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Federico Flom
Federico Flom
Articles (110) 

Ron Baron - Why He Bought His Top-5 Conviction Picks

January 31, 2012 | About:
Ron Baron founded Baron Capital Management in 1982. Before that, he worked for several firms and became known for being a short-seller between 1973 and 1974 in the bear market.

Ron Baron primarily focuses on small and medium-sized growth companies. The idea is to invest in companies that have growth prospects. How does he find them? He carries out bottom-up company research. In addition, he is a long-run player and looks for attractive prices before making a deal. Most importantly, he tries to avoid paying attention to short-term market fluctuations when the reasons to purchase are more important.

Unfortunately, the company went through two events that were not successful: the hostile takeover attempt of Woodward & Lothrop of Washington, D.C., in 1984 and Philadelphia's Strawbridge & Clothier in 1986.

I analyzed Ron Baron's top conviction picks (stocks that he has kept buying in the last quarters) and was attracted by some of his picks, for example, FDS and RBA, companies that I consider have strong moats and good management.

FDS: Ron Baron INCREASED 1.36% his position

FactSet is a leading provider of financial and economic data and analytics to the global investment industry. The offers include company fundamentals, earnings estimates, economic data, research reports, M&A data and more.

In terms of revenue, 80% thereof is represented by buy-side users, while the remaining 20% by sell-side clients.

In the last quarter, FDS has seen certain improvement. Revenue grew 13.4% vis-a-vis the prior year. Unfortunately, the operating margin was 34%, which meant a drop of 30 basis points in relation to the previous year.

FacSet increased its employee database year over year. Other figures show that sales increased 8.1% in a three-year period, and EPS increased as well, to $3.72.

FDS has a current high ROE of 33.62% which has been increasing from 26% (average 2003-2008 period) and 30% (average 2009-2008 period). Revenue has grown 13% year over year since 2008 while EPS grew 15% year over year since that period. This shows solid ROE, revenue and EPS growth numbers, things that Ron Baron surely has looked at.

FactSet also trades with a P/E of 24.6 versus the industry average of 24.4, but its P/B and P/S multiples of 7.7x and 5.7x look overvalued compared to industry averages of 2.6x and 1.5x. These multiples do not appear undervalued compared to other companies in the sector.

FactSet's most important product is the Portfolio Analysis Workstation which continues to lead the industry and drive growth. FDS established a presence with institutional asset managers, which has helped the company achieve 95% client retention over the past several years. Ron Baron saw this and was attracted by this product, which has high barriers to entry for potential competitors because of extensive product development and strong client relationships.

FDS currently trades at 22x Zacks' 2011 estimate of $3.48. This represents a premium to industry averages. The company average 2011 P/E multiple of 27x is in line with its five-year trailing P/E multiple range of 35x to 14x, and I expect the company to trade in the same range going forward. In terms of valuation, I found no compelling opportunity to invest in FDS at this time.

I think Ron Baron was attracted by the fact that FDS has a recurring revenue stream from 95% of its client base and enjoys an underleveraged balance sheet which gives the financial flexibility to expand its services.


EQIX: Ron Baron INCREASED 0.82% his position

Equinix manages data centers providing collocation and network-neutral connections to more than 650 networks. Some of its customers include financial exchanges and trading firms, traditional enterprises, telecom providers and content companies.

The business is capital-intensive in its nature, so investors consider its plans for capital expenditure should be carefully followed. The company expects to increase its plan in 2012.

The m9arket capitalization of the company is $4.86 billion and earnings per share of $2.78 are forecast to reach $3.4 by the end of 2012. Equinix showed an operating margin of 18.71% in the third quarter of 2011.

Ron Baron surely got attracted by the fact that Equinix is a leading player in the peeringsection of the U.S., serving the world's leading Internet service providers (ISPs), broadband providers, international networks and major content providers.

Equinix has extended its market leadership position in Europe, which is one of the largest co-location markets in the world. Europe is an important growth opportunity for the company, as recent research conducted by IDC/Interxion indicates healthy growth in the European market for premium carrier-neutral co-location services. IDC estimates that the carrier-neutral co-location market in France, Germany, the Netherlands and the U.K. was worth $725 million in 2008. It expects this market to grow at a CAGR of 23% to 2.0 billion in 2013, impacted by strong demand.

Considering Equinix's unique market position, I believe the stock deserves to trade at a premium to its peer group. The trailing 12 months P/E is 56.2x, compared to 36.1x for the industry and 16.9x for the S&P 500. The stock is currently trading above the low end of its historical P/E range.

With its leading market position, Equinix's earnings are expected to grow almost as fast as its peer group and significantly faster than the S&P 500 over the next five years.

EQIX's ROE does not show a solid trend. It has a low 2.4% ROE and a poor net margin of 3%. Equinix shows a solid revenue growth of 38% on average over the last two years. I do not like these numbers, and its P/E of 56 compared to the industry average of 17, in addition to a high P/B of 2.8x and P/S of 3.8x, compared to industry averages of 1.6x and 1.2x, makes me think shares are overvalued.


