The Berkshire Special 2018

"If your thesis is correct, hold the stock regardless of what the price is doing"

Baron Capital’s Ron Baron on his firm’s investing framework, his bet on Tesla, and more

Published 6 years ago on May 30, 2018 14 minutes Read

He always wanted to be a doctor when he was a kid, but destiny had something else in store. After failing to secure admission in medical school, Ron Baron worked as a cabana boy and ice cream truck driver to help pay his college fees. In 1970, he became a securities analyst and named his dog Big Mac after one of his first successful stock recommendations. The medical fraternity’s loss eventually proved to be the investing community’s gain with Baron successfully founding a money management firm in 1982 that today has over $27 billion in assets under management. Baron explains that successful investing is not just about finding the right company but also holding on to it as it grows. Baron believes the biggest mistake investors generally make is to avoid paying a small premium for a strong growing business. Articulating on his investing framework, Baron explains why be believes Tesla is on to something big and why stock prices are irrelevant as long as the business is doing well.

Could you take us through Baron Capital’s investing process, especially since you started with small-caps? There you don’t have much information, and also face illiquidity risk.

We started off with $100 million in 1992 and today manage over $27 billion in assets. We’ve made over $25 billion in profit for our clients since we started, and I hope to double our money again over the next five to seven years. We invest for the long term and, over time, become quite knowledgeable about the businesses that we invest in. That knowledge mitigates the risk that an investor would ordinarily face. The idea about not having great knowledge about businesses couldn’t be further from the truth. Of the 146 people at our firm, we have 37 analysts and portfolio managers. The reason we hire these people is because they are supposed to become very knowledgeable about the businesses we invest in and, as a result, we hope to be more discerning about opportunities and, in turn, buy stocks at attractive prices. One such idea is that whenever companies announce that they are going to invest significantly in their own businesses, stock prices tend to fall as they are penalising current earnings. This gives us an opportunity to invest in such companies at better prices. 

Most people spend time worrying about illiquidity, and are careful about when they are making the investment. What they want to do is to invest on the basis of what their beliefs are. For example, who will become the next president? If Trump became president, with the policies that he would follow, what’s going to happen? What if there’s Brexit? What’s going to happen if there is a trade war? What’s going to happen if interest rates rise and what happens if oil prices go up? Everyone has a point of view about what they think is going to happen and, for the most part, invest in liquid securities. That’s macro investing. We don’t do that.

We focus on companies that are smaller. You need liquidity only if you are buying and selling all the time. For example, in the Baron Growth Fund, the average holding period is 13-14 years, while the average holding period for most mutual funds is nine months to a year. So, if you are buying and selling in a very rapid fashion, you need a lot of liquidity. But if you are making investments over an extended period of time, then you need less liquidity. If the business is going to flourish then you will end up making a lot of money. To give you an example, a chunk of our $25 billion profit has come from relatively small number of companies — 15 companies fetched us $11 billion. We made a billion dollars in Charles Schwab, another billion dollars in Wynn Resorts, and a billion dollars in Vail Resorts. If an investment doesn’t fetch us $350 million, it won’t be in our top 15 holdings. So, we make investments anticipating developments that will take place in these businesses. We study the companies intensively and don’t rely on Wall Street to tell us what to buy and sell. We do our own research. We study businesses and study the people who manage those businesses. 

Our process is also about building the right team. We try to find great hardworking, ethical, smart individuals to work for us. We hire them, train them, and keep them. There hasn’t been a single year where we have had a layoff. We have never fired someone because our business isn’t doing well. Normal mutual funds such as T Rowe Price enjoy profit margin of 40%. It pays employees about 30% of its revenue. Our business is different. We pay our employees 50-55% of our revenue and our profit margin ranges anywhere from a low single digit to the 20s. We are investing in our business by hiring great folks who can fetch us great investments, so that our clients can sleep tight, and so can the team. They don’t have to worry about us. Our balance sheet is strong — so when the market isn’t doing well, we take a hit and not the employees. We are not about maximising profit at Baron Capital. We want good people who can give our clients, our shareholders, the best return. 

When do you decide that it’s time to exit? 

We look at whether we’ve made a mistake — and it’s never about the price. If we’ve made a mistake in terms of a business plan not working out as expected, we sell. It’s all about the fundamentals of a business and not about the stock price. Stock price is irrelevant as long as the business is doing well. In the case of Tesla, we kept buying the stock from 2014 to 2016. During that period, the stock didn’t go up and today it is quoting at $302. When we started investing in it, there was no revenue. Last year, Tesla clocked $12 billion in sales and this year it is going to be about $17 billion and next year it is going to be $25 billion. 

