“You can’t innovate a candle to create a lightbulb.” Director of Manufacturing. Tesla plant. Austin, Texas. November 2021.
On November 12, 2021, three Baron Funds’ analysts and I spent the morning visiting the massive 10.5 million square foot, brand new Tesla, Inc. (TSLA, Financial) car factory in Austin, Texas. Our tourguide was the plant manager, a 41-year old PhD in mechanical engineering who had formerly been a Ford Motor Company (F, Financial) senior executive on the Ford F-150 program. The Ford F-150 pickup truck is the most popular truck ever built and produces more than 100% of Ford’s annual profits.
The Tesla plant was pretty amazing. How big is a 10.5 million square feet factory? I am not sure whether the Tesla Austin plant could fit three Pentagons or five Pentagons under roof. But that plant is definitely supersized and the largest facility I have ever visited. That factory was then scheduled to open several months after our visit...which it has this month.
While we were touring the factory, I asked why we should believe that others with seemingly substantial capital resources and cash flow couldn’t innovate to make an even better car...or truck...than Tesla? That was when the executive told us that, “you can’t innovate a candle to make a lightbulb. You can innovate to make a better candle. But, you can’t continuously improve a candle to make a lightbulb. You need to start all over.” Elon clearly believes in First Principles (i.e., tearing everything down and starting again from scratch with no preconceptions). The manager explained to us that Tesla and Elon are all about the culture of innovation.
When we asked for examples of an innovative Tesla manufacturing process that would be difficult for others to replicate, he showed us how the front of a Tesla car was now being cast as one part. Elon likes to say that “the best part is no part.” Casting reduced the number of parts in this section of the Model Y car’s front end from 171 to two! The Model Y now requires 1,600 fewer welds and 30% fewer expensive robots. The manufacturing process then became faster and less expensive, producing a higher quality, more consistent end product with less scrap. Why can’t others copy this process? “Because it is expensive to institute and entails risk of execution that another company’s Board might find objectionable. Further, union work rules could prevent or delay new tasks that are required. And, finally, there are no casting machines available. Elon bought all the casting equipment that will be produced for the next three years.”
Herbert Dies, Volkswagen’s (XTER:VOW3, Financial) CEO, recently remarked that it takes Volkswagen 30 hours to manufacture a car. “It takes Elon less than 10 hours.” Dies is “hopeful that VW will be able to ultimately produce a car in 20 hours.” In the meantime, Tesla continues to make progress reducing costs, improving quality, and cutting manufacturing times. The Tesla plant in Austin has 500 stations in its assembly line. The car stops at each station for 45 seconds. The plant manager told us that Elon asked why the production line couldn’t move faster between stations than he could walk. The friction of air resistance was then measured. “QuestionEverything” was the theme of the 2017 Annual Baron Investment Conference. Elon takes this to another level. When I recently asked a Tesla executive with whom I regularly speak, “How does Elon do that?” “How have you achieved such outstanding performance results?” was the reply. “Elon does it by questioning everything. Just like you do.”
Intel’s (INTC, Financial) capital spending process is guided by a process they appropriately named “copy exactly.” This means that they attempt to “copy exactly” what they have already built and attempt to improve tried and true processes iteratively. Similarly, Toyota’s (TM, Financial) “kaizen” manufacturing philosophy is based on improving manufacturing by using “just in time” processes to eliminate waste and reduce inventory carrying costs. Clearly neither company contemplates disruptive change that will dramatically lower costs and improve quality.
Ford is another example of typical industrial manufacturing business executive mindsets. The April 18, 2022, Bloomberg Businessweek cover story features Ford CEO Jim Farley behind the wheel of an electrified Ford F-150 Lightning. The article is titled, “Hey Elon, THIS is a truck.” I thought the article was terrific. One idea especially stood out to me. Since the F-150 is such a popular vehicle, it “argued for a gradual approach to electrification. Essentially the company retrofitted an existing F-150 with an electric powertrain rather than develop an entirely new truck.” No all-in financial andoperation bet by this company on electrification. Such bets on disruptive manufacturing plants, processes, and vehicle design enable Tesla to earn more than 30% gross margins and very high returns on capital, which are both increasing compared to low teens margins and low and declining returns on capital for most other internal combustion engine (ICE) OEMs! Tesla’s cars not only cost less to build and sell, but they have characteristics that we regard as superior to its ICE competitors. This reminded me of an Einstein remark all those years ago, that “We cannot solve our problems with the same thinking we used when we created them.”
