hotels on water”), Norwegian Cruise Line Holdings, Ltd. and Royal Caribbean Cruises Ltd. We believe cruise line prospects are strong due to (i) a favorable industry structure whereby the three largest companies comprise 80% of the industry, and are rationally addressing new ship additions and customer pricing (fewer last minute discounts), (ii) high barriers to entry and limited competition due to the high cost to build a new passenger ship (approximately $800 million to $1 billion), (iii) lower oil prices (a key cost component) are providing a tailwind for earnings, (iv) excess Caribbean ship capacity is being redeployed to China, a new source of future demand, (v) strong growth prospects, and (vi) favorable valuations (approximately 15 times earnings amidst 25% earnings growth).
REITs (20.7%):
Business conditions are generally strong for our REIT companies, and they may continue to benefit from low interest rates, occupancy growth and increased rents at a time of limited new construction activity, improved balanced sheets that can support corporate growth, continued access to unprecedented low cost capital, and accretive investment opportunities. We are mindful, however, that although some REIT valuations are “fair” in our opinion, many of the Fund’s non-REIT real estate-related companies’ valuations are generally more compelling. Also, REITs may be more vulnerable to an eventual rise in interest rates than non-REITs.
Building Products/Services Companies (17.2%):
We have continued to invest in several residential-related real estate companies that we believe will benefit from a multi-year recovery in housing. Within the residential real estate-related category, we favor building products/services companies such as Home Depot, Inc., Lowe’s Companies, Inc., Mohawk Industries, Inc., Masonite International Corp., Builders FirstSource, Inc., and CaesarStone Sdot-Yam Ltd. because they typically benefit from an increase in new and existing home sales and the acceleration in spending for home repair and remodeling.
Real Estate Service Companies (10.5%):
We are optimistic about the prospects for our commercial real estate service companies, such as CBRE Group, Inc., Jones Lang LaSalle, Inc. and Kennedy-Wilson Holdings, Inc. We believe each company’s business prospects, balance sheets, and growth prospects are strong and valuations are attractive.
Real Estate Operating Companies (7.9%):
We recently attended an annual investor meeting with the management of Brookfield Asset Management, Inc. We are big fans of CEO, Bruce Flatt, and his management team, and continue to believe the company has several opportunities to drive growth in the years ahead. We are also optimistic about the prospects for Forest City Enterprises, Inc., a diversified real estate operating company that is planning to convert to a REIT in the months ahead and should continue to execute on its plan to increase cash flow, repay debt, sell non-core assets, and improve shareholder value.
Homebuilders & Land Developers (4.6%):
We remain optimistic about the multi-year outlook for housing as we believe the pieces are falling in place for a moderately growing housing market. Although we favor specific homebuilders, such as Toll Brothers, Inc., and land developers like Howard Hughes Corp., we generally prefer to gain exposure to the housing market by investing in the residential building products/services category because these companies benefit not only from an improvement in home sales but also from consumer spending on home repair and remodeling.
Casinos & Gaming Operators (3.7%):
We remain bullish on the prospects for MGM Resorts International because Las Vegas business trends are encouraging, the company is focused on improving profitability (its “$300 million profit plan”), of possible strategic initiatives to unlock shareholder value (a potential U.S. REIT and/or asset sales), and its favorable valuation. We are researching possible investments in additional casino & gaming companies.
Tower Operators (3.6%) (5.7% including tower REIT, American Tower Corp.):
We remain optimistic about the prospects for our tower investments such as American Tower Corp. and SBA Communications Corp. These companies combine the stability of traditional real estate (five to ten year lease agreements that generate stable and growing cash flow) with the secular industry tailwind of increasing demand for wireless data-intensive devices such as iPhones, iPads, and other wireless devices. Barriers to entry remain high due to zoning restrictions that limit competing tower development.
Senior Housing Operators (3.4%):
Since the inception of the Fund at the end of 2009, our investments in senior housing operators have been major positive contributors to performance. Favorable demographic trends, an improving housing market, industry consolidation (two of the Fund’s senior housing companies were acquired in the last five years), cash flow growth, and an improvement in valuation contributed to the appreciation in the shares of our senior housing investments. In 2015, however, we have become more cautious about the prospects for senior housing and decreased the Fund’s investment in this real estate category from 12.3% at the end of 2014 to only 3.4% of the Fund’s net assets by the end of the third quarter of 2015. Brookdale Senior Living, Inc. is in the midst of its challenging merger integration with Emeritus Corp. and is also facing an increase in senior housing construction activity. In the near term, we are more optimistic about the prospects for Capital Senior Living Corp., which we believe is facing fewer challenges than Brookdale.
