Baron Durable Advantage Fund | Q3 2024

Baron Durable Advantage Fund® (the Fund) gained 5.7% (Institutional Shares) during the third quarter which compared to the 5.9% gain for the S&P 500 Index (the Index), the Fund’s benchmark.

Year-to-date, the Fund is up 23.3%, outperforming the Index’s 22.1% return.

There was a lot going on in the world this quarter. Nevertheless, markets continued to grind higher with large-cap, mid-cap, small-cap, domestic and international, growth and value equities all getting a bid and generating solid returns. Even gold and investment grade bonds were up. We were happy to have kept pace with the Index and consider year-to-date gains of 23.3% (on top of last year’s 45.5% rise) to be strong.

Our goal is to outperform the Index by 100 to 150bps per year, net of all fees and expenses over full-market cycles, while minimizing the risk of permanent loss of capital. We seem to be right on track with a 119bps lead at the three quarter mark of 2024. Of course, short-term performance results can be lumpy, as was demonstrated by a 24.8% drawdown in 2022, we will not achieve our goal over every period of time (and likely not over every market cycle). However, we have a lot of conviction in our process, and we think that the last three years were instructive in that when investing in high quality businesses with durable competitive advantages, even significant declines in stock prices do not have to result in permanent losses of capital. Patience, confidence in our analysis of the fundamentals, and a long-term ownership mindset go a long way in securing that outcome. Since inception, almost 7 years ago, the Fund has appreciated 16.5% on an annualized basis, which compares favorably to the Index’s 14.0% annualized return and to our targeted range of outperformance.

From a performance attribution perspective, we outperformed in Financials, Health Care, and Communication Services with stock selection in these three categories contributing 145bps to relative returns. The Fund underperformed in Consumer Discretionary, Real Estate, and Information Technology (IT), where stock selection detracted 151bps from relative returns. Not owning Energy stocks (the worst performing sector in the Index during the quarter) added 30bps, while not owning Utilities (the best performing sector during the quarter) was a 30bp drag. All in all, it was uneventful but equated to in-line performance for the quarter.

From a company specific perspective, and inspecting results from the absolute return perspective, we enjoyed a high batting average, as one would expect in a broadly rising stock market, with 28 contributors against just 7 detractors. Meta, Blackstone, S&P Global, and Brookfield were our top contributors generating between 65bps and 96bps each, while 17 out of the 28 contributors posted double-digit gains during the quarter. LPL Financial was our only double-digit decliner, inflicting a 38bps loss.

For the first time since the market began its recovery in 2023, Index returns were NOT dominated by the Magnificent Seven, which contributed 55bps (or 9%) of the quarterly return while now comprising 31% of the Index. This compares to the Magnificent Seven accounting for 59% of the gains in the first half of the year and to 62% of the Index’s total return in 2023 when the group averaged approximately 28% of its weight. After signaling that the easing cycle was upon us, the Federal Reserve (the Fed) has finally cut interest rates by 50bps in September which we think caused investors to start looking beyond the Magnificent Seven and resulted in increased participation and improved market breadth. More importantly, the majority of our companies continue to execute well with their stock performance driven more by growth in fundamentals rather than multiple expansion. In the third quarter, while the Fund gained 5.7%, the weighted average multiple of its holdings expanded by just 0.3%¹, which suggests that the remaining 5.4% can be attributed to the improvement in the business fundamentals. Having said that, there is no question that a recovery in multiple has played a part in this year’s gains for the Index and for the Fund. Based on our calculations multiple expansion has accounted for approximately 7.2% of the Fund’s 23.3% year-to-date gain, implying that 16.1% of the rise can be traced to the improved fundamentals of the businesses we own. Of course, multiples go up or down every year, depending on the macro environment, investor psychology, geopolitical situations, etc., and multiple expansion (or contraction) can have a disproportionate impact on the Fund’s performance over the short term, as it did in 2022 when the Fund’s multiple declined 26.1%. However, we are subscribers to Benjamin Graham’s view that over the short term the market is a voting machine but over the long term it is a weighing machine. Over the last 5 years, the Fund has appreciated 136.6% on a cumulative basis, with 89% of that attributable to the improvement in fundamentals. We believe that stock prices can fluctuate, sometimes wildly, as a result of the changes in multiples investors are willing to pay based on current circumstances, but that over the long term they will almost always come to reflect the factual and quantifiable fundamentals that underline their businesses.

