The large cap equity market is widely viewed as a bulwark of every well-balanced investment portfolio. The thinking among investors is that a large cap allocation functions as ballast, given the perceived relative stability inherent in most big, well-established companies. This reasoning, combined with the belief that the efficiency of this asset category makes it especially challenging for active managers to beat the benchmark, tends to steer many large cap investors toward passive investment vehicles.
While we understand the thinking behind passive investing in the large cap category, its emphasis is on the lower-growth, dividend-generating stocks that dominate the space. For a smart, targeted approach to growth investing in large cap equities, we believe an actively managed fund such as Baron Fifth Avenue Growth Fund is the better choice.
The large cap category contains some of the world’s most successful companies. Consider that Google parent Alphabet, Inc. (GOOG, Financial) has a market cap of $470 billion,1 nearly 100 times the size of the smallest large cap companies.2 To uncover these large cap growth opportunities, portfolio manager Alex Umansky looks for big ideas in fast growing markets with the potential to become mega markets of unprecedented size.
We employ a margin of safety, investing only when the company is trading at a price at least 20% below our estimate of intrinsic value. Our adherence to this principle means that we look for companies we believe are still early in the growth stage of their life cycle. It also differentiates us from many others who described themselves as growth investors.
We manage a high conviction portfolio of just 30 to 40 stocks, compared with a peer average of 288 securities.3 The Fund has low turnover – 14.54%, compared with an average of 64.59% for its peer group.3 Weightings reflect our level of conviction, rather than the conviction of the Fund’s benchmark, the Russell 1000 Growth Index, and our top 10 holdings represent more than 50% of the portfolio. We have a long-term perspective, with an average holding period of more than five years over the past three year period.
We look for specific characteristics in the companies in which we invest. Many of our holdings are high quality platform companies. In particular, we emphasize the following:
We also look for companies we consider “mispriced” as a result of market biases or inefficiencies. Examples of these biases include
- an over-emphasis on short-term results
- the lack of an easily understood “comparable,” where the traditional means of assessing a company do not translate well
- the use of conventional valuation metrics such as P/E ratios
- confusing sell-side analyst coverage
- a mischaracterization of the company’s business
Finally, we favor businesses that we believe are benefiting from dominant secular trends that carry the potential for a significant increase in growth and profitability, often for an entire industry or group of companies. Below are some examples where we are taking advantage of market biases to invest in what we consider to be underappreciated opportunities.
IT Sector Misfits
According to the MSCI GICS industry classification, roughly 40% of the Fund’s assets are invested in the Information Technology sector. Alphabet, Facebook, Inc., Alibaba Group Holding Ltd., MasterCard, Inc., and Visa, Inc., represent the majority of the Fund’s holdings classified as IT. We do not consider these companies to be true IT businesses. None of them sell software, servers, or semiconductor chips to companies, governments or consumers. Consequently, their fundamentals do not correlate with what are traditionally considered the drivers of growth in IT – corporate technology refresh cycles or government budget flushes and IT infrastructure upgrades.
We think Alphabet, Facebook (FB, Financial), and the others in this group are part of the digital revolution, a long-term megatrend that is transforming virtually all aspects of modern life. Digitization – the shift to online, networked, computer-supported processes – is opening the door to what we believe are attractive opportunities for investors who appreciate just how transformational this trend is.
Alphabet is the world’s dominant search engine. In our view, Alphabet also happens to be one of the most innovative companies on Earth, with a vast array of initiatives and businesses ranging from YouTube to Calico (its foray into longevity). The company’s core business is a powerful platform that benefits from the network effect, economies of scale, and formidable barriers to entry. Most advertisers want to work with Alphabet. Data is becoming increasingly important, and Alphabet owns the most data of any company we know. We believe the value of that data and its monetization opportunities will become more apparent over time. The company is the Fund’s second largest holding, and the value of our investment has doubled in the time we have owned it. As big as it has become, we think Alphabet has a long and robust growth trajectory ahead.
Facebook, the world’s largest social network, in our view is the largest beneficiary of the shift in consumer engagement to mobile. Mobile is no longer a device or an application. It has become a way of life. About four years ago, we participated in Facebook’s IPO at $38 per share. As user engagement transitioned from desktop to mobile, growth slowed and the stock collapsed. We thought Facebook was a unique company with real competitive advantages and viewed mobile monetization as a question of “when” rather than “if.” Market overemphasis on short-term results allowed us to build our position at an average cost of $26 per share. Facebook is currently trading at $114, or three times our initial investment.
We think Facebook will continue to grow. It is using its leadership position to offer targeted advertising capabilities at scale. The company is in the early stages of monetizing online video and Instagram, which have begun to contribute to incremental revenue growth. WhatsApp and Oculus provide additional avenues for potential growth opportunities.
We think of Visa (V, Financial) and MasterCard (MA, Financial), two of the largest global payment networks, as digital railroad companies, laying down the virtual tracks along which consumers and businesses conduct transactions. Together, they command more than 90% of market share. In addition to their dominant positions in the U.S., they have significant exposure to international markets, where the adoption rate of electronic payments is rising rapidly. Visa and MasterCard enjoy high barriers to entry as a result of their strong, well-established brands, large merchant acceptance networks, and extensive banking relationships. We also view them as an excellent hedge against inflation, since they charge a flat percentage of the money involved in the transactions they handle.
Not the Online Walmart
Ask your typical investor to name the Walmart online, and many will reflexively say Amazon.com, Inc. (AMZN, Financial) In one very narrow sense, we agree with that description. Amazon has been successful at attaining its original goal. Last year, it became the fastest company to reach $100 billion in annual sales, and it is now the world’s largest online retailer. But we think of Amazon as much more than that.