Other (2.7%):
More than five years ago, we first began acquiring shares in Brookfield Infrastructure Partners L.P., an owner and operator of a globally diversified portfolio of high quality infrastructure assets. We remain optimistic about the prospects for Brookfield because we believe the shares are attractively valued and the company has several new and exciting growth opportunities.
As noted earlier in this letter, we are generally optimistic about the prospects for cruise line companies. Our favorable view is supported by several factors including: a favorable industry structure whereby the three largest cruise lines control approximately 80% of the industry, manageable new ship additions, rational pricing strategies, high barriers to entry, lower oil prices, emerging growth opportunities in China and Cuba, and favorable valuations.
Recently, we added to our cruise line portfolio (we have owned Norwegian Cruise Line Holdings since its January 2013 IPO) with the purchase of shares of Royal Caribbean Cruises Ltd. The company operates 44 ships with an additional eight under construction, and serves 480 destinations on all seven continents. Management is targeting to double its earnings per share from $3.39 in 2014 to $7.00 in 2017 through moderate capacity growth, cost containment, and improvements in occupancy and rates. We believe the company could exceed those goals and generate $7.50 in 2017, representing an average annual growth rate of 30% between 2014 and 2017.
In our view, the shares are attractively valued at approximately 15 times 2016 estimated earnings. At only 16 times our estimated 2017 earnings per share of $7.50 (25-30% 2017 estimated earnings growth), the shares would reach $120 per share in the next 12 to 18 months versus a current price of $92 per share or 30% upside.
Summit Materials, Inc. is a heavy construction materials company with good exposure to infrastructure, residential and commercial construction. The firm operates in materials (aggregates and cements), products (asphalt and ready-mixed concrete) as well as services (paving operations). We recently met with management and believe that business prospects, both organic and potential future acquisitions, are strong. We estimate that the company may generate approximately $275 million of cash flow in 2015 and that cash flow may grow by more than 50% in the next two years to $435 million in 2017. At 9 to 10 times 2017 estimated cash flow, the shares would appreciate approximately 20 - 40% in the next 12 to 18 months. We are bullish.
In the last few months, we took advantage of the market weakness to acquire additional shares of some of our high conviction companies. We added to our position in Hilton Worldwide Holdings, Inc., the largest hotel company in the world, at what we believe is an attractive valuation of less than 10 times estimated cash flow. We believe the company’s owned hotels would be valued in the private market at 13 to 14 times cash flow.
We also acquired additional shares of MGM Resorts International at less than $20 per share, a 33% discount to our estimate of the company’s $30 per share intrinsic value. We also acquired additional shares in KennedyWilson Holdings, Inc., a global owner and manager of a high quality real estate portfolio, at prices that are at a significant discount to our assessment of the company’s private market value and at similar prices to where management was recently buying shares.
Outlook
We continue to believe that the prospects for the equity market and the Baron Real Estate Fund remain attractive.
Q. Why do we remain optimistic about the prospects for the equity market?
A. Although equity markets may remain choppy in the months ahead primarily due to increased uncertainty regarding economic growth prospects and Federal Reserve policy, we continue to believe that the precursors for a sustained market correction are not evident. We remain bullish.
The foundation for our constructive view is based on the following considerations:
1. The U.S. economy appears to be “not too hot, not too cold”. We believe that economic growth is expanding moderately, without signs that a recession is on the horizon. This economic environment should, in our view, be a positive backdrop for stocks.
2. Interest rates are likely to remain low. In our opinion, concerns about interest rates becoming a major headwind to equities and real estate are unwarranted. Moderate U.S. economic growth and uncertainties abroad do not portend a rapid increase in interest rates. Once the Fed increases interest rates, we anticipate a slow and gradual pace of tightening, and believe that equities can perform well should that occur.
3. Inflation concerns seem well off in the horizon. With no signs of a significant acceleration in wage and consumer price inflation, the Fed and the bond market are unlikely to be concerned. Further, lower gasoline and import prices should be a boon to U.S. consumers. We believe non-inflation growth should also bode well for equity returns.
4. Investor sentiment is poor. Investor sentiment appears to have swung from overly optimistic at the beginning of 2015 to overly pessimistic today. In the cycle of stock market emotions, we believe that the best time to buy stocks to help generate maximum returns occurs when sentiment is poor, although we cannot guarantee this will be the case.
