Baron Global Advantage Fund®: A Distinct Approach to Global Investing

The most transformative secular growth trends in the world today are global. Internet and mobile disruption, health care innovation, robotics and AI, energy efficiency, paperless payments – these and other secular shifts are all happening on a global scale. Many leading businesses are global, selling and sourcing their products and services across the world.

The U.S.’s share of the global pie is also shrinking. In 1960, U.S. GDP represented 40% of global GDP. By 2023, this percentage shrunk to about 13%.¹ Many disruptive changes originate in the U.S. and the repercussions undoubtedly reverberate globally. However, over the last decade, the drivers of global growth have come from overseas.

A global approach gives Baron Global Advantage Fund the flexibility to capture opportunities in the market wherever they might arise! In today’s economy, opportunity is borderless. No country or region has a monopoly on good ideas or good entrepreneurs. We can invest in cloud-based data storage and analytics service Snowflake Inc. in the U.S., leading financial corporation Bajaj Finance Limited in India, and argenx SE, a Dutch biotechnology pioneer. Because we are not restricted by geographic boundaries, we need not forego investments in these or any other stocks.

This freedom to invest regardless of borders allows us to think more broadly and more horizontally. We believe horizontal expertise – the ability to compare business models across sectors, sub-industries, regions, and market caps – is key to effective capital allocation. Orit Gadiesh, chairman of Bain & Co., coined the term “expert-generalist” to describe this approach – someone who has studied widely and deeply in many fields and applies insights from them to investing.

Baron Global Advantage Fund

Baron Global Advantage Fund is managed by Alex Umansky, who brings over 30 years of research and investment management experience to what we believe is a truly distinct approach to investing in global equities. The Fund is differentiated by its high conviction – 37 stocks as of September 30, 2024, high active share of 93.1%, low three-year turnover of 10.75%, and long-term view of risk, return, and volatility.

We are pleased to report that in March 2022 the Fund was named the best fund in its category by Lipper analytics for risk-adjusted returns over five years ended 12/31/21.²

Disruptive Change

With more than 58,000 publicly traded companies in the world, global equities present a formidable market in which to invest. How do we find the stocks that we think represent the most promising investment opportunities among the thousands of possibilities?

We focus on disruptive change. We believe the only constant in the world’s economy is change.

Understanding whether a change is real, durable, and material, and identifying which companies will be disrupted and dislocated and which will grow stronger and bigger is key to finding the best investment opportunities, especially in the global space. Examples of disruptive change include:

The Fund invests in Big Ideas – unique, competitively advantaged companies that are agents or beneficiaries of disruptive change on a global scale. These are companies that are in it for the long term, investing in game changers such as digitization, AI, and machine learning that reach across multiple industries and are set to transform the world as we know it. They have visionary leaders that inspire and encourage a culture of constant innovation and improvement. They are unique.

We do not manage to the benchmark. Our country and sector exposures are purely a reflection of where we are finding Big Ideas. As seen in the graphic below, approximately 39% of our assets by weight are in U.S. equities, as many of the leading beneficiaries of disruptive change are U.S.-based companies. We are also big believers in the growth opportunities in emerging markets, where our exposure is significantly higher than that of the MSCI ACWI Index. As seen in the second graphic below, on a sector basis, our highest exposure is to Information Technology, which is again a reflection of the companies that are benefiting the most from disruptive change.

¹If 0% weighting is shown, that category has a 0.5% or lower weighting. Figures may not sum to 100% due to rounding.

A Differentiated Investment Approach

To identify the companies that we believe are the agents and/or beneficiaries of disruption, we take a multi-pronged approach, looking for unique companies we believe have open-ended growth potential, excellent management, and durable competitive advantages, at an attractive valuation.

Growth potential

First, we must be convinced that the company can become materially larger, reaching what we call its endgame. To do so, we first determine the size of the market opportunity. Then we look at the company’s current market share and estimate the market share it will need to capture to meet our objective or endgame. We project cash flows based on different growth rates over different periods of time and calculate the projected EBIT. Then we bring our calculations back to present value. The process is akin to the one used to ascertain discounted cash flow, except the reverse.

In evaluating growth potential, we favor companies with:

• Secular, organic growth
• Free cash flow and higher or rising returns on invested capital
• Low capital intensity
• Positive optionality (hidden assets, unexpected/mispriced monetization opportunities) 

Secular, organic growth

We prefer companies that grow organically over the long term. Organic growth is repeatable and we think more durable, whereas growth by acquisition is neither. In addition, acquisitions can carry higher risk, as many are bought at a premium and/or may have packaged themselves for sale by overearning while underinvesting in growth.

Free cash flow and higher or rising returns on invested capital (ROIC)

We run screens for free cash flow yield and ROIC as a source of investment ideas. We prefer free cash flow as a valuation measure because unlike earnings, it cannot be manipulated. We also emphasize ROIC, as it demonstrates whether growth can be profitable and is the metric most correlated to future stock performance. Growth for the sake of growth is not maintainable.

