Ron Baron‘s letter to Baron Fund shareholders for the second quarter ended June 30, 2015.
“If Rocky Aoki can make 60% profit margins selling dead fish, how is it possible I can’t make as much selling highly engineered, industrial, cutting tools?!!!” Eitan Wertheimer. Former Chairman. ISCAR. Now a Berkshire Hathaway company named IMC. April 30, 2015. New York City.
On Wednesday, April 30, 2015, Eitan Wertheimer, the former Chairman of ISCAR, visited me for lunch in our New York City office. Eitan was traveling from Tel Aviv, Israel to Omaha, Nebraska to attend Berkshire Hathaway’s annual shareholder meeting. In 2006, Eitan sold 80% of ISCAR, his family’s industrial cutting tool business to Warren Buffett’s Berkshire Hathaway for $4 billion. In 2013, after ISCAR had again about doubled in size, Eitan sold Buffett his family’s remaining 20% interest for $2.05 billion! Eitan is now devoted to his favorite Israeli philanthropies that strive to minimize socio-economic inequalities, “not by sharing the cake by cutting it into more pieces, but by making more cakes;” to improve education in engineering to help Israel increase its’ economy’s growth rate; to promote education as vital to integrating Ethiopians into Israeli society; and to create the most advanced hospital in the Middle East. Eitan has also founded a micro banking loan fund for startup industries in the Negev and Galilee, which has created wealth for a growing number of talented and underprivileged Israeli children! Whew!
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Eitan and I have a few friends in common. One arranged for Eitan to visit me on his way to what Buffett calls “The Capitalist’s Woodstock” in Omaha. My lunch with Eitan in late April was one of my most enjoyable this year…which is saying quite a lot since I would characterize so many of our lunches as incredibly enjoyable.
But, back to my story. ISCAR is an Israeli business founded in 1952 in a dilapidated shed in Nahariya, Israel by Stef Wertheimer, Eitan’s dad. Stef started his business after emigrating to Israel from Germany in 1937. He began by making precision, metal working tools in Israel’s Western Galilee. ISCAR has since become one of two leading, global, precision, cutting tool businesses. Stef ultimately relocated ISCAR from that shed to become an anchor tenant in several industrial parks in the Galilee. His idea was to provide jobs for Israelis in that region. A condition of Eitan’s sale of ISCAR to Berkshire fulfills his dad’s wish that the business founded by Stef and his wife Miriam remain in Israel. That apparently was fine with Buffett who remarked that he purchased ISCAR with high expectations that ISCAR has exceeded. “Israel isn’t a place you would go to look for oil, but there isn’t a better place to find talent,” according to Buffett.
Eitan took over his dad’s business in 1984. Although Eitan was only 33 years old at the time, he had been working for ISCAR since he was six years old and already had successfully acquired, turned around and sold seven businesses! “Doing less is more…”
The year before he joined ISCAR, Eitan studied at Harvard Business School. The subject of the case he considered most interesting was about Hiroaki “Rocky” Aoki, the founder of Benihana, the Japanese restaurant chain. “Benihana sold dead fish and earned 60% profit margins!” according to Eitan. “How is it possible ISCAR couldn’t earn profit margins as high selling highly engineered, specialty cutting tools?”
