Key-Person Risk an Issue for This Solid Growth Fund

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Baron Growth features a veteran stock-picker and appealing approach, but succession risk and high fees limit its Morningstar Analyst Rating to Bronze.

Ron Baron, CEO and CIO of his eponymous firm, has led this fund since its 1994 inception, but he's no longer alone. Longtime analyst Neal Rosenberg, who first joined here as assistant manager in 2016, took on greater comanager duties in August 2018. The move eases concern about succession but doesn't remove it entirely as Rosenberg lacks a track record of his own.

Rosenberg's addition hasn't altered the fund's approach. Baron has long gravitated toward small-cap companies with strong prospects for secular growth thanks to emerging, if not established, competitive advantages. He typically buys stocks as small caps--those he added to the portfolio in 2019's second quarter all had market capitalizations under $5 billion--but he tends to hold on, a practice that lands the fund in mid-cap territory. Baron rarely trades and stays within his circle of competence. He tends to avoid speculative areas like biotech, positioning the fund in more-established names like CoStar Group CSGP and MSCI Inc MSCI , longtime top holdings that carry wide Morningstar Economic Moat Ratings. Unsurprisingly, the fund has historically been more exposed to the economic moat and financial health factors than the Russell 2500 Growth Index, per Morningstar's risk model. This patient approach and preference for profitable companies has led to strong returns. From the fund’s 1994 start through July 2019, its annualized and risk-adjusted returns easily surpassed the Russell 2000 Growth Index and better-fitting Russell 2500 Growth Index, with notable downside protection.

Still, the fund doesn't come without concerns. Baron is 76 and responsible for most of its strong record, and while Rosenberg is gaining experience and is backed by a deep research team, Baron's skills will be hard to match. Additionally, with nearly $9 billion in total assets, the strategy isn't as nimble as it once was. Ultimately, expenses remain the fund's largest drawback, as it levies fees considered to be high relative to peers.

Performance | Positive | by Christopher Franz, CFA Aug 28, 2019 This fund hovers near the small- and mid-cap border and leans toward growth stocks. Whether measured against the Russell 2500 Growth Index or its prospectus Russell 2000 Growth Index, the fund's strong performance warrants a Positive Performance rating.

Since its Dec. 30, 1994, inception through July 2019, the fund's institutional share class returned an annualized gain of 13.4%. That trounced both the Russell 2500 Growth Index's 9.7% and the Russell 2000 Growth Index's 8.0%, and it also fared better on risk-adjusted metrics, thanks largely to better performance in challenging markets, such as the early-2000s dot-com bubble and 2007-09 financial crisis.

However, the fund hasn't fared as well over the past 10 years as it moved up the market-cap ladder into mid-cap territory. Over the 10 years ended July 2019, its annualized 14.9% return slightly lagged the Russell 2500 Growth's 15.0%, though it edged the Russell 2000 Growth's 13.7%. Still, it has held up in most pullbacks since the financial crisis, and its near-term results are more encouraging, landing atop most peers and fueled by a secular growth bull market. Indeed, it comfortably led the Russell 2500 Growth Index in 2019 through July, thanks to strong performance from its industrials and healthcare stocks, specifically longtime holdings CoStar Group and Idexx Laboratories IDXX .

Price | Negative | by Christopher Franz, CFA Aug 28, 2019 Baron funds are pricey, with a 1% management fee and a 25-basis-point 12b-1 fee on almost all retail shares. This fund receives a Negative Price Pillar rating. It has the largest asset base in the family but hasn't extended the benefits of economy of scale. While its assets have increased considerably over the past decade, its price tag is little changed. A 1.29% expense ratio on the retail shares is well above the median 1.04% for retail no-load mid-cap funds, and the institutional share class also has above-average costs compared with its Morningstar Fee Level peer group.

While the fund tends to pay low brokerage commissions relative to mid-cap peers, a cost advantage of its low-turnover strategy, investors in taxable accounts should be wary of high potential capital gains exposure.

Process | Positive | by Christopher Franz, CFA Aug 28, 2019 A key factor that distinguishes Ron Baron and much of the investment team is a lengthy time horizon. They seek stocks that can double in size within five years and generally hold for the long term, applying a private equity mindset to public markets. The fund's turnover is usually below 15% and is often one of the lowest in the mid-growth Morningstar Category. Baron prizes steady growers benefiting from innovation and strong competitive advantages. While such firms are rarely bargains, he is valuation-conscious, buying when they are attractively priced relative to their earnings prospects over three to five years. The approach earns a Positive Process rating.

