Opinion: This investor overwrites his fund’s benchmark index with these 10 values
Do you want to improve your investment performance? Then shut down the noise and take a moment to learn the basics from the best in the business.
With that in mind, I recently met Neal Kaufman, who manages the Baron Health Care Fund BHCFX,
In its short three-year lifespan, the mutual fund turns off the lights. The fund crushes its benchmark S&P 1500 Health Care and its healthcare category by more than 12 percentage points, in annualized terms, over the past three years, according to Morningstar.
Here’s a Morningstar chart showing the returns and rankings for the calendar year through October 11.
How does Kaufman get this feedback? He cites five principles that guide him in stock selection. Here is a review, with examples of companies.
# 1. Look for open-ended growth opportunities
One of the fundamentals of New York-based Baron Capital is investing in companies selling into large and expanding markets, says Kaufman.
This is the case of a medical device company called DexCom DXCM,
It offers continuous glucose monitors for diabetics. The company’s G6 monitor is convenient because it eliminates the need for finger sticking. The monitor sends readings to smartphones, providing alerts of dangerously high or low blood sugar levels.
Unfortunately, diabetes is on the rise, in part because of the obesity epidemic. By 2045, the number of people with diabetes worldwide will increase by more than 50%, compared to 2019, to reach 700 million, predicts the International Diabetes Federation. Diabetes is the seventh leading cause of death from disease in the United States, according to the Centers for Disease Control and Prevention. DexCom is in the process of obtaining regulatory approval for an upgraded version of its device called the G7.
# 2. Ride the secular tailwinds
In investing, “secular” refers to business trends that are not vulnerable to changes in the business cycle. Capturing secular trends is another core investment principle at Baron Capital. There are many secular trends in healthcare. One is the adoption of minimally invasive surgery.
This is preferable because it reduces blood loss during surgery and pain levels during recovery. Baron Health Care has two companies in this space: Intuitive Surgical ISRG,
which sells robots that help with surgery, and Edwards Lifesciences EW,
which offers a system that helps physicians perform a less invasive aortic valve replacement.
# 3. Invest in companies with a sustainable competitive advantage
This one comes up so often among top performing managers, from Warren Buffett to the bottom, that it’s a “must have” on your list of qualities to look for in companies.
Protective moats give companies coveted pricing power. And, of course, by definition, they protect market share. Businesses reach moat through strong brands, superior technology, industry leadership, a large installed base that increases switching costs, or services that benefit from the “network effect”. This means that the more people use a service, the more valuable it becomes to everyone in the network. Think about social media platforms.
For fluke, Kaufman cites Guardant Health GH,
a market leader in liquid biopsies, or the use of genetic sequencing to detect signs of cancer in blood samples. Guardant is gaining a ditch due to its technology platform, regulatory approvals, and strong reimbursement profile among insurers. Intuitive Surgical is another example, due to its innovative technology, large installed base and regulatory approvals.
Also consider Schrödinger SDGR,
which offers software that interprets the physics of drug molecules to predict how they might alter the body’s chemistry to treat disease.
“This is traditionally done by medicinal chemists,” says Joshua Riegelhaupt, deputy portfolio manager at the Baron Health Care Fund. “It’s expensive and it takes years.”
Using Schrödinger software, researchers can select from hundreds of compounds to find a short list of potential winners, reducing research time and costs.
Last year, all of the top 20 pharmaceutical companies licensed Schrödinger software. This large installed base and the technological advance of Schrödinger give it a gap. The company says its approach can be used in research in many other fields, including aerospace, energy, semiconductors and electronic displays.
# 4. Invest for the long term
Stocks never go straight up. Not even the actions of quality companies. When controversy and turmoil arise, a long-term investment horizon helps you keep a name and avoid being rocked. Anyone who has followed the early controversies and twists at Tesla TSLA,
perhaps Ron Baron retained an outsized position in various Baron funds even as the EV company was vilified. Tesla has become a “10-bagger”, after being multiplied by 10.
“We don’t invest in companies based on what might happen in the next few quarters or two. We’re looking at five years, ”says Kaufman. “There will be setbacks. Having a long-term perspective helps us.
Holdings worth buying after the sales include Guardant Health, which is on the decline amid rumors it could make an acquisition. Another is Arrowhead Pharmaceuticals ARWR,
because investors may have misinterpreted the study data and misjudged the weakness of biotechnology this year.
# 5. Invest in recurring income
The Baron Health Care Fund has extensive exposure to the proverbial pieces of “picks and shovels” in the healthcare field. These are the companies that have predictable revenues because they offer equipment, chemicals, software, and other products that help large pharmaceutical and biotech companies research therapies.
“We like to invest in companies where we can be confident about recurring revenues and model the margins and what their profits can be,” Kaufman explains. The stable nature of these businesses also offsets the volatility among biotech names.
Here are some examples of strong recurring income companies in Kaufman’s fund: Thermo Fisher Scientific TMO,
Bio-Techne TECH,
and Mettler-Toledo International MTD,
all of which sell instruments and reagents used in research and diagnostics; ICLR icon,
who provides clinical research services; and Schrodinger, the company that provides analytical software for use in drug research.
Michael Brush is a columnist for MarketWatch. At the time of publication, he owned ARWR. Brush suggested DXCM, TSLA, ARWR, TMO in his stocks newsletter, Brush Up on Stocks. Follow him on Twitter @mbrushstocks.