Investor Ron Baron on investing during periods of entropy

Investor Ron Baron on investing during periods of entropy

Ron Baron, founder of Baron Capital

Anjali Sundaram | CNBC

I started my career as a securities analyst in 1970. It was a turbulent time.

The Vietnam War, Watergate, President Richard Nixon’s resignation, the Iranian hostage crisis, a recession, inflation, double-digit interest rates, gas prices that had tripled. The only crisis we haven’t faced this decade has been a pandemic. Also, amidst the chaos, the stock market collapsed, leading to a global bear market that lasted from 1973 to 1974. It was one of the worst downturns since the Great Depression. The only thing comparable was the financial crisis of 2007-2008.

My experience in the 1970s was fundamental. The stocks I recommended were small-cap companies. they contain Disney, MC Donalds, Federal Express, Nikeand Hyatt.

After these stocks doubled or tripled, I recommended selling. That was because I was earning brokerage commissions—not a salary. Looking back a few years later, virtually all of these stocks have continued to grow dramatically.

I came to the conclusion that instead of trading stocks or trying to predict market fluctuations, finding great companies and investing in them at attractive prices and staying invested for the long term is a better strategy.

I believed then, and I believe now, that you don’t make money by predicting short-term market movements.

In my 52 years as an investor, I’ve never seen anyone consistently and accurately predict what the economy or the stock market would do. So whenever trivial events happened and stocks consistently declined, I believed that this represented a long-term opportunity.

Invest in “pro-entropic” companies

I’ve also learned to invest in “pro-entropic” companies. In times of entropy – disorganized chaos – I have found that many of the best companies not only survived, but thrived. They took advantage of the opportunities that presented themselves in difficult times. They acquired weaker competitors at bargain prices or gained market share when their competitors faltered. They accommodated customers, created loyalty and goodwill, and increased lifetime value. As they continue to invest in key areas like R&D and distribution, they’ve eradicated extra fat elsewhere in their budgets, creating long-term efficiencies. As conditions normalized, they were better than ever able to use their resilience.

After the 1973-1974 bear market, I saw this pattern appear again and again. The stock market crash of 1987, the bursting of the dot-com bubble of 2000-2001, the financial crisis of 2007-2008 and now. That’s why I like to say that we invest in companies, not stocks.

We look for companies that grow faster than average over full market cycles. We invest based on what we think a company will be worth in five or ten years, not what it is worth now.

Our goal is to double our money about every five or six years. We seek to achieve this by making long-term investments in companies that we believe have competitive advantages and are led by exceptional people.

The Tesla example

Tesla is probably the most famous company we currently own. But I want to point out that it’s not an outlier. In fact, Tesla is the perfect example of how our long-term investment process works.

We invested for the first time in 2014. I thought Elon Musk was one of the most visionary people I’ve ever met. What he proposed was so revolutionary, so disruptive and yet so meaningful.

We’ve owned his shares for years while Tesla was building his business. Sales rose, but the stock price, while extremely volatile, was mostly flat. We’ve remained invested throughout this period, and when the market finally caught on in 2019, Tesla’s share price was up 20x. That’s why we try to invest in companies early – because you never know when the market will finally see the value we’ve seen, and that drives the stock price higher.

We only invest in one type of asset – growth stocks. Why? Because we believe growth stocks are the best way to make money over the long term.

While the simple answer to fighting inflation is to invest for the long term, the concept of compounding tells us why. … Over time, this effect increases …

Historically, our economy has grown at an average of 6% to 7% a year in nominal terms, or has doubled every 10 or 12 years, and stock markets have accurately reflected that growth. US GDP was $865 billion in 1967, 55 years later it’s $25.7 trillion – or more than 28 times the 1967 level.

That S&P 500 Index was 91 in 1967. Today it is around 3,700.

We seek to invest in companies that are growing twice as fast when we believe their stock prices do not reflect their favorable prospects.

Stocks are also an excellent hedge against inflation. Inflation is in the headlines again, but it has always been there. The purchasing power of the dollar has fallen by about 50% every 18 years on average over the past 50 years.

While inflation causes currencies to depreciate over time, it has a positive impact on property, businesses and economic growth. This means stocks are the best way to counteract the debasement of your money.

While the simple answer to fighting inflation is to invest for the long term, the concept of compounding tells us why. If your savings are generating returns, compounding those returns can generate even more returns. Over time, this effect increases and profits grow faster and faster.

So if you earn 7.2% on an investment, which is the stock market’s historical annual growth rate (excluding dividends) for the last 60 years, the growth of your investment will be exponential. In 30 years you will have almost seven times your original amount, in 40 years 12 times and in 50 years more than 23 times!

I would also like to point out that the stock market is one of the most democratic investment vehicles – unlike real estate, private equity, hedge funds, etc., my parents have the opportunity to increase their savings for everyone. That’s why I’m still doing what I do today, 40 years later.

Ron Baron is Chairman and CEO of Baron Capital, a firm he founded in 1982. Baron has 52 years of research experience.