Asset-light, low capital-intensity businesses

We like asset-light, low capital-intensity businesses because as they scale, margins can expand significantly. Shopify Inc., which has built an online platform connecting third party vendors with customers, illustrates this concept. After the platform is built, the cost involved in adding new businesses or customers is de minimis, meaning that the incremental margins on these additions are exceptionally high.

Positive optionality

We have found that the market tends to undervalue or even ignore businesses, products, or services a company may have that are peripheral to its core business. For example, most of the analysts covering Tesla, Inc. focus on its electric vehicles, with little or no attention paid to the rest of Tesla’s portfolio, encompassing batteries, solar and other energy solutions, software offerings such as full self-driving, and even insurance. We are invested in Tesla based on our expectation that, despite near-term challenges, it will continue to grow its automotive business over the long term given its first mover advantage, technology innovation, vertical integration, brand, and growing supplier support. But we also believe that the optionality offered by its other endeavors are substantial, and we do not have to pay much to own them.

Company specific criteria

In addition to the size of the potential market, we develop a company thesis for each of our investments. In particular, we seek companies with the following attributes:

• Uniqueness
• Durable competitive advantage
• Platform business
• Exceptional management
• Recurring revenue
• Pricing power

Uniqueness

The uniqueness of a company is determined by its culture, which is shaped by the values and vision of its leaders. Elon Musk, CEO of Tesla and Space Exploration Technologies Corp. (SpaceX), has said, “Constantly think about how you could be doing things better. Keep questioning yourself.” We think this vision is a large part of the force behind these companies’ stories of innovation and relentless focus on the future that have produced – and we think will continue to produce – outstanding results for their investors.

Durable competitive advantage

To build a durable competitive advantage in today’s knowledge-based economy, we believe that a company must continually improve – the Japanese term is kaizen – and innovate. If a company stands still while its competitors move ahead, it will inevitably fall behind, lose its edge, and die. We think this is especially true given increasing digitization, or the shift to computer-processed information. In the digital era, innovation happens at a much more rapid pace than in the past as companies can iterate much faster, assessing the success of a product or service and challenging its capabilities to deliver something better. Digitization has moved well beyond traditional IT companies and is penetrating and transforming many other industries, including health care, banking, commerce, and consumer goods and services.

Platform business

Baron Global Advantage Fund is invested in companies that have built, or are on their way to building, a platform that others can use to easily connect their businesses, market and sell their products and services, and co-create value. Users, sellers, providers, and others typically seek to work with these businesses, leading to better monetization opportunities over time. We think that, as a group, platform companies offer the most significant growth opportunities in the global market today as they benefit from economies of scale, the network effect, and formidable barriers to entry. We think our focus on identifying and investing in future platform companies gives us a competitive edge, as we are getting in on the ground floor where we see massive potential growth opportunities.

Exceptional management

Management can make or break a company. A great product or service will only rarely, if ever, save a mismanaged company. In addition, we believe a firm’s unique culture – the shared values, attitudes, standards, and beliefs – is shaped by management. For these reasons, our assessment of the strength of a company’s leadership is at the core of our research process. We look for a track record of successful capital allocation with proven ability to reinvest excess cash flows at high rates of return.

Recurring revenue and diverse customer base

From both a business and investor perspective, the recurring revenue model has many benefits, including predictable and measurable revenue, higher levels of customer retention, steady and repeatable cash flow, reduced risk, and greater opportunities for growth. We also prefer a diverse customer base as it helps reduce risk as well since the loss of one or two customers will not break the bank. Our concentrated portfolio necessitates that each of our holdings is diversified.

Pricing power

We prefer companies that have pricing power tied to the utility of their product or service rather than a monopolistic grip on that product or service. For instance, we like software-as-a-service businesses, which use a subscription revenue model and typically become deeply embedded in customer workflows. This dynamic allows the vendor to raise prices in exchange for incremental improvements. As Warren Buffett puts it, “If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business.” We agree.

Long-term holding Illumina, Inc., the leading provider of next-generation DNA sequencing instruments and consumables, is an excellent example of what we are looking for in a company. DNA sequencing – the reading and analysis of the three billion chemical “letters” in a human genome – is a transformative technology, with potentially far-reaching impact in the prevention and treatment of disease. Illumina, which was founded in 1998, was at the forefront of the genome sequencing revolution, and its machines now generate 90% of all DNA sequence data. Its razor/razor blade business model means that a high percentage of its revenue is recurring, generating steady cash flow even when sales of its systems lag. Illumina’s user base also continues to expand. It is becoming increasingly common, for instance, to sequence a patient’s cancer tumor to determine custom therapies and targeted drugs. Genome sequencing is also starting to become a foundational part of patients’ health records. We believe this exceedingly well-run company will continue to benefit from increasing adoption of DNA sequencing.

