Compared to large-cap stocks, the landscape of small-cap stocks is broader, less well-known, and more volatile. While these aspects of the small-cap space may cause some investors to steer clear, it has its distinct advantages. Historically, small caps have outperformed large caps while providing investors with diversification. We also believe that, given current market conditions, now may be an opportune time in which to invest in small cap stocks. This equity asset class tends to outperform large caps in a rising interest rate environment. In addition, small-caps are typically less exposed to foreign exchange headwinds generated by a strong dollar and a strengthening U.S. economy.
Baron Capital got its start investing in small-cap stocks. We believe that the vastness, diversity, and relative lack of coverage of this equity asset class is tailor made for the acumen and selectivity of a skilled active manager. These factors distinguishing the small cap space create opportunities for active investors who engage in comprehensive, hands-on research to discover stocks that may have been overlooked by other investors.
In-depth research can also help separate the wheat — the higher quality stocks we favor — from the lower quality chaff. Because the latter group may cause much of the volatility in the small cap space, an active portfolio that avoids these companies can be a smart way to help balance risk and reward. In contrast, a passive vehicle does not have the option to exclude underperforming stocks.
Baron Small Cap Fund
Baron Small Cap Fund is an actively managed Fund that seeks to leverage the advantages of the small cap universe while minimizing its potential disadvantages. The Fund was launched in 1997 with Cliff Greenberg as portfolio manager. Cliff is a veteran investor with more than 30 years of experience through multiple market cycles and investment environments.
The Fund differs from classic small cap growth funds in a number of important respects, including its approach to investing and portfolio management, the types of names it favors, the number of stocks it holds, and the length of time it holds them.
We combine fundamental, bottom-up research with a long-term perspective to find companies with significant growth opportunities, sustainable competitive advantages, and visionary management, at an attractive valuation. We prefer companies 1) that are able to show significant organic revenue growth (usually 5–20% per year), which can increase margins so profits are growing faster than revenues; 2) that can supplement this with accretive acquisitions, debt repayment or share repurchases, so that per-share earnings grow even faster; and 3) where trading multiples can (ideally) expand or maintain present levels. We think this approach is key to investing in small cap companies, whose future tends to be less secure than their larger counterparts.
The soundness of our approach is demonstrated by the performance of many of our long-term holdings. We currently hold 17 stocks in the portfolio that have more than tripled since we first invested in them.
The holding periods for these stocks range from 3 to 12 years, and the average annualized return is 32.0%. Together, these holdings comprise about one-third of the portfolio’s assets.
We hold another 16 stocks that have more than doubled in the time we have owned them. Combined, these stocks comprise about a quarter of the portfolio and have produced an average annualized return of 35.1%.
It is stocks like these on which we are focused and in which we are investing.
Our goal for Baron Small Cap Fund is to continue to offer investors a lower risk product with better relative performance. Our past performance, although not a guarantee of future performance, testifies to the soundness of this investment strategy. Based on five-year monthly rolling returns 9/30/1997 to 9/30/2015, the Fund’s performance has been in the top quartile of the Morningstar Small Growth Category average close to half the time, the top half 87% of the time, and never in the bottom quartile. It has also outperformed its peer group, as measured by the Morningstar Small Growth Category average, 97% of the time.
Finding and Watering Winners
As Cliff likes to say, “We water our winners and trim our weeds before the world knows they are weeds.” We use our experience to resist the urge to sell when a stock takes a hit for non-fundamental reasons, such as market or sector volatility. On the other hand, we will not hold a stock indefinitely, but strive to maintain a healthy sell discipline, based on a periodic conviction check to ensure that the growth opportunity, in our view, remains intact (or not).
One of our top ten holdings is aircraft parts manufacturer TransDigm Group, Inc. While TransDigm (TDG, Financial) earns a modest return on original equipment parts, it earns far larger margins on after-market replacement parts for airframes that remain in service for decades. This creates recurring cash flow that it uses for acquisitions and shareholder dividends. When we first bought TransDigm in 2006, it had $411 million in revenues. Today, annual revenues are up to $2.7 billion.
We also own Acuity Brands, Inc. (AYI, Financial), which provides LED lighting systems for commercial real estate facilities. After our initial purchase in 2011, the stock dropped off sharply after an earnings miss. We used the weakness to significantly increase our position. At the time of purchase, Acuity’s revenues were $1.7 billion. Annual revenues have since grown. to $2.7 billion.With its strong brands, extensive network, and expertise in complex lighting schemes, we think Acuity will benefit from the construction trend in energy-smart buildings and the growing number of buildings being retrofit with energy efficient lighting systems.
We invested in Waste Connections, Inc. (WCN, Financial), a solid waste collection and disposal service, in 2009. At the time, revenues were $1.1 billion. Today, revenues have nearly doubled to $2.1 billion. The company enjoys a monopoly in the majority of the regions in which it operates due to high barriers to entry and avoidance of high-competition urban markets, and volumes are increasing through steady organic growth augmented by strategic acquisitions.
We have owned Information Technology (IT, Financial) company Gartner, Inc. (IT) since 2007. The company is the leader in IT research and analysis, with a highly valued brand in the IT community. Since our initial purchase, Gartner’s annual revenues have grown from $1.1 billion to $2.1 billion today. Gartner’s market is vast and its penetration rate is less than 3%. The industry is rapidly evolving and growing in importance, leading users to turn to third-party providers such as Gartner for insights into trends.
