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Sydnee Gatewood
Sydnee Gatewood
Articles (2604) 

Ron Baron's Baron WealthBuilder Fund 2nd-Quarter Shareholder Letter

Discussion of markets and holdings

Dear Baron WealthBuilder Fund Shareholder:

Performance

Baron WealthBuilder Fund (the “Fund”) advanced considerably in the second quarter of 2020 and meaningfully exceeded its comparable benchmarks. The Fund gained 35.46% (Institutional Shares) in the quarter. The S&P 500 Index (the “Index”) gained 20.54%. The MSCI ACWI Index, which measures global markets, increased 19.22%.

The Fund’s gains in the quarter have more than offset the sudden and rapid declines in the first quarter as COVID-19 began to impact America and halt many global economies. The Fund has now advanced 10.42% since the start of the year. This result compares favorably to its benchmarks. The Index has fallen 3.08% in the first six months of 2020. The MSCI ACWI Index has declined 6.25%.

While COVID-19 remains a threat to world health, governments have met this pandemic with an unprecedented level of financial stimulus to prevent the health crisis from becoming a liquidity and financial crisis. Stay at home measures have had a severe impact on many individuals’ ability to earn and spend. However, investors have looked past their depressed results and valued businesses on their potential growth and anticipated future profits.

Economic events and cycles do not neatly line up with quarters or even years. The COVID-19 pandemic did not begin precisely on January 1 and we doubt its conclusion (as measured by the development of widely available therapeutics or a vaccine) will exactly coincide with the final day of a month or year. Therefore, we find it more insightful and helpful to understand how the Fund has performed thus far through the COVID-19 cycle rather than only the previous three-month period.

2020 can be divided into three segments: pre-COVID-19, the COVID-19 panic, and the COVID-19 temporary normal. The underlying funds’ investments vary across market caps, sectors, geographies, and growth rates. These categories have performed differently in these various periods. That diversity has contributed to the strong relative and absolute returns exhibited so far in the year.

Pre-COVID-19: December 31, 2019 – February 19, 2020

The Fund performed very well during the pre-COVID-19 environment, December 31 through the Index’s peak on February 19. This period was a continuation of the 2019 economic conditions. Disruptive and high-growth companies that exhibited revenue expansion and operational efficiencies were rewarded as the likelihood of their long-term success increased. Underlying funds with investments in disruptive companies, like the concentrated Baron Focused Growth and Partners Funds, led the performance. High-growth diversified portfolios, like Baron Opportunity and Global Advantage Funds, also did well. Several funds’ performance was helped by advances in Tesla, Inc. (NASDAQ:TSLA). That company demonstrated that its new China factory could produce vehicles at lower costs than at older facilities. It has also manufactured at higher volumes than predicted to meet unprecedented foreign demand. Companies like CoStar Group, Inc. (NASDAQ:CSGP), Twilio Inc. (NYSE:TWLO), and GDS Holdings Limited (NASDAQ:GDS) also rose due to wide acceptance of new products and services and consolidation of their markets. Smaller positions in Baron International Growth and Emerging Markets Funds lagged because COVID-19 impacted those markets before the pandemic reached America.

The COVID-19 Panic: February 19 – March 23, 2020

Things suddenly and drastically changed in late February. Over about a month’s time, the Index fell 33.8% until bottoming on March 23. COVID-19 cases grew exponentially, and governments took drastic steps to “flatten the curve,” which were often at the expense of economic activity. Economies around the globe came to a standstill. Investors reacted with panic selling during these unprecedented times. Individuals and corporations around the world reined in spending. Businesses that curtailed operations were discarded by investors. Limited refuge was found in “essential” Consumer Staples, a category Baron Funds has generally avoided due to less favorable growth prospects and reservations about their long-term sustainable competitive advantages.

Larger companies were considered able to sustain operations and exhibit some growth, albeit at a slower pace, despite the economic shutdown. They declined less rapidly than the Index and were held in funds like Baron Opportunity and Fifth Avenue Growth Funds. Baron Health Care Fund was populated with businesses that could assist in the discovery of disease treatments and would benefit from the anticipated increase in government and private funding. The stock prices of these businesses also declined less than the overall market.

But those were the exceptions. This short period saw stock prices rapidly deteriorate for travel and leisure businesses held in Baron Growth Fund. Guests at hotels were non-existent as travel was largely prohibitive. Both the near-term financial viability and the longer-term business models were questioned if the pandemic persisted.

Disruptive businesses, owned by Baron Partners and Focused Growth Funds, also saw their stock fall sharply. In our opinion, investors were not properly assessing business opportunities, but rather exited highly valued companies at alarming rates. Disruptive businesses fit that criteria. Investors focused on short-term results instead of long-term business opportunities. They sold businesses with high valuations. Disruptive businesses often penalize near-term earnings by investing in future products and operations. They often hire staff, build facilities that are operating subscale, and launch products that do not yet have a sufficient scale to produce strong profits. These actions depress current earnings and artificially inflate commonly used valuation metrics.