Take, for instance, Amazon Web Services, the cloud computing business that reached $10 billion in annual sales last year – a pace faster than the original Amazon. There’s also Amazon Prime, with 60 to 80 million members, the Kindle and other electronic devices, streaming videos with proprietary original content, and an online marketplace used by more than 70,000 third-party sellers. Amazon Logistics Services is starting to compete in the trillion-dollar freight industry. Most recently, it introduced its grocery delivery service AmazonFresh. Practically every month, it seems, Amazon unveils a new innovation, product, or service.
So what, exactly, is Amazon? We think Amazon has built an online/ digital service platform enabled by massively scalable IT and an unparalleled logistics infrastructure. This infrastructure enables Amazon to be not only the biggest online retailer, but also the largest public cloud service provider, a leading streaming service provider and digital content seller, and a major provider of fulfillment (and advertising) services to third-party retailers.
In addition to the lack of an obvious comparable and the mischaracterization of its business, Amazon’s stock has been subject to an over-emphasis on short-term results. We invested in Amazon in 2009, when the company had never turned a profit, because it was reinvesting in future growth. Amazon ignored its critics (as it always has) and continued to innovate, experiment, and place large bets against conventional wisdom. The stock has increased more than two and a half times since we first invested. Amazon remains our highest conviction investment idea.
The True Platform Company
Many of the Fund’s holdings are in platform companies, which we think offer some of the biggest growth opportunities in the large cap market today. These companies have built a platform others can use to connect their businesses, sell products and services, market, and co-create value. Although “platform” has become a buzzword, especially in technology, we think few businesses have earned the term. As a result of power law distribution effects, in which one or two providers will end up monopolizing an industry, the economies of scale, network effect, and barriers to entry that characterize the platform company can lead to dominance within its vertical market. While many platform companies are classified as IT, we have found platform companies in other sectors as well.
Illumina, Inc. (ILMN, Financial) is a health care company that is the leader in platforms used for DNA sequencing, the process of determining the precise order of nucleotides with a DNA molecule. Illumina provides the tools used for over 90% of the world’s sequencing output. Illumina is benefiting from a major shift into personalized medicine driven by DNA sequencing. It is already becoming common practice to sequence a cancerous tumor and prescribe drugs targeting the genetic mutations specific to that cancer. In the reproductive health arena, DNA sequencing is being used to help identify chromosomal abnormalities early in a pregnancy.
When we bought Illumina in 2011, the stock had been decimated by two missed quarters, reduced guidance, and the threat of a government shutdown (at the time, roughly one-third of revenue was from academic research, which relies on federal funding). None of this had to do with Illumina’s competitive advantages or potential growth opportunities. We took advantage of the selloff to establish a position. The stock has appreciated more than 300% in the time we have owned it.
The Priceline Group, Inc. (PCLN, Financial) is a Consumer Discretionary company that provides online platforms connecting retailers in the travel space – hoteliers, airlines, rental cars, restaurants – with consumers. Priceline first became known for its “Name Your Own Price” system, where travelers would name their price for airline tickets and other travel services. The company has since grown to become the global leader among online travel agencies, operating in more than 200 countries through six primary brands: Booking.com, priceline.com, agoda.com, KAYAK, Rentalcars.com, and OpenTable. The stock has more than doubled in the time we have owned it. We think Priceline has a long runway for growth, especially in emerging markets, where industry penetration levels are still much lower than in developed countries.
Equinix, Inc. (EQUIX, Financial), the leading provider of Internet Business Exchanges, is an example of a platform company in the Financials sector. Early on, Equinix employed its scale and “network neutral” policy, which allows customers to connect with one another, to attract large telecom networks. Once Equinix established its leading market position, other telecoms, major enterprises, and e-commerce and cloud computing companies felt compelled to join the Equinix “ecosystem” to easily and efficiently access these networks.
Equinix is a beneficiary of continued growth in Internet traffic, globalization of financial markets, IT outsourcing, cloud computing, and mobility. It converted to a REIT in 2015 (and was moved from the IT to the Financials sector – another example of miscategorization). Earlier this year, Equinix acquired TelecityGroup, making it the largest European data center provider. It also acquired a Japanese data center provider and a firm with technical expertise in migrating customers from legacy data center infrastructure to a hybrid one in which Equinix acts as the intermediary between the enterprise IT shop and the cloud.
Conclusion
The large cap category is a reflection of the strength of the U.S. economy. The Russell 1000 Index, which is comprised of 1,000 of the largest companies in the U.S. equity markets and is considered a bellwether index for large cap investing, represents more than 90% of the total market capitalization of all listed U.S. stocks. The interrelationship between the markets and the economy is where we, as long-term investors in growth, we believe have an advantage. We expect the markets to continue to exhibit short-term volatility as it overreacts to Brexit, Fed policy, China’s economy, energy prices, geopolitics and other uncertainty-generating events. History suggests that most of these challenges will prove temporary or manageable. Over the long term, we believe the U.S. economy, and by extension, the large cap growth businesses in which we invest, will continue along the path of improvement and expansion.
The performance data quoted represents past performance. Past performance is no guarantee of future results. The investment return and principal value of an investment will fluctuate; an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. For performance information current to the most recent month end, visit www.BaronFunds.com or call 1-800-99BARON. The Fund’s transfer agency expenses may be reduced by expense offsets from an unaffiliated transfer agent, without which performance would have been lower. The expenses of the Fund are 0.84%.
1. All data is as of June 30, 2016 unless otherwise noted.
2. There is no full consensus agreement about the exact cut offs for different market cap categories. Currently, the cut off for inclusion in the large cap S&P 500 Index is $5.3 billion.
3. As of March 31, 2016.
