Baron Funds commentary for the second quarter ended June 30, 2017. Long letter – good read whether bull or bear on Ron or Tesla
I felt exactly how you would feel if you were getting ready to launch and knew you were sitting on top of two million parts…all built by the lowest cost bidder on a government contract.” John Glenn, pioneer astronaut, U.S. Senator and first American to orbit Earth. 1962.
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That was John Glenn’s answer when asked what went through his mind while waiting to be launched into space aboard an Atlas rocket 55 years ago. Glenn’s apprehension was what we all feel when using critical infrastructure that may have been built with substandard parts, inferior materials or construction practices that cut corners. We don’t invest in businesses that purchase exclusively from low cost bidders and skimp on consequential spending to boost short-term profits. Conversely, we don’t invest with business managers whom we consider profligate. Managers of our portfolio companies believe their businesses will benefit over the long term by demanding premium quality from their suppliers, even if it costs more.
Despite Tesla’s requirements functional design resulting in minimal waste, it often obtains better pricing for outsourced parts than its competitors. We believe its parts vendors try to accommodate this unique and fast growing company because they think Tesla’s engineering skills and designs will make them better suppliers! Further, since Tesla can insource production, it has the advantage of knowing exactly what a product should cost and how to produce it. Mary T. Barra, General Motors’ CEO who has been trained as an engineer, has instructed her supply chain to “use Tesla suppliers…even if they cost more!” Her rationale is that despite incurring higher costs to build a car, maintenance and warranty costs will be lower; car safety will be improved; and GM’s reputation will be enhanced. We think “quality” is as important in real estate and services businesses as it is in manufacturing.
Mike, a good friend of mine, recently left his position as CEO of a large publicly owned real estate investment trust. He has since founded a privately owned real estate development company. My friend’s first project is in an up and coming, downtown New York City neighborhood. It is a $180 million total cost apartment project built on land that cost $57 million. When Mike sought equity partner financing, one investor who agreed to invest, after studying Mike’s plans, told my friend to “spend more.” If he did, that investor said he would invest more. Mike until then had been trying to keep his costs as low as possible to earn as high a return on investment as possible. After receiving that advice and thinking about it overnight, my friend called his architect. “I want to spend $3-5 million more,” Mike told the designer. Architecture, windows, lighting, materials and finishes were all upgraded…as were kitchens and bathrooms. Although Mike says it is not yet obvious his increased costs will be reflected in higher initial rents, he is confident his building will rent up faster than neighboring buildings, will stay occupied longer and, ultimately, will command those higher rents he desires.
There is a difference when you “build to own” versus “build to sell.” When we were building our house which began to run significantly over budget, I complained to the contractor. He responded by showing me all the places where we could save money by using lower quality materials or finishes which wouldn’t be noticed by a casual observer. “We are not planning to ever sell our home,” I told him. “Please don’t try to save us money on what you can’t see. That’s where we want to spend money to improve the quality of our house. We just want to know in advance what things will cost. We don’t want to be surprised.” I then told him my family lived in a rental apartment in New York for almost 20 years so we could invest in our business. “There’s a big difference between a rental and a co-op in New York,” my wife told me. “It’s in the walls.” When we finally did purchase a co-op in 1996, I told Judy she was right. I told our builder that story to be certain he understood we wanted the quality of our home to be at least the quality level of our apartment.
Letter from Ron
are rarely businesses that sell undifferentiated commodities and which, as a result, must be the low-cost provider to survive. We are anxious for our portfolio companies to invest in their businesses even if it penalizes their current profits or costs more than expected to achieve the highest quality that is appropriate. This is since we think such capital investments will be worthwhile in the long term.
Footnote to John Glenn story which began this letter.
On May 25, 1961, President John F. Kennedy announced to a joint session of Congress that the U.S. “should commit itself to achieving the goal, before the decade is out, of landing a man on the Moon and returning him safely to Earth.” In 1966, with NASA preparing for its first moon landing, the space agency’s budget represented 4.4% of annual United States’ federal spending. In 2017, NASA’s budget represents 0.47% of annual federal spending! Until three years ago, no new spacecraft had been designed, built, and flown since the 1960s. This is because building a new spacecraft means developing innovative technologies which always takes our government longer and costs more than anticipated! In 2010 our government decided instead to outsource the development of new spacecraft and related technology to the commercial space flight industry. Government executives believed private companies could likely build a higher quality product for lower cost! I for one am certain this was a good decision. Boeing and Elon Musk’s SpaceX were awarded contracts to design, build, and fly new spacecraft to ferry U.S. astronauts to the International Space Station (ISS). American astronauts are presently being flown to the ISS aboard Russian rockets from the 1960s until Boeing or SpaceX spacecraft are available!!!! The cost of commercial flights to the ISS will be a fraction of the cost of previous government flights, in part because rockets will be reusable. The rockets will also be significantly more reliable.
“This was a really interesting conversation. Most investors are only interested in news and current sales and earnings. You were asking about fundamentals, scaling, and events that would play out over years. Few investors I meet have those time frames. Most zone out in any conversation that goes beyond a year or two. I am blown away by this meeting.” Dr. Ion Yadigaroglu. Founder and Principal. Capricorn Investment Group. June 20, 2017.
As part of our ongoing effort to gain further insight into Tesla’s prospects, we recently met with Dr. Ion Yadigaroglu, a venture capitalist. Ion is an engineer with a doctorate in physics from Stanford. Ion has been programming since he was eight years old! Ion’s dad is a prominent nuclear scientist. So much for Ion’s creds. When Ion studied at Stanford graduate school, his roommate founded eBay. Ion’s $1,300 investment in the eBay startup became worth millions. In 1992, at the dawn of the Internet, Ion met Elon Musk. Elon had come to Palo Alto to research battery technologies in Stanford’s labs. Elon dropped out after only six days!
Further, while at Stanford, Ion was the teaching instructor for JB Straubel, Tesla’s CTO and chief engineer. Ion believes JB and his team are better at battery technology than anyone else. It was lucky for Ion that he met both Elon and JB. Ion invested in Tesla when it was just beginning, and so far has made a lot more than he did in eBay. After meeting Ion, we concluded it was lucky for Elon and JB they met Ion as well.
Our meeting with Dr. Yadigaroglu is one example of Baron Funds’ differentiated primary research approach. Few institutional investors have met with Elon and JB. Fewer still, we’re guessing, have met with the co-founder’s teaching instructor at Stanford. We believe fewer and fewer in the investment industry are performing even the most basic research on businesses. There is a reason for this. During the past 15 years, boosted by virtually instantaneous communications, computer algorithms, and the increasing popularity of ETFs, securities trading volumes have multiplied exponentially. As computers and software have replaced traders and marketplaces, brokerage commission revenues have fallen dramatically. Brokerage commissions historically have been used to pay for investment research. Ergo, investment research budgets have been cut significantly; there are now far fewer financial analysts; and “price discovery” and markets have become less efficient.
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