Baron Discovery Fund®: Finding Growth Opportunities in Earlier Stage Small Caps

Many investors steer away from small-cap stocks, wary of their reputation as riskier and more volatile than their larger-cap counterparts. While this can be the case, we believe investors who avoid this asset class are missing out. In our opinion, small-cap stocks offer fantastic opportunities for research-driven investors who are able to do the deep dive to find the hidden gems. As a firm that got its start investing in small-cap stocks over 40 years ago, we are long-time believers in the potential for small caps to generate alpha for investors

Baron Discovery Fund

Of our three small-cap funds, Baron Discovery Fund, launched in 2013, is our newest. The Fund invests in earlier stage small-cap growth companies – stocks with market caps typically at or below the weighted average of the Russell 2000 Growth Index. It is managed by Randy Gwirtzman and Laird Bieger, who, in addition to their more than 10 years as portfolio managers, worked closely together for 12 years prior to that as research analysts at Baron Capital. They each have 27 years of investment research experience. During their long history of collaboration, Randy and Laird have developed what we believe is a distinct approach to investing in small-cap equities.

As seen in the table below, this strategy has produced strong results since the Fund’s launch. The Fund has a Morningstar Medalist Rating of Silver, based on its proven long-term growth approach, focus on innovation, impressive manager team, and deep research bench.

The Fund has an attractive upside capture of 104.66% and downside capture of 100.59% for the five-year period. Its 1.71% alpha given its 1.02 beta over five years is equally attractive, especially in an asset class that is known for its volatility. The Fund has always maintained high active share. Its current active share is 96.4%.

Advantages of Small-Cap Equities

Small-cap stocks enjoy several advantages, in our view. With approximately 2,000 listed U.S. stocks (excluding penny stocks), this category has plenty of companies to analyze. Small caps can offer greater and faster growth potential than their larger peers, as they are earlier in their growth trajectory and have captured just a small portion of their overall target market.

In addition, small caps tend to be underfollowed on Wall Street. On average, a large-cap company is followed by over 20 analysts, compared with under 10 for the average small cap. This sparser coverage in part is a reflection of SEC regulations that make it difficult for funds to own more than a certain percentage of a company. The result is that many large mutual funds forego small-cap companies because they cannot take a position big enough to have a material impact on their overall portfolio.

As active growth managers with the extensive research capabilities needed to spot promising companies early on, we think the relative lack of coverage gives us an advantage. A primary goal of active management is to add value by capitalizing on market inefficiencies. With many small-cap stocks flying under the radar, the inefficiency that results makes this space particularly suited to active managers. When compared to large caps, stock returns of smaller companies are more driven by company-specific events and less so by industry and market events.1 This means the skilled stock picker who is able to understand and evaluate a company’s idiosyncrasies has more opportunities in this asset class.

On the downside, small caps can be volatile. As long-term investors, we are accustomed to riding out short-term volatility and will selectively take advantage of a downswing to initiate or build a position. As less well-established businesses, small caps can also carry more risk than their larger peers. As detailed below, we take a multi-faceted approach to managing risk, which we believe is critical to successful management of a small-cap portfolio.

A Differentiated Process

We like to say that investors have never heard of many of the companies in which we invest, but they will. We look for highquality, fast-growing, earlier-stage companies in some of the most transformative and exciting areas of our economy. We find these companies by combining a thematic approach with bottom-up stock selection, backed by extensive due diligence. We believe this approach, combined with our disciplined management of risk, differentiates us from our peers.

We emphasize fast-growing areas of the economy such as:

• Cloud computing
• Cybersecurity
• Semiconductors
• Defense and aerospace
• Genetics
• Minimally invasive surgical procedures
• Biotechnology and pharmaceuticals
• The use of technology in health care products and services
• Unique retail concepts

These are all transformational, secular trends – dynamic, evolving, and among the fastest expanding areas of the economy.

To build a portfolio around these and other themes, we leverage our industry expertise and extensive research experience and capabilities to source the most promising investment opportunities. Because we seek to invest only in stocks in which we have strong conviction, we generally hold 50 to 70 names in the portfolio, compared with a category average of nearly 150 stocks. The limited number of holdings, coupled with our long-term perspective, allows us to do the due diligence needed to gain an in-depth understanding of these companies, including getting to know their management teams and visiting key sites they may hold. It also gives us the chance to research new investment prospects. As with all Baron Funds, we look for what we believe to be companies with strong management, durable competitive advantages, and open-ended growth opportunities, at an attractive valuation.

An Integrated Approach to Managing Risk

Smaller companies can enjoy phenomenal growth in a short period of time. However, as any small-cap portfolio manager can attest, they can have volatility on the downside as well. Although we are long-term investors, the volatility of this asset class demands that we incorporate risk management into every aspect of our investment process. We think our comprehensive approach to risk is reflected in our beta of just 1.02 for the five-year period, which we believe is highly unusual among smaller-cap, high-growth portfolio managers, especially given our alpha of 1.71% over five years. The dimensions of our approach include:

• Extensive due diligence
• Balance among growth profiles
• Dynamic valuation analysis
• Position sizing
• Industry exposures
• Predictable revenue and cash flow in the largest positions

Extensive due diligence

We believe the best risk management starts with knowing our companies. We evaluate the strength of their management teams, competitive advantages, and long-term growth prospects, and determine the appropriate valuation based on our independent research. Of course, this is the same investment process that we employ to generate potential alpha as well. When we look at a balance sheet, we focus on free cash flow relative to overall debt. If the cash flow is recurring and predictable, the company can have higher leverage. If the cash flow is less predictable, we will want to see a lower debt burden.

