"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."