Baron Growth Fund | Q2 2024

Baron Growth Fund® (the Fund) declined 8.23% (Institutional Shares) for the quarter ended June 30, 2024. This trailed the return of the Fund’s benchmark, the Russell 2000 Growth Index (the Benchmark), which declined 2.92% for the quarter. The Russell 3000 Index, which measures the performance of the 3,000 largest publicly traded U.S. companies, gained 3.22% for the quarter.

The Fund’s underperformance was primarily due to price declines in four of our largest positions. These positions have been significant contributors to our long-term performance, and we believe the declines were caused by short-term factors rather than structural changes to earnings power. We believe all remain compelling investment opportunities and are confident the Fund remains positioned to deliver superior returns over time across market cycles.

Our performance this quarter was adversely impacted by share price declines in 4 of our top 10 positions. Shares of excess and surplus (E&S) insurer Kinsale Capital Group, Inc. declined after its written premium growth slowed more than anticipated during the company’s fiscal first quarter. While growth of 25% was modestly slower than expected, it was a robust result that is indicative of continued share gains. We believe that Kinsale is uniquely positioned to capture market share in the vast and growing E&S market and are optimistic about its prospects to earn outstanding returns on capital going forward.

Shares of CoStar Group, Inc. also declined in the quarter. We attribute a portion of the decline to broad-based multiple compression across software stocks, and part to short-term fluctuations in sentiment regarding the company’s new residential lead generation product. CoStar began to monetize its residential offering in February, and had an excellent start, generating $39 million of net new sales in less than two months. However, the pace of adoption seemed to slow in May and June, leading to share price declines. We believe that few businesses progress linearly and variability in results across quarters is to be expected. We view the residential real estate market as a vast and underpenetrated opportunity. As an asset class, single-family residential properties represent more than $40 trillion of value in the U.S., or around 60% of the total value of U.S. real estate. We estimate that CoStar’s residential products will serve a total addressable market (TAM) that exceeds $15 billion of annual recurring revenue, or almost four times larger than the company’s flagship Suite offering currently serves. We estimate that offering a residential product in international markets could increase that TAM by a further factor of four.

Shares of MSCI Inc. also declined in the quarter as new sales were impacted by tighter budgets at many of its investment management clients. Despite headwinds, MSCI grew its total revenue 10% organically, and its recurring subscription run rate 14%. We have been investing in MSCI since its IPO in 2008 and have observed its performance across multiple business cycles, including the Great Recession and COVID. We believe that the company’s competitive positioning remains unrivaled, it continues to benefit from durable secular trends, and its cash flow generation capabilities remain best-in-class. We expect end-market conditions to improve over time, leading to an acceleration in growth and corresponding multiple expansion.

Shares of Vail Resorts, Inc. declined as adverse weather conditions reduced financial results. Vail has succeeded in converting a sizeable portion of its customer base to season passes, which dampens but does not eliminate the impact of weather. We believe that Vail boasts an irreplaceable network of ski resorts. We expect the company to grow at attractive rates by adding more customers on season passes, raising prices consistently, and upselling customers to higher priced offerings. We think that growth can be amplified by continued acquisitions, particularly as the company makes headway in the vast European market.

We think that the recent appreciation in shares of Guidewire Software, Inc. illustrates the benefits of our long-term approach. Guidewire is a leading provider of core systems software for property and casualty (P&C) insurers. The Fund has been investing in Guidewire since its IPO in 2012 and has earned a 15.5% annualized return on the investment since our first purchase.

Guidewire was founded in 2001 to help modernize the core systems of P&C insurance carriers. Moving to Guidewire’s software from legacy technology helped to reduce carriers’ operating costs while improving their agility and ability to innovate. The company’s best-in-class technology, large SI ecosystem, and perfect track record of go-lives enabled it to capture meaningful market share among carriers. Like almost all technology developed in the early 2000s, Guidewire’s software was installed “on-premise,” with customers assuming responsibility for operating the software and keeping it updated.

Approximately five years ago Guidewire recognized a looming innovators dilemma as software applications began transitioning from on-premise delivery to software-as-a-service (SaaS). Guidewire took a proactive approach and elected to disrupt its own on-premise business to pursue leadership in SaaS core systems. This approach reduced revenue growth and meaningfully increased expenses during this transition period. The lower profitability and higher uncertainty led to a period of challenging stock performance, as shorter-term oriented investors elected to sell the stock with the hope of buying it back after the transition was complete.