Ron Baron – Introduction
Rocky Aoki made Benihana successful by “doing less!” He solved problems before they occurred by eliminating factors that created the problems. The most significant operations problems experienced by restaurants are high labor costs, high food waste, significant food storage costs and limited customer seating capacity. Aoki solved these problems by introducing hibachi tables in his restaurants so customers could sit at tables with cooking surfaces. That eliminated the need for backroom kitchens and provided more seating for customers. It also reduced labor costs to 10-12% of sales, a fraction of conventional restaurants, by providing cooks with direct customer interaction. Increased sales in his stores and a simplified menu virtually eliminated food waste, normally 30% of food costs. There was another benefit to food preparation on hibachi tables by loquacious cooks. Benihana was able to fill its restaurants by making food preparation “theatre.” The takeaway by Eitan? Solve problems before they occur. “Do more by doing less…”
ISCAR cutting tool plants make dirty, greasy objects. Buffett wrote in a letter how impressed he was by ISCAR’s immaculate plants. “They appeared to be pharmaceutical facilities,” according to Buffett. Eitan told me it took less effort to keep his plants well organized than to operate disorganized facilities which by definition are inefficient. How did he accomplish this? Pretty much by explaining to his fellow employees how important it was to be efficient since that would produce greater profitability which would permit ISCAR to grow faster; pay higher wages; and, insure the success of its business which would inure to everyone’s benefit. Eitan was successful convincing all his engineers and factory workers that was the case. With one exception. That individual, however, was one of his most brilliant engineers whose cluttered office was the exact opposite of what you might expect from an individual with such a methodical, systematic, orderly thought process. Although Eitan repeatedly asked that person to clean his office, he had been unsuccessful. Until, one day, he came up with the solution. He visited his engineer the first thing in the morning. “I’ve invited your motherin-law for lunch,” he told the engineer. That individual’s office was never again in disarray! “Doing less is more.” The simplicity of the idea that avoiding problems rather than having to fix them is powerful. Both for ourselves and for the problem solving executives of businesses in which Baron Funds invests. We are pretty sure the problem avoiding and problem solving abilities of the executives who lead the competitively advantaged businesses in which we invest like Tesla, Illumina, Vail, Hyatt, Under Armour, Gartner, Edwards Life Sciences, Manchester United, CoStar and many many others are important reasons those businesses have been so successful.
As for us, we think that following our very simple process of investing in fast growing, competitively advantaged, well managed businesses for the long term; trying not to worry about short term news that we regard as unpredictable “noise;” hiring the nicest, hardest working, smartest individuals who are team oriented; safeguarding our reputation; and, making individuals with whom we work feel “safe” in a wonderful environment keeps our team moving forward toward what I tell our fellow employees is “No Finish Line.” “A billion here, a billion there and pretty soon you’re talking real money.” Senator Everett McKinley Dirksen. Republican Majority Leader. 1962.
When Senate Majority Leader Everett Dirksen reportedly uttered that now famous phrase in 1962, America’s GDP was $600 billion. It is now $18 trillion! That represents compounded, annual, nominal growth for our nation’s economy of 6.7% per year, about 2.6% per year “real,” 4% per year from inflation. Further, it’s not just our economy that has experienced 4% annual inflation. Virtually everything except commodities and technology have experienced nearly the same annual inflation. Whether houses, cars, subway and bridge tolls, buildings, food, art, real estate, air fares, hotel rooms, wages or college tuition. When my two sons and I were discussing inflation over breakfast last week, we tried to recall their freshman year college tuitions in 1998 and 1999. According to Google, tuition was then $21,000 per year and is now $42,000 per year! Again representing 4.3% per year price appreciation. Health care costs have increased more.
U.S. stocks have increased in value about 6.5% per year, nearly the same as our economy’s growth rate since 1962. When you add stocks’ approximately 3% annual dividends, U.S. equities have appreciated more than just about any other asset class since the 1960s, approximately doubling in value every 10 years. Looked at another way, the purchasing power of your dollars has fallen approximately in half every 17 years during the past 50 years. Warren Buffett wrote in Berkshire Hathaway’s 2015 annual report celebrating the 50th anniversary of his business that, “It now takes $1 to buy what could be bought for 13¢ in 1965.” That is three doubles over fifty years, approximately 4% cost inflation per year!
According to Jim Grant in the June 26, 2015 Grant’s Interest Rate Observer “The Federal Reserve’s mission is to cause the price level to rise by five-fold over the course of a healthy lifetime. This is the honest meaning of a 2% inflation target. Central bankers call it “price stability.” While the Federal Reserve might say they target 2% annual inflation, the actual number, in our opinion, has been nearly twice that amount. As Yogi Berra would say, “A nickel ain’t worth a dime.”
We invested in United Inns early in my career. That company was then Holiday Inns’ largest franchisee. Tom Kizor, United Inns’ Vice President and CFO, never tired of telling me, “There’s a lot of good that comes from 2.5% annual inflation.” I didn’t fully understand what he meant in 1982. I do now.
