Baron International Growth Fund | Q2 2024

Baron International Growth Fund® (the Fund) gained 1.25% (Institutional Shares) during the second quarter of 2024, while its primary benchmark index, the MSCI ACWI ex USA Index (the Benchmark), was up 0.96%. The MSCI ACWI ex USA IMI Growth Index (the Proxy Benchmark) gained 0.71% for the quarter. The Fund modestly outperformed the Benchmark and the Proxy Benchmark during a quarter where international equity returns lagged their U.S. and global counterparts.

During the second quarter, inflation readings failed to slow sufficiently to clearly warrant the initiation of a Federal Reserve (the Fed) easing cycle, while global growth and employment conditions offered mixed signals. As a result, equity market breadth and leadership continued to narrow as the uncertain macro environment, contrasted by strong near-term fundamentals for the so-called Magnificent Seven and associated AI proxies and beneficiaries worldwide, ensured that such AI proxies drove the lion’s share of second quarter returns. Beneath this surface level, we note that in contrast to the first quarter, the momentum of U.S. and global growth and employment conditions seemed to peak early in the quarter and moderate, with consumption clearly weakening late in the quarter. This allowed bond yields, and more importantly real yields, to moderate through the quarter, ending notably below the April highs and well below the recent peak levels of October 2023, which preceded the Fed’s most recent pivot. Our current bias is that recent moderating economic trends will trigger a Fed easing cycle sooner rather than later, a development which would likely warrant a mean- reverting inflection point for many market underperformers, including international and emerging markets (EM) equities. Interestingly, we point out that despite the year-to-date rise in bond yields and the U.S. dollar, the MSCI Emerging Markets Index slightly outperformed the S&P 500 Index during the second quarter, while strongly outperforming the Dow Jones Industrial Average, the equal-weighted S&P 500 Index, and the Russell 2000 Index. We find this performance particularly admirable and perhaps a foreshadowing in the face of widespread skepticism and capital outflows. In our view, the MSCI ACWI ex USA Index was dragged down during the quarter by the impact of the surprise outcome of the initial French election results on Eurozone equities, leading to an unusually low correlation between international and EM equities during the quarter. As seasoned international investors, we highlight that abrupt market reactions to political events and/or elections often present attractive opportunity, as political and market “breakers” tend to materially dilute extremist rhetoric, allowing elevated risk-premium to recede and normalize. We anticipate that recent international equity underperformance will be contained and subsequently mean-revert.

As we referenced in our previous letter, a portion of the surprisingly solid showing in at least EM equities can be attributed to the broadening recognition of AI-related equities within international jurisdictions. Further, as AI enthusiasm has spread from the “GPU/data center arms race” to the notion of “edge AI,” or AI on server/PC/handset, many more individual companies can be seen as at least cyclical beneficiaries as edge AI would necessitate a significant and long-deferred replacement cycle for such edge devices. As the second quarter progressed, updates from Apple, Taiwan Semiconductor, Dell, Lenovo and others drove growing interest in the many companies in the hardware/handset ecosystem – a substantial portion of which reside in international/EM jurisdictions, in addition to the well- recognized semiconductor and high-bandwidth memory leaders, and, in our view, this phenomenon helped drive solid relative performance. We remain confident that international equities currently offer an attractive long-term entry point, with valuations and relative earnings expectations at multi- decade lows, high investor skepticism, and fundamental catalysts that we view as underappreciated by investors and allocators. As always, we remain confident that our diversified portfolio of well-positioned and well-managed companies can capitalize on their potential over the coming years regardless of the external environment.

