Dear Baron Global Advantage Fund Shareholder:
The fund lost approximately 5% in the first quarter of 2016, which compared to a fractional loss and a fractional gain for the fund’s two benchmarks. We got hit hard during the January selloff and did not come back as much when the market rallied. We suffered from some profit taking as Just Eat (JE., Financial), Amazon.com (AMZN, Financial) and Worldpay Group gave up some of last year’s gains and got clobbered in Health Care, where our earlier stage, smaller market cap investments not only went down more during the selloff but also failed to participate in the ensuing recovery. In many ways, this first quarter of the year was the reversal of the last quarter with the exception of China, where our investments continued to outperform. We only had three double-digit gainers (Mellanox Technologies [MLNX] up 28%, Cetip SA [BSP:CTIP3] up 18%, and ASML Holding [ASML] up 13%) against 16 double-digit decliners.
What we used to describe as unusually volatile market conditions is starting to feel like the norm. The MSCI All Country World Index fell more than 10% last August and again early this year only to regain most of its value in a matter of weeks both times. Investors seem to be scared of everything. Fed policy and rising interest rates, corporate earnings, China’s economy, energy prices, terrorism, politics and elections, Britain leaving the EU and inflation are just a few of the many issues contributing to the heightened anxieties. The stark disparity in short-term price performance between the leaders and the laggards continues to make for a difficult investing environment. In this edition’s Letter From Ron, our communicator-in-chief attributes some of this increase in volatility to the emergence of sophisticated algorithms that enable high frequency ETF and stock trading and opines that “time is on our side” while referencing Warren Buffett (Trades, Portfolio) and Mick Jagger. Not surprisingly, we tend to agree. Vitaliy Katsenelson is the CIO.
Vitaliy Katsenelson is the CIO of Investment Management Associates in Denver and the author of "The Little Book of Sideways Markets." He penned an article titled "Economics 1991" that recently circulated through our BRAKE (Baron Reading And Knowledge Exchange) reading network. A fellow émigré from the former Soviet Union, Katsenelson observed how the recent actions of central banks bore an odd resemblance to the command-and-control policy that we both experienced in Soviet Russia. To illustrate, he used an example of sugar, two types of which were typically available in our local grocery stores: the cheap one priced at 96 kopecks (Russian cents) per kilo and a premium one at 104 kopecks. He remembered these prices vividly because they did not change for a decade.
“The prices were not set by sugar supply and demand but were determined by a well-meaning bureaucrat (likely an economist) somewhere in Moscow Central. If all Russians had decided to go on an apple pie diet and started baking pies for breakfast, lunch and dinner, sugar demand would have increased, but the prices still would have been 96 and 104 kopecks. As a result, we would have had a shortage of sugar – a very common occurrence in the Soviet era.”
In "The Wealth of Nations" in 1776, Adam Smith introduced the concept of the invisible hand and explained the important role that it plays in a capitalist economy as a signaling mechanism that helps balance supply and demand. High demand leads to higher prices telegraphing suppliers that they will make money if they produce extra goods. Additional supply lowers prices, bringing them to a new equilibrium. This is how prices are set for millions of goods globally on a daily basis in free-market economies. In the command-and-control economy of the Soviet Union, the prices of goods had little to do with supply and demand but were instead typically used as a political tool. This, Katsenelson believes, is in part why the Soviet economy failed. To make good decisions you need good data, and if prices carry no data, it is hard to make good business decisions.
Analogous to Russian sugar, the well-meaning central bankers have been setting the price for the most important commodity in the world – money. “Interest rates are the price of money, and the daily decisions of billions of people and their corporations and governments should determine them. Like the price of sugar in Soviet Russia, interest rates today have little to do with supply and demand and thus have zero signaling value.”
The consequences of well-meaning (but not all-knowing) economists setting the cost of money are widespread, from misguided cost of capital assumptions used in analysts’ DCF models to encouraging companies to spend on projects they shouldn’t to ill-advised mergers and acquisitions.