We do not typically invest in biotech or drug companies, as the binary nature of these stocks runs counter to the lower risk profile of the Fund. We do like a number of health care companies that are involved in distribution, packaging, and other services, which tend to be lower risk, and less volatile than the development companies.
One such category we like is Contract Research Organizations (CROs), which provide clinical drug development to pharma and biotech companies. We have invested in CROs for some time, and currently own three: ICON plc, INC Research Holdings, Inc., and PRA Health Services, Inc. According to industry experts, about 40% of all clinical compounds are developed by third parties, and this percentage is expected to grow to at least 60%.
Another health care holding, DexCom, Inc., (DXCM, Financial) sells a continuous glucose monitoring system for diabetics. Although this is an unusual investment for the portfolio because of its extended trading multiple, we think DexCom’s fundamentals justify our investment. Over the last three years, DexCom has launched a series of new products driving a dramatic acceleration in revenue growth. We believe the company’s new product pipeline remains robust and will lead to further adoption among the growing population of diabetics.
Top 10 holding IDEXX Laboratories, Inc. (IDXX, Financial) is a leader in veterinary diagnostics. The company is benefiting from secular growth spending on pets, driven by favorable demographics, increased use of diagnostics, and an increasing focus on preventative care. It has had much success placing its proprietary testing instrument in clinics, and has a deep pipeline of tests and products. Its razor/razorblade model results in high retention rates and incremental margins. IDEXX is transitioning to all-direct distribution, which we expect will further enhance margins and future growth.
Consumer Discretionary companies no longer dominate the Fund given the current hyper-competitive retail landscape. However, we still hold a number of stocks in the sector, including Bright Horizons Family Solutions, Inc. (BFAM, Financial), the leader in corporate-sponsored childcare in the U.S. and U.K. The company is benefiting from growing numbers of working women and dual income households. Its business model is characterized by high revenue and earnings visibility, low capital intensity, superior return on investment, and high cash flows. We expect continued strong compound growth, driven by additional childcare centers and back up services, accretive acquisitions in a highly fragmented market, geographic expansion, and cross selling of new, higher margin services.
New Holdings
It has been a challenging market in which to find promising new investments for small cap investors. Companies experiencing robust organic growth are scarce, and those that are growing tend to trade at multiples that are too high for us to be able to justify. That said, we are always looking for new names to add to the portfolio, because, although past performance is not a guarantee of future performance, we firmly believe that, over the long term, we can replicate the success we have had with past and existing investments in companies that have demonstrated dramatic growth and become worth substantially more over time, generating impressive compound returns for our investors.
In mid-2015, we initiated a position in Press Ganey Holdings, Inc. (PGND, Financial), the leading provider of patient satisfaction surveys, management reports, and national comparative databases for health care providers, with more than 65% market share. Press Ganey’s foundation is a vast proprietary data set, which it collects from government-mandated surveys and then analyzes and standardizes to provide clients with findings and actionable recommendations. We think Press Ganey is positioned to benefit from the shift toward a more patient-centric health care marketplace. Its massive database gives it a significant competitive advantage, and it sells its services on a recurring revenues model, with a 97% client retention rate.
Another recent purchase is Houghton Mifflin Harcourt Co. (HMHC, Financial), a leader in K-12 educational content and services. It has globally recognized brands; rich, iconic and proven content; a reputation as an educational innovator; and a deep competitive moat around its franchise. After going through a pre-packaged bankruptcy in 2012, the company has brought in new management to lead the transition to a business model that incorporates digital instructive content. We think Houghton will benefit from a large and growing market, as educational budgets are augmented and the business relationship shifts from a lumpy textbook adoption cycle to a more sustainable digital subscription-based model.
A Note on Recent Performance
Like most actively managed small cap portfolios, the Baron Small Cap Fund did not fare well against its benchmark recently. Our type of fund often doesn’t participate in surging markets because we eschew high multiple, low quality, and “flavor of the day” stocks, which often are the leaders in strong bull markets in the small cap space. In addition, as a function of its long-term approach, the Fund includes some securities that have grown beyond their market cap at the time of our initial investment. As a result, the composition of the Fund can look very different than its benchmark. We seek to manage the portfolio’s average market cap size by harvesting gains in our larger companies to fund our purchases of new small-cap companies. Last year, the average market cap of new purchases was $1.9 billion (as of 9/30/2015).
In addition, we believe these recent less-than-optimal results were likely a function of an outlier market that behaved in a way that disfavored our Fund and, in fact, most active managers. Stocks that did well tended to fall into one or more of two categories: 1) momentum driven stocks for which nothing went wrong; and 2) non-earning biotech and high multiple technology stocks. Many stocks that did well became market favorites, trading at lofty valuations with which we are not comfortable, or at revenue multiples or other concoctions, which tend not to hold up well when the market corrects. On the flip side, if a company missed earnings, or was subject to any bad news whatsoever, its stock tended to decline further and for a longer period of time than usual.
We believe this outlier market is at or nearing the end of its run, and that the market is reverting to more normal conditions. As disciplined long-term investors, we strive to look past short-term market aberrations. We invest in high quality businesses that we believe can continue to significantly grow their profits and value over time. We believe this is the correct positioning over the long term. We also continue to discover exciting new companies to add to the portfolio, building toward our goal of providing our investors with a lower risk product that will potentially generate solid relative performance.
