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Well-Managed, Competitively Advantaged Growth Companies Wanted

Ron Baron has a system that IDs high-potential growth companies with fundamental analysis, intense focus on management and valuation models

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Jul 10, 2017
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Ron Baron (Trades, Portfolio) got his first taste of investing profits as a teenager. That was apparently enough to get him into the investment management industry and later to launch his own firm in 1982.

Baron Capital Management today manages more than $18.5 billion and operates a stable of mutual funds that have posted outstanding results in the past 12 months, but every year hasn’t been outstanding for investors in his mutual funds.

Still, those who persevere for the long term have been rewarded with average annual results that outstrip those of the Standard & Poor's 500.

Who is Baron?

He was born in 1943, and grew up in Asbury Park, New Jersey. The New York Sun reports he got an early start; he saved $1,000 from shoveling snow and other part-time student jobs, and quadrupled it through astute stock trades. After studying chemistry at Bucknell University and law at George Washington University Law School, he worked at several brokerage firms between 1970 and 1982.

Saying he wanted to help "regular" people as well as the rich, Baron started his own company, Baron Capital Management, in 1982 (bio based on information from Wikipedia.org and New York Sun).

What is Baron Capital Management?

The company provides investment advisory services to high net worth individuals, pension and profit sharing plans and other entities. In its Form ADV filed on May 22 it reported that pension and profit-sharing plans accounted for the largest share of regulated assets under management (up to 75%).

It is also the umbrella organization for several subsidiaries, including Baron Funds, which offers 13 mutual funds in seven categories:

  • Small Cap.
  • Small-Mid Cap.
  • Mid Cap.
  • Large Cap.
  • All Cap.
  • International.
  • Specialty.

The Specialty category comprises an energy and resources fund and a real estate fund.

These are the funds, collectively worth more than $18.5 billion, that make up the stable at Baron Funds (each listing shows the name, symbol, net asset value and year of inception based on information at the firm’s website; note that several funds have additional classes, for client groups such as individual and institutional investors):

  • Baron Growth Fund $5.9 billion, 1994.
  • Baron Small Cap $3.37 billion, 1997.
  • Baron Emerging Markets Fund $3.21 billion, 2010.
  • Baron Asset Fund $2.69 billion, 1987.
  • Baron Partners Fund $1.69 billion, 1992.
  • Baron Real Estate Fund $925.53 million, 2009.
  • Baron Opportunity Fund $221.7 million, 2000.
  • Baron Focused Growth $186.93 million, 1996.
  • Baron Fifth Avenue Growth Fund $151.65 million, 2004.
  • Baron Discovery Fund $119.4 million, 2013.
  • Baron International Growth Fund $101.74 million, 2008.
  • Baron Energy and Resources Fund $98.29 million, 2011.
  • Baron Global Advantage Fund $22 million, 2012.

Looking at the funds' descriptions, one word appears in almost all of them  growth  and sometimes the phrase "significant growth potential."

With several funds, each managing well over a billion dollars worth of assets, and a total of more than $18 billion under management, Baron and Baron Capital Management are major financial players, thanks in large part to their pursuit of growth companies.

What is Baron’s investment strategy?

Broadly, the firm describes itself this way, on its Web site, “Baron is an asset management firm focused on delivering growth equity investment solutions.”

It goes on to say it has become known for its long-term, fundamental, active approach to growth investing.

The strategy is made up of three pillars, according to the firm’s Form ADV filed Feb. 28:

  • Fundamental analysis.
  • Meeting with management.
  • Valuation models.

The first objective of the fundamental analysis is to understand the key drivers of growth and profitability on a company-by-company basis. That's both to identify opportunities and to confirm investment theses.

They examine financial information to determine:

  • Opportunities and growth potential of a business.
  • The business model.
  • Uniqueness (or moat) of the products and services.
  • Predictability of revenue and earnings growth.
  • How effectively management uses capital.
  • Barriers to competition (related to product and/or service uniqueness).
  • The regulatory environment.

Baron and associates say that meetings with management are critical, and they stay in touch through the life of an investment. The items they assess in these meetings and other contacts include character, vision, competence, business practices, management style, ownership, experience and track record.

The third strategic pillar is building five-year valuation models; with these models they assess a company's opportunities and risks and estimate its intrinsic value. The models look back five years and forward five years. There are four elements in the models:

  • Key drivers of revenue growth including unit growth and pricing power.
  • Profitability, including ROIC, free cash flow and earnings growth.
  • Cost structure, including fixed and variable costs and incremental profitability.
  • Capital structure, including allocation decisions and financing activities.

Baron writes, in the First Quarter 2017 Quarterly Update, “Baron Funds’ investment strategy is simple. We purchase stocks of well-managed, competitively advantaged growth companies that we believe are increasing in value with dollars that we believe are falling in value.” He adds they try to invest in businesses growing 15% per year, rather than in businesses that grow 6% to 7% a year.