In the second quarter of 2024, we modestly outperformed the Benchmark, as well as our all-cap growth-oriented Proxy Benchmark. By sector or theme, solid stock selection across multiple themes within Industrials and Consumer Discretionary were the largest contributors to relative performance this quarter. Notable outperformers were HD Korea Shipbuilding & Offshore Engineering Co., Ltd., as part of our sustainability/ESG theme, InPost S.A. and Coupang, Inc. within digitization, Recruit Holdings Co., Ltd. in Japan staffing, and Trent Limited in EM consumer. In addition, solid stock selection in the Communication Services sector, led by Bharti Airtel Limited, Tencent Music Entertainment Group, and Indus Towers Limited in our digitization theme, also bolstered relative results. Broadly offsetting the above was adverse stock selection effect in the Health Care sector, primarily attributable to our biotechnology/ diagnostics related holdings (Stevanato Group S.p.A, Eurofins Scientific SE, and Genmab A/S). In addition, negative stock selection in the Materials sector, owing to a couple investments in our sustainability/ESG theme (AMG Critical Materials N.V. and Suzano S.A.), also weighed on relative results.

From a country perspective, our overweight positioning together with solid stock selection in India was the largest contributor to relative performance this quarter. Favorable stock selection effect in Korea, Canada, and Poland also bolstered relative results. We remain excited about our investments in India and are encouraged by the recent re-election of Prime Minister Modi for a historic third term, which bodes well for policy continuity and a positive economic outlook. Partially offsetting the above was our overweight positioning together with poor stock selection in Brazil, and negative stock selection effect in U.K., Italy, and the Netherlands.

Semiconductor giant Taiwan Semiconductor Manufacturing Company Limited (TSMC) contributed in the second quarter due to expectations for a continued strong cyclical recovery in semiconductors and significant incremental demand for AI chips. We retain conviction that TSMC’s technological leadership, pricing power, and exposure to secular growth markets, including high-performance computing, automotive, 5G, and IoT, will allow the company to sustain strong double-digit earnings growth over the next several years.

HD Korea Shipbuilding & Offshore Engineering Co., Ltd. is the holding company of Hyundai Heavy, the largest global shipbuilder based on orderbook size and the global leader in high-end vessels including liquified natural gas (LNG)-powered ships. Shares contributed on strong quarterly results at subsidiary Hyundai Samho, which delivered better-than-expected margins on higher pricing. In addition, year-to-date newbuild ship order demand and pricing for the group was better than expected. We retain conviction. Korean shipbuilders have an oligopoly in LNG carrier shipbuilding, LNG dual-fueled container ships, and tankers. The tightening regulation on carbon emission, which will be fully adopted by the International Maritime Organization (IMO) by 2030, should drive higher demand for LNG dual-fueled ships as well as carbon-free ammonia-fueled ships. We expect a structural shortage of compliant ships to emerge as the IMO deadline nears, which should benefit HD Korea Shipbuilding given its leading position.

Shares of Trent Limited contributed to performance during the quarter. Trent is a leading retailer in India that sells private label apparel direct-to-consumer through its proprietary retail network. Shares were up this quarter on better-than-expected quarterly sales performance as well as continued footprint expansion of its Zudio value fashion franchise. We remain investors, as we believe the company will generate over 25% revenue growth in the near-to-medium term, driven by same-store-sales growth and outlet expansion. In addition, we believe operating leverage and a growing franchisee mix will lead to better profitability and return on capital, driving more than 30% EBITDA CAGR over the next three to five years.

​Shares of Stevanato Group S.p.A detracted from performance. Stevanato sells packaging for injectable drugs. During the pandemic, the significant demand created by COVID vaccines resulted in a global shortage of vials. As a result, lead times were elongated, and customers stocked injectable drug packaging above normal inventory levels. As the supply chain situation normalized and demand for COVID vaccines declined, customers have been working through this excess inventory, leading to lower near-term vial sales and underutilized vial manufacturing capacity. We still think this is an attractive industry long term and remain investors.

Eurofins Scientific SE is a global leader in bioanalytical testing in the food, environment, pharmaceutical, and clinical sectors. Shares fell after a short report from Muddy Waters Research alleged the CEO had a conflict of interest regarding real estate leasing as well as poor accounting standards. We think the allegations echo a short report from 2019 and believe any impact on fundamentals is not significant. Eurofins is still a market leader in higher-growth areas of testing, unlike its peers which operate in more commoditized inspection and certification.