The stock hasn’t performed great — it was up 70% last year and this year it is down 6%. The price goes up and down on the basis of how many cars are they making in this quarter. How many cars a week are they making? The key for us is whether the company is going to be a $100-billion company or $500-billion company or a trillion dollar company? And are they going to make over the long term a profit margin of 15% or 20% or 5%? So, we have an estimate as far as where we think they should end up. 

In short, we try to discover businesses that, first, can become much larger than they are at present. Second, there is something about the business that gives it a sustainable competitive advantage which others can’t duplicate. Third, it’s all about the management team — exceptional, honest, that work hard and are not going to cheat us; they are going to work for us as opposed to themselves. 

Where does your conviction come from? In the case of Tesla everything that it is doing is revolutionary.

Tesla has a leader who is driven, smart, and incredible. I talk to Elon Musk on a regular basis. In fact, one of the directors of SpaceX, in which we have an investment and who is also one of the first investors in Tesla, was up here for a couple of hours. We spoke about the capture of the regulator by the regulated. 

In 1906 when Henry Ford started making cars he didn’t have the capital to go across the country and open up dealers to distribute the products. So he franchised in perpetuity, licences to distribute his cars. These dealers became among the most powerful political forces in the US. They control the legislators, they sponsor the local little league teams, donate to hospitals and are governors of states. So, they are politically powerful and extract a tremendous leverage from the original equipment manufacturers (OEMs) to distribute their products. Hence, OEMs are at a tremendous disadvantage against an upstart like Tesla because they have to sell their cars through a dealer, unlike Tesla, which sells directly to customers.

In fact, if you go to a GM dealer in the US to buy a Bolt or a Volt car, one of their electric or hybrid cars, the dealer will convince you to buy a gasoline car. And the reason is that they make money on servicing the car, and not on selling it. There’s very little servicing in electric cars. The dealers don’t want it. The unions don’t want it because half the plants that the OEMs have are used to make engines. There’s no motor being used in the Tesla car. Unions don’t want to lose their jobs. Car companies can’t afford to write-off the plants. In addition they have huge obligations to buy back cars that they’ve leased as well as be forced to buy back at prices that are higher than their worth. There is a structural disadvantage to people who are making cars against an upstart that can get financing and build a car. This guy can get finance and can build a car that people want to buy — there’s unprecedented demand for the Model 3, which is priced at $45,000-$50,000. 

The dealers are trying hard to prevent Tesla from selling cars directly to consumers. The regulators make laws to prevent competition from coming in. But the risk is that we have so much extra cost built in the ecosystem that some guy can come along and undercut the cost dramatically. As a result, he can take all the business away by breaking through if has the staying power to withstand the regulators. 

Does Tesla have the staying power? 

Look at Model 3, which is a mass market model, that is going to sell for let’s say $50,000. If you’re doing 5,000 cars a week, that’s $250 million in sales a week or about a billion dollars of sales a month. Their suppliers are so excited about the product that they have given Tesla 50 to 90 days to pay for it. And what that means is every time they sell a billion dollars of cars a month, they create a billion dollars of float. They don’t pay taxes on it. And next year they are going to do 10,000 a week instead of 5,000 a week. That’s another billion a month.

Secondly, they should be making $10,000 in profit a car. On 250,000 cars a year, $10,000 per car translates into $2.5 billion in profit, and at $8,000 a car, that’s $2 billion. That’s extra cash flow. 

Thirdly, in the US, if you want to sell those big ugly gas-guzzling cars, the auto makers have to buy something called ZEV (zero emission vehicle) credit. And the only guy who can sell it to them at scale is Tesla. On average for every car that Tesla sells it gets $6,000 ZEV credit from automobile companies that enable them to sell big gas guzzlers in New York, Michigan, Texas or California. There are 13 states that now have this requirement and they require 2% of the cars to have ZEV credit this year. Next year 4%, next year 6%, next year 8%, and next year 10%. So every year the requirement for ZEV credit is going up. So, Tesla is making $6,000 for every single car it sells. The OEMs have sold 300,000 cars so far, 150,000 in the United States. And they’ve collected $891 million of ZEV credit. So, you are going up there and selling an extra 250,000 cars or 500,000 cars, that’s $6,000 extra per car Tesla is going to make. That’s another billion dollars. And they are spending right now about $3.5 billion a year. 

We are investing in a business that’s building a business. Those businesses are incurring losses as they have overheads, structure, design and research. Of course that’s the way it works. But once the plan is operating, Tesla will make all that extra billions a year, which will offset the money that it is going to invest. 