David, a good friend who happens to be one of the great hedge fund traders, called me in March 2022. “How does
Tesla obtain nickel and lithium for its car batteries? Are the prices Tesla pays spot or at fixed prices under long-term contracts?” He was obviously trying to determine if Tesla’s earnings for its next quarter would beat or miss analyst expectations. After describing how Tesla is working hard to obtain raw materials in large quantities at attractive prices over the long term, I gave my friend the following advice. “David, you are missing the point. Tesla is now producing a little more than 310,000 cars per quarter. In three years, they will be producing more than one million cars per quarter, and in 10 years, more than five million cars per quarter. Your focus on whether they make a little more or a little less in a quarter due to higher costs or supply-chain disruptions will make you miss a giant opportunity. In a few years no one is going to remember whether margins and deliveries were a little higher or lower and costs were a little higher or lower in the quarter.”
After spending the morning in Austin, we flew to Boca Chica, Texas to visit the Space Exploration Technologies Corp. (SpaceX) Starbase thatafternoon. Starbase is the company’s rocket assembly, fuel depot, maintenance, launch pad and landing site for its fully reusable Starship launch system. The site, which looks like a Star Wars movie set, supports testing, flight preparation, landing, and refurbishment for SpaceX’s “RRR” Starship spacecraft and Super Heavy rockets. “RRR” means rapidly reusable rockets. Baron Funds is a significant investor in SpaceX. SpaceX is a separate privately owned Elon Musk business. It is not part of Tesla. I will write about our afternoon at Starbase in my next “Letter from Ron.” I will tease that the entire day was a hoot.
“Baron invests in people not just buildings.” Ron Baron (Trades, Portfolio). 1982-2022.
Michael Baron’s father-in-law David Brand lives in Virginia Beach. David attended an election rally in the fall of 2021 to learn more about Glenn Youngkin, who at the time was campaigning to become Virginia’s next Governor. Soon after David arrived, he was surprised that Glenn’s “advance man” knew him. “I understand we have a relationship in common,” Glenn began when he met David. “I know Michael and Ron Baron (Trades, Portfolio) very well. Several years ago, when I was Carlyle’s CEO, Baron Funds was an important Carlyle shareholder. For a few years following Carlyle’s initial public offering in 2012, our business and its stock price didn’t achieve the results we had expected. When I visited Michael and Ron to apologize for Carlyle’s performance, Ron’s reaction was unexpected. ‘Don’t worry, Glenn. This will work out. It’s just a blip. In a few years, you will see that Baron made a very good decision investing in Carlyle, which was actually a very easy decision. We were just investing in you and David (Rubenstein).’” David Rubenstein was one of The Carlyle Group Inc.’s (CG, Financial) three founding partners. Glenn then told David Brand, “I will never forget how much I appreciated Michael’s and Ron’s support. It seemed like they were the only investors who appreciated an accurate appraisal of our business and focused on long-term opportunity instead of short-term headwinds.”
Following his election as Virginia’s Governor, Glenn returned to Virginia Beach last fall to thank his hometown voters. David participated in that event. When Glenn arrived to speak, he hopped out of a large, black, state-owned SUV with a spinning red light on the roof. He was now surrounded by security. When he spotted David in the crowd, he shouted out, “I wonder what Michael and Ron would say if they could see me now?”
By the way, we were right about both Carlyle’s people and its prospects. Carlyle has been an attractive investment for Baron Funds. Since we first invested in Carlyle in 2012 during that company’s initial public offering, Carlyle’s share price appreciation plus dividends have achieved an annualized rate of return for its shareholders of 16.8% as of year end. The stock market, as measured by the S&P 500 Index, had an annualized rate of return of 15.9% during the same period.
