Baron Growth Fund | Q3 2024

Baron Growth Fund® (the Fund) gained 11.15% (Institutional Shares) for the quarter ended September 30, 2024. This exceeded the return of the Fund’s benchmark, the Russell 2000 Growth Index (the Benchmark), which gained 8.41% for the quarter. The Russell 3000 Index, which measures the performance of the 3,000 largest publicly traded U.S. companies, gained 6.23% for the quarter.

The Fund generated strong performance during the quarter. Notably, our outperformance was driven by rebounds in several stocks that had suffered price declines earlier in the year. All have continued to generate robust fundamental growth this year, as they have over the long term. While stock prices may diverge from fundamentals in the short term, we believe that stock prices inevitably follow earnings growth over time. We believe that all our holdings offer compelling and durable growth opportunities, which we believe positions the Fund to deliver superior returns over time across market cycles.

The Fund generated robust absolute and relative performance during the quarter. We observe that some of the Fund’s best performing stocks, including MSCI Inc., Gartner, Inc., Kinsale Capital Group, Inc., and FactSet Research Systems Inc., all detracted from our performance last quarter. We believe that investors sold many of these companies earlier in the year due to temporarily slower growth, or to fund investments in relatively more speculative stocks. This quarter all these companies demonstrated improved financial performance in line with our long-term expectations, driving robust appreciation in their share prices.

Shares of excess and surplus (E&S) insurer Kinsale jumped 21% after it reported 21% growth in premiums and 30% growth in earnings for its most recent reporting period. We note that shares declined 27% in the prior quarter despite the company reporting premium growth of 25% and earnings growth of 44%. This dramatic fluctuation in share price is illustrative of the market’s myopic focus on short-term results, which presents significant opportunities for long-term investors. We believe that 21% growth in premiums, like last quarter’s 25% growth, is a robust result that is indicative of continued market 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 MSCI rose 21% after declining 14% in the prior quarter, as strong sales execution enabled the company to accelerate growth despite tight budgets at investment management clients. MSCI grew its total revenue 10% organically and its index run rate by 12%. 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 see early signs of improving end-market conditions, which we expect will accelerate growth and drive multiple expansion.

Shares of FactSet rose 13% in the quarter, more than recouping last quarter’s 10% decline, helped by better-than-expected sales and strong margin performance. The company’s differentiated product portfolio and focus on workflow consolidation has enabled it to continue to take market share from competitors. FactSet management also highlighted early signs of improving customer buying patterns, which we expect will translate to enhanced free cash flow generation over the intermediate term.

Shares of Gartner gained 13% in the quarter after falling 6% in the prior period. Gartner’s core subscription research businesses inflected higher, and we believe that growth will continue to accelerate over the next several quarters. We believe that Gartner will emerge as a critical decision support resource for every company that is evaluating the opportunities and risks of AI on its business, which we expect to provide a tailwind to Gartner’s volume growth and pricing realization over time. We expect Gartner’s sustained revenue growth and focus on cost control to drive continued margin expansion and enhanced free cash flow generation.

Historically, periods of relative underperformance for the Fund have been followed by much longer periods of meaningful outperformance. We are optimistic that this quarter will once again mark a turning point. Over the last 10 years, the Fund has experienced four periods of underperformance. On average, these periods of underperformance lasted for about year, with the average shortfall being 10.4% cumulatively or 8.7% annualized. The Fund followed these periods of underperformance with much longer and more robust periods of outperformance. On average, the periods of outperformance lasted for approximately 24 months, and on average the Fund outperformed by 26.9% cumulatively or 13.7% annualized during these periods.

The rise and fall of shares of Super Micro Computer, Inc. (Supermicro) further illustrates the danger of trying to chase short-term performance at the expense of a focus on long-term fundamentals. Supermicro, a manufacturer of computer servers and full-scale rack solutions, benefited from exuberance for AI-related investments earlier this year. Shares soared 255% in the first quarter alone, propelling the stock to a market capitalization of nearly $60 billion. While the company’s revenue growth is significant, it is non-recurring and does not convert to earnings or free cash flow at attractive rates.

While other investors chased shares of Supermicro, we diligently adhered to our process, and did not compromise our rigorous quality standards simply to pursue a short-term investment trend. As Isaac Newton could have confidently predicted 300 years ago, once Supermicro’s stock momentum started to wane, shares tumbled. As of September 30, shares of Supermicro have declined 66% from their high on March 8, underperforming the Benchmark by more than 70%. To add insult to injury, in late August, Supermicro delayed the filing of its 10-K, citing concerns regarding its internal controls over financial reporting. In late September, the Wall Street Journal reported an investigation into accounting irregularities has been opened by the U.S. Department of Justice.

