Baron Funds’ Spring 2015 Newsletter titled, “The Advantages Of Mid-Cap Stocks.”
Mid-cap stocks have been described as the “sweet spot” for investing in the equity markets. We agree. We launched our mid-cap growth fund, Baron Asset Fund, nearly 28 years ago, when few other investment managers were focused on mid-caps.* In our experience, mid-cap stocks tend to offer higher growth opportunities than their large-cap counterparts and less risk than their small-cap peers. For these reasons and others, we think the mid-cap universe presents compelling investment opportunities, particularly in today’s volatile markets. Advantages include:
- Outperformance compared with other major asset classes
- Lower volatility than small-cap stocks
- More growth opportunities than large-cap stocks
- Less analyst coverage than large-cap stocks
Over the past 25 years, mid-cap growth stocks, as measured by the Russell Mid-cap Growth Index, have consistently outperformed both large-and small-cap growth stocks, as
shown in the chart to the right.
Baron Funds: Mid-cap stocks performance
In addition to delivering superior performance, mid-cap growth stocks have had a consistently higher Sharpe Ratio, which measures riskad-justed returns, than small-cap growth stocks, and the same Sharpe Ratio as large-cap growth stocks.
We think several factors play into the favorable risk/reward characteristics of mid-cap stocks. We believe mid-cap businesses offer the greatest growth potential at time of purchase, having developed beyond their initial, usually riskier, start-up phase, but not yet having reached the more mature stage of their life-cycle. When compared to small-caps, mid-cap companies typically have better balance sheets, readier access to capital, lower cost of capital, more stable revenues and earnings, and accelerating cash flows to reinvest back into their businesses. When compared to large-cap companies, mid-caps tend to be more nimble, deploy resources more quickly, and have more avenues for rapid, sustained growth. A mid-cap company is also more likely than a large-cap company to be targeted for acquisition.
We think certain market factors also benefit mid-caps.
Baron Funds: Market factors that benefit mid-cap stocks
First, simply because they are situated in the middle of the market cap universe, mid-cap stocks have a relatively broader pool of prospective buyers. As a group, large-cap growth managers have approximately 11% of their portfolios invested in mid-cap growth stocks. The percentage of small-cap growth portfolios invested in mid-caps is even greater – about 21%.
Second, many mid-cap stocks are not extensively covered on Wall Street, especially when compared to large-cap stocks. For instance, while some 49 analysts cover Apple, Inc., and 47 follow Intel Corp., 11 analysts currently cover FleetCor Technologies, Inc., a large holding in Baron Asset Fund whose stock has climbed almost 500% in the past three years. This relative lack of coverage gives experienced portfolio managers like Baron the opportunity to identify and invest in companies with favorable long-term growth prospects at attractive valuations.
As a firm, we look for what we believe are well-managed businesses with significant competitive advantages and strong long-term growth potential, and we try to buy these businesses at valuations we consider attractive. As fundamental, research-based investors, we dedicate significant time researching the industries and businesses in which we invest, and continue this research process over the life of each investment.
We believe the depth and breadth of knowledge and experience of our 29 research analysts and portfolio managers is the key to what differentiates us from other actively managed funds. We take a longterm perspective, and as is typical of our portfolios, Baron Asset Fund has a lower turnover than many of its peers (12.43% three-year average, vs. 72.20%).
Baron Asset Fund, which is managed by Andrew Peck, invests in companies that we believe have sustainable competitive advantages – something that differentiates their product or service from what competitors can provide, while also discouraging new entrants into their markets.
Some of the advantages that we believe our investments possess include proprietary databases or analytical capabilities, industry leading platform companies, or long-established and well-regarded consumer brands.
Investments with proprietary databases or analytical capabilities typically have attractive business models, characterized by highly recurring subscription-based revenue streams, high incremental operating margins, and significant free cash flow. Examples in the Fund include Nielsen N.V., FactSet Research Systems, Inc., Gartner, Inc., and Verisk Analytics, Inc. While targeting different industries, these companies play a critical role in their respective clients’ daily workflow, creating great customer loyalty and high switching costs.
Nielsen, a global information and measurement company that has been in business for almost 100 years, illustrates the advantages of a proprietary database and sophisticated analytics. Its “Watch” ratings are the currency on which television advertising is sold in the U.S., and its “Buy” data is a critical planning tool for consumer packaged goods companies. It has stayed relevant and profitable through a strategic growth plan focused on building out additional analytic capabilities in complementary areas, such as digital and radio.
