Baron Small Cap Gets a Makeover

Cliff Greenberg, skipper of Baron Small Cap Fund (symbol BSCFX), is a resolutely bottom-up stock picker. But ear to the ground, he's getting signals about the big picture from what officials of the companies his fund owns are saying. It looks awfully similar to what Pimco boss Bill Gross calls the "new normal" for the diminished U.S. economy.

The good news, says Greenberg, is that company revenues are no longer in free fall, as they were for about six months from the final few months of 2008 through early 2009. The debt markets are open again, but the cost of rolling over a bank credit line is much steeper. "The banks are extracting higher fees these days, but at least they're lending now," he says.

The main problem, says Greenberg, is that the consumer and the economy are impaired -- and they won't return to the pre-2008 salad days. "We as consumers have overspent, and the shock of the loss in net worth of the consumer class is such that it will shake the way people spend money forever," he says. Greenberg, whose fund is a member of the Kiplinger 25, thinks the U.S. economy's long-term annual growth rate has been halved, from 3% to 1.5%.

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The implications of Greenberg's thesis for companies and stocks are clear. Companies whose revenues abruptly dropped 20% to 30% during the period of economic free fall will see modest revenue growth of 5% to 10% now. Profit margins for many companies will not return to 2006-07 levels, and for many businesses, they will be lower. Greenberg thinks price-earnings ratios for growth companies will be permanently lower because of structurally lower economic growth. For instance, a stock that traded at 20 times earnings in the past will now fetch a price-earnings multiple of 15 to 18.

Greenberg, whose fund returned 12% year-to-date through June 12, is nonetheless bullish about his portfolio. Many businesses have cut costs dramatically. Even modest growth in revenues will produce sizable profit expansion, he says, particularly in 2010, fueling a rebound in share prices.

Since August 2008, Greenberg, who historically hasn't traded much, has remade his portfolio extensively. He's added 17 new names, tossed out 35 stocks and reduced the number of holdings from 100 to 80. In choosing new holdings, he looked for high-quality companies whose stocks had been crushed. The ideal situation, he says, is to buy great companies with depressed earnings trading at depressed P/Es.

For example, he purchased J. Crew Group (JCG), the clothing retailer. Wall Street cut the retailer's 2009 earnings estimate in stages, from $2 to 50 cents a share. The stock plunged 84%, to $8, as Americans stopped shopping and J. Crew unloaded excess inventories for a song. Greenberg says the retailer may never return to the level of sales per square foot it achieved before the recession, but he adds that profit margins will rebound because of cost cutting and a more stable economy. He thinks that the company can earn $1.75 a share or more in a normal economy and trade at 18 times earnings, suggesting a price of at least $31.50. The stock, which closed at $24.96 on June 15, has more than tripled since bottoming in November 2008.

Greenberg's eclectic mix of holdings includes Ritchie Brothers Auctioneers (RBA), the world's largest auction house for used farm and industrial equipment; Covanta Holding Corp. (CVA), the leader in trash-to-energy power generation for municipalities; and Strayer Education (STRA), a for-profit education company that focuses on working adults.

Baron Small Cap, with annual fees of 1.32%, is a fine small-company growth fund. Greenberg is a stickler for valuation, and he's superb at dissecting businesses to understand how they generate profits and cash flows. He has run the fund since its inception in September 1997 and, through June 12, 2009, produced an annualized return of 7%, a wide seven percentage points a year better than the Russell 2000 Growth index.