Of course, not everyone finds it that simple, and complexity begins with individual stock picks. In the Baron Partner Funds Letter for the first quarter of 2017, he and his team members outlined their thoughts on some of their picks:

  • IDEXX Laboratories (IDXX, Financial): They argue that the veterinary diagnostic company’s direct go-to-market business model, combined with product enhancements made possible by R & D, will put upward pressure on revenue and earnings growth over time.
  • Vail Resorts Inc. (MTN, Financial): Recent acquisitions will help drive season pass sales and the number of visits, which help improve cash flow and protect earnings against poor snowfall seasons.
  • Under Armour Inc. (UAA, Financial): Shares declined in the first quarter, and may do the same in subsequent quarters as the company tries to diversify its American wholesale distribution, while also expanding into other geographic regions and product categories. However, the Baron managers believe these are temporary setbacks, and long-term demand and earnings potential remain generally positive.
  • AO World PLC (AO., Financial): The leading online seller of major domestic appliances in the United Kingdom, the company has been hit by higher manufacturing prices as the British pound weakens against the Euro. Nevertheless, the managers believe prices will stabilize later this year, while the company continues to take market share from competitors, and its German business keeps expanding.
  • Zillow Group Inc. (ZG, Financial): The leading online real estate company in a highly fragmented U.S. market. New products launched late last year or early this year will help it grow market share in the future.

But the lion’s share of attention in the Partner Fund Letter is given to Tesla Inc. (

TSLA, Financial), the fund’s largest holding (14.2% of total investments). Baron says of Tesla:

  • The company has more than tripled its revenues since 2013.
  • Competition from the Big Three and other legacy auto manufacturers has been relatively weak so far. He points out General Motors (GM, Financial) hoped to sell 30,000 Bolt cars this year but sold only 3,000 in the first quarter. On the other hand, Tesla has 373,000 orders for the Model 3, each confirmed with a $1,000 deposit.
  • Infrastructure: Over the past five years, the company has made "substantial" investments in showrooms and maintenance facilities, charging stations, battery and solar roof plants and manufacturing capacity.
  • Panasonic (NGO:6752, Financial) will invest more than $3 billion in Tesla’s battery factories. And, China’s largest, publicly-owned company has bought 5% of Tesla’s shares for $1.8 billion.
  • They expect the company to have its first million-car year in 2020 or 2021, generating $70 billion in revenue and an operating profit of more than $7 billion. Baron remains guarded about Tesla, saying a A lot has to go right for that to take place." Nevertheless, he believes the odds are favorable.

We suspect Baron must be more than cautiously optimistic to keep such a major proportion of the portfolio in this one stock. As noted, he and his company do intensive fundamental research, talk extensively with management and others who know, and create valuation models for each of their prospects and holdings.

Current holdings

Consumer Cyclical and Technology stocks comprise the largest holdings of the Partner Fund, as shown in this GuruFocus chart:

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These are the top 10 holdings in the Partner Fund, at the end of the first quarter (table from the Partner Fund quarterly report):

746707162.jpg

With the exception of Tesla, none of the major holdings are household names in the broader investment community. Yet they have generated outstanding returns for the year to date and over the past year.

Performance

Baron notes in the Partner Fund Letter that while the fund experienced three "disappointing" years (2014-2016), performance had picked up in the first quarter of 2017:

1921016058.jpg

That outperformance is continuing. Yahoo! Finance reports the fund (retail class) has jumped 28.41%, year to date.

Other cumulatives beat the S&P 500; average annual returns are shown with the excess over the S&P shown in brackets:

  • 15 years: 9.6% (2.9%).
  • 20 years: 10.2% (2.5%).
  • 25 years: 12.1% (3%).

Further, it’s not just the Partner Fund that is having a good year. Here are one-year results for a number of other funds in Baron stable (data from US News & World Report):

  • Baron Asset Fund: +22.78%.
  • Baron Discovery Fund: +40.96%.
  • Baron Emerging Markets Fund: +22.68%.
  • Baron Energy and Resources Fund: +3.71%.
  • Baron Fifth Avenue Growth Fund: +24.83%.
  • Baron Focused Growth Fund: +19.53%.
  • Baron Global Advantage Fund +28.78%.
  • Baron Growth Fund: +19.68%.
  • Baron International Growth Fund: +18.36%.
  • Baron Opportunity Fund: +25.53%.
  • Baron Real Estate Fund: +15.84%.
  • Baron Small Cap Fund: +23.36%.

The Baron Partner Fund has tough years from time to time, but patient investors will be rewarded with outperformance – provided they buy in like value investors when the price is right.

Conclusion

Like many other gurus, Baron and his firm do fundamental, bottom-up research and talk with management and other stakeholders.

What’s unique about Baron is his emphasis on growth, combined with valuation models, which should help deliver the best of both worlds: strong growth and the safety that comes from buying the right stocks at the right prices.

As results from the past year and 2013 show, Baron and his team can generate enviable returns when conditions are ripe. But investors should also factor in those "disappointing" years before buying or following his lead.

Disclosure: I do not own shares in any of the companies or funds in this article and do not expect to buy any in the next 72 hours.

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