Baron Capital got its start investing in small cap stocks and currently has three small cap Funds. We launched our newest offering, Baron Discovery Fund, a little over three years ago to cover stocks with market caps typically at or below the weighted average of the Russell 2000 Growth Index (now under $1.8 billion).
The Fund is co-managed by Randy Gwirtzman and Laird Bieger. Prior to the Fund’s launch, Randy and Laird worked at Baron for 12 and 13 years, respectively, as research analysts focused on small cap growth stocks. Over the years in their role as research analysts, Randy and Laird had come across many promising companies in earlier stages of development, in industries in which other portfolio managers had less comfort investing, or with market caps below the level at which Baron’s other small cap Funds typically invest. Both felt that many of these companies could become pioneers in their markets with long runways for growth. Baron Discovery Fund was launched as a vehicle to capture these opportunities.
We approach the earlier stage small cap space with the same Baron investment process used with all of our Funds, employing fundamental, bottom-up research to discover and invest for the long term in companies with, in our view, strong management, sustainable competitive advantages, and open-ended growth opportunities, at an attractive valuation.
In addition, we emphasize fast growing areas of the economy such as cybersecurity, software-as-a-service, semiconductors, and the internet within the Information Technology sector; and medical devices, pharmaceutical, and biotechnology within the Health Care sector. We seek to manage risk in the volatile small cap category by balancing the portfolio among three growth profiles and across sectors and sub-industries with uncorrelated drivers of growth.
As seen in the chart below, this approach has produced outstanding results in the three-plus years since we launched the Fund. As of 12/31/2016, based on total returns, Morningstar has ranked the Fund in the 8th percentile in its Small Growth Category for the 1-year time period and the 24th percentile for the 3-year time period. The Fund has an attractive 3-year upside capture of 97.82% and downside capture of 94.27%. Its active share of 96.62% is among the highest in its category.
We believe the earlier stage small cap space offers a compelling opportunity for a skilled active growth manager to deliver alpha. With roughly 3,300 listed U.S. stocks (excluding penny stocks), this category offers plentiful companies to analyze. At the same time, Wall Street analyst coverage of small caps in general is relatively sparse, resulting in less efficiency in the space. On average, a large cap company is covered by 25 analysts, compared with six for the average small cap. This number is even lower for the types of companies in which Baron Discovery Fund invests.
The primary goal of active management is to add value by capitalizing on market inefficiencies. As one of the most inefficient equity segments, small caps can be especially rewarding for active managers. When compared to large caps, stock returns of smaller companies are more driven by company-specific events and less so by industry and market events.1 This means the skilled stock picker who is able to understand and evaluate the idiosyncrasies of companies has more opportunities in the small cap space.
We use our industry expertise and extensive research experience and capabilities to source a select number of investment opportunities for the Fund. Because we seek to invest only in stocks in which we have strong conviction, the number of holdings is relatively low when compared to peer funds, with about 60 names in the portfolio vs. a category average of 208 stocks. Over the long term, we are looking for annual appreciation of 15% on a stock-specific basis.
Three Growth Profiles
While we don’t manage to particular weightings, we seek to include some less volatile and/or more cash-flow-oriented positions in the Fund to help manage risk. Assets are typically allocated as follows: 40-45% high growth, 40-45% growth, and 10-20% ballast.
High growth These are higher risk/return companies typified by revenue growth of 20% or more that we believe will lead to dramatic earnings growth in the future. This category includes newer businesses with novel products or services. Yet these companies are not venture businesses. An example is Glaukos Corporation (GKOS, Financial), a medical device company that sells a stent used to treat glaucoma, a disease that damages the optic nerve due to fluid buildup inside the eye. Glaukos’ first generation device, which is inserted into the eye during cataract surgery, has been proven to decrease intraocular pressure. Glaukos also has a promising product pipeline that includes next generation stents for stand-alone glaucoma procedures and an injectable drug delivery implant. The company has a two-year lead over its competitors, patent protection, and strong clinical data. We believe the addressable market exceeds $5 billion.
Another example of a high growth company is Wingstop Inc. (WING, Financial), a franchisor of Wingstop fast-casual restaurants, which offer a chicken wing-based menu. Wingstop offers franchisees high returns on new units at a relatively low initial investment. This attractive feature, combined with innovative marketing, has driven industry-leading unit and same-store-sales growth over the past few years, which we believe can continue for several more years. With 98% of its units franchised, we believe Wingstop will be highly capital efficient, eventually allowing management to return significant amounts of capital to shareholders.
Growth These are companies that typically have revenue growth of 15%-20% that we think will lead to significant future earnings growth. These companies are generally more established than the higher growth companies in which we invest. An example is MACOM Technology Solutions Holdings, Inc. (MTSI, Financial), a high performance analog semiconductor company. MACOM sells its semiconductors, components, and subsystems to the communications, aerospace/defense, and industrial (including medical) markets. MACOM’s engineered analog chips are valuable IP-protected products. Their value is borne out by high operating margins of 23% (which we believe can expand to 40%). We believe the company can triple its revenues to $1.5 billion over the next five years, and increase profits even faster. We think its addressable market is $9.5 billion.
Ballast These companies are typically more yield or asset oriented than businesses in the other two categories, generating solid growth in free cash flow. This category also includes special situations where we see a possible valuation upside as the company is new to the market as the result of a spinoff or IPO, or is a “fallen angel” with a strong business that is currently impaired but capable of repair. We regard our investments in this group as “ballast” for the portfolio as they typically have lower betas than those of the higher growth portions of the portfolio, which helps to dampen volatility.
