Ron Baron is the creator of Baron Capital Management, the co-portfolio manager of Baron Asset Fund and remains portfolio manager of the Growth and Partners Funds. From 1970 to 1982, he worked for several brokerage firms and developed a reputation as a short seller during the bear market of 1973-74. He established Baron Capital Management in1982. The firm engaged in hostile takeover attempts of regional department stores Woodward & Lothrop of Washington, D.C., in 1984 and Philadelphia's Strawbridge & Clothier in 1986, but neither of them was successful.
Ron Baron invests mainly in small and mid-size growth companies. He is fond of companies with open-ended growth opportunities and defensible niches. Baron applies a bottom-up company research, invests for the long term, and tries to purchase companies at what he thinks are attractive prices. He invests in growth companies with a value-oriented purchase discipline. He ignores short-term market fluctuations when he thinks the fundamental reasons for acquiring a company have not changed. On average, Baron holds investments for longer than five years.
I consider it essential to acquire companies that sell products or services that are needed or desired, have no close substitute, and are not regulated. I examined Ron Baron's portfolio and found that he also shares those business tenets. I will detail his holdings and the possible reasons why he picked these stocks.
1. Arch Capital Group (ACGL)
The diversified financial services holding company Arch Capital Group puts an emphasis on the insurance sector. Arch Capital Group is engaged in a variety of insurance and financial service activities through subsidiaries, including Arch Insurance Services, and the ownership of intermediaries, underwriting agencies, service providers and insurance companies.
Arch Capital combines the specialty insurance that more commodity-driven insurers overlook with property-casualty reinsurance on a worldwide basis. Underwriting selectivity is paramount to Arch Capital's strategy, a philosophy that has produced better-than-average underwriting results on a regular basis. Arch Capital's major insurance operations focus on specialty products that require a comprehensive understanding of specific risks that few competitors have the insight to underwrite. Profitability is rewarded over revenue growth, as the group's underwriters have incentive to refrain from writing bad business. The firm has a wide range of specialty products that span several industries, a factor that I find attractive due to the changing nature of these esoteric lines of insurance. While the majority of Arch Capital's specialty insurance is written in the United States, the firm also issues policies in Europe and other places.
Arch Capital has created a strong strategy that balances separate and largely unrelated insurance lines of business. Due to management's commitment to profitability over growth, shareholders have benefited over the last 10 years. I believe Arch Capital could return to past levels of profitability once economic conditions improve, but without a moat to protect profits and given the uncertainties of the reinsurance business, doubt remains high.
Arch Capital's current net profit margin is 13.4%, currently lower that its 2010 margin of 25.18%. I do not like when companies have lower profit margins than in the past. It's important to analyze why that happened. Its current return on equity is 9.67%, which is lower than the +20% standard I look for in companies I invest and also lower than its 2010 average ROE of 19.19%.
In terms of income and revenue growth, Arch Capital has a three-year average revenue growth of 1.07% and a three-year net income average growth of 14.46%. Its current revenue year-over-year growth is -5.57%, higher than its 2010 revenue growth of -7.36%. The fact that revenue increased from last year shows me that the business is performing well. The current net income year-over-year growth is -48.21%, lower than its 2010 net income year-over-year growth of -3.92%. I do not like when current net income growth is less than the previous year. I look for companies that increase both profits and revenues.
In terms of valuation ratios, Arch Capital is trading at a price/book of 1.1 times, a price/sales of 1.6 times and a price/cash flow of 5.8 times in comparison to industry averages of 1.0 times, 1.0 times, and 11.5 times, respectively. It is essential to analyze the current valuation of Arch Capital and check how it is trading in relation to its peer group.
For the last five years, premium to equity has been substantially decreasing, reflecting the firm's reluctance to write new business in a declining price environment. Given the recent soft market for insurance, Arch Capital has relatively large excess capital that it is waiting to deploy when a better environment eventually develops. Losses from the surge in catastrophe claims over the last two years are much lower than its rivals. I believe Arch Capital is financially healthy.
2. Choice Hotels (CHH)
Choice Hotels is one of the major hotel franchise companies in the world with hotels, inns, all-suite hotels and resorts open and under development in countries around the world under the brand names Comfort, Quality, Clarion, Sleep Inn, Rodeway Inn, Econo Lodge and MainStay Suites.
Choice Hotels is one of the biggest franchisors of hotels, having approximately 8% of hotel rooms in the U.S. affiliated with its midscale and economy brands. Choice's exclusive focus on franchising restricts capital expenditure requirements and enables the company to generate industry leading returns on invested capital, with ROICs averaging over 100% the last five years.
Choice has an appealing recurring fee, high ROIC, low capital intensity franchisor business model. Franchised hotels, in comparison to owned hotels, require minimal capital expenditures and generate high operating margins and returns on invested capital. Owners of Choice franchised hotels are locked into recurring fee, long-term contracts, generally 20 years in duration, providing revenue and cash flow stability.
