Baron Health Care Fund | Q3 2024

In the quarter ended September 30, 2024, Baron Health Care Fund® (the Fund) advanced 5.81% (Institutional Shares), compared with the 6.74% gain for the Russell 3000 Health Care Index (the Benchmark) and the 6.23% gain for the Russell 3000 Index (the Index). Since inception (April 30, 2018), the Fund increased 13.02% on an annualized basis compared with the 11.47% gain for the Benchmark and the 14.03% gain for the Index.

The Fund modestly trailed the Benchmark by 93 basis points in the third quarter due to stock selection.

Investments in health care equipment, health care distributors, life sciences tools & services, and pharmaceuticals were mostly responsible for stock- specific weakness in the period. Stock selection in health care equipment was a 100-plus basis point drag on performance, owing to notable declines from iRhythm Technologies, Inc. and Edwards Lifesciences Corporation. Weakness in health care distributors and life sciences tools & services was driven by poor performance from medical distributor McKesson Corporation and global contract research organization ICON Plc. The bulk of the relative shortfall in pharmaceuticals came from not having positions in large-cap companies Johnson & Johnson and Bristol-Myers Squibb Company, whose share prices were up 11.7% and 26.5%, respectively, in the period.

Somewhat offsetting the above was strong stock selection in biotechnology, where Arcellx, Inc. and argenx SE accounted for most of the relative gains. Solid stock selection in health care facilities and health care supplies together with higher exposure to these better performing sub-industries also added value.

Our strategy is to identify competitively advantaged growth companies that we can own for years. Similar to the other Baron Funds, we remain focused on finding businesses that we believe have secular growth opportunities, durable competitive advantages, and strong management teams. We conduct independent research and take a long-term perspective. We are particularly focused on businesses that solve problems in Health Care, whether by reducing costs, enhancing efficiency, and/or improving patient outcomes.

We continue to think the Health Care sector will offer attractive investment opportunities over the next decade and beyond. Health Care is one of the largest and most complex sectors in the U.S. economy, accounting for an estimated 17.3% of GDP in 2022 and encompassing a diverse array of sub-industries. Health Care is also a dynamic sector undergoing changes driven by legislation, regulation, and advances in science and technology. We think navigating these changes requires investment experience and sector expertise, which makes the Health Care sector particularly well suited for active management.

Arcellx, Inc. is a biotechnology company focused on cell therapies for multiple myeloma. Shares contributed this quarter after the company confirmed that data from its iMMagine-1 trial in late-line multiple myeloma will be presented at the American Society for Hematology conference later this year. This is the first set of pivotal data for Arcellx’s lead CAR-T treatment, and we expect it will look good. We are looking for superior safety data and comparable or better efficacy data than that of Legend/ Johnson & Johnson’s competing product Carvykti. Arcellx and partner Gilead/Kite have reported that they have not seen any significant neurological side effects, which would be a meaningful point of differentiation for the product.

Argenx SE is a biotechnology company focused on autoimmune disorders. Shares increased on positive sentiment around Vyvgart’s second commercial indication in rare nerve disorder chronic inflammatory demyelinating polyneuropathy, which was approved in late June and should be a strong launch into a large addressable market, in our opinion. Shares also benefited after competitor data from Amgen’s Uplinza failed to impress in myasthenia gravis, Vyvgart’s current core indication. Upcoming clinical catalysts should continue to drive long term growth, including readouts in myositis, Sjogren’s syndrome, multifocal motor neuropathy, and the subcutaneous formulation launch.

UnitedHealth Group Incorporated is a leading health and well-being company that operates across four segments: UnitedHealthcare, Optum Health, OptumInsight, and OptumRX. Despite complex Q2 results that involved multiple adjustments and an elevated medical loss ratio that management attributed to a cyberattack on its Change Healthcare platform, shares increased on positive management comments and reaffirmation of adjusted EPS guidance for 2024. We believe UnitedHealth should continue to see strong growth and profitability, driven by positive demographic trends and its ability to manage costs by leveraging its size and scale, continuing its industry-leading technology investments, expanding its expertise in population health, and growing its portfolio of providers.

 

Edwards Lifesciences Corporation is a medical device company that sells surgical and transcatheter heart valves. The company reported lower-than- expected Q2 financial results and reduced guidance. Management cited workflow backlogs in hospital catheter labs for the shortfall in the company’s transcatheter aortic valve replacement business. Competitive pressure is an alternative explanation. We also anticipate lower-than- expected earnings in 2025 as a result of dilution from a couple of acquisitions and the sale of its critical care business. We took a tax loss while we reconsider the investment thesis.