The COVID-19 Temporary Normal: March 23 – June 30, 2020

We believe the market and economy are currently amid a “COVID-19 temporary normal,” which began at the market’s bottom on March 23. The Fund’s performance since has been exceptional, increasing 57.7%. Underlying funds that held businesses with disruptive business models and large addressable market opportunities led the performance: Baron Discovery Fund’s holdings in small technology businesses; Global Advantage Fund’s fast-growing globally competitive businesses; and Partners Fund’s concentrated portfolio dominated by companies with potential to disrupt large segments of the economy all did well. We believe the COVID-19 pandemic has not created a “new normal” where people will be permanently

isolated, and global commerce is hampered. Instead, COVID-19 has accelerated changes in the economy that we had previously believed would eventually occur. Investors now realize that these disruptive businesses are often advantaged in this forthcoming economy. These businesses had often digitalized platforms, operated more efficiently with the lower density footprint, and were providing the infrastructure for changes in commerce.

Tesla, Inc. produces its cars with more automation than competitors. Its cars are connected through the cloud and continuously improve with software updates after they have been purchased. Tesla sales occur without physical dealership locations. Zillow Group, Inc. (NASDAQ:ZG) facilitates home transactions without interested buyers present at the property. It allows for increased research and transactions. Wix.com Ltd. (NASDAQ:WIX) enables companies to build online brands, reach customers, and more efficiently manage their business. We believe these changes of convenience and efficiency in the economy would have occurred regardless of COVID-19, but the current pandemic has accelerated the rate of conversion.

Investors have closely examined balance sheets and assessed that the Fund’s businesses with irreplaceable assets can sustain during the pandemic and their properties will ultimately be utilized. Baron Real Estate Fund’s holdings in hotels and housing did well. We believe competitors’ reduction in capital expenditures has tightened future supply and increased the value of existing assets. Business and leisure customers are expected to return. Convention business in 2021 has remained steady for Hyatt Hotels Corp. (NYSE:H), while skiers at Vail Resorts, Inc. (NYSE:MTN) continue to purchase advance season passes. However, June’s increase in COVID-19 cases and slowing economic reopening plans in many states tempered the returns.

The only mild constraints on overall Fund returns during this COVID-19 temporary normal period have been mid-sized businesses found in Baron Growth and Asset Funds. They hold many businesses that have continued to operate throughout the entire year and their returns across the various periods have been steadier. Additionally, their holdings in financial businesses have not increased as rapidly during this period. The financial service data and analytics providers, MSCI, Inc. (NYSE:MSCI) and FactSet Research Systems, Inc. (NYSE:FDS), have continued to do exceptionally well. Their products have been incrementally more valuable as clients have dispersed from corporate offices. Both companies’ data and analytics is vital to enable their customers’ smooth operations. However, the valuations of Primerica, Inc. (NYSE:PRI), Arch Capital Group Ltd. (NASDAQ:ACGL), and The Charles Schwab Corp. (SCHW) remain based upon fears that the income generated from their assets has been permanently impaired. We strongly disagree with that assessment. We still view these businesses as able to grow organically, consolidate competitors at favorable valuations to improve services and operational efficiency, and earn higher future returns on a larger asset base. We continue to think we will earn 3 to 4 times on these three investments in the next 10 years and more than 50% in the next 2 years.

We do not attempt to predict the unpredictable, and the various economic turning points of COVID-19 are such unpredictable events. We do not assert to have accurately forecasted how long the investor panic would last nor claim to know when developed therapeutics or a vaccine will end the health crisis (although we are confident that such developments will occur). There may be an economic rebound when the Fund trails its benchmark for a short period. Government intervention or a scientific discovery could temporarily revitalize highly levered or weaker operational businesses not held in the underlying funds. While some real estate and financial investments should also benefit, other categories may trail as some other businesses rebound from their lows.

However, we remain confident in the Fund’s underlying holdings to sustain themselves during this difficult time. We also believe in many of these businesses’ ability to emerge from the COVID-19 pandemic with an enhanced competitive position and lead change in the new economy. We anticipate the Fund performing well on both an absolute and relative basis over the course of the entire cycle.

We encourage you to read the various quarterly letters found in this report for a deeper understanding of the funds that make up the Baron WealthBuilder Fund.

Fund of Funds Structure and Investment Strategy

Baron WealthBuilder Fund closely mimics the way we would incrementally invest across our various funds and strategies. Baron WealthBuilder Fund allows investors to diversify across several Baron Funds’ products, gain exposure to various market caps, sectors, and geographies in a single structure, and have us rebalance the allocations in a tax efficient manner. The portfolio managers of each underlying fund abide by the same core investment process and philosophy, focused on proprietary research to discover competitively advantaged businesses with immense opportunities led by smart and honorable executives. Baron Funds has had broad historical success. Our investment approach and process have yielded outstanding results since the Firm’s founding in 1982. As of 6/30/2020, 16 of 17 Baron Funds, representing 98.5% of Baron Funds’ assets under management (“AUM”), have outperformed their respective passive benchmark since their inceptions. Twelve of those funds, representing 97.3% of Baron Funds’ AUM, rank in the top 17% of their respective Morningstar categories; and nine funds, representing 65.1% of AUM, rank in the top 7%. Since their inclusion in Baron WealthBuilder, all underlying funds have exceeded their respective benchmarks. We have always strived to provide top performance in various asset categories. Baron WealthBuilder Fund allows individuals to gain access to a variety of these strategies in a single fund. We are very pleased with the composition and results.

