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Sydnee Gatewood
Sydnee Gatewood
Articles (2475) 

Baron Capital Commentary: The Importance of a Disciplined Investment Approach in a Volatile Environment

An excerpt from a Q&A sesstion with Ron Baron, Neal Rosenberg and Michael Baron

Baron Growth Fund

How has Baron Growth Fund performed prior to and during the crisis?

Neal Rosenberg: The Fund has had strong relative performance so far this year. Through the end of May, the Fund was down just over 3% on a year-to-date basis. We were around 350 basis points ahead of our benchmark, the Russell 2000 Growth Index, which had declined about 6.65% over the same period. Most important, the Fund had generated almost 700 basis points of outperformance from positive stock selection, which is where we devote our time and our resources with our team of 37 analysts and investment and portfolio managers.

That positive stock selection has been partially offset by allocation, mainly by being overweight Consumer Discretionary stocks and underweight Health Care stocks.

The Fund’s risk metrics continue to stay strong as well. As of March 31, 2020, the beta of the portfolio was about 0.85 as measured over the prior five-year period, and the upside capture was 90% and the downside capture just 74%. More recently, over the prior three-year period, our upside capture was 104% while our downside capture was still just 79%.

Ron Baron (Trades, Portfolio): I would like to touch briefly on the penalty we have borne by our investments in travel and leisure stocks such as Vail Resorts, Inc. (NYSE:MTN), Choice Hotels International, Inc. (NYSE:CHH), Marriott Vacations Worldwide Corp. (NYSE:VAC), Penn National Gaming, Inc. (NASDAQ:PENN), which represented about 16% of our assets in the Fund at the start of the year. When the pandemic hit and travel shut down, many of these stocks fell by 50% or so. Now they're starting to recover, and we believe these stocks will double in price in the next two or three years to make up for what's happened to them so far.

How are you managing the portfolio?

Neal Rosenberg: Baron Growth Fund is a fundamentally oriented strategy. When times are good, we conduct research to understand what can go right and what can go wrong. When times are unusual or unprecedented, we do research to understand what's happening to businesses, how their management teams are adapting, and what the short-, intermediate-, and long-term financial implications will be. The goal of the strategy since inception has always been to deliver superior returns over time with less risk. We've historically achieved that by being diligent and disciplined regarding the quality of the businesses in which we invest.

Our investments share a set of common attributes. These include items like large addressable markets; powerful and favorable secular trends; high and growing barriers to entry; recurring, or at least highly visible, revenue; high margins and higher incremental margins; strong free cashflow conversion; and what we believe are best-in-class management teams.

Can you share some perspective on what you're seeing in end markets? I presume your conversations with management teams have evolved a bit since we last spoke.

Neal Rosenberg: Since our last update call, we've had the opportunity to review March and April quarterly results. We've spoken with management teams several more times and have had the opportunity to continue to do more primary due diligence. I would say, at a high level, most business activity came to a sudden stop in mid-to-late March, consistent with the series of state lockdown orders.

Those trends remained depressed into April before starting to climb off the bottom in mid-to-late April and more significantly through May. At this point, almost every company that we've spoken with has reported the trends are improving day over day and week over week, which is obviously very encouraging. There are some geographic differences and based on our research, the Northeastern United States continues to lag on a relative basis. But let me drill down on a few industries.

Financials: In Financials, Baron Growth Fund has large investments in market data and analytics vendors. These are companies like MSCI, Inc. (NYSE:MSCI), FactSet Research Systems, Inc. (NYSE:FDS), or Morningstar, Inc. (NASDAQ:MORN). Here, we've seen revenue and bookings trend remain largely intact. We've observed consistent demand for data and analytical tools and ESG products and only very modest delays in some of the largest-ticket items. Margins remain high, variable costs are being well controlled, cashflow generation remains robust and balance sheets are appropriately scaled.

Information Technology: In IT, we own a lot of software and internet businesses. Generally, these businesses are thriving. For example, Wix.com Ltd. (WIX), a leading provider of website design and hosting services, has seen an acceleration in its business. It's been less expensive to acquire new customers, easier to convert registered users to paying customers and so far, easier to retain customers. With our investments selling larger-dollar-value deals, we've observed some slowdown in the pace of business. Those deals aren't lost for good but are just being pushed out to later in the year. We think deal closure rates have really started to pick up in May and should improve over the remainder of the year. Many of our IT investments are focused on facilitating digital transformation. This is a theme we've talked about with customers and companies for three or four years now. We think that, pre-COVID-19, digital transformation was in the early adoption phase; post-COVID-19, we think that all businesses will be forced to adopt a digital-first strategy or risk becoming obsolete. So we think this bodes very well for demand for all of our IT investments.

