"Graduates" of other Baron funds find a home at its Fifth Avenue Growth Fund.

    About six years ago, Mitch Rubin's bout with empty nest syndrome sparked the idea for the Baron Fifth Avenue Growth Fund.
    In Rubin's case, the dreaded middle-age malady didn't come from having children who had grown up and left home. At the time, he was in his early thirties and his children were infants.
    But Rubin, now 39, found himself missing some of the companies that had been ejected from Baron's small- and mid-cap funds because they had grown too large. "I kept a list of larger companies I liked but that we couldn't own, and they did great," he recalls. "Just because a company goes from a $2 billion to an $8 billion market cap doesn't mean it's no longer attractive." He mentioned the idea of starting a fund stocked with larger companies to Baron Funds founder Ron Baron.
    In April 2004, that idea took shape with the introduction of the Baron Fifth Avenue Growth Fund, which Rubin has managed since inception. It focuses on companies with market capitalizations of $5 billion or more and generally gravitates to those at the smaller end of the large-cap universe.
    Rubin estimates that between 40% and 50% of the fund's holdings are "graduates" of other Baron funds that he has been following for years. Others seemed riskier when they were smaller, but became more attractive as larger, more established companies. Another 15% to 20% overlap with the Baron iOpportunity Fund, an Internet and information technology-centered fund he has managed since early 2000. The returns of that fund have been in the top 1% of its Morningstar mid-cap growth category over the last three years, and the top 8% over the last five years.
    The question is whether Rubin can translate his success with iOpportunity into a more broadly diversified, large-company growth stock fund. His long-term familiarity with many of the "boomerang children" stocks in the portfolio and broad analytical coverage from Baron's analysts, he says, will help him do that. And with most of his personal investments split between the two funds he manages, he's prepared to put his money where his mouth is.

"When I first got into the investment business people thought of Magellan as the place to find the best companies in America," he says. "That's what this fund is about. People should feel comfortable with it as a core holding."
    Fifth Avenue's launch came at a time when small- and mid-cap stocks in general had been outperforming larger companies for several years. Last year the trend continued, as the S&P 400 MidCap and S&P 600 SmallCap indexes rose 11.3% and 6.7%, respectively, beating the 3% increase in the S&P 500 LargeCaps. At the same time, valuation multiples of small- and mid-sized companies remain higher than those of larger companies. But larger growth-company stocks have gained ground in recent months, and Rubin says their modest valuations mean they have plenty of room for growth.      
    "I don't view it as a question of whether one size of stock will outperform another," he says. "But I know that the S&P 500 Index has been flat for most of the last five years, while the companies we own have been growing earnings at a rate of 20% to 30%. It's not often that you can buy high-quality, large-cap growth companies at value prices."

    To obtain value, Rubin will often follow a stock for years and wait for a sharp drop in price, often 30% or more, to buy it. Last year, he picked up cruise operator Carnival Corp. after concerns about higher oil prices and terrorism sent the stock into a tailspin.
    "Those factors are irrelevant to the long-term view of the cruise industry," he says. "Gas only accounts for about 6% of the cost of running a cruise line. And terrorism is not going to curb the public's desire to travel." Over the long-term, he believes, Carnival will benefit from growing consumer demand for cruises and increased Internet sales, which are more profitable than travel agent bookings.
    Like Carnival, many of the stocks that find their way into Baron Funds are consumer-friendly and easy to understand. The firm's investment strategy starts with top-down-driven "themes," such as the aging and affluence of the baby boomer generation, the trend toward outsourcing and the evolution of wireless communication. Recurring, predictable revenues are a must, a mandate that came to the forefront in the late 1990s when Ron Baron departed from the go-go style of most small-cap growth fund managers by avoiding technology companies whose products he felt would become obsolete.
    At the time, Rubin was slowly making his way up the ladder in the investment industry. He had joined Baron Capital in 1995 after a two-year stint as a sell-side analyst at Smith Barney. Before that, the Harvard Law School graduate had been working long hours at a law firm doing "mind numbing" corporate work.  A conversation with a family friend who had made the transition from being a lawyer to an equity analyst convinced him to make the move to Smith Barney. Two years later, an introduction by a colleague led to a meeting with Ron Baron, whose long-term investment philosophy struck a chord. 
    Rubin's style is similar to that of his boss and mentor, with some modifications. While Baron might have 40% to 60% of fund assets in the top ten ideas, Rubin prefers a more equally weighted portfolio of 50 to 60 names, each accounting for 2% to 3% of assets. He is also more willing to invest in technology stocks, although Fifth Avenue's tech stake is still much smaller than that of most large-cap growth funds.
    Rubin says he treads carefully in the sector. "We don't want to invest in high-obsolescence products like semi-equipment, high-end hardware manufacturers," he says. "We prefer companies with sustainable, recurring revenues, such as E-Bay and Google." 
    Like its sibling funds, this one also has an ample presence in consumer stocks such as Best Buy, Urban Outfitters, Target and Nike. Financial services firms such as T. Rowe Price Group play off the theme of growing baby boomer affluence, while the aging of that generation creates opportunities for health care companies such as diagnostic testers Quest Diagnostics and Laboratory Corporation of America. The digitization trend led Rubin to Getty Images, a company with a $6 billion market capitalization that licenses digital imagery to media outlets.
    A focus on companies like Getty Images and others at the smaller end of the large-cap scale appeals to Litman/Gregory fund analyst Rajat Jain. In a recent issue of the "No-Load Fund Analyst," Jain notes that the Baron approach of finding an "earnings double" becomes progressively difficult as one goes further up the large-cap spectrum. "We think the capitalization range that the fund is currently focusing on is its sweet spot, and that should help it outperform its larger-cap indexes," he notes.
    Rubin's goal is to double his investment in a stock over a three- to five-year period. Much of the firm's analysis focuses on determining whether a company's earnings potential over that period is robust and sustainable enough to deliver the return he's looking for.
    If a stock has fallen substantially short of 50% return over three years, or 100% return over five years, he will generally sell it. If it has risen rapidly, he may decide to trim the position rather than sell if the company's earnings potential is strong enough.
    The firm's research style emphasizes hands-on conversations with companies, industry analysts, customers and competitors, as well as identifying market inefficiencies. That concerns Jain, who notes that "it is evident that Rubin and his team do not get the same level of access to management in the larger-cap space as do their colleagues at Baron with small-cap companies." At the same time, he adds, that downside is mitigated by better shareholder relations and reporting practices at larger companies, and the fact that Rubin and his team have been following many of the stocks for years.
    Rubin thinks he can successfully translate his firm's "pick up the phone and talk to management" style into a larger company environment. "If I am willing to travel I can meet senior management at just about any company in America," he says. "It may take three or four trips to get the whole story, and I may not have as many phone conversations with the CEO as I would with a smaller company. But do I know these companies well? Absolutely."

    Operating in the large-cap space also makes it more difficult to exploit market inefficiencies by looking for undiscovered "gems," but Rubin says that won't stop him from finding great buying opportunities. "The market inefficiencies with large-cap stocks are very different, but they do exist," he says. "If a good company misses its numbers and the stock slides, we get a chance to buy at a more favorable price. Our universe of great companies in growing industries doesn't change that much, but their valuations are changing all the time."

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