On September 16, 2013, Barron’s published an Editorial Commentary, “No Time Like the Present.” The author reported that “average Americans today are much more prosperous than they were 60 years ago.” Their life expectancies are far longer; their health better; and everyday conveniences are far greater than during the 1950s. “Consumer goods that ordinary Americans can afford today were unavailable then to even the wealthiest Americans.” As evident from a ubiquitous Sears catalogue of that era, “nearly every consumer good costs less work time today than it did back in that mythical golden era.” While most things except technology and commodities cost more in absolute terms, the amount of time you need to work to afford those goods has fallen sharply.
“What cost 50% of an average American’s disposable personal income in the 1950s costs 32% today.”
We expect American living standards, in large part, due to advances in health care, technology, research discoveries and innovation to continue to improve dramatically in coming decades. This is even though we expect goods and services to cost more in “2015 dollars.”
Indebtedness of our nation is now significantly greater than it was from the 1930s through 1982 when it approximated 170% of GDP. It is now approximately 340% of GDP, after peaking at 370% of GDP in 2009. It had been around 300% of GDP only once before in the past century, in 1929. Defaults and bankruptcies in the 1930s then reduced it to the 150-170% of GDP levels that prevailed until 1982.We do not expect defaults and bankruptcies again since Federal Reserve Board members past and present, Fisher, Bernanke and Yellen have taught us how to manage our economy better. We expect inflation to gradually reduce the burden of servicing that debt that will enable our country (and others) to deleverage in coming decades without negatively impacting our nation’s growth. Stocks have been the best asset class that has most consistently protected the purchasing power of your savings.
“Tesla is a formidable company.” Mary Barra. CEO. General Motors.April 2015.
“I’ve spent time in the Model S, and I have a lot of respect for it….It’s an impressive vehicle.” I found CEO Barra’s remarks unusual since I think it unlikely she would make similar statements about Ford Motor Company, Chrysler or any other automobile manufacturer and their cars. As noteworthy, I thought, was a remark by a Ford Motor Company executive who recently told me, “The most interesting question I would like answered is whether and when Tesla can build one million cars per year on a sustained basis.” Tesla plans to build 50,000 -55,000 cars in 2015 after building 35,000 cars in 2014 and 22,000 in 2013! The company hopes to build 500,000 cars in 2020 and several times that number annually in the following decade. We will see.
We have been an investor in Tesla for a year and a half. I presently visit the Tesla plant in Fremont, California three or four times a year.
I had wanted to visit General Motors, Ford Motor and Chrysler plants for quite a while to compare those facilities to Tesla’s. I became even more interested after two Baron analysts visited BMW’s research and production facilities in Germany last summer. I recently had the perfect opportunity for a “field trip” to a General Motors’ truck plant in Flint, Michigan. Four of our analysts were planning to visit Diplomat Pharmacy’s distribution center in Flint and invited me to tag along. Diplomat delivers to individuals, high cost, difficult to administer drugs that require special handling. Baron Funds is an investor in Diplomat. Our plan was to spend the morning with Diplomat, have lunch at the Flint GM plant and spend the afternoon touring that facility before heading home.
I arrived in Flint at 11 PM the evening before our meetings. I had been on my way home to New York following a brief research trip to the West Coast. After spending the next morning with Diplomat’s management team in their office/distribution facility, we were driven across town to the GM plant. The General Motors’ factory employs 2,820 union workers. We met with the head of the GM Truck division, that plant’s manager and the head of its union for a two-hour sandwiches and salads lunch. We were told demand for GM heavy trucks was so strong that this plant, built in 1947, presently operates six days a week, 24 hours per day. We then toured the facility, spoke with its production line workers and were shown how to align fasteners on truck doors and drive trucks off the production line.
When we were leaving late in the afternoon, the head of the autoworker’s union rushed after me to say “goodbye” and give me his card. “Ron, of all the things we talked about and showed you today, there is one thing I want to make sure you understand. This plant’s manager and I are good friends. We speak every day to resolve problems. My union understands this plant needs to be profitable to protect our jobs. We will be flexible about work rules as long as management protects our jobs.” The union leader then told me his members had done such outstanding work last year that each earned $9,000 bonuses as a reward for their productivity!
