Baron Asset Fund | Q3 2024

U.S. equities closed higher for the fourth consecutive quarter. Generally upbeat economic reports coupled with the Federal Reserve’s (the Fed) long- awaited interest rate cuts spurred a meaningful rotation out of large-cap/ Magnificent Seven/growth/momentum stocks and into value/cyclicals/small caps. Sectors that stand to benefit from lower interest rates did particularly well, notably Utilities, Real Estate (REITs), and Financials. Materials also outperformed thanks to rising prices for precious metals such as silver and gold. Energy was the only sector to decline in the period, falling alongside the price of oil. Information Technology (IT) and Communication Services also underperformed.

Baron Asset Fund® (the Fund) rose 8.34% (Institutional Shares) in the quarter, outperforming the Russell Midcap Growth Index by 180 basis points due to solid stock selection. It is noteworthy that the best-performing factor driving stock returns during the period was Earnings Quality, and, as we would have expected, this environment proved favorable for our investment style.

Stock selection in IT accounted for the bulk of the outperformance. Strength in the sector was driven by sharp gains from application software holdings Guidewire Software, Inc. and Fair Isaac Corporation (FICO). Shares of Guidewire, a property and casualty (P&C) insurance software vendor, advanced after its subscription gross margin improved by more than 1,000 basis points in its most recently reported quarter; data and analytics company FICO performed well after reporting solid fiscal third quarter earnings results and raised fiscal 2024 guidance. Another material contributor in IT was syndicated research provider Gartner, Inc., whose shares appreciated double digits after the company’s core subscription research businesses inflected higher in the second quarter.

Health Care was another standout sector thanks to strong performance from The Cooper Companies, Inc., a medical device company with two business units: CooperVision, a leading manufacturer of soft contact lenses; and CooperSurgical, which targets women’s health care and fertility. Cooper’s stock increased after impressive second quarter results. We expect continued solid earnings growth in its core contact lens business, driven by price increases, additional manufacturing capacity coming online, continuing mix improvement, the likelihood of lower interest expense (both from debt repayment and lower rates) and the dissipation of FX headwinds. Besides stock selection, the Fund benefited from its higher exposure to the Real Estate sector along with its lack of exposure to the lagging Consumer Staples and Energy sectors.

Somewhat offsetting the above was the disappointing performance of certain holdings in Industrials and Real Estate together with lack of exposure to the top performing Utilities sector. Weakness in Industrials was driven by the Fund’s sizeable positions in data and analytics vendor and Verisk Analytics, Inc. and private rocket and spacecraft manufacturer Space Exploration Technologies Corp. (SpaceX). Despite reporting generally solid second quarter earnings, Verisk was a modest detractor, as its stock pulled back after its transactional revenue was modestly softer than expectations. SpaceX’s primary focus is developing and launching advanced rockets, satellites, and spacecrafts, with the ambitious long-term goal of enabling human colonization of Mars. SpaceX is also generating significant value through the rapid expansion of its Starlink broadband service. Driven by its vast constellation of proprietary Starlink satellites, Starlink has seen substantial growth in its active user base. SpaceX is also making significant progress on its newest rocket, Starship, the largest, most powerful rocket ever flown. This next-generation vehicle represents a significant leap forward in reusability and space exploration capabilities. We value SpaceX using prices of recent financing transactions.

Real estate data and marketing platform CoStar Group, Inc. was negatively impacted by deceleration in net new sales of homes.com, its residential product offering. We remain encouraged by the website traffic growth and growing brand awareness for the platform, and we are optimistic that sales momentum will improve as the company builds out a dedicated residential sales force and enhances its customer targeting. We believe performance in CoStar’s non-residential business remains strong, and we expect to see better organic growth as the commercial real estate market improves and salespeople return to focus exclusively on a single product.

Shares of P&C insurance software vendor Guidewire Software, Inc. advanced after the company’s subscription gross margins improved by more than 1,000 basis points in its most recently reported quarter. After a multi- year transition period, we believe the company has substantially completed its transition from an “on premise” to a “cloud-based” software provider. We believe cloud will be its sole path forward, with annual recurring revenue (ARR) benefiting from new customer wins and the migration of its existing customer base to InsuranceSuite Cloud. We also expect Guidewire to shift its R&D resources to product development from infrastructure investment, which should help drive cross-sales into its sticky installed base and potentially accelerate ARR over time. We believe Guidewire will become the most critical software vendor for the global P&C insurance industry, capturing 30% to 50% of its $15 billion to $30 billion total addressable market and generating margins above 40%.