With its low fixed costs, Choice's franchising business model also has the benefit of exposing the company less to economic downturns than hotel companies with owned and managed hotels, and Choice has performed better than the industry in the last three recessions in the U.S. In 2009, Choice revenue dropped by 12%, compared to 17% for the industry, and EBITDA decreased by 22%, considerably less than the 50%-plus decline in EBITDA experienced by some large operators with owned and managed hotels. Also lowering risk for prospective investors in Choice, the firm has one of the least leveraged balance sheet in the industry, with net debt/EBITDA at only 1 times in 2010.
Choice's current net profit margin is 17.28%, currently lower that its 2010 margin of 18.02%. In terms of income and revenue growth, the company has a three-year average revenue growth of -0.15% and a three-year net income average growth of 3.28%. Its current revenue year-over-year growth is 7.1%, higher than its 2010 revenue growth of 5.65%. The fact that revenue increased from last year shows me that the business is performing well. The current net income year-over-year growth is 2.75%, lower than its 2010 net income year-over-year growth of 9.35%.
In terms of valuation ratios, Choice is trading at a price/book of -85.5 times, a price/sales of 3.5 times, and a price/cash flow of 16.4 times in comparison to industry averages of 3.9 times, 1.7 times, and 12.6 times, respectively. It is essential to analyze the current valuation of Choice and check how is trading in relation to its peer group.
Choice's financial health has increasingly improved since the economy exited the last recession, and the firm is one of the most healthy publicly traded hotel companies. The firm's EBITDA/interest coverage ratio was at over 20 times in 2010, which compares to a median coverage ratio of approximately 6 times for lodging companies in our coverage universe. I predict that Choice will comfortably be in compliance with financial covenants in 2011.
3. Verisk Analytic (VRSK)
Verisk Analytics is a major provider of risk assessment solutions to professionals in insurance, healthcare, mortgage lending, government, risk management, and human resources. The company's objective is to help risk-bearing businesses understand and manage their risk. The company offers value to its customers by providing data that, combined with its analytic methods, creates embedded decision support solutions. It is an aggregator and supplier of detailed actuarial and underwriting data pertaining to United States property and casualty (P&C), insurance risks. It provides solutions for detecting fraud in the United Sates P&C insurance, healthcare and mortgage industries, and sophisticated methods to predict and quantify loss in diverse contexts, from natural catastrophes to health insurance.
Verisk is one of the insurance industry's top risk specialists. Its ubiquitous solutions enhance its clients' ability to manage insurance programs and claims processing. The firm has an appealing business model with high revenue visibility, significant barriers to entry, high switching costs, and a scalable operating model. In our opinion, these factors have aided the company create a wide economic moat around its operations.
Established in 1971 as a not-for-profit organization to help United States P&C insurers meet certain regulatory reporting requirements, Verisk has expanded its products and services over the years to turn into a risk management solutions provider mainly servicing P&C insurers, mortgage lenders, and health-care claims payors.
Verisk shares mutually beneficial relationships with its clients whereas clients feed the company with disparate sets of transaction data pertaining to insurance risks. Verisk aggregates the data, tailors it, and then offers it as a part of a solution that helps clients perform a wide range of tasks. These include but are not limited to developing insurance policy language, setting underwriting premiums, detecting fraudulent claims, and forecasting potential loss events. The firm typically charges a fixed annual fee from its clients to gain access to its offerings. This annual membership-based business model offers a fairly stable and recurring revenue stream -- 75% of total revenues are based on subscriptions.
Since its inception, Verisk has amassed more than 14 billion records and its client list includes all of the top 100 P&C insurance providers, five of the six major mortgage insurers, the 10 largest global reinsurers, and 14 of the top 20 mortgage lenders. For us, it would be very difficult for another firm to match Verisk's client list and/or replicate the scale of its data repository.
Due to the embedded nature of its products in its clients' daily activities, Verisk's provisions become an indispensable information source, resulting in a very sticky business. Since Verisk's products and services get deeply entrenched in clients' decision-making processes, it's not easy for clients to replace them. This creates high switching costs. Of its top 100 clients in fiscal 2010, 99 have been with the firm for over five years, a testament to the must-have nature of its products.
Furthermore, Verisk's flexible technology infrastructure allows the company to expand its operations with minimal capital investments. The firm's largest cost component is the cost of developing its infrastructure, predictive models, and analytical tools, which are mostly fixed. Therefore the incremental cost of adding new members is very low, allowing the company to expand its margins while its membership base grows.