The makeup of the underlying investments looks very different than the indexes, and therefore, the Fund has a high active share when measured against its benchmarks. We feel the diversity in regions and sectors should dampen risk while still providing strong absolute returns. While holding nearly the same number of securities as the its benchmark (421 in the Fund vs. 502 in the S&P 500 Index), the similarities end there. The holdings in the Fund have a lower dividend yield (0.4% vs. 1.9% for the S&P 500 Index), with companies electing to reinvest earnings back in their businesses for growth. And the approach is working; the projected earnings per share growth rate over the next three to five years is 24.4% for the Fund’s holdings vs. 10.2% for the S&P 500 Index (or 139.2% higher growth). We think that many of our investments can exceed those stated projections. These businesses have grown at nearly double the Index’s growth rate over the preceding five years (the Fund’s five-year historical earnings per share growth rate for the Fund is 20.4% vs. the S&P 500 Index’s 12.4%). Yet these companies are only 40.0% more expensive than the S&P 500 Index’s holdings (the Fund’s trailing price-to-earnings ratio is 30.1 times versus 21.5 times for the S&P 500 Index). We feel that this valuation metric is misleading for the Fund’s holdings as many have depressed margins as they sacrifice current profitability for more sustainable and higher long-term growth rates. The significantly higher growth for a modest premium in price should, we believe, reward long-term investors.

The portfolio is also distinct in its sector weightings. The S&P 500 Index has a higher share of Consumer Staples, Energy, Materials, and Utilities businesses than our Fund. These sectors typically consist of defensive companies that have been traditionally important but have limited unique traits, future growth prospects, and are heavily reliant on unpredictable commodity prices. Those sectors are 15.4% of the S&P 500 Index, yet account for only 1.6% for the Fund. Instead, the Fund favors Consumer Discretionary, Industrials, and Real Estate and segments of Information Technology companies where the competitive advantage is more apparent and the growth projections more robust. Those sectors account for 63.4% of the Fund, yet only 49.1% of the Index.

Finally, the Fund has exposure to international companies unlike the S&P 500 Index, which only has investments in domestic businesses. We anticipate the diversity to provide benefits with lower volatility over time. The Fund is also differentiated from the global coverage of the MSCI ACWI Index. North America is 60.1% of MSCI ACWI Index compared to 85.2% for the Fund. The greater international exposure for the MSCI ACWI Index is heavily skewed towards slow growth developed markets, whereas the Fund seeks faster growth in emerging economies. Of the Fund’s international investments, 38.6% are in Asia/Pacific ex-Japan. This number is only 30.0% for the MSCI ACWI Index. However, the MSCI ACWI Index has 58.1% of its international investments in slower growth European and Japanese companies while these regions only constitute 34.5% of the Fund.

Thank you for joining us as fellow shareholders in Baron WealthBuilder Fund. We continue to work hard to justify your confidence and trust in our stewardship of your hard-earned savings. We will also remain dedicated to continuing to provide you with the information we would like to have if our roles were reversed. We hope this letter enables you to make an informed decision about whether this Fund remains an appropriate investment.

Respectfully,

Ronald Baron
CEO and Portfolio Manager

Michael Baron
Assistant Portfolio Manager

  1. The indexes are unmanaged. The index performance is not Fund performance; one cannot invest directly into an index. The S&P 500 Index measures the performance of 500 widely held large cap U.S. companies. The MSCI ACWI Index is an unmanaged, free float-adjusted market capitalization weighted index reflected in US dollars that measures the equity market performance of large- and mid-cap securities across developed and emerging markets. The indexes and the Fund are with dividends, which positively impact the performance results.
  2. The performance data in the table does not reflect the deduction of taxes that a shareholder would pay on Fund distributions or redemption of Fund shares.
  3. Not annualized.

The discussions of the companies herein are not intended as advice to any person regarding the advisability of investing in any particular security. The views expressed in this report reflect those of the respective portfolio managers only through the end of the period stated in this report. The portfolio manager’s views are not intended as recommendations or investment advice to any person reading this report and are subject to change at any time based on market and other conditions and Baron has no obligation to update them.

This report does not constitute an offer to sell or a solicitation of any offer to buy securities of Baron WealthBuilder Fund by anyone in any jurisdiction where it would be unlawful under the laws of that jurisdiction to make such offer or solicitation.

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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