We don’t know the second and third derivatives of the consequences that command-control interest rates will bring, but we suspect that increased market volatility will continue to confront investors for the foreseeable future.
TAL Education Group (XRS, Financial) is a leading Chinese K-12 tutoring company, operating over 300 learning centers in two dozen cities across China. Shares of TAL rose in the first quarter, driven by growth in student enrollments of more than 50%. We maintain conviction in TAL Education Group as we see its significant opportunity to gain market share in after-school tutoring by expanding existing learning centers, opening new learning centers in existing cities and expanding into new cities while generating strong cash flow.
Cetip SA Mercados Organizados administers over-the-counter markets in Brazil for trading and registration of fixed income securities, derivatives and auto liens. The stock increased after the announcement of a takeover offer from BM&F Bovespa at a premium valuation. Shares also benefited from appreciation of the Brazilian real against the U.S. dollar and strong quarterly financial results. We continue to own the stock because we expect the merger with BM&F Bovespa will create significant shareholder value.
Check Point Software Technologies Ltd. (CHKP, Financial) is a leading cyber security vendor. Fears of slowing cyber security spending abated when Check Point reported a solid close to its year and showed early signs of strength in its next generation software products with subscription revenue growth acceleration. As a leader in the cyber security market, with a large cash balance and strong cash generation, we see continued opportunity for profitable growth.
Mellanox Technologies supplies semiconductor-based interconnect solutions and services. Strong fourth quarter results re-instilled investor confidence in Mellanox’s ability to grow profitably. In addition, the completion of its EZchip acquisition and adjusted guidance laid out a strong financial case for this combination. We view Mellanox’s Ethernet business as a significant open-ended opportunity. We expect Mellanox to be a high-end market leader and protect its high margin business model with strong innovation and product leadership.
Shares of Facebook Inc. (FB, Financial), the world’s largest social network, rose in the first quarter, driven by improving consumer engagement and monetization. Facebook is the largest beneficiary of the shift in consumer engagement to mobile. Facebook is using its leadership position to provide global advertisers targeted marketing capabilities at scale. Facebook is in the early stages of monetizing online video and Instagram, which are starting to contribute to incremental revenue growth. WhatsApp and Oculus provide additional avenues for growth opportunities.
Shares of Just Eat PLC, the leading online food takeout marketplace in Europe, Latin America, and Canada, were down in the first quarter despite reporting second half of 2015 results that beat consensus analyst expectations. Potential entry by Uber into restaurant delivery in the U.K., Just Eat’s largest market, is driving heightened competitive concerns. We believe Just Eat competes in a different market segment from Uber and other delivery-oriented companies. We think Just Eat is the leader in a winner-take-most/all business that will not be meaningfully disrupted by new competitors.
Shares of Amazon.com Inc., the world’s largest retailer, declined in the first quarter despite reporting strong revenue growth due to retail margins being lower than anticipated. Amazon has responded by instituting substantial fulfillment and supply chain fee increases for merchants on the platform. We estimate that these fee increases should start to alleviate the recent pressure on retail margins in the upcoming quarters. Amazon’s other major business segment, Amazon Web Services (AWS), continues to gain traction with enterprise customers, and over time, we expect AWS to be the larger contributor to value creation for the company.
Shares of TerraForm Global Inc. (GLBL, Financial), an owner of renewable energy power plants in emerging markets, fell during the quarter due to uncertainty related to the implications of a potential bankruptcy of parent company SunEdison (SUNEQ). In addition, TerraForm Global was unable to execute on transactions to create its formation portfolio. These factors make the company difficult to value, and the stock sold off as a result. We continue to hold the stock as we believe the company is solvent and has enough liquidity to continue.