Balance among growth profiles

We seek to balance the portfolio among high growth, growth, and what we call “other” stocks to help manage risk. Weights for each category are typically around 45% in high growth, 35% in growth, and 20% in other.

High growth

These are higher risk/return companies typified by revenue growth of 20% or more that we believe will lead to dramatic future earnings growth. This category includes newer businesses with novel products or services. Yet they are not venture businesses. We invest only in companies with fully formed business strategies. For example, in biotechnology and pharmaceuticals, we favor companies with either approved drugs, large pipelines addressing multi-billion dollar clinical market opportunities, or companies that have wrapped intellectual property around an already proven pharmaceutical to create a new, protected franchise.

Top 10 holding Floor & Decor Holdings, Inc., a specialty retailer of hard-surface flooring, is one of the more exciting growth concepts in retail, in our view. The market is fragmented and gaining share versus carpeting. We also believe the category is less susceptible to e-commerce competition due to the physical properties of the products. The company has over 200 warehouse stores, which average nearly 80,000 square feet and are typically much larger than competing stores. By sourcing directly from vendors, Floor & Decor can sell at low prices. Longer-term, we believe the company can grow 20% per year as it plans to triple its store count to 500.

Growth

These are companies with revenue growth of around 10% to 20% that we think will lead to greater future cash flow and earnings growth due to expanding margins. These firms tend to be more established than their high-growth counterparts.

Cybersecurity software company CyberArk Software, Ltd. is a good example of a growth investment. It provides identity-based security software focused on privileged access management (PAM). The PAM platform prevents against theft of the credentials of privileged accounts (such IT administrators) and restricts access to critical resources. CyberArk is a market leader that is leveraging its foothold in PAM to expand into adjacent markets.

Other

This category is constructed to help dampen volatility by offsetting holdings in other parts of the portfolio that may have higher beta. This category is also typically not as correlated to the market as the other two. These holdings might be more yield- or asset-oriented and generate solid free cash flow growth. They could also be special situations where we see valuation upside in a company that is new to the market through a spinoff, IPO, or restructuring; a company with a strong business that has been mismanaged but has a new, better management team; or a “fallen angel” (a great company that has stumbled for some reason).

Two examples in this category are Mercury Systems, Inc., an electronic subsystems provider to major defense contractors, and Kinsale Capital Group, Inc., a property and casualty insurance carrier. Mercury is known for high-quality products delivered on time and on budget, all of which are critically important for missile defense, radar, and electronic warfare applications. Mercury serves an overall addressable market of approximately $40 billion, including two major market segments – C41 (communication, command and control, and mission management) and sensor and mission systems.

Kinsale is a niche player focused exclusively on the excess and surplus (E&S) lines market, which includes risks that are unique or difficult to place in the standard insurance market. The company’s small size, E&S market focus, underwriting discipline, and efficient technology platform enable it to increase premiums while delivering industry-leading underwriting margins. Management is highly regarded and has decades of experience in the E&S market. The company has steadily grown earnings and book value per share faster than its peers in the time we have held the stock, and we believe Kinsale continues to have a long runway for growth in an attractive segment of the property and casualty insurance market.

We also employ a concept that we call investing in reverse. At times, we come across a company that checks all the boxes – great management, a terrific business plan, product or service, an open-ended growth opportunity – but is too expensive in our view. We will continue to conduct due diligence and update the stock’s valuation because, based on our experience, we think we will be able to buy it on a dip that brings it below our calculation of valuation.

Dynamic valuation analysis

We are active managers not only in our stock selection process, but also in our strict valuation focus during our investment holding period. Just as we will not buy a stock if we think the valuation is too high, we also re-balance the portfolio regularly according to our own calculations of valuation and price targets for each holding. We continually update valuation with one-, three-, and five-year targets for each holding. Should a stock get over-valued on a medium or long-term basis, we will trim and reinvest the proceeds in other companies, which serves to continually de-risk the portfolio.

We also seek to manage risk by diversifying the portfolio across subindustries with uncorrelated drivers of growth. In every bull market, there are sub-industries in bear markets and vice versa. Because we invest across a wide range of sub-industries, we will use the cash generated from trimming a position or flows to initiate or build a position in a sub-sector where we see value.

Position sizing

We limit the number of holdings in the portfolio, which allows us to focus on stocks in which we have high conviction and devote resources to doing as deep a dive as possible on each company we invest in. To hedge against the potential volatility and risk of a more concentrated fund, we manage the portfolio so that no one holding exceeds 4% by weight for an extended period of time.

Industry weightings

Another way in which we seek to minimize beta is by managing the portfolio so that with regard to industry weightings, we do not stray too far from the benchmark. This strategy is partly by design because as long-term investors and bottom-up stock pickers, we are not in the business of making market or industry bets. However, it is also because the heaviest index weightings – Information Technology, Industrials, and Health Care – are where we find the growth in today’s economy.

Predictable revenue and cash flow in the largest positions

At any given time, the top 10 stocks in the portfolio comprise roughly 25% to 35% of assets. These companies, which are listed in the table on the previous page, have relatively more predictable revenue and cash flow, which helps to hedge against potential volatility.

Conclusion

We continue to find fast growing and innovative companies at valuations that we believe are sufficient to meet our investment return goals.

We encourage you to take a closer look at Baron Discovery Fund. As significant personal investors in their Fund, Randy and Laird are committed to maintaining its strong track record of performance. Of course, there are no guarantees.