Glenn, like most CEOs of businesses in which Baron has invested, regard Baron as a long-term partner in their businesses. We work hard to build trust and maintain our reputation as a long-term investor so that executives will think about us in that light. We do not want to be considered as a trader seeking short-term profits by front running favorable quarterly earnings or selling before quarterly earnings that may be somewhat below Wall Street analysts’ expectations. Our reputation enables us to develop perspective regarding management talent and their decisions as well as understanding businesses’ competitive advantages. We also nearly always encourage executives to invest in their businesses to grow faster if they perceive attractive opportunities...even if that penalizes profits and share prices in the short term.
Just like we invested in the executives of Carlyle, we invested in Dick’s Sporting Goods CEO, Ed Stack, who also considered us as his partner...just as Carlyle’s Glenn Youngkin and David Rubenstein did...
Michael Baron graduated from Duke University in 2003 and received his MBA from the University of Pennsylvania’s Wharton Business School in 2010. He started working at our privately owned, family investment advisory business, Baron Capital, as a financial analyst, after his college graduation and returned after he received his MBA in 2010. David Baron likewise followed nearly the same career path as his brother after graduating from Emory in 2002 and receiving his MBA from Columbia Business School in 2009. Three years ago, both Michael and David added portfolio management roles to their responsibilities as members of our Firm’s 40-person research analyst/portfolio manager team...as well as their roles on our executive committee.
Dick’s Sporting Goods, Inc. (DKS, Financial) was the first stockMichael recommended to us shortly after he joined Baron Capital in 2003. Dick’s share price has since increased about nine-fold. Unfortunately, we sold our investment in Dick’s about six years ago and, although it was a successful investment, we did not realize the full benefit of Michael’s recommendation. We sold too soon because I was concerned that competition from internet retailers would have a permanent negative impact on Dick’s stores’ profitability. I was wrong. Dick’s stock price so far has about doubled after we sold...and its prospects have brightened!
We sold even though we considered Ed Stack, Dick’s Chairman and CEO, a terrific retailer, a great entrepreneur and a special person. Ed had built Dick’s from three bait and tackle stores his dad started into a uniquely positioned, nationwide chain of 730 sporting goods stores. In fact, Dick’s is now the largest nationwide sporting goods chain. Ed had purchased the three bait and tackle stores, the foundation of Dick’s business, from his dad. Ed’s mother loaned him the money to buy his dad’s stores! I’m not exactly sure what that signifies. But it may have something to do with Carl Icahn (Trades, Portfolio)’s proclamation that “everything I have is for sale except my children...and maybe my wife.”
Ed and his newly appointed CEO Lauren Hobart visited us last month. Ed asked for the meeting to introduce us to Lauren, as well as to discuss the prospects for Dick’s new, large format stores with attached outdoor, student athletic fields. Lauren then described how well its new format stores were doing in two smaller communities. We also spoke about the successes of Dick’s omni-channel retailing efforts and how desirable Dick‘s stores have become to shopping centers trying to lure shoppers to return to their malls.
“I was always struck by your reference to ‘we’ when we visited Baron and were facing a vexing issue,” Ed began. “It was always, ‘How are we going to deal with this?’ You were our partner, and you didn’t expect us to work hard just to make you and your investors as much as possible by focusing on maximizing current profitability. You always encouraged us instead to invest in our business to make it substantially larger and more profitable over the long term…even if that meant sacrificing profit growth in the short term.”
“I have known you since 1979 and have finally figured out how you choose businesses in which to invest. You meet lots of executives, you find individuals you think are really smart, work hard, you consider talented, and, most importantly, whom you trust...and then you find a way to invest in them.” Tom Pritzker. Chairman. Hyatt Hotels Corp. 2021.
David Baron is responsible for our Firm’s significant and very profitable long-term investments in well-managed and competitively advantaged travel and leisure businesses. Among them are Hyatt Hotels Corp. (H, Financial), Vail Resorts, Inc. (MTN, Financial), Choice Hotels International, Inc. (CHH, Financial), Red Rock Resorts, Inc. (RRR, Financial), Marriott Vacations Worldwide Corp. (VAC, Financial), and Penn National Gaming, Inc. (PENN, Financial). We believe these businesses all havesignificant barriers to competition...and exceptional managers who take unusual care of their structural advantages.