After conducting extensive and holistic due diligence, we elected to maintain our ownership. We believed that while the transition would be difficult and time consuming, Guidewire was uniquely positioned to succeed in becoming the gold standard in SaaS core systems. We also expected that winning that leadership position would ultimately result in 50% market share of an addressable market that would eventually exceed $20 billion of annual recurring revenue. We expected the winner to benefit from near-perfect retention rates and a margin profile that can approach or exceed 40%.

We are pleased by the way that our thesis is developing. Guidewire’s SaaS revenue is now approaching $500 million, up from just $65 million when the transition began. We estimate that its win rate for SaaS deals exceeds 80%, ahead of our expectations and higher than its on-premise win rate. Expense growth has flattened, leading to dramatic margin expansion and a clear path towards our long-term profitability targets. The stock has jumped in response, gaining 81% over the last year, dramatically better than the Benchmark, which gained approximately 9%. Despite the excellent recent performance, we see continued attractive returns ahead as the company continues to execute on its expansive product roadmap.

Table II groups our portfolio based on our assessment of the attributes that best characterize each investment. While this does not perfectly correlate to the Global Industry Classification Standard, the industry standard nomenclature, we believe it provides added transparency into our thought process.

Sources: FactSet PA, Baron Capital, and FTSE Russell. 
* Individual weights may not sum to displayed total due to rounding. 
** Represents the blended return of all share classes of the Fund.

Our investments in Real/Irreplaceable Assets, Core Growth, and Financials represent between 16.6% and 47.2% of the Fund’s total investments, and aggregate to 91.1%. Another 8.9% of total investments are invested in businesses that we consider to be Disruptive Growth businesses, which we believe offer greater growth potential, albeit with more risk relative to other investments. We believe this balance appropriately reflects our goal to generate superior returns over time with less risk than the Benchmark. As shown in the table above, our Disruptive Growth investments outperformed the Benchmark, while our investments in the other three cohorts trailed the Benchmark in the quarter.

Performance data quoted represents past performance. Past performance is no guarantee of future results. The indexes are unmanaged. Index performance is not Fund performance. Investors cannot invest directly in an index.

The Fund has meaningfully outperformed its Benchmark over the long term. The Fund has gained 12.52% on an annualized basis since its inception on December 31, 1994, which exceeds that of the Benchmark by 4.82% and the Russell 3000 Index by 1.84%, annualized. This represents robust absolute and relative returns across a variety of market environments, driven primarily by favorable stock selection. We attribute this result to not losing money during periods of significant market drawdowns, such as the nine years ended December 2008, as well as robust absolute and relative performance versus the Benchmark during the most recent five-year period, which featured two significant market corrections.

While the Fund did not make much money from December 31, 1999, through December 31, 2008, a period which includes the highs of the Internet Bubble and the lows of the Financial Panic, it did generate a positive annualized return of 2.46%. Conversely, a hypothetical investment in a fund designed to track the Fund’s Benchmark would have declined in value by 4.71% on an annualized basis over the same time. Similarly, a hypothetical investment in a fund designed to track the Russell 3000 Index would have declined 2.95% annualized. (Please see Table IV–Millennium Internet Bubble to Financial Panic). From the Financial Panic to present, the Fund generated an annualized return of 13.43%, which has exceeded that of its Benchmark by 1.46% annualized.

We believe that the power of compounding is better demonstrated by viewing these returns in dollar terms. A hypothetical investment of $10,000 in the Fund at its inception on December 31, 1994 would be worth $324,776 on June 30, 2024. This is approximately 3.6 times greater than the $89,140 the same hypothetical investment made in a fund designed to track the Benchmark would be worth, and over 60% more than a hypothetical investment in the Russell 3000 Index. Hypothetically, our returns were achieved with approximately 28% less volatility than the Benchmark, as represented by its beta. (Please see Tables III and IV.) Importantly, we believe that the returns in the portfolio have come primarily through the compounded growth in the revenue and cash flow of the businesses in which we have invested rather than increases in valuation multiples. We are pleased that our long-term investments in what we believe are competitively advantaged companies with attractive growth prospects and exceptional management teams have generated attractive returns in good markets and have helped to protect capital during more challenging ones.

Specialty insurer Arch Capital Group Ltd. contributed to performance after reporting positive financial results that exceeded Street expectations. Operating ROE was 21% in the first quarter, and book value per share rose 40% due to strong underwriting profitability and the establishment of a deferred tax asset at the end of 2023. Favorable conditions persist in the P&C insurance market with strong growth and attractive returns despite signs of increasing competition. We continue to own the stock due to Arch’s capable management team and our expectation of significant growth in earnings and book value.