The firm's managers and analysts emphasize quality of management and cultivate ongoing relationships with the people who run the companies they hold. In years past, confidence in management sometimes induced them to make private investments in companies boasting innovative products, but Baron and his colleagues have since stepped away from private investments.

This fund's benchmark is the small-cap Russell 2000 Growth Index, but it has small/mid-cap flexibility. Baron buys stocks with market caps up to the largest stock in the index, which as of July 2019 was around $8.2 billion. Even so, the fund's $8.6 billion average market cap in June 2019 was still below the then $12.9 billion mid-cap growth category median.

This strategy has become more concentrated in recent years. It has held around 60 stocks since early 2016, versus closer to 100 previously, and its 51.5% stake in its top 10 holdings as of June 2019 was double what it was five years ago. Lead manager Ron Baron's low-turnover approach explains part of this concentration, as he's reticent to sell his winners because of market cap, resulting in a top-heavy portfolio. He first purchased top holding and large-cap stock CoStar Group in 2004 and current top-10 holdings Vail Resorts MTN and Choice Hotels International CHH in the late 1990s.

Keeping winners to such a degree presents challenges. As legacy and larger-cap positions take up a greater share of portfolio assets, new holdings are typically initiated at much smaller sizes, often well below 50 basis points. Additionally, the strategy's total size--nearly $9 billion across vehicles--limits its ability to build positions of size in smaller companies, though it has been bigger in the past.

Still, the portfolio remains heavy in companies with solid balance sheets and competitive advantages, evidenced by its peer-topping exposure to the economic moat and financial health risk factors. It has long been invested in consumer discretionary and financials names--Baron's traditional hunting grounds--while avoiding materials, energy, and more speculative areas such as biotechnology.

People | Positive | by Christopher Franz, CFA Aug 28, 2019 Led by veteran manager Ron Baron, the fund earns a Positive People rating. Baron, 76, founded Baron Capital in 1982 and BAMCO, Baron Funds' advisor, in 1987. He managed the first Baron fund, Baron Asset BARAX, from its mid-1987 inception until early 2008, delivering outstanding results. He's been at the helm of this fund since its inception at the end of 1994, again compiling an excellent record. While this fund has emerged as the firm's flagship offering, Baron has also had strong results at Baron Partners BPTRX and Baron Focused Growth BFGFX. He has more than $1 million in this fund and most of its peers within the Baron Funds lineup.

Early on, Baron did much of his research himself, assisted by a few analysts. However, he has since built a larger investment team, which now totals 13 additional portfolio managers and 20-plus sector analysts. The firm's expanded research capabilities have enabled Ron Baron to broaden this portfolio beyond the consumer and financials stocks that drove its earlier fortunes.

The firm has begun to address succession planning. It appointed longtime equity analyst Neal Rosenberg as assistant portfolio manager in 2016 and as comanager in 2018. While Rosenberg is new to the management ranks, he's been an analyst at the firm since 2006 and has covered various sectors. He's transitioning his existing coverage to other analysts and invests at least $100,000 here.

Parent | Positive | by Christopher Franz, CFA Oct 3, 2018 Led by founder and CEO Ron Baron, 36-year old Baron Capital features a roster of stock-pickers focused on long-term investing. Baron, 75, defines the growth boutique's investment culture as CIO and leads four of the firm's 17 funds. Succession has been an issue, but the employee-owned firm has taken steps to address it by naming assistant and co-portfolio managers on several funds, including all of Baron's charges. Among the appointed comanagers are Baron's two sons, who also serve on the firm's management committee and are slated to inherit his firm ownership. While above-average fees are a minus, the firm's strong investment culture and transition planning merit a Positive Parent rating.

Most of the firm's nearly $30 billion in assets under management are invested in its legacy small- and mid-cap growth mandates, but its non-U.S. strategies, such as Baron Emerging Markets, launched in late 2010, are gaining traction. The firm recently launched two sector funds managed by longtime analysts, an offshoot of a domestic large-cap offering, and a fund-of-funds managed by Baron himself. These shouldn’t be a distraction for the firm’s investment team, 37-strong, which has grown in recent years, and many managers continue to focus on single or related offerings. Baron managers are typically well-aligned with shareholders, with most investing above the $1 million level.