Tom Pritzker is the Chairman and largest investor in hotelier Hyatt. We have been friendly since our first meeting in a coffee shop at The Hyatt Regency at Chicago’s O’Hare Airport in the late 1970’s with his dad, Jay. Jay Pritzker was one of the first business executives to mentor me at the start of my analyst career. Tom is just like Jay. A terrific executive who is surrounded by others, like Mark Hoplamazian, who are also incredibly talented. Finally, whatever Tom says he will do, he will do. Always. A handshake, not a contract, is all that is required. And, he always has great stories...which David Baron and I just love.
Postscript 1. “You never stop taking notes onyour Microsoft Surface computer. If you want to make sure your sons are wealthy, let them publish your notes on your death. You are right in the middle of so many important trends. It would be so interesting to read about your opinions real time.” Tom Pritzker. “Thanks for the compliment, Tom. While what I learn is interesting to me, I’m not sure anyone else, except my family and those with whom I work, would find these notes interesting.” January 2022.
Postscript 2. Reacting to our decisionsnottoinvest in Theranos’ Elizabeth Holmes who was recently convicted of fraud and will likely to go to prison... movie producer Harvey Weinstein who is now in prison for sex crimes... ponzi schemer Bernie Madoff who was tried for fraud and died in prison...and, last but not least, WeWork’s Adam Neuman whom I read recently had been assessed as “a potential billionaire or fraudster”....Anita
Nagler, Independent Director of our family-owned investment management company, Baron Capital Group, told me that I “have a great b.s. detector.” Anita was the former head of enforcement at the SEC in Chicago.
Postscript 3. My wife Judy and I recently watchedthe popular Netflix drama, “Inventing Anna.” This tale about a make-believe oligarch heiress Anna Delvey was advertised as “a true story except for the parts that are made up.” On more than a few occasions, I have felt we met such people…and fortunately due to the intense research we perform on our investments and their executives, we chose not to invest with them. I have written in previous “Letters from Ron” about our meetings with Elizabeth Holmes (September 2017)...Harvey Weinstein (September 2017)...and Bernie Madoff (December 2008). When I decided to write about this topic, I found those letters. Since I thought you could find those discussions of interest as illustrative of our investment process, we have attached those paragraphs as addenda to this letter.
“You bought a Tesla car?!!! Mike, I told you to buy Tesla’s stock, not the car!” Ron Baron (Trades, Portfolio). Palm Beach, Florida. Conversation with doorman. December 2021.
In 2018, the doorman in our Florida apartment building told me he had been investing in Bitcoin. Curious, I asked how he was doing. “Great, Ron. I purchased Bitcoins at $14 to $600 each more than eight years ago. They are now selling for more than $20,000!” “Wow, that is fantastic Mike. I don’t know very much about crypto currencies, but I do know that your Bitcoin profits could be life changing for you and your family. If I were you, I would sell your Bitcoin and buy Tesla.” Several months later the price of Bitcoin fell to $13,000. When I next saw Mike, he told me he had taken my advice, sold his Bitcoins and had purchased a red Model 3 Tesla!!! His wife loves their Tesla so much, he went on, that Mike hardly has an opportunity to drive it! “Mike, I’m really glad you and your wife like your Tesla Model 3, but I told you to buy Tesla stock, not the car!!!”
There is a postscript to this story. When we saw Mike recently, I asked how he was doing with his investments. “Fantastic, Ron. I am now investing in Bitcoin, again.. and Ether, too.” My wife Judy responded, “Gee, Mike, maybe you could help Ronnie. He has never really understood how to invest in Bitcoin.” “I can do better than that, Mrs. Baron. There is a website that tells you all you need to know about crypto. All Ron needs to do is go there and he can trade Bitcoin just like me...”
The moral of this tale? Make investment decisions based upon your own work, careful study and fundamental research or observations, not on what others recommend or how they are investing for themselves. Regardless of whether the “others” you are copying are Elon Musk...Warren Buffet...Ron Baron (Trades, Portfolio)...or your doorman.
We will continue to provide you with information about Baron Funds that we would like to have if our roles were reversed. Thank you for your confidence in joining us as investors in Baron Funds.