Going one layer deeper, we analyzed the change in the weighted average consensus expectations for 2024, for revenues, operating income, and operating margins. Revenue expectations for 2024 increased 1.0% (after increasing 0.9% last quarter), operating income expectations increased by 1.7% (increased by 2.5% last quarter), and operating margin expectations increased by 16bps (increased by 24bps last quarter). Overall, business trends continue to be solid, with an increase in revenue expectations for 2024 in most of our sectors and an increase in operating income expectations in all of our segments:

• 1.1% revenue and 3.0% operating income increase in Communication Services – Meta, for example, reported “broad-based strength across regions and verticals” and that their core AI investments (using AI to improve engagement as well as the targeting and impact of ads) are seeing “strong returns as improvements to both engagement and ad performance have translated into revenue gains”
• 1.5% revenue and 2.2% operating income increase in IT – we’ve seen broad strength with increases in all sub-industries including software, semiconductors, and IT consulting with the strongest positive revisions continuing to be in semiconductors, led by the AI investment cycle. For example, Monolithic Power reported 290% year-over-year growth in its Enterprise Data segment, offsetting weakness elsewhere and driving the company to overall revenue growth of 15%. Broadcom guided it’s AI-related revenues to reach $12 billion for the year up from a prior guidance of $11 billion, and NVIDIA continues to report unprecedented growth at scale with its datacenter segment revenues now at over a $100 billion revenue run rate, growing at above 2.5 times year-over-year.
• 1.4% revenue and 2.1% operating income increase in Financials – the rating agencies, S&P Global and Moody’s are benefiting from a robust issuance market, while our alternative asset managers such as Blackstone and Brookfield are seeing solid fundraising and deployment trends.

We have a lot of confidence in our process and continue to believe that we put together the right collection of competitively advantaged companies with durable growth characteristics and great management teams. We think that rolling monthly returns can be a useful way to measure whether we are achieving our goals. Over the very short term, our strategy has outperformed in just over half of the observations. But as the time period lengthens, our win percentage improves markedly. On a rolling monthly basis, we have outperformed the Index 61% of the time over 1-year, 76% of the time over 3-years, and 95% of the time over 5-years. The numbers are even better when compared to our universe of peers.

The performance data quoted represents past performance. Past performance is no guarantee of future results. Current performance may be lower or higher than the performance data quoted. The index is unmanaged. Index performance is not Fund performance. Investors cannot invest directly in an index.
Sources: Baron Capital, S&P Global Inc., and Morningstar Direct.

Shares of Meta Platforms, Inc., the world’s largest social network, were up 13.6% this quarter after reporting impressive quarterly results with 22% year-over-year revenue growth and 38% operating margins. Despite its size, Meta continues to find opportunities such as Instagram Reels to outgrow the broader digital advertising industry. Our industry checks have validated advertiser adoption and satisfaction, with particular improvements in monetizing Reels and click-to-message ads. Meta is a leading innovator in the use of generative AI (Gen AI), with a dedicated AI research lab and the best open-source models to date, and its core apps are starting to incorporate Gen AI in the user experience. Longer term, we believe Meta will leverage its leadership in mobile advertising, massive user base, innovative culture, leading Gen AI research and potential distribution, and technological scale to perform, with additional monetization opportunities ahead.

Blackstone Inc. is the world’s largest alternative asset manager with $1 trillion of assets under management. Shares increased 24.4% on strong fundraising results with $39 billion of inflows in the quarter and a step-up in capital deployment with $34 billion deployed, as well as solid realizations of $23.5 billion with continued ample dry powder of $181 billion. We retain conviction in Blackstone due to its strong brand, unmatched fundraising track record, and durable fee stream underpinned by long term or perpetual capital.