5. Valuations are reasonable (and, in some cases, cheap). In the third quarter, numerous stocks were sold indiscriminately without regard to value, largely because external influences such as fears about China’s economy and a possible Fed interest rate hike weighed heavily on the market. In our opinion, equity valuations are now generally fair (the S&P 500 P/E is approximately 15 times forward earnings) and remain attractive versus bonds (especially factoring in longer-term inflation expectations of at least 2.0%). We believe the valuations of numerous real estate companies, such as hotels, timeshare, and real estate services, as well as certain residential real estate-related companies, are cheap relative to their historical valuations and future growth prospects.
6. Additional reasons to be optimistic. The U.S. banking system has improved dramatically and is now maintaining strong capital ratios. With large U.S. cash positions, corporate balance sheets are well positioned for merger & acquisition activity, capital expenditures, employment growth, stock buybacks, and dividend increases. There is a large pool of private equity investment capital poised for deployment. Jobs are being added. Household formation has been accelerating, and the outlook for housing is brighter.
With all of these factors in place, we believe the equity market will continue to successfully climb a “wall of worry” and generate positive returns.
Q. What may be some of the equity market challenges in the next several months?
A. While we are optimistic about the prospects for equities, we are mindful of the challenges that may arise such as (i) China’s slowing economy and the possible spillover effects, (ii) a change in Fed policy and a corresponding increase in interest rates, and (iii) stock valuations. At this stage, we are not overly concerned about these items.
China’s slowing economy and the possible spillover effects:
This summer, concerns regarding a rapid decline in China’s economic growth appear to have been the initial catalyst for a correction in the global markets. We believe that the U.S. economy will avoid a contagion from China and will continue to expand. Why? According to a report published by Goldman Sachs, only 2% of the S&P 500 Index’s revenues are generated from China. Further, less than 1% of U.S. exports are shipped to China.
The Fed and interest rates:
With respect to the Fed, in our opinion, too much attention has been focused on the timing of the first hike in the Federal Funds rate. In our view, the initial Fed tightening will have more of a psychological impact rather than much of an economic one because minimal fractional changes in short-term interest rates will still yield historically low borrowing costs.
However, if the market does correct following the initial Fed interest rate hike, we suspect that may present a buying opportunity. Since 1954, there have been eight periods when the Fed increased interest rates. In no instance did the U.S. market peak coincide with the first Fed rate hike. In fact, on average, the S&P 500 Index increased by approximately 10% in the 12 months following the first Fed tightening. The big picture: Historically, an improving U.S. economy, despite being accompanied by rising 10-year U.S. Treasury yields, has been positive for the equity markets.
What appears to be lost in the message about the timing of the first interest rate hike is that the Fed has indicated that it is going to limit these hikes to a minimum. The Fed tightening will likely be gradual and slow rather than aggressive given the still slow pace of inflation, moderate economic growth, and the sluggishness in the labor force. We believe that U.S. interest rates will continue to be a long-lasting underpinning for real estate-related stocks and the broader U.S. stock market.
Lastly, although interest rates may head higher next year, reflecting an improvement in the economy, macro forces may put a “cap” on Treasury yields. These include the modest pace of the U.S. economic recovery, the Fed’s intention to maintain low interest rates, and lingering structural economic issues in Europe, China, and Japan.
Below, we detail our thoughts on how real estate stocks and the Fund may perform if interest rates rise.
Stock valuations:
In our opinion, the valuation of the stock market is not expensive, but generally “fair.” Why? According to data provided by Standard & Poor’s and Omega Advisors, Inc.:
- The forward P/E multiple of the S&P 500 Index is 15 times versus its historical multiple of 17.4 times average forward P/E multiple at bull market peaks since 1960.
- We believe that measures of equity market valuation should be compared to alternative rates of return in bonds. Accordingly, since 1960, the 10-year Treasury at bull market peaks has ranged from 4.1% to 12.7% and averaged 6.7%. Yet currently, the 10-year Treasury yield is 2.03%! In the context of these historically low interest rates, we do not believe that the S&P 500 P/E multiple is extreme.
Q. Why do we remain optimistic about the prospects for the Baron Real Estate Fund?
A. In our opinion, the prospects for real estate-related securities and the Fund remain attractive.
First, the ingredient package that has fueled the recovery in real estate the last five years remains in place. We believe business conditions for commercial and residential real estate are generally appealing. In most geographic markets, demand continues to outstrip supply which bodes well for business fundamentals. Credit has improved, balance sheets are in solid shape, interest rates are low and we anticipate they will remain low, and valuations are reasonable. We believe these factors bode well for real estate securities.