Semiconductor production equipment manufacturer Tokyo Electron Limited detracted in the second quarter, driven by investor concerns about a slower-than-expected near-term revenue growth recovery. We remain optimistic about Tokyo Electron’s long-term prospects. We expect semiconductor production equipment spend will grow robustly for years to come, as chipmakers expand capacity to meet rising demand, with AI as a key long-term catalyst. We believe the company will remain a critical enabler of major chipmakers’ technological advancements.

The table above does not include the Fund’s exposure to Russia (less than 0.1%) because the country falls outside of MSCI’s developed/emerging/frontier framework.

Exposure by Market Cap: The Fund may invest in companies of any market capitalization, and we strive to maintain broad diversification by market cap. At the end of the second quarter of 2024, the Fund’s median market cap was $18.5 billion. We were invested 70.1% in large- and giant-cap companies, 19.8% in mid-cap companies, and 7.3% in small- and micro-cap companies, as defined by Morningstar, with the remainder in cash.

During the second quarter, we added several new investments to existing themes and increased our weighting in certain positions established in prior periods. We endeavor to increase concentration in our highest conviction ideas.

We initiated a position in Ajinomoto Co., Inc., a Japanese multi-national which traces its roots back to 1909 as the inventor of monosodium glutamate (MSG). The company has since become one of the most profitable food companies in the world and has expanded into a wide range of products and services across seasonings, pharmaceutical contract development and manufacturing, and semiconductor functional materials. We expect that Ajinomoto’s core food business will maintain steady growth, supported by Southeast Asia’s emerging middle class, as rising incomes drive both higher volume and the upgrade to higher-priced premium products. Most notably, we are optimistic about the growth prospects for Ajinomoto Build-up Film (ABF), an insulating material used within the packaging of high-performance semiconductors, including CPUs and GPUs in PCs and servers. Ajinomoto invented ABF in the late 1990s and has since maintained a near monopoly in this material, which plays a critical role in electrical isolation, signal routing, and heat dissipation. We expect Ajinomoto’s high- margin ABF revenue to surge over the next five years, driven by strong AI-related demand for high performance chips, increasing ABF content per chip to support ever more complex chip designs, and an uplift in ABF pricing. We forecast that Ajinomoto can more than double its earnings over the next five years, with ABF driving most of the profit growth.

As part of our digitization theme, we initiated positions in Park Systems Corporation, Indus Towers Limited, BE Semiconductor Industries N.V. (Besi), and eMemory Technology Inc. Park Systems is a Korean manufacturer of nanoscale metrology systems and the leading global supplier of Atomic Force Microscopes (AFM) for the semiconductor industry. Unlike electron microscopes and optical inspection tools which produce two-dimensional images, AFM uses a cantilever with a very sharp tip to produce a three-dimensional topographic map of a surface with superior, atomic-level resolution. Until recently, AFMs were mainly used in academic research. However, over the last five years, as the dimensions of chip features have become ever smaller and chip design has become increasingly vertical, legacy optical equipment has struggled to meet more stringent inspection demands. Thus, the semiconductor industry has started using AFMs for sub-angstrom measurements and defect analysis to improve manufacturing yields. We believe AFMs are still in the early stage of adoption and will see strong demand over the next five years, ultimately becoming a mainstream tool uniquely suited for the rising complexity and intensity of semiconductor inspections. We are confident that Park Systems will maintain its dominant market share in AFMs thanks to its significant technological advantages and sticky customer relationships. We also expect that Park Systems’ unrivaled AFM platform will enable the company to successfully expand into new innovative products, such as a tool to repair photomasks used in EUV lithography, which is already starting to receive meaningful orders. With strong expected growth in leading edge semiconductor manufacturing capacity to meet surging AI demand, increasing penetration of AFMs, and an expanding product line, we believe Park Systems will generate over 20% compounded earnings growth over the next three to five years.