Shares of rating agency and data provider S&P Global Inc. rose 16.1% due to solid quarterly performance and operating momentum. The company reported better-than-expected results, with growth in revenue of 14% and EPS of 30%, leading to an increase in full-year guidance. Elevated bond issuance continued in the third quarter due to falling interest rates, favorable economic conditions, and tight credit spreads. The company also reported billed issuance growth of 124% in July and 51% in August, which should drive robust near-term performance for the Ratings segment. We also think equity market strength will support continued upside for the Indices segment. We remain shareholders due to the company’s durable growth and significant competitive advantages.

Alphabet Inc. is the parent company of Google, the world’s largest search and online advertising company. Shares of Alphabet declined 8.7% in the third quarter, reflecting potential downside from two antitrust trials against Google and investor uncertainty about Google’s ability to navigate a Gen AI-first world. The Justice Department has alleged that Google Search is a monopoly, and Google’s ad tech division is currently under trial. While we do not believe that significant negative structural remedies to Google’s business (especially on the Search side) are likely, uncertainty remains, which is impacting the stock. We are also monitoring the quickly evolving Gen AI technology and the potential implications on consumer behavior around Search, including the shift to chatbot-first form. On the positive side, trends in Alphabet’s Google Cloud Platform remain positive, and advances in Gen AI should produce improvements in products in adjacent fields (e.g., travel) as well as in the core success of Google’s customers (the advertisers) through better, more personalized advertising that should generate superior return on ad spend.

LPL Financial Holdings Inc. is an independent broker-dealer with over $1.5 trillion of client assets under management. Shares of LPL declined 16.6% in the quarter. As an asset custodian LPL is able to invest idle client cash, which comprises less than 4% of its assets under management, into interest- bearing deposits that contribute a significant amount to revenue and earnings. Shares fell after the sector was hit by fears that regulators could force broker-dealers such as LPL to pay much higher deposit rates to customers, reducing the revenue and earnings they can obtain from idle client cash. These fears were driven by pricing changes by competitors such as Wells Fargo and Bank of America. We are actively monitoring these developments but have not yet seen evidence that the regulatory changes will occur, and LPL has expressed confidence that it is compliant and will not have to increase rates. In any case, we believe that the current valuation offers a positively skewed risk/reward equation. LPL’s organic growth has remained strong, and we remain investors.

Microsoft Corporation is a leading software company targeting the entire market, including both infrastructure and applications. Shares gave back some gains from the prior quarter, declining 3.6%. Despite delivering slightly better revenue results, core Azure growth came up just shy of expectations with growth of 30% year-over-year in constant currency (1% below expectations), as a result of a soft European market and continued constraints on supply capacity in AI. Commercial bookings improved on the back of large deals for Azure, giving the company good visibility into the first half of fiscal 2025. Profitability was in line with expectations with 43% operating margins, as was EPS on continued good cost discipline. While Microsoft reiterated its fiscal 2025 guidance of double-digit top-line and operating income growth, quarterly guidance called for Azure growth to slow before accelerating later in the fiscal year as capital expenditure increases. We believe this investment is a leading indicator for growth, with more than half of the spend related to durable land and data center build- outs, which should monetize over the next 15-plus years. We remain investors. 

The portfolio is constructed on a bottom-up basis with the quality of ideas and conviction level, rather than benchmark composition and weights, determining the size of each individual investment. Sector weights tend to be an outcome of the stock selection process and are not meant to indicate a positive or a negative view.

As of September 30, 2024, our top 10 positions represented 48.8% of the Fund’s net assets, and the top 20 represented 75.5%, and we exited the quarter with 34 investments, up from 32 at the end of the second quarter.

IT and Financials represented 59.1% of the Fund. Communication Services, Health Care, and Consumer Discretionary represented another 28.0% while the remaining 12.9% were invested in Industrials, Real Estate, and Consumer Staples as well as in cash.

The Fund continues to benefit from significant inflows. During the quarter, we added to 11 of our existing holdings, with the largest being: Amazon, NVIDIA, Mettler-Toledo, and Apollo. We also initiated 3 new positions: a leading aerospace & defense supplier, TransDigm, the leading government- focused consulting company, Booz Allen, and the leading cold storage REIT, Lineage. We reduced 11 existing positions and sold out of our small industrial holding, TE Connectivity.