Education Realty Trust, Inc. (EDR, Financial) is an example of a ballast company. It is the second largest U.S. student housing operator, with a $2 billion portfolio nationwide. We believe we are in the early innings of an outsourcing trend in which universities constrained by tighter budgets are reaching out to the private sector to develop and operate student housing. We think the company will benefit from the resulting increases in occupancy and rents as well as the build-out of its development pipeline.
Focus on sub-industries
While we are focused on the fastest growth areas in the economy, we also seek to manage risk by diversifying the portfolio across sectors and sub-industries with uncorrelated drivers of growth. The Fund currently has investments across nine sectors and numerous sub-industries.
The following are some examples of sub-industries in which we are finding promising investment opportunities.
Biotech/pharma These sub-industries have been a market favorite for some time, which can make it challenging to find stocks with attractive valuations. Investors in this category must also contend with the possibility of binary outcomes, as a biotech or drug company can either see its share price soar if its drug receives FDA approval or plummet if approval is denied. Yet we believe it is worth investing in biotech pharma because of the high growth potential of many of these companies. We think we are able to navigate successfully around the potential pitfalls of bio-pharma investing because of our in-depth understanding of the FDA approval process and the science behind pharmaceutical compounds.
Our general focus in this space is on companies with either approved drugs or large pipelines addressing multi-billion dollar clinical market opportunities. Examples include TherapeuticsMD, Inc., which makes hormone replacement drugs for menopause and other conditions, and Flexion Therapeutics Inc., which makes long lasting injectable pain relief drugs for arthritis.
Other companies we favor have wrapped intellectual property around an already proven pharmaceutical to create a new, protected franchise. The risk of not receiving approval for such products is significantly lower than for a typical bio-pharma investment. An example is Pacira Pharmaceuticals, Inc. (PCRX, Financial), whose FDA-approved medication is comprised of the pain killer bupivacaine combined with proprietary IP called Depo-Foam that enables its timed release. The product is appealing as it can in many cases eliminate the need for post-operative opiates and result in a shorter hospital stay.
Health care services Contract Research Organizations (CROs) that provide outsourced drug development services to biotech and pharma companies are positioned to benefit from growth in this space without the binary outcome concerns that a single-drug bio-pharma company may face. CRO fundamentals are improving as pharma companies increase R&D spending, biotech funding climbs, and the FDA approval process becomes quicker and more efficient. Bio-pharma’s need for a lower, more variable cost structure and inherent lack of infrastructure are also driving growth in CRO services. We estimate CRO clinical outsourcing currently represents about a third of a $48 billion addressable market, with annual growth of 5-8%. In addition to demographic tailwinds, CROs appeal because of their consistent revenues and cash flows and ability to carve out a market-leading position. We recently initiated a position in top 10 CRO Medpace Holdings, Inc.
Software-as-a-service We view IT as one of our most fertile hunting grounds for emerging growth stocks. IT is an industry that has seen phenomenal growth over the past few decades, and in the course of its growth, irreversibly altered our way of life. We see no signs of this growth trajectory slowing down. Although it may seem as if everything has become digitized, there are many areas that IT has just begun to penetrate. At Baron, we think about which areas are transforming, and where we see the best opportunities for sustainable growth.
We believe that, as a group, software-as-a-service (SaaS) businesses are benefiting from a generational change in computing. SaaS companies license centrally hosted software on a subscription basis to customers who access the software via the internet. This lease arrangement allows customers to outsource support costs to the SaaS provider, and to make smaller recurring payments rather than a large lump sum purchase. These companies are typified by recurring revenue streams with high cash flow growth potential, high margins, and large market opportunities.
Amber Road, Inc. (AMBR, Financial) is a SaaS business that enables some of the world’s largest companies to navigate difficult trade regulation environments. Given a trade environment that we think will continue to increase in complexity, we believe that Amber Road is uniquely well positioned to help its customers. Another holding, Benefitfocus, Inc. (BNFT, Financial), provides employers, insurance carriers, and consumers a single web-based platform for shopping, enrolling, managing, and exchanging benefit information.
Cybersecurity Cybersecurity is another IT area in which we are finding promising investment opportunities, although the intense competition in this space means it is important to be selective. Qualys, Inc. (QLYS, Financial) is a cloud-based cybersecurity services provider to large corporate clients that specializes in assessing software vulnerabilities of hardware attached to internet networks. Qualys is accelerating its growth and continues to trade at what we believe is a reasonable multiple of real free cash flow, whereas many of its peers are still losing money. It’s a fully subscription-based business, which leads to high revenue visibility.
Other sub-industries While many of our investments are in IT and Health Care, our research is far ranging, and the portfolio has holdings across nine different sectors and many sub-industries. For instance, in Materials, the Fund owns Flotek Industries, Inc. (FTK, Financial), a manufacturer of innovative, eco-friendly citrus-oil-based chemicals used to increase recoverable reserves from shale oil and gas wells in North America.
Conclusion
Because the majority of earlier stage growth stocks garner little attention from Wall Street, finding the most promising companies requires intensive, in-depth research. We invest in this deep level of research because we believe these companies have the capacity to grow in ways that are not possible for larger businesses. Our long-term mindset means that we take the time to realize the full potential of growth opportunities overlooked by investors focused on short-term performance. We believe our research-intensive, bottom up approach combined with our long-term perspective is the key to our outstanding performance to date, and will continue to generate significant alpha over time, although there are no guarantees.