IRhythm Technologies, Inc. sells a small wearable patch (the Zio) for the detection of heart arrhythmia. Shares fell during the quarter. The company has been the subject of multiple investigations by the DOJ and the FDA. The FDA recently conducted a site inspection during which it identified issues across the product portfolio. In light of the uncertainty around these ongoing investigations, we took a tax loss while we reconsider the investment thesis.

DexCom, Inc. sells continuous glucose monitoring device for patients with diabetes. Shares fell after DexCom reported lower-than-expected Q2 financial results and reduced 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) and a shortfall in international sales. Some of these issues are temporary and potentially addressable. Others raise questions about DexCom’s growth potential. Our investment thesis is under review.

We build the portfolio from the bottom up, one stock at a time, using the Baron investment approach. We do not try to mimic an index, and we expect the Fund to look very different than the Benchmark. We loosely group the portfolio into three categories of stocks: earnings compounders, high-growth companies, and biotechnology companies. We define earnings compounders as companies that we believe can grow revenue at least mid-single digits and compound earnings at double-digit rates over the long term. We define high-growth stocks as companies we expect to generate double-digit or better revenue growth. They may not be profitable today, but we believe they can be highly profitable in the future. We expect the portfolio to have a mix of earnings compounders, high-growth, and biotechnology companies.

We may invest in stocks of any market capitalization and may hold both domestic and international stocks. As of September 30, 2024, we held 40 stocks. This compares with 529 stocks in the Benchmark. International stocks represented 10.5% of the Fund’s net assets. The Fund’s 10 largest holdings represented 54.7% of net assets. Compared with the Benchmark, the Fund was overweight in biotechnology, life sciences tools & services, health care facilities, and health care supplies; and underweight in pharmaceuticals, health care services, and managed health care. The market cap range of the investments in the Fund was $1.7 billion to $842.0 billion with a weighted average market cap of $199.0 billion. This compared with the Benchmark’s weighted average market cap of $258.6 billion.

We continue to invest in multiple secular growth themes in Health Care, such as genomics/genetic testing/genetic medicine, innovative medical devices that improve outcomes and/or lower costs, minimally invasive surgery, anti- obesity medications, picks and shovels life sciences tools providers, the shift to lower cost sites of care, and animal health, among others. To be clear, this list is not exhaustive: we own stocks in the portfolio that do not fit neatly into these themes and there are other themes not mentioned here that are in the portfolio. We evaluate each stock on its own merits.

* Individual weights may not sum to the displayed total due to rounding.

During the third quarter, we added six new positions and exited six positions. Below we discuss some of our top net purchases and sales.

We added to the position in Danaher Corporation, a life sciences tools company with a market-leading position in the bioprocessing market. We continue to think the bioprocessing market is an attractive market over the long term driven by the growing demand for biologic drugs such as vaccines, recombinant proteins, and monoclonal antibodies. While the industry has faced post-COVID inventory destocking headwinds over the past two-plus years, we think Danaher is well positioned to benefit when market demand recovers. The company has been an active purchaser of its stock, signaling management’s confidence in the future.

We purchased Regeneron Pharmaceuticals, Inc., a biopharmaceutical company that was built on a foundation in basic scientific research and antibody development. The company has successfully developed several blockbuster medicines, including Eylea and Eylea HD for retinal diseases (such as wet age-related macular degeneration, diabetic macular edema, and diabetic retinopathy) and Dupixent for immunological and inflammatory diseases (such as atopic dermatitis, asthma, and COPD). While Eylea is nearing the end of its patent life and faces potential biosimilar competition, the company has been transitioning patients to Eylea HD, which is a higher dose, longer-acting formulation of Eylea, and Dupixent is growing rapidly through indication expansion. Beyond the current product portfolio, Regeneron has an exciting new product pipeline with over 35 candidates in various stages of development, including a novel treatment for treating severe food allergy, a combination checkpoint inhibitor therapy for melanoma, lung cancer and other solid tumors, biospecific antibodies for blood cancers, and Factor XI antibodies for blood clot prevention, among others. Based on Regeneron’s track record of success discovering and developing new drugs, we are optimistic the pipeline will deliver some successes, which we think will drive upside in the stock.