TransDigm Group Incorporated was our largest new purchase during the third quarter. TransDigm is a leading designer, manufacturer, and supplier of aerospace and defense solutions. With a 90% proprietary portfolio, the company has best-in-class pricing power with mid-single digit pricing growth through the cycle, operating in a highly attractive, fragmented industry that is supported by long-term secular tailwinds of growth in air travel with customer stickiness, longevity of design wins, and attractive unit economics. While the company earns a modest return on original equipment parts, it is able to earn high margins on after-market replacement parts for aircraft staying in service for decades. TransDigm’s parts are custom designed at the pre-production stage and are approved by the Federal Aviation Administration (FAA) and aircraft manufacturers, making it more challenging and riskier for customers to replace the company in the supply chain once the part has been approved as the potential cost savings are usually not attractive enough for the time it takes and the risks involved in approving an alternative. Additionally, its low cost, low volume product set makes it difficult for PMA (generic) providers to re-engineer the products and undercut the company’s prices for most parts.

Noted for its heavily decentralized structure that incentivizes business unit managers to perform with larger equity compensation packages than peers, the company continues to find ways to operate more efficiently, driving EBITDA margins up consistently to the low 50s today with a pathway to mid-high 50s margins over the next several years.

Management also has a disciplined strategy of deploying capital through acquisitions, focused on finding targets with proprietary aerospace/defense-oriented solutions while returning the remaining capital to shareholders via special dividends. The team has made approximately 50 acquisitions over the last 30 years. Co-founder Nick Howley built the company into what it is today with current CEO Kevin Stein stepping into the role in 2018 following Nick’s retirement and successfully continuing along the path Nick set. We believe TransDigm is one of the best-run industrial companies setting the gold standard for industrial compounders globally.

We also initiated a new position in Booz Allen Hamilton Holding Corporation, which is a premier government services consultant. Booz Allen employs over 35,000 people, who provide civil and military government services to the federal government and 65% of whom have security clearances. Booz Allen’s consultants are considered to be the best at tackling sensitive and high-priority cybersecurity, intelligence, defense, and spending efficiency projects. The company is an industry leader and has historically outgrown the defense budget and peers by 2% to 4% per year across market cycles. Under longtime CEO, Horacio Rozanski, the company has thoughtfully invested in AI, cybersecurity, software, and other advanced technologies to stay ahead of peers and remain an important partner in providing mission-critical and highly technical solutions. Currently, Booz Allen is the largest single provider of AI services to the federal government.
 

With the world unfortunately not becoming safer, and with the return of great power competition with Russia and China, we believe that the defense budget would sustain durable growth while the need for Booz Allen’s solutions will only expand over time. We expect to see durable overall budget growth across the government for mission-critical, technology-oriented endeavors. Booz Allen will continue to outgrow peers by 2% to 4% a year, translating to mid- to high single-digit organic revenue growth with a stated objective of using M&A as an accelerant to bring new critical capabilities to the firm that could see overall growth closer to a low double- digit rate. Providing these hard-to-replicate, necessary solutions should enable better pricing and slightly higher margins over time as well. With a forward-thinking CEO and management team, unique set of solutions tailored for the current environment and its talented workforce, Booz Allen is set to compound value for investors the foreseeable future.

Our last new purchase during the third quarter was cold storage REIT, Lineage, Inc. Lineage is the global leader in the temperature-controlled logistics industry. It owns 482 temperature-controlled warehouse facilities, with 2.9 million cubic feet and 9.8 million pallet positions in 19 countries. The company has 33% market share in the U.S. (#2 Americold has 19% share, #3 US Cold has 6% share, #4 Interstate has 2% share, all others less than 1.3%) and 12% globally (#2 Americold has 6% share, #3 US Cold has 1.6% share, NewCold has 1.0%, all others less than 1%).

Lineage owns an irreplaceable portfolio with dominant share in high-barrier markets including limited land availability, high replacement costs, and difficulties in obtaining land and zoning entitlements. Demand for its space is resilient and non-cyclical, driven by frozen and refrigerated food consumption. The company also has pricing power because temperature- controlled warehousing is mission critical to customers and often represents a relatively modest expense compared to their other supply-chain costs and a small portion of the overall costs of goods sold. Lineage also benefits from scale thanks to better data and technology as compared with less sophisticated peers. We also like the company’s high quality management team that are well aligned with shareholders and that have proven to be strong operators and capital allocators with 115 acquisitions completed in the last 15 years, two-thirds of which have been sourced proprietarily.