Shares of Gartner, Inc., a provider of syndicated research, contributed to performance in the quarter. Gartner’s core subscription research businesses inflected higher in the second quarter, and we believe growth is poised to continue accelerating over the next several quarters. Longer term, we think Gartner will emerge as a key resource for companies evaluating the opportunities and risks of AI on their business, providing a tailwind to Gartner’s volume growth and pricing realization over time. Sustained revenue growth coupled with Gartner’s focus on cost control should drive ongoing margin expansion and enhanced free cash flow generation, in our view. The company’s balance sheet remains in excellent shape and can support continued aggressive share repurchases and bolt-on acquisitions.

Shares of Fair Isaac Corporation (FICO), a data and analytics company focused on predicting consumer behavior, contributed to performance. The company reported solid fiscal third quarter earnings results and raised its fiscal 2024 guidance. Management recently spoke at several conferences and expressed optimism about the trends in its two key divisions—scores and software. In addition, recent interest rate cuts are expected to lead to more mortgage activity and the associated need by lenders for more FICO credit scores. While some near-term areas of uncertainty remain (most notably scores volumes based on the timing of changing macroeconomic conditions and a potential CFPB investigation into scores pricing), we believe FICO will be a steady earnings compounder, which should drive solid returns over a multi-year period.

The Charles Schwab Corporation detracted from performance following a weak second quarter update. The broker-dealer generates significant earnings from net interest income on idle client cash. Clients have been moving cash into higher-yielding money market funds, forcing Schwab to utilize external sources of funding to support its balance sheet. This external funding is more costly than other liabilities on its balance sheet, and it is intended to be temporary. However, it has taken Schwab longer than expected to reduce its reliance on these funds, which disappointed the market. While the timing has been extended, we believe Schwab will eventually pay down these funds, leading to accelerated earnings growth.

DexCom, Inc. sells a continuous glucose monitoring device for patients with diabetes. Shares fell after DexCom reported lower-than-expected second quarter financial results and reduced its guidance for the year. Multiple issues surfaced during the earnings report. Management cited: 1) disruption from the expansion of its sales force; 2) channel dynamics including market share losses in the durable medical equipment channel and a revenue per user headwind from Medicare Advantage plans offering pharmacy access to its members; 3) a negative impact from faster-than-anticipated rebate eligibility; and 4) a shortfall in international sales. Some of these issues are temporary and potentially addressable. Others raise questions about DexCom’s growth potential. As a result, we exited our investment.

West Pharmaceutical Services, Inc. manufactures components and systems for the packaging and delivery of injectable drugs. Shares fell on lower-than-expected financial results and reduced guidance for the year attributed to ongoing inventory destocking by its pharmaceutical customers. Post-pandemic, customers continue to use the inventory stockpiled to meet elevated pandemic-era demand. West was also able to shorten the lead time needed to meet new demand, giving customers confidence to safely reduce their inventory levels. We believe the inventory-related issues are temporary, and West remains a dominant player with competitive advantages in the growing market for injectable drugs. Management has stated that end-patient demand is in line with its expectations, market share shift is not occurring, and its win rates on packaging for new molecules remains strong. They expressed confidence that West can return to the long-term financial construct of 7% to 9% revenue growth with 100 basis points of operating margin expansion annually.

At September 30, 2024, Baron Asset Fund held 52 positions. The Fund’s 10 largest holdings represented 49.2% of net assets, and the 20 largest represented 70.7% of net assets. The Fund’s largest weighting was in the IT sector at 30.4% of net assets. This sector includes software companies, IT consulting firms, and electronic components companies. The Fund held 20.2% of its net assets in the Health Care sector, which includes investments in life sciences companies, and health care equipment, supplies, and technology companies. The Fund held 18.5% of its net assets in the Industrials sector, which includes investments in research and consulting companies, aerospace and defense firms, and human resources companies. The Fund also had significant weightings in Financials at 13.0% and Consumer Discretionary at 7.8%.

As the chart below shows, the Fund’s largest investments all have been owned for significant periods – 7 of the 10 largest holdings have been owned for longer than a decade. This is consistent with our approach of investing for the long term in companies benefiting from secular growth trends with significant competitive advantages and best-in-class management teams.