We purchased Vaxcyte, Inc., a biopharmaceutical company with a next- generation vaccine platform. Vaxcyte recently showed data suggesting that their pneumococcal vaccine is better than the current vaccines on the market today. Pneumococcal vaccines are one of the largest vaccine categories today, with approximately $8 billion in worldwide sales. The vaccines are recommended for children under 5 or adults over 65 to prevent pneumococcal infection. The incumbents’ technology has hit a ceiling where their vaccines require too much protein carrier, which causes immune interference and lowered response to the pneumococcal antigen. As Pfizer and Merck have tried to add more serotypes to their vaccines, they’ve lost efficacy on some of the historically relevant serotypes. Vaxcyte’s platform allows a lower protein carrier/antigen ratio so the company can include more serotypes while minimizing carrier suppression. Vaxcyte recently reported impressive Phase 1/2 data for their VAX31 vaccine in adults.

VAX31 looked at least as good as Pfizer’s standard of care PCV20 vaccine on the existing 20 serotypes (and was statistically superior on several serotypes) and added strong immune coverage of 11 additional serotypes. VAX31 now covers 95% of circulating strains in U.S. adults and 98% in the EU. They will now run Phase 3 studies in adults and start a Phase 1/2 for VAX31 in children. We think that the pneumococcal vaccine market will be $10 billion-plus in 2030, that VAX31 can capture significant share, and that this will be a durable business.

We purchased Insmed Incorporated, a biopharmaceutical company with three lead drugs that could collectively generate $8 billion-plus of peak sales. We are most excited about brensocatib, which recently reported data in non-cystic fibrosis bronchiectasis (NCFBE), which is a $5 billion-plus opportunity. Based on our research, the data is a game-changer for patients both in terms of a 20% reduction in pulmonary exacerbations and an improvement in lung function. We think there could be as many as 500,000 NCFBE patients in the U.S. and that the disease is widely underdiagnosed (or rather, mis-diagnosed as asthma/COPD) given there are no approved treatments. In addition, brensocatib is a pipeline in a product. It’s a DPP1 inhibitor that is very potent against neutrophil serine proteases. Neutrophil serine protease activity is key in the cycle of inflammation and lung damage in bronchiectasis and is also known to play an important role in chronic rhinosinusitis without nasal polyps, an additional $1 billion-plus opportunity where Insmed will have data in the second half of 2025. In addition, another drug, Arikayce is on-market to treat refractory MAC lung disease and will likely get a front-line label with Phase 3 data expected in 2025. A third drug candidate, TPIP, is early stage but shows impressive efficacy/safety in PAH/ PH-ILD and could be a best-in-class option.

We purchased Ultragenyx Pharmaceutical Inc., a biopharmaceutical company focused on developing treatments for rare genetic diseases. Impressively, the company has gotten 4 drugs approved across 5 indications in 10 years, and it has a large clinical pipeline with several potential blockbuster opportunities in late stage development. While the company’s approved products continue to grow 20%-plus, we are most excited about the company’s new product pipeline. Setrusumab is in Phase 3 studies for Osteogenesis Imperfecta, a rare genetic disorder that causes bones to break easily. The drug helps patients increase bone mineral density and reduces the number of fractures patients experience. We think this could be transformative for patients and could be a $1 billion-plus peak sales drug. We are also excited about Ultragenyx’s GTX-102, an antisense oligonucleotide that treats Angelman Syndrome, a rare genetic disorder that affects the nervous system and causes severe development delay and intellectual disability. Early data showed dramatic improvement for patients across several behavioral and cognitive endpoints, and Ultragenyx just started a registrational study. The company is also working on a drug for Wilson disease, a rare genetic disorder that causes copper to build up in the body, where we will get proof-of-concept data soon. We think each of these programs has potential for significant value creation, transforming the company to one with significantly higher revenue and profits.

We sold McKesson Corporation after the company reported disappointing quarterly financial results. We took tax losses in iRhythm Technologies, Inc. and Edwards Lifesciences Corporation after the stocks fell for the reasons mentioned above. We sold Tempus AI, Inc. after the stock reached our long- term price target. We reduced Merck & Co., Inc. to fund other ideas.

Many of the same trends from the beginning of the year continued into the third quarter.

In managed care, higher medical cost trends continued, but stock performance improved as investors look ahead to potentially better trends next year. Despite a somewhat messy quarter from UnitedHealth Group Incorporated relative to analyst expectations, its core business remained on track and management raised 2024 guidance. SG&A leverage was particularly impressive, and management believes there are “billions of dollars” of efficiencies to be achieved through the implementation of AI and machine learning over the next several years. We believe UnitedHealth, which maintained Medicare Advantage pricing discipline in 2024 and saw weaker enrollment as a result, will see outsized MA enrollment in 2025 as competition, which underpriced in 2024, cuts benefits and exits markets to rebuild margins.