We also utilized our inflows and took advantage of the correction in the shares of Amazon.com, Inc. and NVIDIA Corporation to add to our positions in these high quality compounders. Amazon is trading at valuation multiples close to the lowest levels in its history with its P/E multiple down 10% in the third quarter and 20% year-to-date. Considering the company’s wide competitive moat and durability of growth with cloud still representing less than 20% of overall IT spend and e-commerce less than 20% of retail, we believe shares are attractive. Similarly, we believe that NVIDIA will continue to be the prime beneficiary of AI, making the recent correction in the stock price a good place to add to our existing position.

As in years past, we have little to offer in the way of a market outlook. Has inflation been tamed? Will we get two more interest rate cuts the rest of this year or none? Harris or Trump? While these questions are not new, the answers remain elusive, and once they get answered, other, similar questions will arise. We practice a probabilistic approach to investing and for the time being we expect to continue to operate in an environment where the range of outcomes will remain relatively wide.

We can, however, offer the following observations. We started the year with a majority of market participants expecting an economic recession, or at a minimum, a hard landing. Since 1955, every time but once, whenever the yield curve had inverted, a recession followed within 6 to 24 months². Over the last 9 months, as the economy proved to be more resilient, the conversation has shifted to the likelihood of a soft landing or possibly even no landing. After posting a 1.6% reading in the March quarter, the U.S. real GDP accelerated to 3% growth in the second quarter of 2024. The unemployment rate remained steady at 4.1%, while inflation continued to soften, hitting 2.4% in September, the lowest rate since February 2021. Then, we finally got an interest rate cut (the 50bps variety), which we believe is the beginning of the Fed easing cycle, which should, in time, stimulate the economy further and rekindle investor interest in broader growth stocks. In the meantime, future cash flows discounted to present time at lower rates increase the intrinsic values of businesses creating a welcome tailwind, indeed.

Importantly, we do not structure or position the portfolio to benefit from any particular market environment. Instead, we focus on investing in high quality businesses – companies with durable competitive advantages, strong balance sheets, and exceptional management teams with a proven track record of operational excellence and successful capital allocation. These companies tend to be leaders in their industries and sell critical products and services to their customers that are hard to replace. That creates stickiness, high switching costs, and pricing power, that enable them to be resilient in the face of macro-economic challenges while continuing to invest in future growth opportunities to take market share and to emerge stronger when the environment inevitably improves.

The rapid advancement of Gen AI technology presents both clear risks and compelling opportunities. While the implications of AI on the global economy and on particular industries and businesses are not yet clear, we believe our portfolio includes many companies that are well-positioned to benefit from this technological paradigm shift, without taking any significant risk of permanent loss of capital.

Every day, we live and invest in an uncertain world. Well-known conditions and widely anticipated events, such as Federal Reserve rate changes, ongoing trade disputes, government shutdowns, and the unpredictable behavior of important politicians the world over, are shrugged off by the financial markets one day and seem to drive them up or down the next. We often find it difficult to know why market participants do what they do over the short term. The constant challenges we face are real and serious, with clearly uncertain outcomes. History would suggest that most will prove passing or manageable. The business of capital allocation (or investing) is the business of taking risk, managing the uncertainty, and taking advantage of the long-term opportunities that those risks and uncertainties create. We are confident that our process is the right one, and we believe that it will enable us to make good investment decisions over time.

Our goal is to invest in large-cap companies with, in our view, strong and durable competitive advantages, proven track records of successful capital allocation, high returns on invested capital, and high free-cash-flow generation, a significant portion of which is regularly returned to shareholders in the form of dividends or share repurchases. It is our belief that investing in great businesses at attractive valuations will enable us to earn excess risk-adjusted returns for our shareholders over the long term. We are optimistic about the prospects of the companies in which we are invested and continue to search for new ideas and investment opportunities.

Sincerely,