Indus is a leading telecommunications tower operator in India. The telecommunications towers sector in India in currently structured as a duopoly, with Indus and a key competitor accounting for approximately 60% market share. The company has been a key beneficiary of ongoing industry consolidation and telecommunication providers’ rollout of 5G services. However, its valuation has remained deeply discounted compared to global tower peers, primarily due to a key customer, Vodafone Idea (Vi), which has been experiencing share losses that triggered insolvency concerns. With its recent improvement in financial viability, Vi resumed monthly payments to Indus, which, in our view, will be a key re-rating catalyst for Indus’ stock. Additionally, as Vi completes an equity raise, Indus will benefit from Vi’s planned 4G expansion and 5G rollout, which will drive tower additions, tenancy ratio improvement, and consequently higher operating leverage and free cash generation. We expect Indus to deliver high single- digit revenue growth and approximately 10% compounded earnings growth over the next three to five years, with nearly all the incremental earnings enhancing distributable free cash flow.

Besi is a leading supplier of semiconductor assembly equipment based in the Netherlands. The company is a pioneer in hybrid bonding equipment and will be a key beneficiary of the proliferation of “chiplets” over the next decade. Moore’s Law, which observed that the number of transistors on a chip doubles every two years, has underpinned the semiconductor industry’s exponential growth over the last six decades. Today, chipmakers squeeze billions of transistors onto an area the size of a fingernail. However, as these transistors are now nearing the size of a single atom, it is becoming extremely costly and complex to make them even smaller. Thus, the industry must innovate in other ways, and is now shifting towards chiplet architecture. Traditionally, multiple computing functions would be integrated on a two-dimensional, “monolithic” chip. Chiplets break apart these functions into individual blocks, such as processing, memory, and input/output communication, which can then be stacked on top of each other, using the third dimension for the first time. A system comprised of chiplets has several advantages, including higher yield, lower cost, and better performance. For example, stacking a memory chiplet directly on top of a processor can significantly improve speed and energy efficiency compared to a monolithic approach, which requires data to move longer distances horizontally around the chip. Hybrid bonding is a new technology used to integrate multiple chiplets and delivers a major bandwidth improvement over conventional chip packaging. Besi enjoys technological and first mover advantages in hybrid bonding, which we believe will enable the company to sustain strong double-digit earnings growth for many years to come.

Taiwan-based eMemory is a world-leading Intellectual Property (IP) provider of embedded non-volatile memory (eNVM) to all major semiconductor chip manufacturers. ENVM is integrated directly into a chip for the purpose of retaining data, such as code and parameter settings, even when power is turned off, and provides higher speed and performance than external memory. The company does not design nor manufacture its own chips, but rather licenses its technology to chipmakers and generates the vast majority of its revenue from royalties. We expect the penetration rate of eMemory’s eNVM IP will steadily increase over the next five years, given its strong advantages in memory density, security, and re-programmability compared with the legacy “eFuse” technology. We are also optimistic about the long­ term potential for eMemory’s Physical Unclonable Function (PUF) IP. PUF is like a chip fingerprint, which is generated by the unique physical properties of every chip. While still at an early stage of adoption, we believe PUF could become a critical solution for multiple chip security issues, such as device authentication and key generation. We expect the company to maintain its dominant position in both eNVM and PUF IP, with deep competitive moats including its highly differentiated technology, decades-long customer relationships, and strong patent portfolio. We forecast that rising eNVM and PUF adoption will sustain over 20% compounded revenue growth over the next three to five years. Moreover, with industry-leading profit margins and high operating leverage thanks to its IP licensing business model, we expect eMemory’s profit will grow considerably faster than its revenue.

We increased our exposure to several existing positions during the quarter, including Epiroc AB, Compagnie Financiere Richemont SA, Taiwan Semiconductor Manufacturing Company Limited, EQT AB, Genmab A/S, Full Truck Alliance Co. Ltd., Prosus N.V., and Shenzhen Mindray Bio-Medical Electronics Co., Ltd.