Having said that there could be a lot of things that could go wrong. You could also be totally wrong about the OEMs — they can do exactly what Tesla is doing and they really can put Tesla out of business. Hence, we are always talking with companies, studying the businesses and making sure that our assessment is going in the right direction. If your thesis is correct, you hold the stock regardless of what the price is doing.

How do you figure out whether a company is trading at a discount? It’s a bargain or trading low for the right reasons?

That’s what research is. In 2020-2021, Tesla could clock $60 billion in revenue and make $10 billion or $15 billion a year in operating profit. And if you see the profit, you put a multiple on it, and you say it’s worth 10x or 15x and so that would get you $150 billion-$200 billion of value. So, that’s how we figure out its worth.

Tesla is a company that you are very bullish on over the next 15 years. What would make you assess your position in Tesla, Jim Chanos has been short the stock for a while?

We try to understand what the opportunities are and what the risks are. People who don’t do research and make up stuff, there’s 38 million shares of Tesla they sell short. So, a very large number of people don’t think they are going to be successful. We don’t happen to be among those. Tesla is going to have the best electric car and better technology in making it. Besides, it is venturing into the ride sharing and batteries businesses. In short, they have an advantage that others don’t have. It makes it very difficult for me to think that they’re going to be caught at any time. However, you can’t just rest on your laurels and there has to be a continual evolution in the way you make your product.

How do you know a stock is a bargain and not a value trap? 

As far as real bargains are concerned, they are few and far between. We are interested in investing in growth. And growth sells at a premium and you just have to be sure that the business is growing. Sooner or later it will become dramatically more valuable, because the business itself will become much bigger. And if we are wrong, we just sell as fast as we can. Just get out as fast as you can when you make a mistake and, hopefully, not too often. When you make a mistake, you just move on. 

What’s your worst mistake?

The worst mistake and the biggest loss I ever made was in Sotheby’s. I invested $500 million in 1999, when we had about $8 billion assets under management. It was a huge investment at $20 a share. My theory was that Sotheby’s will be acquired by eBay or Amazon. One of these two companies would take them with their physical auctions and put them on the web. The stock went to $40 after we bought it, so we were already sitting on $500 million profit. I felt on top of the world. 

I visited Jeff Bezos three times in 1999, as also Meg Whitman at eBay. I tried to get them to buy Sotheby’s, but didn’t invest in Amazon, or in eBay! It was at this time the scandal broke out of Alfred Taubman conspiring to fix prices with the chairman of Christie’s. The stock collapsed to $10. I was forced to sell my stock and incurred a loss of $250 million. That’s the biggest monetary loss. But the worst monetary loss was not investing in Jeff Bezos — just think about that. Here I was talking to Bezos all the time about trying to sell my junkie and he had this really weird laugh that pretty much implied that why was I not investing in Amazon! 

Why did you not invest in Amazon? Hindsight is 20:20 but going back in time, what is it that prevented you from investing?

It looked expensive and I didn’t understand it enough. I have ideas all the time that for some reason or the other get side-tracked and we don’t invest in them. The companies do well and some ideas that we do invest in, the companies do poorly. I have them on both sides. We’re certainly not infallible.

What have your wins taught you? 

When I invested in Vail, for the first 10 years we made just 60-70%. In 2006, the stock was still at $26-27 and now it’s $220-230. In the past 12 years we made 8-9x return. So, you have to be patient. You can’t expect when you buy a stock that it keeps going up 1.5% every single month, at the end of 10 years you would have made 4x. You have to be prepared at any point in time to lose 20% of your money, and make sure that you have enough time to make it back. 

In 2008-09 when the market was collapsing, our assets fell from $20 billion to $10 billion. Here is my whole life spent up to 2008 building what I had and all of a sudden I lose half of it! But I told my analysts to go look for opportunities as no one else was doing it during the panic.  

Your most important investing precept is that you invest in people. It is easier said than done. So, how do you go about it?

I tell people that from the time they’re children, you’re meeting and judging people. You know who you like, who you think is smart, who works hard, who you want to be friends with and so forth. It’s the same thing. People look you in the eye and you judge them. Actions speak for themselves. Warren Buffett says that when he buys a business from someone, he says he wants to know how that person acts. You’ve got to know what drives them. You’ve got to know how people live. Are they flashy? Do they have different houses? Do they go on fancy vacations? Do they have girlfriends? You have to learn about the people because that is who you are investing in. 

Is frugality a virtue that you look for in CEOs? 

Well I like them to be careful, not frugal. I want them to make their businesses grow. I want them to invest. And so you wouldn’t think that Elon Musk is frugal. Or maybe he is. I mean he is careful about the way he spends his money, the return he is getting for it. I want someone who loves his business. You can see it. People reveal themselves. It doesn’t take much. You just observe and they tell you who they are.