Baron Capital Investment Approach

Baron Capital’s research team is our most important source of ideas. The team’s centralized structure facilitates frequent interaction and collaboration. Research analysts are sector and industry specialists with expertise in their coverage areas and the companies they cover, including many in which we do not invest. Portfolio managers are typically generalists, but may have particular geographic, industry, or market cap expertise. 

Existing investments

Successful investments may lead to new ideas, which may or may not be in the same industry. In some instances, we identify earlier stage companies that exhibit characteristics of previous successful investments, or we will invest alongside a management team with whom we have invested before. In other instances, an existing investment in a smaller cap fund may outgrow that fund’s market cap and make it an eligible investment for a larger cap fund.

Capital markets

We invest in IPOs in the same way we would invest in any other company: for the long term.

Our reputation as research-intensive, long-term investors enhances our attractiveness for companies going public. Companies view us as owners of their business rather than renters of their stock.

We may take a small position in an IPO and continue to conduct research on the company. If we strengthen our conviction, we will add to the position. 

Industry events

Industry events are an opportunity to gain insight into industries and companies that financial statements and earnings calls may lack. These events provide our investment professionals with valuable information on industry trends, new product launches, and company updates as well as the opportunity to meet with industry experts, suppliers, vendors, clients, and distributors.

Professional contacts

We have built relationships over many years with investment professionals on both the buy and sell sides. Meetings with the management team of prospective investments, including non-deal roadshow meetings, are an additional source of potential new ideas.

Published and online sources

Industry publications, sell-side research reports, trade magazines, online news sources, and internally generated research provide insights into the factors that impact a company’s growth opportunities. These sources are particularly helpful for our non-U.S. research team, as they seek to pinpoint opportunities across regions, industries, and countries.

As the bedrock of our process, research is conducted throughout the life of each investment and is designed to ensure our investment criteria are present. Because we invest like owners of a business rather than renters of stock, we think with a longer-term, value-creating mindset.

Our Research Process

1. Identify the growth opportunity

We look for secular, not cyclical, growth. We estimate a company’s total addressable market (TAM) over the long term to size the opportunity, its significance, and likely duration. A company’s TAM may also expand through an acquisition or merger, a new product or service with different end markets, a technological or medical breakthrough, or expansion into new regions, for example.

Analyzing the industry, demographic, political, technological, regulatory, and other trends is key to identifying promising growth companies. This is especially important for non-U.S. strategies, as it helps narrow the universe of companies trading on foreign exchanges.

2. Develop an investment thesis 

The investment thesis details how a company meets our criteria and can achieve the growth we anticipate.

We research whether the company benefits from a durable competitive position relative to others. This competitive advantage could derive from a unique product or service, a strong brand, a platform/ecosystem of suppliers and customers, proprietary data or technology, first-mover advantage, low-cost production capabilities, dominant market share, key talent, pricing power, regulatory barriers that limit would-be competitors, or any combination thereof.

A strong management team is essential. We assess management’s character, vision, competence, business practices, management style, ownership stake, and experience and track record. We favor entrepreneurs who have built past successful businesses. Management whose interests are aligned with those of their shareholders and who have instituted effective corporate governance practices is important as well. 

3. Test, and verify the investment thesis 

We conduct extensive due diligence to test the thesis. We meet with management and speak with vendors, suppliers, competitors, and others. Through a rigorous interview process, we assess the character, track record, and strategic vision of management, as well as the company culture.

We think it is important to visit company headquarters, factories, stores, and other facilities.

To verify our thesis, we analyze past performance and conduct external checks with vendors, customers, competitors, partners, former employees, and industry experts. We review financial statements and other company materials. We look at ownership structure and executive compensation to determine whether the interests of management and shareholders are aligned.

4. Build a model 

We build comprehensive proprietary five-year models to quantify a company’s opportunities and risks, estimate the intrinsic value of its business, and determine a stock price target. Each model includes five years of historical data and five years of forward-looking estimates. We consider the following factors, among others: 

We consider how ESG factors may influence key model assumptions. We monitor and reassess our models throughout the life of an investment, adjusting inputs as data evolves and views change.

5. Value and stress test 

We typically look for a threshold annualized return of 15% over time. If the forecasted return is less, we might place the stock on a watch list. We apply the valuation methodology we believe is appropriate for each business and industry. For example, we look at free cash flow for subscription-based companies and EBITDA multiples for asset-intensive businesses. We also analyze investment returns under different scenarios.

We value companies using our own methodology. Others may view a company as expensive based on trailing or one-year forward multiples. That same company might seem inexpensive to us because we take a different approach. We attempt to assess the rate and predictability of the growth trajectory of a company over the next five or more years.