We initiated a new position in Welltower Inc., which owns and operates senior housing and medical office buildings in the U.S. and internationally. We believe that operating fundamentals in the senior housing industry will continue to be robust, and Welltower is well positioned to capture both a cyclical and secular inflection in growth during the coming years. If occupancy of the company’s units were to return to levels achieved before the pandemic, we believe that senior housing cash flow would grow by more than 50%. In addition, we believe that there is further structural upside opportunity to both occupancy and operating margins by enhancing asset management, employing proprietary data analytics, and introducing initiatives such as amenity-based pricing. We recently met with the entire Welltower executive team in our offices and came away encouraged by the multi-dimensional growth opportunities ahead. Welltower has recruited top senior executives from the multi-family housing market to execute and deploy various initiatives that they believe can drive profitability beyond what other industry participants have achieved.

In addition, the broader industry backdrop hasn’t been this favorable in many years. Underlying demand is supported by a demographics boom with the over 80 population projected to grow at a 4% to 5% CAGR over the next five years versus annual growth below 2% coming out of the Great Financial Crisis. Supply is expected to remain muted since construction starts are declining rapidly, current developer economics are no longer attractive and entitling and building a new project takes roughly five years. The current financing environment for senior housing remains capital constrained, with loans either coming due and/or interest rate caps coming off assets that were acquired during a period of low interest rates. We believe this should provide an active and growing external acquisition pipeline, where management can invest capital at an attractive “cost basis” below replacement cost. Lastly, we believe that management, led by Shankh Mitra (CEO), John Burkart (COO), Tim McHugh (CFO), and Nikhil Chaudhri (CIO), are astute capital allocators focused on driving accretive value per share. Putting this all together, we see a path for earnings to more than double over the next five years, leading to attractive return prospects for the fund.

We also initiated a small position in Duolingo, Inc., the world’s leading language learning app with over 100 million monthly active users. The app has achieved remarkable levels of user engagement by effectively “gamifying” the otherwise tedious process of learning a foreign language. The company has maintained impressive levels of user growth (daily average user growth greater than 50%) and revenue growth (40%-plus), executed well against its new product roadmap, and achieved impressive 40%-plus incremental margins. We believe the management team is best in class, very technically capable (CEO and CTO both have PhDs in machine learning from Carnegie Mellon University), and product focused. We imagine several material upcoming catalysts; the broader launch of its AI tier (Max) that allows users to have real-time conversations with AI-based characters, and a substantial improvement of its Advanced English offering. We believe that these two initiatives will allow Duolingo to effectively address the broader worldwide market of 1.8 billion people currently learning English. As these new products rollout, we believe they should allow Duolingo to achieve higher pricing per user and lower customer churn. In addition, we believe there is an opportunity for the company to expand into related educational markets, such as Math and Music.

We reduced our position in Fair Isaac Corporation as its shares reached new all-time highs. We exited our position in DexCom, Inc. for the reasons discussed above. We managed down our investment in Gartner, Inc., the Fund’s largest position. We reduced our position in FactSet Research Systems Inc. as the sales environment remained challenging among its core financial services customers. We exited our position in LPL Financial Holdings Inc. as we evaluate the impact that lower interest rates may have on its business.

As discussed, the Fed’s decision to begin cutting interest rates spurred a meaningful rotation during the quarter, leading mid-cap stocks to outperform large-cap stocks for only the 4th time in the last 14 quarters. Entering the third quarter, mid-cap stocks had trailed large caps by more than 24% cumulatively over the last 3-plus years. We hope the latest rate cut cycle will mark the beginning of a period of outperformance for mid-cap stocks. In fact, data compiled by Goldman Sachs shows that mid-cap stocks are the best-performing market cap segment when the Fed cuts rates. Going back 40 years, Goldman found that in the year after a rate cutting cycle commences, mid-caps outperform large caps by about 3 percentage points and small caps by about 8 points.

This historic data is consistent with our belief that lower rates should result in the market ascribing a higher valuation to the future earnings streams of all companies. We believe this development would disproportionately benefit the types of businesses we favor – companies that benefit from long-term secular growth drivers with highly visible and growing earnings streams. In addition, we believe these types of companies have been out of favor relative to more speculative businesses, and we are optimistic that this trend will continue to reverse.

Sincerely,