After two-plus years of “COVID hangover” headwinds (customer destocking, cautious biopharmaceutical spending, weakness in China), life sciences tools companies continue to experience sluggish end-market demand. Intra- quarter commentary from certain contract research organizations suggested ongoing uncertainty due to a slowdown in biotechnology funding versus the first half of the year. We think the biotechnology funding slowdown is temporary, as the IPO and follow-on market re-accelerated in the month of September. In addition, lower interest rates should boost valuations of earlier stage biotechnology companies and make it easier to raise capital, which should flow through to life sciences tools companies as their biotechnology customers invest in more R&D. We also think destocking headwinds are closer to the end. Trends in China remain depressed, but we are optimistic that they will improve even if they don’t return to pre-COVID levels of robust growth. We remain invested in life sciences tools companies that we believe have good long-term growth prospects.

Health care provider volumes remain healthy. We are investors in HCA Healthcare, Inc., the best-in-class hospital operator, Tenet Healthcare Corporation, which has a growing ambulatory surgery center business that is becoming a bigger percentage of its cash flows, and RadNet, Inc., a leading operator of imaging centers which is benefiting from the shift in imaging volumes towards outpatient centers, faster growth in higher margin advanced imaging modalities like MRI, CT and PET/CT, and an emerging AI business.

Business trends for medical device companies like Intuitive Surgical, Inc., Boston Scientific Corporation, and Stryker Corporation remain strong, driven by new product cycles and healthy procedure volumes.

We added several new biopharmaceutical positions during the quarter, and we remain positive on our core existing positions, including Eli Lilly and Company, which we think has a durable leadership position in the large obesity market; argenx SE, which has a drug that treats severe autoimmune diseases; and Arcellx, Inc., which has a differentiated cell therapy platform to treat multiple myeloma.

Regarding drug pricing, in August, the Centers for Medicare & Medicaid Services (CMS) announced the pricing for the first 10 drugs selected for negotiations. The new prices, which will go into effect on January 1, 2026, imply a 20% to 25% net price cut for the products on the list. This was roughly in line with investor expectations and had already been incorporated into guidance for the companies affected. CMS will select an additional 15 drugs for negotiation by February 1, 2025, with negotiated prices going into effect in 2027. For now, the impact of the Medicare drug pricing program seems manageable for the industry, but we are closely monitoring the situation, including how the program impacts biopharmaceutical R&D spending.

Starting with this quarterly letter, we plan to highlight one or two promising Health Care innovations every quarter. This quarter we will highlight two. First, researchers in China reported that they reversed a woman’s type 1 diabetes with a stem cell transplant. Companies like Vertex Pharmaceuticals Incorporated, which we own in the Fund, are also working on cell therapies for type 1 diabetes. What’s different about the China program is that the cells were taken from the woman’s own body, reprogrammed and then implanted back into the patient. The potential advantage of using the patient’s own cells is that the patient’s immune system might not reject and attack the cells as foreign. Two and a half months after the implant, the woman was producing enough insulin to live without needing additional insulin and she has sustained that level of production for more than a year. The woman was already taking immunosuppressants for a liver transplant, so unfortunately the study doesn’t answer the question whether these cells reduced the risk of immune rejection. The researchers are working on ways to reprogram the stem cells so that they can “hide” from the body’s own immune system and avoid the need for immunosuppressants which would be a breakthrough.

The second Health Care innovation comes from the work of researchers at Harvard-affiliated Brigham and Women’s Hospital. They developed a nasal spray that in preclinical studies offered nearly 100% protection from respiratory infections caused by COVID-19, influenza, viruses, and pneumonia-causing bacteria. The nasal spray forms a gel in the nasal cavity that captures respiratory droplets from the air, immobilizes viruses and bacteria, and neutralizes them with over 99.99% effectiveness. The spray would complement vaccines and add a layer of protection that could prevent infections. This is the first nasal spray to come close to this level of protection. The results are pre-clinical, meaning they come from a study involving mice, not humans, and the study was conducted in a laboratory, not the real world. Nevertheless, this new nasal spray has potential to have a significant positive impact on public health. The researchers are also exploring whether the nasal spray can block allergens, which could help people who suffer from allergies.

Overall, our long-term outlook for Health Care remains bullish. Innovation in the sector is robust. Advances in science and technology are leading to new ways to diagnose, monitor, and treat diseases. We continue to follow our process for identifying investment opportunities and creating a portfolio of competitively advantaged growth companies with strong management teams.

Thank you for investing in the Fund. I remain an investor in the Fund, alongside you.

Sincerely,