Pacira Pharmaceuticals Inc. (PCRX) is a specialty pharmaceutical company that sells a drug for local surgical analgesia (an anesthetic) called EXPAREL. At the end of the third quarter of 2015, Pacira received a favorable resolution of certain FDA issues, and we re-established our investment at the lower levels caused by the prior regulatory uncertainty. In our opinion, shares were down in the first quarter due to the general negative industry dynamics around pharmaceutical companies.
Shares of Glaukos Corporation (GKOS) declined in the first quarter as a result of the massive correction in the biotech/pharma space. Glaukos, which manufactures stents to relieve glaucoma pressure, expects 26% to 30% growth in 2016, which we think will drive revenue to $90 millin to $93 million. While major label expansion to deliver Glaukos’ iStents without cataract surgery (current FDA approval) is still some years away, we retain conviction because of the growth opportunity presented by the rising incidence of glaucoma as a result of the aging U.S. population.
Portfolio structure
The portfolio is constructed on a bottom-up basis with the quality of ideas and conviction level having the highest roles in determining the size of each individual investment. Sector or country weights tend to be an outcome of the portfolio construction process and are not meant to indicate a positive or a negative “view.”
During the quarter, we eliminated five investments and did not initiate any new ones. The top 10 positions represented 54.2% of the fund, the top 20 were 82.2%, and we exited the quarter with 33 holdings.
We used the market weakness during the quarter to increase our investments in Pacira Pharmaceuticals, EPAM Systems (EPAM), athenahealth (ATHN), Constellation Software (CSU) and FireEye (FEYE).
We modestly trimmed our investment in TAL Education Group, which remains a top five position and a core holding in the portfolio. Philosophically, we believe that eliminating lower conviction names and reallocating capital into the higher conviction investments is the appropriate response to increased uncertainty in the market. We followed through on that philosophy by exiting investments in Brookfield Infrastructure Partners (BIP), Qunar (QUNR), ICICI Bank (IBN) and Smiles SA (SMLE3).
Outlook
The year got off to a rough start. Investors seem to be scared of everything. Stock market volatility, disappointing earnings, a hard landing for the Chinese economy and Asian contagion, rising interest rates and distortions caused by global central bankers – heightened anxieties everywhere we look.
Over the past four years, we have attributed corrections, reversals and general market weakness to among other things, the following: U.S. government sequestration/shut down leading to a possible default on its debt, the European crises as Portugal, Ireland, Greece and Spain (affectionately known as PIGS) threatened insolvency and the demise of the EU, Russia’s intransigence (annexing Crimea and invading Ukraine), Iran’s nuclear ambitions and consequences if there was no nuclear deal, oil going too high, oil going too low, Greece (Parts II and III – exiting and alternatively being kicked out of the Euro), the Ebola crises, ISIS and terrorism and so on. Though the concerns were legitimate, most proved to be passing or manageable, and the Standard & Poor's 500 Index rose over 77% during that time (2011 to 2015).
We do not mean to suggest that the risks are not real or that they should be ignored. We simply point out that we live and invest in an uncertain world and that’s unlikely to change. Economic growth in China has been slowing down for almost a decade and a hard or soft landing or what the government will do with the exchange rate are difficult to predict. Similarly, we think it is hard to know whether oil should be trading at $40 per barrel or $60 per barrel and where it will be some years from now. What we can do is continue to focus on our process and on the companies in which we invest. Finding and investing in what we believe are competitively advantaged businesses will continue to be our primary goal.
While we expect the markets to remain volatile, we remain constructive on the overall environment. Over the last 50 years, despite the doubling of the population, average global income per capita has tripled, life expectancy has risen by one-third, and child mortality is down 70%. Literacy rates are up meaningfully and average IQs are considerably higher even after adjusting for inflation and better nutrition. People are healthier, smarter and more prosperous than they have ever been. All predictions of doom have repeatedly proved wrong. Despite disasters and reverses, quality of life and material wealth and prosperity have continued to increase everywhere in the world, and we think that’s also unlikely to change.