We exited several positions during the quarter consistent with our efforts to seek greater concentration in our higher conviction investments. Disposals included Watches of Switzerland Group PLC, B3 S.A. – Brasil, Bolsa, Balcao, Ceres Power Holdings plc, Yum China Holdings Inc., and Kingsoft Corporation Ltd.

In many ways, we see the evolution of market behavior in the second quarter 2024 as an extension of the first quarter: inflation readings failed to slow sufficiently to clearly warrant the initiation of a Fed easing cycle, while global growth and employment conditions offered mixed signals, and equity market breadth and leadership continued to narrow into nearly the exclusive confines of the Magnificent Seven and associated AI proxies and beneficiaries worldwide. Under the hood, we observe that the details are more nuanced. First, in contrast to the first quarter, the momentum of U.S. and global growth and employment conditions seemed to peak early in the quarter and moderate, with consumption clearly weakening into late Spring/ early Summer. This allowed bond yields, and more importantly real yields, to moderate through the quarter, ending notably below the April highs and well below the recent peak levels of October 2023, which preceded the Fed’s pivot. We will be carefully following ongoing employment and consumption indicators, and the related implications for growth and inflation expectations, as our current bias is that recent moderating trends will trigger a Fed easing cycle sooner rather than later. Such a development would likely warrant a mean-reverting inflection point for many market underperformers, including international and small/mid-cap equities – much as we experienced during the final quarter of 2023; though, if viewed as a more lasting economic inflection point, we would expect any associated leadership change to be more durable.

As highlighted in our previous letter, we note a broadening out of the perceived beneficiaries of the AI deployment, which collectively represent an increasing weight within the international indices. More recently, as AI enthusiasm has spread from the “GPU/data center arms race” to the notion of “edge AI,” or AI on server/PC/handset, many more individual companies can be seen as at least cyclical beneficiaries, as edge AI would necessitate a significant and long-deferred replacement cycle for such edge devices. As the second quarter progressed, updates from Apple, Taiwan Semiconductor, Dell, Lenovo and others drove growing interest in the many companies in the hardware/handset ecosystem – a substantial portion of which reside in international jurisdictions, in addition to the well-recognized semiconductor and high-bandwidth memory leaders. This nuance, we believe, has potential implications going forward for the traditional AI/Magnificent Seven plays; while the long-term opportunity appears compelling (and consensus), given current valuations, any pause in the momentum of the GPU arms race in the transition from training to inference, or from data center capex to the rollout of software-driven AI applications at scale, would likely spark a major inflection in market leadership away from U.S. equities. In other words, it is possible or even likely that it will take time to utilize the vast expansion in AI processing capacity that is building up at the hyperscale/data center level in the pursuit of the productivity promise of AI, notwithstanding a potentially imminent global handset/server/PC upgrade cycle. In such a scenario, we would expect to see a notable change in Magnificent Seven/U.S. equity dominance with improved relative performance for non-U.S. equities.

A word on recent elections and political catalysts throughout the international markets: during the quarter, we witnessed surprising outcomes in closely watched elections in Europe/France, Mexico, and India, while in Brazil, President Lula offered disturbing rhetoric regarding fiscal balance and BCB independence. We see the recent and final outcome in France in July as tempering fears of extremism, while although closer than anticipated, the election result in India and ensuing government/ministerial makeup is supportive of a healthy and quite positive status quo. Though political developments in various jurisdictions appear more populist and potentially adverse to the interests of capital owners, extreme ideology and political rhetoric is notoriously over-discounted on the surface, while in the intermediate term, political and market “breakers” tend to materially dilute the feared impact, allowing elevated risk-premium to recede. While the process can be frustrating and volatile, we suspect this pattern is likely to prevail, and we believe patience is warranted and likely to be rewarded. We look forward to our next communication.

Thank you for investing in the Baron International Growth Fund.

Sincerely,