While the automation in GM’s Flint plant seemed to me significantly less than at Tesla’s in Fremont, the relationship between the auto workers and GM’s management was the most encouraging thing I learned that day. It was an enormous contrast to what I had expected. One more thing. When I asked the plant manager whether he had ever seen or driven a Tesla and if he had, what did he think? “I haven’t driven one. I have seen one. It’s a beautiful car,” he replied. “My 16 year-old-son also thinks the Tesla is a beautiful car. If it were made by General Motors, my son would try to figure out how to buy one.”
We often tell investors in Baron Funds that “we invest in people.” Tesla’s Elon Musk is one of those people in whom we have invested. Will Danoff is the portfolio manager of the $125 billion Fidelity Contrafund. He also happens to be a friend of mine and an individual I admire, both because he is an exceptional portfolio manager and analyst and because he is a thoughtful, nice person. A favorite Will maxim is to “bet on billionaires.” In the case of Tesla’s Elon Musk, we couldn’t agree more.
Baron Investment Conference 2015. November 6, 2015. Metropolitan Opera House. Lincoln Center. New York City.
We hope you will be able to attend our 24th annual investment conference on November 6th. The meetings have grown from fewer than 35 attendees at our first meeting in 1992 at New York City’s Harmonie Club to more than 5,000 at New York City’s Met last year. We believe our conferences reflect increased investor interest in both the businesses in which Baron Funds has invested and in our Firm’s investment strategies. Our entertainment throughout the day, has morphed from Beatlemania, a Beatles’ “cover band,” and “Heada-Lettuce” at our first meeting, to Carrie Underwood at lunch and Sir Paul McCartney leading an incredible 93 minute “sing-a-long” to end the day last year. This hasn’t caused our shareholders to lose interest in our event, either.
Our meetings are intended to allow you to meet and question executives of businesses in which Baron Funds has invested. We will again have some pretty special speakers this year… whom we think you might find as entertaining and impressive as our entertainers! We also intend for these meetings to give you an opportunity to meet and question Baron portfolio managers and analysts, our client services representatives, Linda and me. We are there to discuss our investments, process and any other topics on your mind….no questions are off limits…all day long. We hope you take advantage of the opportunity and regard that day as one to “kick the tires” of Baron Funds.
On Thursday, before our Conference, and early Friday morning, there are special programs for institutional investors, registered investment advisers, independent financial advisers and consultants. These programs are intended to provide attendees with a chance to meet and speak one-on-one with our analysts and portfolio managers. Again…no topics are off limits.
Finally, the entertainment. At lunch and at the end of the day. As usual, we think it will be incredibly cool…outstanding, as a matter of fact. Also, as usual, it will be at our expense, not yours. And, as usual, it will be a surprise. No, we can’t tell you who it is. Only Linda and I know for sure. Linda because she signs the contracts and the checks. Me because I choose the entertainers.
We hope we will see you at The Met on November 6th. For those of you who can’t attend, though, you will be able to watch our meeting streamed live on Baron Funds website…everything but the entertainment, that is (we are contractually prevented from streaming entertainment). You can get a sense of our meeting by watching CNBC’s Squawk Box that morning from 6 AM to 8:30 AM (Eastern Standard Time). Becky Quick will first interview me and then the two of us will interview several executives with whom we have invested and with whom we expect Baron Funds to make a lot more money…although we obviously can’t promise that.
We like to say that “we invest in people.” When you attend our annual conferences or watch us on CNBC or visit us at our website, we hope you will gain a better understanding of the businesses in which we have invested; of the individuals who lead those businesses; and the character and talent of the individuals with whom I work. In the end, we think it’s all about people. It is why I expect to never stop “working.”
Thank you again for joining us as fellow shareholders in Baron Funds.We will continue to work hard to justify your confidence in us. See you in November.
CEO and Chief Investment Officer
August 3, 2015