Health Care: In Health Care, our companies are seeing consistent underlying demand since they provide critical supplies and devices to essential businesses. A few are benefiting from the global search for a COVID-19 vaccine. For example, with West Pharmaceutical Services, Inc. (NYSE:WST) the world's leading provider of drug delivery devices, we saw accelerated growth pre-COVID-19 from long-term durable secular drivers. Now we think West is poised to be a critical supplier to all the pharmaceutical companies pursuing a COVID-19 vaccine, which could add billions of units annually.

Industrials: In Industrials, our largest position is CoStar Group, Inc. (NASDAQ:CSGP), the leading provider of information and marketing services to the commercial real estate industry. We've seen a significant acceleration in CoStar’s digital marketplace businesses. Customers are using more technology to advertise properties, conduct virtual tours, analyze pricing, and execute sales and leases. This has been partially upset by slower trends in its commercial real estate data licensing business. We think the company's revenue streams are extremely well-diversified, its contracts are extremely sticky, and its competitors are sub-scale, under-managed and undercapitalized.

The Fund has significant exposure to the Consumer Discretionary sector. How are you analyzing those businesses and why do you remain confident that they will be long-term winners given the uncertainty?

Ron Baron (Trades, Portfolio): Let me give you an example. Penn National Gaming, Inc. (NASDAQ:PENN) is a regional casino company. Before the pandemic, it had revenues of $5 billion a year and $1.5 billion in EBITDA. The revenue went to zero when the pandemic hit and the economy shut down. But as a regional casino company, most of Penn Gaming’s customers are local so when it re-opened its locations, people were standing in line to get inside. Because the company is a major source of tax revenue for the states in which it operates, these states will do anything to ensure they can re-open. In addition, Penn Gaming recently acquired online sports betting company Barstool Sports, which we believe is a multi-billion-dollar opportunity.

We have a view of what Penn Gaming and other travel and leisure businesses are worth. They're now selling at half price and we think they will double in value in the next two or three years.

Where are you finding new investment ideas?

Neal Rosenberg: Given the renewed focus on health care as a result of the pandemic, we're looking hard for ideas in that industry that meet our investment criteria. Most of our current Health Care investments are in devices and animal health, which are niche areas that offer compelling fundamentals and attractive investment opportunities.

Historically, we've shied away from biotech and pharma for a couple of reasons. First, most of the small-cap biotechs are pre-revenue and tend to have binary outcomes. They will have one product in development and either it will work and there'll be lots of equity value or it will fail and there'll be no equity value. We've also always struggled with evaluating competitive advantage for these businesses. As hard as it is to assess one therapeutic in development, it's even harder to know what competitors might be working on. Finally, we've always struggled with the need to reduce health care costs and have worried about the possibility of an unexpected price reduction of a key product.

However, we’ve started to find more ideas in Health Care that meet our investment criteria. We own a couple of small biotech positions. We invested in Schrodinger, Inc. (NASDAQ:SDGR) when it was still a private company along with investors like Bill Gates (Trades, Portfolio) and David E. Shaw. We added to our position the first quarter when it came public. Schrodinger is a hybrid software/biotechnology company that enables users to search for drugs on a computer rather than in the lab. We think it is well positioned to benefit from the increase in drug development research as a result of the pandemic.

More broadly, we think the search for a COVID vaccine is like this generation's Manhattan project. There's lots of money and innovation being poured into vaccine programs and novel therapeutics. We think the outcome won't only be a vaccine but a variety of leaps forward to scientific manufacturing, distribution, and regulatory practices. We're focusing on what these outcomes could be and which businesses could benefit.

We're also looking hard for more names in IT. We think more industries will adopt hybrids of in-office and work-from-home arrangements, so we're looking at companies that provide services, technology, or productivity tools to support a more geographically diverse, independent, and staggered workforce.

In terms of where we are not focused, while the Fund has owned traditional brick and mortar retailers in the past, we think many were already facing secular headwinds that will only be accelerated by the pandemic. We exclusively invest in growth businesses with a long-time horizon, and we won't compromise on quality just because a stock or an industry seems cheap at a moment in time.

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About the author:

Sydnee Gatewood
I am the editorial director at GuruFocus. I have a BA in journalism and a MA in mass communications from Texas Tech University. I have lived in Texas most of my life, but also have roots in New Mexico and Colorado. Follow me on Twitter! @gurusydneerg

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