ANSS: Ron Baron INCREASED 0.6% his position

Ansys develops software solutions for design analysis and optimization.

Ansys can take advantage of a large economic moat as well as hefty profits thanks to the switch of costs to clients and several entry barriers.

Financially speaking, ANSS's market cap is $4.07 billion and TTM operating cash flow/capital expenditures are at 12.08. MRQ net profit margin increased to 28.0% from 25.76% year over year and sales/assets increased to 0.0725 from 0.0705, while assets/equity decreased to 1.36 from 1.39.

High switching costs for clients and significant barriers to entry are the main advantages of Ansys. The company generates hefty profits with a narrow economic moat. It takes time for engineers to learn a new simulation tool, and companies usually employ the same simulation solution throughout the development cycle of their products. In addition, during its 41 years in business, the company has accumulated a significant amount of intellectual property that would take considerable time and resources for a competitor to replicate.

Ansys ROE is 10.77%, lower than its average ROE of 14% during 2007-12 and 22% during 2004-12. The company has some overvaluation in its P/E and P/S, trading at 31.7x and 8.8x, compared to industry averages of 30.1x and 3.6x. Its P/B of 3.4x is lower than the Industry average of 4x.


RBA: Ron Baron INCREASED 0.32% his position

Ritchie Bros. Auctioneers is the world's largest auctioneer of industrial and agricultural equipment. The company operates in 110 locations across 25 countries.

It is considered the largest in the sale of construction equipment. This enables the company to profit from good results, regardless of the outside economic situation.

Now, RBA's most important challenge is to take customers away from private sellers who are currently dominating the resale market of used equipment.

Although it operates in a highly volatile market, Ritchie has mostly escaped the drawbacks of the construction market. In prosperous times, contractors are more likely to sell their older equipment and buy new, and in bad times contractors save money by acquiring used equipment. As a result, RBA has exhibited an impressive 12% annual average growth rate since 1998. Even during the recent severe recession, the U.S. still spent about $1 trillion on construction in countercyclical end markets such as highway infrastructure, education and health care. Baron has researched this and likes RBA for its highly stable business and potential growth in a U.S. housing recovery.

RBA has an average net margin of 18.44% in the period of 2010-12 in comparison to a net margin of 24% (2007-12) and 19% (2004-12). I do not like the fact that margins decreased. Also, RBA's return on equity is currently at 11.7% (2010-12 average) in comparison to its average ROE of 16.2% during 2005-12. I do not like the trend of deacelerating ROE.

RBA has a P/E of 39x, a P/B of 4x and P/S of 6.7x, which are higher than industry averages of 24.4x, 2.6x and 1.5x.


CHH: Ron Baron INCREASED 1.46% his position

Choice Hotels is one of the largest hotel companies in the U.S. The company does not own hotels but acts as a franchisor. It focuses primarily on the midscale and economy segments of the hotel industry. It operates through the following brands: Comfort Inn, Quality, Clarion, Sleep Inn, Rodeway Inn and Econo Lodge.

The company is recovering demand after a downturn in the lodging industry. The RevPAR rate grew 5.4%. Nevertheless, there is still underperformance given the poor economic situation. Poor results can be attributed to two issues: 1) they are less cyclical than the upscale and luxury segments, and 2) the economy and midscale segments rely more on personal travel among middle-class and lower-income consumers.

In terms of last quarter results, the figures can ensure good expectations. Revenue increased 5% and EBITDA reached $64.5million, a 13.2% increase.

One disadvantage I found is that the company's current pipeline of hotels as a percentage of existing hotels remains at less than 10% and CHH continues to have the weakest pipeline of new hotels among global hotel operators. One reason some analyst mention for that weak pipeline is the management's strategic decision to focus solely on franchised hotels and not on the attractive market of managing hotels for property owners. The company experiences the problem that some developing international markets lack a solid supply of experienced hotel managers, limiting growth prospects for hotel franchisors. In addition, the legal environment is not favorable to franchising in many emerging international markets, such as China.

Surely Baron was attracted by the fact that CHH performed better than its competitors in the last recession. In 2009, Choice revenue declined by 12%, compared to 17% for the industry, and EBITDA declined by 22%, considerably less than the more than 50% decline in EBITDA experienced by some large operators with owned and managed hotels. The company has one of the most conservative balance sheets in the industry, with net debt/EBITDA at only 1x in 2010.

CHH has an average profit margin of 18% from 2010-12, which is equal than its percentage margin of 18% from 2007-12 and 17% from 2004-12. This shows good margin stabilization. It has a current P/E of 20, compared to the industry average of 28x, and a P/S of 3.5 compared to the industry average of 1.7.


About the author:

Federico Flom
Equity Research Analyst

Rating: 3.4/5 (5 votes)


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