Shares of P&C insurance software vendor Guidewire Software, Inc. contributed to performance for the quarter. After a multi-year transition period, we believe the company’s cloud transition is substantially over. We believe that cloud will be the sole path forward, with annual recurring revenue (ARR) benefiting from new customer wins and migrations of the existing customer base to InsuranceSuite Cloud. We also expect the company to shift R&D resources from infrastructure investment to product development, which will help to drive cross sales into its sticky installed base and potentially accelerate ARR over time. We are also encouraged by Guidewire’s subscription gross margin expansion, which improved by more than 1,000 basis points in its most recently reported quarter. We believe that Guidewire will be the 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%.

The stock of Altair Engineering Inc., a prominent player in the multi-billion- dollar Computer Aided Simulation market, contributed to performance. Better-than-expected quarterly results and an optimistic demand outlook from management drove the stock’s upward movement. While macro commentary across software companies was mixed this quarter, Altair’s leadership noted improving demand trends. The company is also poised to benefit from go-to-market changes, including increased partner traction, sales force verticalization, pricing adjustments, and enhanced cross-selling efforts across product segments. The potential acquisition of a key competitor, ANSYS, Inc., could position Altair as a standalone simulation software company in the public market, potentially boosting investor interest. We expect Altair will continue to benefit from the ongoing increase in product complexity, requiring customers to adopt more simulation while reducing compute costs, and product innovation should allow it to be adopted by a broader set of users within Altair’s customers.

We seek to invest in businesses with attractive fundamental characteristics and long-term growth prospects. These attributes include high barriers to entry, sustainable competitive advantages, large and growing addressable markets, and durable secular tailwinds. We invest in business models that have recurring or predictable revenue, generate attractive incremental margins, are cash generative, and are not dependent on third-party financing. We invest with management teams that seek to consistently reinvest into their businesses to raise barriers to entry and pursue long-term profitable growth. We work with our growing team of analysts to conduct iterative and holistic due diligence by interacting with representatives of all company stakeholders. In addition to visiting regularly with a company’s management team, we join our analysts in speaking with a company’s existing and potential customers, key suppliers, and large competitors. We use such findings to refine our understanding of a business and its industry, assess its growth trajectory, test the durability of its competitive advantages, and ultimately reinforce or refute our investment thesis. We do this in an iterative manner and ultimately spend as much time researching long-held positions as we do when researching new potential investments.

We hold investments for the long term. As of June 30, 2024, our weighted average holding period was 16.9 years. This is dramatically longer than most other small-cap growth funds, which, according to Morningstar, turn over about 71% of their portfolios annually based on an average for the last three years. The portfolio’s 10 largest positions have a weighted average holding period of 18.7 years, ranging from a 7.6-year investment in Kinsale Capital Group, Inc. to investments in Choice Hotels International, Inc. and Vail Resorts, Inc. that now both exceed 27 years. We have held 24 investments, representing 89.0% of the Fund’s total investments, for more than 10 years. We have held 11 investments, representing 11.0% of the Fund’s total investments, for fewer than 10 years. We believe that Table VII and Table VIII quantify the merits of our long-term holding philosophy.

The cohort of investments that we have held for more than 10 years earned a weighted average annualized rate of return of 16.3% since we first purchased them. This exceeded the performance of the Fund’s Benchmark by 7.7% annualized. Six of these investments have achieved annualized returns that exceeded the Benchmark by more than 10% per year.

The cohort of investments that we have held for fewer than 10 years has returned 23.7% annually on a weighted average basis since our initial purchase, exceeding the Benchmark by 15.1% annualized. Three of these investments have achieved annualized returns that exceeded the Benchmark by more than 10% per year, including two that have achieved annualized returns that exceeded the Benchmark by more than 20% per year.

As of June 30, 2024, we owned 35 investments. The top 10 holdings represented 68.0% of the Fund’s total investments, all of which have been held for a minimum of seven years. All were small-cap businesses at the time of purchase and have become top 10 positions through stock appreciation. Our holdings in these stocks have returned 18.9% annually based on weighted average assets since our initial investment, exceeding the Benchmark by an average of 10.6% annually. We attribute much of this relative outperformance to the superior growth rates and quality exhibited by these businesses relative to the Benchmark average. We believe all our positions offer significant further appreciation potential individually, and that the Fund’s diversification offers potentially better-than-market returns with less risk than the market as measured by beta. Note that diversification cannot guarantee a profit or protect against loss.

Thank you for joining us as fellow shareholders in Baron Growth Fund. We are appreciative of the confidence you have shown in us, and we will continue to work hard to justify that confidence.

Respectfully,