Baron Asset Fund®: The Underappreciated Advantages of Mid-Cap Growth Stocks

Bridging the gap between large- and small-cap equities, mid-cap equities can offer the best of both asset classes.

Mid caps can be a lower risk option than their small-cap peers, as they tend to have stronger balance sheets, readier access to capital markets, more experienced management teams, longer and deeper customer relationships, and more robust free cash flow streams to reinvest in their businesses or return to shareholders. Compared to large caps, mid cap companies often have more agile, less bureaucratic management and a more entrepreneurial approach that can help propel growth through faster decision making and execution, in our view. They may also be earlier in their efforts to target large addressable markets for their products or services.

Baron Asset Fund

Baron Asset Fund is our mid-cap investment option. It is managed by Andrew Peck, who also serves as Baron Capital’s co-CIO. Andrew applies our research-intensive, long-term investment approach to manage a high conviction, low-turnover, in-the-box portfolio of mid-cap growth stocks. He brings close to 30 years of investment experience to the Fund, which he co-managed starting in 2003 before assuming sole control in early 2008.

A Differentiated Investment Approach

We manage the Fund using a consistent, repeatable, and time tested investment process and approach that is differentiated by the following characteristics:

• Long-term perspective with low turnover
• High-conviction portfolio with a limited number of names
• Bottom-up approach with a focus on company fundamentals
• Style purity 

Long-term perspective with low turnover

Consistent with Baron Capital’s long-standing investment philosophy, Baron Asset Fund is managed with a long-term perspective. We believe this long view gives us an edge over many of our competitors. Most active mid-cap managers are focused on the short term, where factors that may have little to do with business fundamentals, such as a quarterly earnings beat or miss or overall market volatility, are frequently the most significant factor driving stock price performance.

As mid-cap managers, we operate in a relatively efficient market, requiring us to focus on the few inefficiencies that exist to gain an investment edge. Since the vast majority of managers employ a short term approach, we believe that our longterm perspective affords us less competition while also allowing us to take advantage of of the shortsightedness of the market. We leverage our extensive research capabilities to conduct a deep dive on the fundamentals of every company in which we are considering an investment. Our research allows us to develop an informed and thorough understanding of the longer-term secular advantages of these companies. Ultimately, we are more interested in the duration of a company’s growth opportunity – rather than being overly focused on its timing. We believe this is a key part of the engine that drives alpha for us.

The Fund’s 4.92% three-year average turnover is significantly lower than its peer group average of 72.14%. The large runway for growth within the mid-cap space means that we can hold our highest-conviction names for many years while maintaining our mid-cap mandate. We believe this is a more tax-efficient approach to managing a portfolio. This low-turnover approach is often attractive to company management teams, as their executives are aware of our reputation as long-term holders of stock and frequently seek us out as investors.

Yet it is important to note that our low turnover is an outgrowth of our investment process rather than a goal in and of itself. If we find and invest in the right companies, we believe that it makes little sense to replace these companies with new and relatively untested ones. We would rather remain invested throughout the duration of the growth trajectory of our highest-conviction companies.

Low turnover does not mean that we are passive buy-and-hold investors. We are constantly researching new, promising ideas and add new names to the portfolio every quarter. We vigilantly monitor our holdings and shift our exposure over time according to where we are seeing the most promising investment opportunities. In recent years, we have reduced the Fund’s long-held exposure to the Consumer Discretionary sector in favor of Information Technology (IT) and Health Care. Within Health Care, we prefer more established, less speculative sub-industries such as health care equipment and suppliers over biotech and pharma. Our IT holdings contain names such as syndicated research provider Gartner, Inc. and simulation software company ANSYS, Inc.

High-conviction portfolio with a limited number of names

Under Andrew’s stewardship, the Fund has consistently held about 50 to 70 stocks. This number is lower than the 100 or so stocks held by the average mid-cap fund, because we believe there are a limited number of truly compelling investment ideas at any particular time. We believe overdiversification can be dilutive of alpha and does not necessarily reduce risk. As Warren Buffett said, “Wide diversification is only required when investors do not understand what they are doing.”

Our top 10 holdings, which comprise 47.2% of the portfolio by weight, are all companies that rank among our highest-conviction names. Our relatively concentrated portfolio, coupled with our long term investment horizon, means we enjoy a significant competitive advantage: namely, we have continually researched our companies longer than virtually anyone else.

While Andrew works with a long-tenured team of analysts, he considers himself an analyst on every one of his holdings. One would be hard pressed to find another investor in IDEXX Laboratories, Inc. – the Fund’s second-largest holding – who has been meeting with management four times a year since 2006, when we initiated a position in the company.

