“The market in 2017 went more or less in an upward direction with little volatility, so everything went up,” he says. “This year we’ve seen volatility more in line with historical averages. That’s good news for us because it gives us a chance to replace good ideas with better ones.”
He and the fund show off their strong independent streak in other ways as well. The fund’s 6.02% tracking error against the Russell 1000 over the last five years is more than three times higher than that of its peers. By some measures, the approach has also raised the fund’s risk profile. Morningstar pegs its standard deviation over the last three years at 14.93, compared with 11.77 for its large-cap growth category peers and 10.26 for the S&P 500. Over the same period the Baron Fifth fund’s beta against the index was 1.20, while peer beta was 1.03.
Umansky believes that traditional measures of risk, such as standard deviation or beta, don’t tell the whole story. And he points out higher volatility, both on the upside and downside, is a natural outgrowth of a more concentrated portfolio where each stock carries more weight.
“We rail against risk-adjusted returns, and I don’t believe volatility is the best gauge of risk for a large-cap growth fund,” he says. “We will be volatile from time to time. But if our thesis is right, our investors should recoup short-term drawdowns and come out ahead.”
He says the fund’s goal is to maximize long-term returns without taking significant risks that there will be a permanent loss of capital, and he employs a number of risk control measures to do that. These include buying stocks that sell at least 20% below the firm’s estimates of intrinsic value and selling them when their price moves up to over 20% above intrinsic value estimates. Portfolio companies must also have high returns on invested capital, a sustainable competitive advantage, dependable recurring revenues, a diverse customer base and ample free cash flow yield.
Umansky prefers scalable “platform” businesses that don’t require huge capital outlays to grow. For example, Apple and Amazon make money from third-party sellers who pay a significant cut of their sales in order to appear on iTunes and Amazon.com. Yet it costs virtually nothing to add new sellers to these platforms. Mastercard, another fund holding, is able to add new global customers quickly and efficiently at minimal cost with its huge “digital railroad.”
But Umansky isn’t fond of banks because he thinks their balance sheets are too difficult to understand. And energy companies don’t make the cut because they are too difficult to value.
The “New Oil”
A number of the portfolio’s most prominent stocks have come under fire recently for different reasons. Mark Zuckerberg’s apologetic testimony before Congress earlier this year over privacy shook Facebook stock, if not the legions of ardent users. President Trump has meanwhile publicly trashed Amazon for draining U.S. Postal Service resources. And some worry that the threat of a trade war with China could weigh on the stock of Alibaba.
Umansky admits he has no particular insight on whether the negative publicity surrounding Facebook will raise costs for those companies or affect ad revenues over the short or long term, what the fallout might be for Alibaba if more protectionist trade policies come into play, or whether Amazon’s growth trajectory will succumb to political pressure. “However, I do believe the substance of the current debate is largely missing the forest for the trees,” he says.