All our portfolios are constructed from the bottom up, stock by stock, based on our conviction about the future growth prospects of each business.

We do not build our portfolios relative to a benchmark nor do we utilize a top-down macroeconomic framework. Our investments do not depend on the direction of factors such as interest rates, inflation data, or energy prices. We do, however, assess how macro factors might affect the growth opportunities for our portfolio companies. 

Relative Analysis

Five key factors used to determine position sizes:

Risk/return analysis 

We conduct a risk/return analysis, applying our four investment criteria --  growth opportunity, competitive advantage, management, and valuation -- and weighing opportunities and threats. We allocate more weight to companies in which we have the highest conviction relative to our perception of risk.  Any number of macro- or company-specific developments can shift the calculus.

End market exposures and diversification 

In constructing our portfolios, we do not adhere strictly to GICS sector or benchmark weightings. Rather, our strategic view of and expertise in an industry generally dictates the emphasis we place on it. With the exception of our high-conviction and non-diversified strategies, our portfolios are diversified by industry or investment themes to help reduce risk exposure.

Some portfolio managers also take into consideration a company’s end markets. Multiple end markets tend to provide more risk buffers and a better risk balance than a single end market. We analyze end markets by industry, geography, country, product lines, and consumer type. 

Regulatory implications 

A deep understanding of relevant regulatory and political developments helps to pinpoint a company’s risk/reward balance and manage our portfolios with a firm understanding of those risks.

Portfolio construction guidelines 

Baron Capital has firm-level and portfolio-level restrictions and guidelines that limit position size and company ownership. Where appropriate, we also have limits on the percentage of a portfolio’s assets that can be invested in an industry group, a sub-industry group, and/or a single issuer.

Liquidity

Maintaining an appropriate level of liquidity gives us the flexibility to rebalance a portfolio and react promptly to a sudden material change impacting a stock. Liquidity is a key consideration, especially for our small-cap strategies and our non-U.S. strategies given the relative complexity of trading stocks on foreign exchanges. 

Position Sizing

Conviction is a result of our research process. Our highest conviction stocks tend to carry meaningful weights. Across our strategies, the top 10 stocks generally represent a significant percentage of each portfolio. 

Our portfolio managers maintain watch lists of prospective investments. A company might appear on the list because its stock price is too expensive or we are assessing a management change, for example.

When initiating an investment, we typically start with a smaller position. As we become more knowledgeable about the company, and the initial investment thesis is confirmed, we will likely add to the position. Some companies become core holdings, and a select group become top 10 holdings. Position sizing is determined primarily by the manager’s level of conviction and assessment of risk, although diversification and other factors may come into play.

Portfolio Management

We believe the key ingredient of a successful long-term strategy is the conviction to hold stocks. Companies positioned for growth and portfolios that are thoughtfully and carefully constructed are the foundation; however, more is needed to generate above-average returns over the long term. 

The ability to hold relates to discipline, behavior, self-awareness, and experience. We analyze past mistakes and successes and seek to maintain awareness of biases and avoid systematic errors. Experience helps our managers resist the urge to sell companies when others are selling in reaction to disappointing short-term results or macro events.

Our extensive research and regular communication with our companies help to distinguish short-term, sentiment-based market moves from the long-term fundamentals of the companies in which we invest. If our thesis remains intact and the stock is attractively valued, we will continue to hold it regardless of the consensus view. While other investors might not recognize a business’s potential, we believe it will become evident over time. This long-term mindset gives us the ability to invest at what we believe is an especially attractive price.

The ability to hold does not mean we stay invested in a company indefinitely or at any cost. As with buy decisions, sell decisions are based on conviction. Has the growth opportunity waned? Has the company’s long-term earnings power deteriorated? Has the competitive advantage weakened? Is there an adverse change in management or strategy? Is the valuation still attractive? These are the most common reasons we will reduce or exit a position.

Other triggers include negative regulatory, economic, political, or industry-specific developments or the loss of alignment in management and shareholder interests. We may also sell to re-invest in a higher conviction company or if we conclude we have made a mistake.

Finally, we may exit or reduce a position to re-balance a portfolio if the position becomes too large or to keep a market-cap-restricted portfolio within its category.

Our process is designed to identify and understand the risks inherent in each investment, along with the potential for long-term returns. As active managers, our goal is not to eliminate or minimize risks; we believe some risk is necessary to achieve excess returns.

The Portfolio and Risk Analytics Department provides extensive risk reporting to portfolio managers and senior management, while authority to make investment decisions remains with the portfolio managers.

Security Selection

Business risk

We manage risk by investing in what we believe are attractively valued quality businesses with appropriate capital structures. Because we believe deep research is key to successful investing, extensive knowledge about a select group of companies is better than a superficial understanding of many companies, in our view.