Verisk's current net profit margin is 21.23%, currently lower that its 2010 margin of 21.31%. In terms of income and revenue growth, the company has a three-year average revenue growth of 14.23% and a three-year net income average growth of 21.35%. Its current revenue year over year growth is 17.0%, higher than its 2010 revenue growth of 10.83%. The current net income year-over-year growth is 16.58%, lower than its 2010 net income year-over-year growth of 91.57%.
In terms of valuation ratios, Verisk is trading at a price/book of -76.9 times, a price/sales of 6.0 times, and a price/cash flow of 21.2 times in comparison to industry averages of 2.9 times, 1.5 times, and 10.8 times, respectively. It is essential to analyze the current valuation of Verisk and check how it is trading in relation to its peer group.
Verisk owes a fair amount of debt on its balance sheet. By the end of the third quarter of fiscal 2011, its net debt position stood at $960 million with a debt/EBITDA ratio of 1.6. Nevertheless, I believe the debt load is manageable. The firm generates solid cash flows, which came in at $300 million or 26% of revenues in fiscal 2010 and covered its interest expense almost 9 times.
4. Hyatt Hotels (H)
Hyatt Hotels is a Chicago-based worldwide hospitality company that manages, franchises, owns and develops Hyatt branded hotels, resorts and residential and vacation ownership properties around the globe. Its hotels and resorts provide business centers, car rentals, catering, weddings, fitness centers, hotel shops, lounges, meetings and events, pools, and restaurants. It has hotel locations in North America, Asia, Europe, Latin America, Caribbean, Australia, New Zealand, Africa, and the Middle East. The company's objective is to offer authentic hospitality by making a difference in the lives of the people they are in contact with every day.
Adjusted EBITDA was $143 million in the fourth quarter of 2011 compared to $118 million in the fourth quarter of 2010, an increase of 21.2%. Net income attributable to Hyatt was $52 million, or $0.31 per share, in the fourth quarter of 2011 in comparison to net income attributable to Hyatt of $6 million, or $0.03 per share, in the fourth quarter of 2010. Adjusted for special items, net income attributable to Hyatt was $52 million, or $0.31 per share, in the fourth quarter of 2011 in comparison to net income attributable to Hyatt of $12 million, or $0.07 per share, during the fourth quarter of 2010. Comparable owned and leased hotels RevPAR increased 6.0% in the fourth quarter of 2011 in comparison to the fourth quarter of 2010.
Owned and leased hotel operating margins raised 310 basis points in the fourth quarter of 2011 compared to the fourth quarter of 2010. Comparable owned and leased hotel operating margins increased 180 basis points in the fourth quarter of 2011 in comparison to that same period in 2010. The firm added seven properties in the fourth quarter of 2011.
Hyatt Hotels is glad to see sustained transient business travel around the world in the fourth quarter. Demand from this segment was the primary driver of their results in 2011, and although group demand in the U.S. was stronger in the fourth quarter of 2011 than in 2010, corporations remain cautious about making longer-term commitments and this continues to limit visibility into forward bookings.
The company is engaged to enriching its brand management expertise and has dedicated significant resources and new systems capabilities to expand its knowledge of its guests and of the meeting planners and corporate travel managers who are current and prospective Hyatt customers. The firm is now applying all of these data and insights to improve its provision of authentic hospitality in ways that will differentiate its brands and it is doing this against a backdrop of extremely strong growth in its loyal customer base -- Hyatt Gold Passport membership expanded by 15% in 2011.
Furthermore, its select-service brands keep gaining momentum. There has been over 14% RevPAR growth in the select-service segment over the past two years, and it intends to build on the back of the 75% expansion of its extended-stay properties in the U.S. and the first openings of Hyatt Place properties outside of the U.S. in 2012. The momentum continues with several developing hotels that will double its presence by 2014.
Hyatt's current net profit margin is 3.06%, currently higher that its 2010 margin of 1.87%. Its current return on equity is 2.27%, lower than the +20% standard I look for in companies I invest but higher than its 2010 average ROE of 1.3%.
In terms of income and revenue growth, Hyatt has a three-year average revenue growth of -1.22% and a three-year net income average growth of -12.38%. Its current revenue year-over-year growth is 4.85%, lower than its 2010 revenue growth of 5.92%. The current net income year-over-year growth is 71.21%. In terms of valuation ratios, Hyatt is trading at a price/book of 1.4 times, a price/sales of 1.9 times, and a price/cash flow of 18.0 times in comparison to industry averages of 3.9 times, 1.7 times, and 12.6 times, respectively.
Hyatt's financial health has increasingly improved since the end of the recession, and the firm's financial health is average among large global hotel operators. EBITDA/interest expense improved to 7.2 times in 2010 from 5.7 times in 2009, and there's and estimate that interest coverage will improve to more than 8 times in 2011. I predict that the company will easily be in compliance with financial covenants in 2011 and 2012.