Respectfully,
Ronald Baron
CEO and Portfolio Manager
March 31, 2022
P.S. One more thing. The first quarter of 2022has been a difficult one for many mutual funds. Especially for funds like Baron mutual funds which have significant investments in rapidly growing technology businesses. We believe current market volatility and lower stock prices are principally a consequence of persistent above normal inflation. This inflation is causing the United States Federal Reserve Bank to increase interest rates and reduce their holdings of government debt. Those actions hurt stock prices in the short term but in the past have substantially reduced inflation. Generally speaking, inflation historically has increased significantly above trend around wars, pandemics and economic recessions. Soon after inflation ebbs, interest rates have typically fallen and stock prices have increased materially. We expect that to again be the case. In the meantime, the businesses in which we have invested have continued to grow substantially. This is although their stock prices in most instances have declined.
1 Excess returns and rankings were calculated using the Retail Share Class of our U.S. mutual funds with at least one year of history. The Retail Share Class is the highest cost and oldest share class. AUM reflects assets in all share classes of our U.S. mutual funds. Since Baron WealthBuilder Fund is a fund of funds investing exclusively in other Baron Funds, its AUM is not included in the above calculations.
2The Morningstar Large Growth Category consisted of 1,236, 1,025, and 765 share classes for the 1-, 5-, and 10-year periods. Morningstar ranked Baron Partners Fund in the 1st, 1st, 1st, and 1st percentiles for the 1-, 5-, 10-year, and since conversion periods, respectively. The Fund converted into a mutual Fund on 4/30/2003, and the category consisted of 405 share classes.
The Morningstar Small Growth Category consisted of 614, 521, and 391 share classes for the 1-, 5-, and 10-year periods. Morningstar ranked Baron Small Cap Fund in the 35th, 38th, 42nd, and 14th percentiles for the 1-, 5-, 10-year, and since inception periods, respectively. The Fund launched 9/30/1997, and the category consisted of 89 share classes.
The Morningstar Mid-Cap Growth Category consisted of 592, 503, and 386 share classes for the 1-, 5-, and 10-year periods. Morningstar ranked Baron Growth Fund in the 20th, 23rd, 20 th, and 1st percentiles for the 1-, 5-, 10-year, and since inception periods, respectively. The Fund launched 12/31/1994, and the category consisted of 53 share classes. Morningstar ranked Baron Focused Growth Fund in the 3rd, 1st, 1st, and 1st percentiles for the 1-, 5-, 10-year, and since conversion periods, respectively. The Fund converted into a mutual Fund on 6/30/2008, and the category consisted of 311 share classes.
The Morningstar Real Estate Category consisted of 255, 205, and 149 share classes for the 1-, 5-, and 10-year time periods. Morningstar ranked Baron Real Estate Fund in the 96th, 1st, 1st, and 1st percentiles for the 1-, 5-, 10-year, and since inception periods, respectively. The Fund launched 12/31/2009, and the category consisted of 127 share classes.
The Morningstar Allocation—85%+ Equity Category consisted of 188 share classes for the 1-year period. Morningstar ranked Baron WealthBuilder Fund in the 96th and 2nd percentiles for the 1-year and since inception periods, respectively. The Fund launched 12/29/2017, and the category consisted of 165 share classes.
Morningstar calculates the Morningstar Category average performance and rankings using its Fractional Weighting methodology. Morningstar rankings are based on total returns and do not include sales charges. Total returns do account for management, administrative, and 12b-1 fees and other costs automatically deducted from fund assets.
3 This is a hypothetical ranking created by Baron Capital using Morningstar data and is as of 3/31/2022. There were 2,166 share classes in these nine Morningstar Categories for the period from 4/30/2003 to 3/31/2022.
4 This is a hypothetical ranking created by Baron Capital using Morningstar data and is as of 3/31/2022. There were 3,436 share classes in these nine Morningstar Categories for the period from 6/30/2008 to 3/31/2022.
Portfolio holdings are subject to change. Current and future portfolio holdings are subject to risk.
The discussion of market trends is not intended as advice to any person regarding the advisability of investing in any particular security. The views expressed in this document reflect those of the respective writer. Some of our comments are based on management expectations and are considered “forward-looking statements.” Actual future results, however, may prove to be different from our expectations. Our views are a reflection of our best judgment at the time and are subject to change at any time based on market and other conditions and Baron has no obligation to update them.
