Ron Baron review and outlook for the third quarter 2014.
Ron Baron – Review
“With so many global uncertainties, why aren’t stock prices falling?” Numerous advisors. Summer2014.
That was the question investors posed to us most often during the third quarter. That is, until U.S. stock prices began to fall broadly in September. Which was when many executives of companies in which we have invested … and whose businesses are doing quite well … began to ask us why their stocks had fallen so much.
Stocks of small growth companies significantly underperformed larger, mature, cyclical companies during the first six months of 2014 … and continued to underperform in the third quarter of 2014. Stocks of fast growing, small cap companies had significantly outperformed stocks of larger companies in 2013. This recent underperformance has taken place even though smaller companies are growing faster than larger ones. Stocks of large companies are performing well because they have been reporting strong growth in earnings per share despite modest revenue gains. This is because during the almost six-year-long, steady economic recovery in the U.S., most large companies focused on reducing operating expenses and not so much on increasing revenues. With increasing demand for their products and services, larger companies have begun to achieve price increases, further boosting their profits. They have also improved earnings per share by repurchasing their stock rather than investing profits to grow faster as many smaller companies have done.
We believe that as a result of the disappointing stock price performance and strong growth many small cap businesses have experienced year-to- date, these companies offer unusually attractive values. We think this is the analogue to real estate, large caps and emerging markets stocks that underperformed in 2013 and have outperformed in 2014.
“It just goes to show ya. It’s always something. If it ain’t one thing, it’s another.” Gilda Radner’s Roseanne Rosannadanna. Weekend Update. Saturday Night Live. 1978.
Negative news from around the globe dominated headlines in the third quarter. Anxiety over the spread of the Ebola virus created fears that business and tourist travel would soon fall. The conflict between Ukraine and Russia that culminated in a Malaysian plane being downed by a Russian missile didn’t soothe what Erica Jong used to call “fear of flying.” Especially since it took place soon after a Malaysian passenger plane disappeared without a trace over the Indian Ocean. ISIS beheadings of combatant and non-combatant hostages in Syria and Iraq terrorized not only citizens and armies in those locales but also global travelers, who either sought more inviting destinations or stayed home.
“Give peace a chance.”John Lennon.1969.
That song was written by John Lennon … with a little help from his friend Paul McCartney … and released as a solo record in 1969. Lennon was then still a member of The Beatles. “Give peace a chance” became the anthem of the anti-war movement in our country in the 1970s. “Give peace a chance” has not been any easier to achieve than it was when Lennon first wrote those lyrics 45 years ago. In Hong Kong, students took to the streets in pro- democracy demonstrations against the Chinese government. Investors found protests in a nation with the world’s second largest economy to be unsettling. In our global economy, unrest anywhere has the potential to affect economic activity everywhere.
Military conflicts, student demonstrations and citizen uprisings were so prevalent during the past three months that Hamas’ missile attack on Israel over the summer from tunnels in Gaza and Israel’s response seem like distant memories. Anti-semitic rallies in France, Germany and the U.K. have not faded from our memories, though, and seem to some reminiscent of Nazi gatherings in 1939. The only positive, we suppose, is Warren Buffett’s observation that stocks generally rise during wartime since producing armaments creates jobs and stimulates our economy!
“We are accountable to the European people for delivering price stability, which today means lifting inflation from its excessively low levels; and we will do exactly that.” Mario Draghi. President, European Central Bank. October 2014.
Southern Europe’s economic depression and the disagreement between Germany, which is seeking to prevent monetization of southern Europe’s indebtedness, and southern Europe, which is looking to escape depression, didn’t engender investor confidence either. Despite Mario Draghi’s efforts to lead his continent’s economies out of their malaise with his version of Quantitative Easing, interest rates in Germany are negative six basis points! In a world where capital moves freely, interest rates on government debt in Italy were lower than in the United States! This, in our opinion, suggests that interest rates in our country will not increase significantly in the near term, because higher rates would further strengthen our currency and slow growth in America’s still highly leveraged economy. That would not be helpful to the competitiveness of U.S. businesses.
Finally, as if all that were not enough, on September 30th, The Wall Street Journal published an article titled, “U.S.Takes Asteroid Threat Seriously.”The paper noted that nuclear warheads scheduled for disassembly early next year are being retained “pending evaluation of their use in planetary defense against earthbound asteroids.”
The Death of Equities. BusinessWeek. August 13, 1979. Dow Jones Industrial Average 880!
Trading volumes in U.S. securities markets in 2014 remain subdued due to investor disinterest. This is reminiscent of the summer of 1979 when trading volumes in U.S. stocks were lackluster and bearish sentiment predominated five years after the 1973-74 bear market, which was considered at that time the worst bear market of a generation. Volumes in the summer and fall of 2014 are about half the shares traded in the years immediately preceding the 2008-09 Financial Panic. Lack of investor interest in equities persists despite widely available credit and historically low interest rates, which give businesses unusual opportunities to make successful investments and should make stocks more valuable. Credit markets that were “frozen” six years ago are now “open.” One example follows. We could list many many more.
In late September, we visited the Los Angeles headquarters of Air Lease, a leading airplane lessor in which we have been a shareholder since April 2011. “Ron, why has our stock fallen over 20% in the past month?” the four frustrated Air Lease executives with whom we met asked me. Their question is especially relevant since Air Lease shares could be worth four times as much in 10 years when their fleet will have increased by 2.5 times. That same question asked of us by Air Lease executives has become the question most frequently asked of us by the numerous executives who visit us and whom our analysts and managers visit every day.
Interest is a significant expense for Air Lease. Interest costs are significantly lower now than six years ago. A positive. For example, two weeks before our visit, Air Lease refinanced $1 billion debt. The company borrowed $500 million for ten years at 4.25% and $500 million for three years at 2.125%. The three-year loan was ten times over-subscribed! The lenders were principally investors in their stock! Another positive. Air Lease Corp (NYSE:AL)’s credit is now so strong it borrows about 80% unsecured. Six years ago, they were borrowing 20% unsecured. Another positive. Air Lease’s customers are doing well and are trying to lease more planes at higher prices. With 379 planes on order