FactSet, a data and analytics provider to the financial industry, is a second example. The company has retention rates of over 95% and continues to take market share by offering broader data sets and more advanced portfolio analytics than its competitors.
A razor/razor blade business model is another way to generate recurring revenue. When coupled with a dominant market position, this type of business model can create a formidable competitive advantage.
Baron Funds: Portfolio holdings
One of our highest conviction holdings, Illumina, Inc., is built on a razor/razor blade model. The company, which is the recognized leader in next generation DNA sequencing platforms, supplies machines as well as the single-use products, such as testing kits, that are used with its machines. Illumina dominates DNA sequencing at a time when the market is accelerating, and it maintains its edge through innovation, with an R&D spend that significantly higher, percentage-wise, than that of its peers.
Similar to Illumina, IDEXX Laboratories, Inc., which supplies diagnostics products to the veterinary industry, features a razor/razor blade business model, a dominant market position, a focus on innovation as reflected in its high R&D spend, and strong secular growth in its market.
We also like platform companies, which benefit from economies of scale and a network effect, where growth in the number of users in turn attracts more users. This leads to dominance within a company’s vertical market, which typically can be extended across geographies.
An example is Equinix, Inc., the leading provider of Internet Business Exchanges (IBXs). Early on, Equinix employed its scale and “network neutral” policy, which allows its customers to connect with one another, to attract large telecom networks as customers. Once Equinix established its leading market position, other telecom networks, major enterprises, web commerce companies, and cloud computing companies were compelled to join the Equinix “ecosystem” in order to easily and efficiently access these networks.
Another example is The Priceline Group, Inc. Travelers gravitate to the company’s various websites because they offer access the Internet’s largest inventory of available rooms. Hotel owners gravitate to Priceline’s websites to access the Internet’s largest group of potential travelers. HomeAway, Inc. offers similar advantages to owners and travelers in the market for second home vacation rentals. Once a platform company has established itself as the leader in its market, it is difficult for competitors to reclaim market share. A disproportionate percentage of the market’s revenues accrue to the market leader, typically at high incremental margins.
Other companies we own are building a platform to complement their core business. For example, The Charles Schwab Corp. has leveraged its existing securities brokerage business to build out an online platform for independent RIAs and financial advisors. The Schwab Advisor Center provides RIAs with a full array of products, services and support needed to maintain and grow their businesses. Schwab’s advisor business has had strong growth in recent years, with fees increasing at a 4-year CAGR of 17.2% (2011–2014). As more RIAs leave wirehouses to set up their own shops, we think Schwab’s advisor business will continue to expand alongside this growing demand.
Well-regarded consumer brands, particularly among luxury goods purveyors, take many years and many millions of dollars in advertising and favorable public relations to establish. But once these brands are well established, they offer large opportunities for companies to extend them both into adjacent product categories and into international markets. Examples include Tiffany & Co., best known for its jewelry and iconic blue box, and Ralph Lauren Corp., known for apparel, sheets, towels, furniture, and even paint. Both companies are well-established U.S. luxury brands that have embarked on ambitious international growth strategies. Both brands have demonstrated their appeal to overseas consumers, especially the status conscious – and rapidly growing – middle and upper classes in emerging market regions.
When a company has sustainable competitive advantages, it is positioned to protect its profitability from competition. Such companies will typically have steadier sales growth, stable profit margins, and the ability to raise prices, resulting in higher returns on invested capital. Strong, financially sound, high quality companies are less sensitive to market conditions and macro-economic events. While a higher quality stock may lag in market rallies where business fundamentals are less important, it may also weather downturns better than lower quality stocks.
Conclusion
We believe Baron’s emphasis on research creates an informational advantage in the mid-cap space. Because mid-caps are less thoroughly covered by analysts, Baron’s research team can take advantage of this void to identify and track opportunities that we believe can produce outsized returns over time. We think our long-term approach and intense research process positions our mid-cap strategy for excellent long-term results for our investors. Of course, we may not achieve our objectives.
Securities issued by medium sized companies may be thinly traded and may be more difficult to sell during market downturns. Even though the Fund is diversified, it may establish significant positions where the Adviser has the greatest conviction. This could increase volatility of the Fund’s returns. The Fund may not achieve its objectives. Current and future portfolio holdings are subject to risk. All performance and performance-related calculations are based on the Institutional share class.
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