Ironically, Supermicro’s dramatic appreciation propelled its market capitalization to $60 billion at one point, catalyzing its removal from the Benchmark during its annual rebalance. Therefore, while the stock’s surge counted against our relative performance through June, its subsequent decline has not been captured in our relative performance during this quarter. We estimate that had Supermicro remained in the Benchmark through September 30, the Fund’s outperformance this quarter would have been closer to 5.00% instead of 2.74%.

Table II below 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 (GICS), 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 16.4% and 49.3% of the Fund’s total investments, and aggregate to 91.5%. Another 8.5% 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 investments in Financials and Core Growth outperformed the Benchmark, while our investments in Real/Irreplaceable Assets and Disruptive Growth 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 12.81% on an annualized basis since its inception on December 31, 1994, exceeding the Benchmark by 4.89% and the Russell 3000 Index by 2.00%. 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 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 13.97%, which has exceeded that of the Benchmark by 1.62% 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 $360,977 on September 30, 2024. This is approximately 3.7 times greater than the $96,637 the same hypothetical investment made in a fund designed to track the Benchmark would be worth, and over 70% 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.

Shares of MSCI Inc., a leading provider of investment decision support tools, contributed to performance. The company reported solid earnings as both sales and cancellations rebounded from the prior quarter. During the quarterly call, management sounded upbeat about MSCI’s long-term prospects and noted that client engagement remained strong across the globe. While near-term macro uncertainty remains, we retain long-term conviction as MSCI owns strong, “all weather” franchises and remains well positioned to benefit from numerous secular tailwinds in the investment community.

Specialty insurer Arch Capital Group Ltd. contributed to performance after reporting financial results that exceeded expectations. Operating return on equity was 20%, and book value per share rose 42% due to strong underwriting profitability and the establishment of a deferred tax asset at the end of last year. Shares likely benefited as well from a less active hurricane season and a market rotation away from banks during risk-off conditions in August. We continue to own the stock due to Arch’s strong management team and our expectation of significant growth in earnings and book value.

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 quarter, and we believe growth is poised to accelerate over the next several quarters. Longer term, we think customers will use Gartner as a critical source of information regarding AI, providing a tailwind to Gartner’s customer count and pricing power. We believe that consistent revenue growth and diligent cost controls can drive margin expansion and enhanced free cash flow generation over time. The company’s balance sheet is in excellent shape and we expect management to deploy capital for aggressive share repurchases and opportunistic bolt-on acquisitions.

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 due to customer inventory destocking. Post-pandemic, customers have been using inventory they had stockpiled to meet elevated pandemic-era demand. West was also able to shorten the lead time needed to meet demand, giving customers confidence that they can safely reduce inventory. We exited our position to reallocate capital towards stocks with more compelling near-term growth profiles.

Global ski resort company Vail Resorts, Inc. detracted from performance due to a drop in the number of season passes sold and the normalization of the ski industry following the post-pandemic surge of visitors. We remain investors. With a captive high-end consumer base who is willing to pay a premium for its services, Vail enjoys significant pricing power. It plans to cut $100 million in costs over the next two years by leveraging synergies within the business, which should result in improved margins. The company uses its strong balance sheet and robust cash flow to invest in its resorts and cover its dividend, and it recently increased its share buyback program. We think shares are attractive at current valuations.

Trex Company, Inc. is the leading manufacturer of composite decking materials for U.S. residential homes. The stock detracted from performance after the company lowered full-year guidance due to softer-than-expected demand for select lower-priced deck products. We believe this softness is isolated and transitory and the multi-year prospects for Trex and composite decking remain bright. Composite continues to gain market share from wood, and Trex is meaningfully expanding capacity to meet future expected demand.

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 September 30, 2024, our weighted average holding period was 17.2 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 19.1 years, ranging from a 7.8-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 23 investments, representing 88.9% of the Fund’s total investments, for more than 10 years. We have held 10 investments, representing 11.1% 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 16.8% since we first purchased them. This exceeded the performance of the Fund’s Benchmark by 7.8% annualized. Five 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 26.8% annually on a weighted average basis since our initial purchase, exceeding the Benchmark by 16.9% annualized. Five 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 September 30, 2024, we owned 33 investments. The top 10 holdings represented 69.1% 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 19.6% annually based on weighted average assets since our initial investment, exceeding the Benchmark by an average of 11.1% 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,