Baron Capital on Coronavirus Impact and Current Market Environment
Baron Capital is a well-known, highly regarded firm with a strong track record of investing in small and medium sized companies. The firm’s $4 billion small cap fund has a long-track record of successful investing and a disciplined strategy of deploying client capital. Thus, the recent question and answer commentary from long time co-managers Cliff Greenberg and David Goldsmith caught our attention.
Could you share your current thinking on the coronavirus pandemic and its impact on the markets and small cap stocks in particular?
Cliff Greenberg: This is a much different situation than normal. In a typical recession, a business may decline 10%-15% on its top line and profits may fall 15%-20%. In this situation, many businesses are just shuttering altogether which means there’s no revenue whatsoever coming in, and profits are not just swinging from $100 to $80, but in some cases, to a loss because the business is still carrying costs to stay in operation in the hope or expectation of things getting better. The size of that drawdown is much larger than normal and nothing I’ve ever seen before.
The potential positive is that although we will likely see a severe decline in profits, it hopefully will last for just a relatively short period of time. The cavalry is coming to try to address the issues. In the past week or so, we have seen both the Federal Reserve and the federal government take significant action, including the passage of a massive fiscal stimulus plan. But we’re also in the midst of an escalating health care crisis while simultaneously debating when and how to restart the economy.
Two months ago, we and other investors were well aware of the coronavirus outbreak, but we were largely focused on supply chain disruption in which a handful of businesses were not going to be able to get their goods out of China. Now, two months later, we are seeing a total dislocation of our economy in which all businesses are being affected. On top of that, we are grappling with the uncertainty of not knowing how severe the medical crisis will be or how long the economy will be shut down.
This shift in outlook has caused a severe sell off, with small-cap stocks most affected. This is not surprising, since small companies are viewed as more vulnerable to economic disruption and their stocks are less liquid so subject to greater swings. Small-cap indexes have declined about 500 basis points more than the S&P 500 Index year-to-date. The Russell 2000 Growth Index, which was up 5% in the middle of February, fell to down 37%, a massive swing of over 40%. To see that kind of swing over such a short period of time is unprecedented. For what it’s worth, it does mean that when the market recovers, small cap stocks will likely outperform.
How are you managing the portfolio in response to the crisis?
Cliff Greenberg: We are speaking with the senior management of all the companies we hold. I had six or seven of those calls today. We are asking them how they are managing their business, how they are strategizing and dealing with what may come next, and how they are positioned for the future. As long-term investors, we have long established relationships with the senior management of many if not most of our holdings. They are very familiar with our extensive and deep research approach, so they will not just take our calls but spend the time needed to answer our questions. We will continue to check in with our businesses regularly because even though we may feel comfortable that we are up to speed with what is going on today, that doesn’t mean that things won’t be different a week from now.
Our main takeaway from these discussions has been a sense that almost all our companies are actually better positioned for the future because weaker competitors are going to be more negatively affected by this crisis. Of course, we are coming across a few companies that we feel a little less comfortable with, either with their balance sheet, their growth prospects, or how management is handling the issues they are facing. With those companies, we are deciding whether we want to reduce or exit our position.
We are also reassessing our investment premises in our companies. We’re trying to re-underwrite our assumptions and re-determine what we think our companies will earn. I have no idea what 2020 earnings are going to be – I don’t think anyone does — and I’m not focused on those. It seems to me that more likely than not this crisis will be over by next year. With that in mind, we can take a pretty good stab at trying to understand what next year might look like based on different scenarios about the economy and how we think our companies will fare.
How have companies in the portfolio been faring in the crisis?
David Goldsmith: The outlook for the entire economy is much more negative now and virtually every stock is being punished, including the high-quality companies in which we invest.
The worst performers in our portfolio are those in which something unexpected has happened to impact short-term profitability. For instance, about a third of the business for technology research company Gartner, Inc. revolves around large technology conferences in which it brings together different industries to showcase their products. Because of the travel restrictions in place, the company has had to cancel all its conferences through the fall. Following the announcements of these cancellations, the stock has tanked. Corporate childcare company Bright Horizons Family Solutions, Inc. has had to close about half of its centers either because people are working at home or regulatory agencies are shutting childcare facilities just as they’re shutting schools. Floor & Décor Holdings, Inc., one of our large retail investments, is shutting its stores; Red Rock Resorts, Inc. is closing its casinos.
These are all terrific companies that found themselves in harm’s way because of the particular circumstances of this crisis. That doesn’t mean that they are not great long-term investments. While these stocks are hurting us in the short term, I think in the long term they will help us.
We do have a handful of companies that have found themselves in a better position in the present situation. Teladoc Health, Inc., the leader in telehealth services, has seen utilization of its services increase dramatically because people are being told not to or don’t want to go to a medical facility. Many of these new users probably didn’t even know telehealth services even existed before now. This will be a sea change event for telemedicine, which will be better positioned and more highly utilized going forward. So even though the stock is up significantly, we think we will still make solid long-term returns from where it’s presently trading.
The point is we are not all that focused on what is going up or down in any particular day. As long-term investors, we look for strong businesses that we think will do well over a long period of time. If they lag for a quarter or two, it’s not the end of the world, it’s usually a buying opportunity. When the opposite happens, we make sure that we think there is still value in the stock at that higher price.
Cliff Greenberg: As a money manager for over 35 years, I have lived through numerous crises, recessions, bear markets, etc. As a long-term investor, I have learned that the best approach is to stick to my knitting and do what I have successfully done in the past. I try not to worry so much about how we are performing at any particular moment or how a particular stock is doing, and not get too upset when I’m facing losses. Easier said than done. But I need to keep my wits and discipline and focus on doing what I think is right long term. I am a major investor in my Fund alongside all of you. It has been painful to watch what has happened to the market and the Fund and also be nervous about what’s going to happen next. We at Baron have a proven, time-tested process, smart, hardworking analysts and portfolio managers, and a lot of experience dealing with situations like this on our side. Although I hope we are through the worst of it, I have no idea whether we are. But at some point this crisis will end, and I remain committed to doing right by the Fund and for the Fund.