Time-risk arbitrage

Historically, a longer time horizon is directly correlated with the likelihood of positive stock market returns. With longer holding periods, the magnitude of a potential loss also tends to decline.

We believe our long-term investment horizon helps mitigate risk and adds a margin of safety. We are less reactive to interim price fluctuations, macro events, and market noise, which reduces the likelihood of an emotional or hasty decision that could result in a loss. Instead, we view short-term volatility as a possible opportunity to add to existing or initiate new positions at attractive prices. 

Of course, there are exceptions. Some stocks decline and never recover. We leverage our knowledge of the businesses we own to discern whether stock fluctuations are the result of the permanent deterioration of fundamentals or simply short-term market moves.

The longer we own a business, the deeper our understanding of where the risks and opportunities are and when and how to act on news, developments, or changes. This knowledge also allows us to size positions with more precision.

Systematic risk

Systematic risk represents vulnerability to macroeconomic events, such as recessions, geopolitical unrest, regulatory or regime changes, natural disasters, or black swan events.

While we stay abreast of such developments, we do not try to forecast them, nor do we think it possible to do so with consistent accuracy. We believe the best way to weather the inherent unpredictability of macroeconomic events is to seek to invest in companies that are better positioned to survive and even thrive in challenging circumstances by leveraging fundamental advantages such as a market leading position, a solid balance sheet, a strong moat, skilled and experienced management, and/or a unique and essential product or service.

Country risk

Managers of our non-U.S. strategies assess the risks specific to a country or region in determining where to invest. This is an ongoing process as geopolitical events such as a regime change, conflict, or any number of factors can have a significant impact on the investment potential of companies within that country or region.

Portfolio Composition

At the portfolio level, we have risk controls that address and monitor liquidity, volatility, and ownership levels of each investment. We calculate risk-adjusted performance metrics on a historical quarterly basis and monitor exposures to a variety of risk factors.

Diversification

For some of our portfolios, we seek to diversify our holdings in part by balancing the risk exposures of our companies, taking into account industry, geographic, and supply chain dynamics, end market exposures, business models, revenue sources, TAMs, and/or regulatory risks. 

Risk measurement and monitoring

As bottom-up, fundamental investors, our approach to evaluating correlations of companies in our portfolios is largely heuristic. This subjects us to the risks of unintended exposures and unexpected consequences. We use MSCI Barra multi-factor models to analyze exposures to fundamental factors, understand how much return and risk resulted from intended or unintended exposures to different factors, and assess the level of risk on a forward basis.

ESG integration

Baron Capital began the process of formally integrating ESG risks into its investment process in 2019, when it became a PRI Signatory and adopted an ESG Policy. We have long sought to find growth companies with durable competitive advantages, and we recognize the importance of enhancing our understanding of material ESG factors and risks, which play an increasingly significant role in defining and sustaining the long-term success we seek. Baron Capital has committed to integrating ESG criteria into its research process at the company level while monitoring how ESG risks and opportunities impact all our portfolios.

It has become clear that investors are paying close attention to a wider spectrum of risks that have environmental or societal impacts, including climate change, data security/privacy, diversity and inclusion, product design and lifecycle management, and business ethics, among others.

We believe well-managed companies are run with the intent to minimize external and internal risks and maximize the ability to capitalize on growth opportunities, while being good stewards of capital, good corporate citizens, and benefiting all stakeholders over the long term.

We believe material ESG risks are critical business risks with the potential to lead to permanent loss of capital, which is something we always seek to avoid. It is also our view that ESG analysis can illuminate potential opportunities for revenue enhancement, cost reduction, margin improvement, and improved returns on capital. Evaluating ESG factors also enhances our research process by improving our ability to ask management teams about the long-term sustainability of their businesses, including approaches to solving strategic and operational challenges and governance.

Toward this end, we continue to:

• Improve the documentation of our ESG research
• Increase the frequency and depth our engagement with company management teams
• Increase the scope of our reporting on ESG matters
• Increase the likelihood that our investment decisions will be influenced by our ESG research
• Add new tools and more resources to facilitate our efforts

Baron Capital’s ESG Committee is responsible for maintaining the Firm’s ESG Policy as well as monitoring trends in ESG and assisting with ESG-related client requests and reporting. 

Firm Policies and Practices

At Baron Capital, risk management is embedded in our organizational culture. Every member of the Firm assumes responsibility for understanding and mitigating risk. Our senior executives lead distinct functions with clearly defined policies and procedures to ensure we identify potential risks before they could become an issue. 

We have a Risk Committee comprised of key Firm executives, the Cybersecurity Committee, and the Compliance department that meets regularly and on an as-needed basis.