Valuation

We estimate the intrinsic value by forecasting the key financial metrics – revenue, margins, capex, depreciation, amortization, etc. – of every company we invest in and will only make the investment if we can buy it at 20% discount to that value. We also sell when the price moves up to over 20% above intrinsic value estimates.

We often find hidden value by looking for underappreciated companies due to market inefficiencies. Many of the platform companies in the Fund fall into this category. Market inefficiencies include:

• Lack of easily understood comparables
• Overemphasis on short-term results
• Use of conventional valuation metrics

Lack of “comparables” / mischaracterization of a company’s business

ASML Holding N.V. is the dominant provider of photolithography equipment to the semiconductor industry, with its technology used by nearly all major semiconductor manufacturers. It has over 80% market share in deep ultraviolet (DUV) photolithography and 100% market share in extreme ultraviolet (EUV) equipment, a critical technology for manufacturing the world’s most advanced chips.

The Netherlands-based company is the sole global supplier of EUV photolithography machines, with each device costing customers hundreds of millions. While Nikon and Canon produce similar equipment to ASML, they operate primarily in the less lucrative DUV market. DUV scanners are used for less complex chips and chip components, but ASML’s EUV systems are essential for producing smaller, more powerful chips needed for high-performance devices like smartphones, gaming consoles, and smart watches. While ASML has already committed years to advancing its EUV technology, the shift to EUV has proven too costly for other companies in the space due to soaring R&D costs. We think it will take years for any real competition to emerge and that ASML’s next-generation high-NA EUV positions the company for continued lithography dominance at the leading edge.

Overemphasis on short-term results

Short-term fluctuations in the market are rarely based on the fundamental strengths or weaknesses of a company. The market will move one way or another in reaction to any manner of macro event that has nothing to do with the intrinsic long-term value of a particular stock. Recency bias is another source of mispricing. Investors tend to overweight the most recent events – the latest earnings report or company news – in their expectations for the future.

Use of conventional valuation metrics

A company’s price to earnings ratio is typically an easy compare – a high P/E ratio means the company is expensive, and a low P/E ratio means it’s inexpensive.

We also think it’s the worst valuation metric there is. First, earnings can be manipulated. Second, by definition, growth companies are penalizing short-term profits to invest in long-term growth. Because of these shortcomings, we think of the widespread use of P/E ratios as yet another source of mispricing. Instead, as discussed above, we focus on free cash flow yield and return on invested capital.

A Differentiated View of Risk

After several years dominated by the COVID-19 pandemic, supply chain disruptions, alarming inflation, and rising rates, not to mention Russia’s sudden and disturbing invasion of Ukraine, risk is understandably top of mind for many investors. However, we do not look at risk in the same way as most investors.

We define risk as the possibility of a permanent loss of capital. At the securities level we seek to manage risk by investing in what we believe are well-managed, high-quality companies with low to no leverage, organic growth, a durable competitive advantage, recurring revenue, and high ROIC and free cash flow yield. On a portfolio level, we seek to manage risk by investing in companies with multiple end markets that are not necessarily correlated.

In addition, although we are not all that sensitive to short-term macro events, we do take into consideration macroeconomic and geopolitical concerns such as government regulations, currencies, interest rates, inflation, and the like if we believe they will have a material impact on our investment thesis. There are many regions across the globe in which we are not invested and likely will not invest anytime soon, because conditions are hostile to the types of investments we look for.

Every day we live and invest in an uncertain world. Events, such as Federal Reserve interest rate changes, inflation, wars, pandemics, and the unpredictable behavior of important politicians across the world, are shrugged off by the financial markets one day, and seem to drive them up or down the next. We often find it difficult to know why the market participants do what they do over the short term. The constant challenges we face are real and serious, with uncertain outcomes. History would suggest that most will prove passing or manageable. The business of capital allocation (or investing) is the business of taking risk, managing the uncertainty, and taking advantage of the long-term opportunities that those risks and uncertainties create.

However, over time, as the table below demonstrates, our strategy has worked. On a monthly basis, the Fund beats its primary benchmark 57% of the time and its peer group average 54% of the time. This is essentially a coin flip. As the time frame increases, the percentage of time the Fund is ahead of both its benchmark and its peer group average increases as well. When measured on a 10-year rolling basis, the Fund outperforms its primary benchmark and the Morningstar Global Large-Stock Growth Category 100% of the time.

¹Since inception of April 30, 2012, as of 9/30/2024.
Calculation is based on monthly returns

These results are not an accident. They are a direct outcome of our long-term approach to risk and return. We own about half of the names when compared to the average actively-managed global fund, because we believe there are a limited number of truly compelling investment ideas at any given time. We acknowledge that the Fund may not be the best fit for the short-term investor who is concerned about volatility because of the increased probability of exiting at the wrong time. However, we believe the Fund is an excellent choice for the investor who is willing to overlook short-term noise in the interest of maximizing potential alpha over the long term.