Bottom-up approach with a focus on company fundamentals

We take a bottom-up approach to investing, seeking stocks that we believe have the potential to double within five years. To help achieve this target, we look for companies with:

• Long-term, secular growth opportunities
• Strong, durable competitive advantages
  • Unique assets
  • Pricing power
  • Dominant market share
• Business models that can support durable growth
  • Scalable
  • High incremental margins
  • Strong and visible cash flow
  • Capital structure appropriate to the industry
• Exceptional management
• Attractive valuation

Long-term, secular growth opportunities

We look for companies that are positioned to benefit from secular growth opportunities with large, addressable markets. We estimate that 300 to 400 companies in our investable universe meet these criteria. We find these opportunities across a wide and varied range of sectors and sub-industries. For instance, veterinary diagnostics company IDEXX is benefitting from significant, sustainable growth in the pet care/animal health industry. The growth trajectory of Equinix, Inc., the leading provider of internet business exchanges, is being driven by increasing internet traffic volume, globalization of financial markets, IT outsourcing, cloud computing, and mobility. A rare few are creating their own growth opportunities. Ski resort owner Vail Resorts, Inc. pioneered the multi-resort season pass, the success of which has enabled Vail to acquire additional resorts, shoring up its position as the largest ski resort operator in North America.

Strong, durable competitive advantages

We believe compelling and durable competitive advantages are key to successful investing in growth stocks. We look for companies that are establishing their competitive advantages, as companies that already have them tend to be more fully priced. Many of our holdings benefit from more than one competitive advantage. We focus on three: unique assets, pricing power, and a leading market position.

Assets that are difficult to replace or replicate make it more difficult for new entrants to compete. Vail Resorts, for example, benefits from restrictions on and expenses associated with developing new ski resorts. CoStar Group, Inc., the leading provider of information and marketing services to the commercial real estate industry, has built a proprietary database over the past 20-plus years, creating high barriers to entry.

Pricing power is another type of competitive advantage that we look for. We prefer companies that have pricing power tied to the utility of their product or service rather than a monopolistic grip on the market. For example, we like subscription-based business models that provide unique, proprietary data and analytics that become deeply embedded in customer workflow. This dynamic allows the vendor to raise prices in exchange for incremental improvements. CoStar and FactSet Research Systems Inc. are both subscription-based businesses. Other examples include Gartner and Verisk Analytics, Inc., which provides risk data to property and casualty insurance companies.

Dominant market share—often as a result of first-mover advantage— provides companies with a formidable competitive advantage in many instances. One example is Fair Isaac Corporation, which is a leading data and analytics company focused on predicting consumer behavior through re-sellable algorithms (FICO Scores) and software (Applications and Decision Management Software). With a 90% market share, FICO Scores are the industry standard in the United States for assessing consumer credit risk, which is a testament to the company’s strong brand and market penetration.

Business models that can support durable growth

We invest in businesses that are scalable and have high incremental margins, strong and visible cash flow, and a capital structure appropriate to the industry. Many of our holdings are asset-light, low capital-intensive businesses because once they have built their core assets – database, platform, etc. – as they scale, margins can expand significantly. Companies such as Equinix, which has built a platform enabling its customers to do business, illustrate this concept. After the platform has been built, the cost of adding new customers is de minimus, resulting in high incremental margins. We also like strong and visible free cash flow, because unlike earnings, it is rarely manipulated by accounting conventions. Finally, we look for a capital structure appropriate to the industry in which the company operates. We are comfortable with a company that leverages its balance sheet to optimize returns if it is an established business with recurring and predictable free cash flow and prudent debt levels. We believe such balance-sheet optimization is a way for companies to maximize shareholder returns.

Exceptional management

For Andrew, identifying a great management team is more of an “art than a science,” honed over his 28 years of experience as an investment professional, over the course of which he has met with and questioned thousands of executives about their companies. We look for a track record of successful capital allocation with proven ability to reinvest excess cash flows at high rates of return. We also look for “skin in the game” – a personal financial stake in the company’s success.

Attractive valuation

We project the long-term intrinsic value of every stock we own using both quantitative and qualitative analysis. Our projection is based on all key financial metrics – revenue, margins, capex, EBITDA, free cash flow, etc. – as well as more qualitative factors, such as the ultimate growth opportunity, quality and durability of the competitive advantage, and management. We will initiate a position only if we believe the stock will increase by an average of 15% per year over a five-year period. We will remain invested in a stock as long as its valuation is supported by our projection of intrinsic value.

Style purity

Baron Asset Fund is a true mid-cap fund. While we do not manage to the benchmark in terms of sector allocation or other factors, we do manage the portfolio to remain comfortably within the mid cap space. We buy stocks with market caps of at least $2.5 billion and below the largest stock in the index. We will sometimes keep a particularly strong stock after it outgrows the mid-cap range, but the Fund’s stake in large-cap names is also in line with the typical mid cap growth fund. The Fund’s $36.43 billion weighted average market cap is in line with its benchmark, as it has been historically.

Conclusion

We started investing in mid caps more than 30 years ago, when few other investment managers were focused on this asset class.1 In our experience, mid caps tend to offer greater growth opportunities than large-cap stocks and less risk than their small-cap peers. Mid caps are more established than small caps, having developed their business beyond the initial, usually riskier, start-up phase. At the same time, they have yet to reach the more mature, less growth-oriented stage of their life cycle. It is no surprise to us that mid-cap stocks have been described as the “sweet spot” of equity investing. We also believe that Baron Asset Fund is an excellent option for an investor looking to tap into the benefits of this “sweet spot.”