Baron Opportunity Fund | Q1 2024

During the first quarter, Baron Opportunity Fund® (the Fund) rose 15.33% (Institutional Shares), outperforming the broader market, including the Russell 3000 Growth Index (the Benchmark), which gained 11.23%, and the S&P 500 Index, which advanced 10.56%.

U.S. equities continued their strong run to begin the year, with all major market indexes achieving new all-time highs on multiple occasions during the first quarter. The S&P 500 Index finished the quarter at a record high, while the NASDAQ Composite peaked on March 22 before fading a bit to close the quarter. The rally was supported by robust economic data and relatively strong corporate earnings, which added fuel to investor hopes for a soft landing. Investors appeared unfazed by concerns about persistent inflation, the timing of Federal Reserve (Fed) rate cuts, record consumer and government debt, and potential government shutdowns. The focus remained on the Magnificent Seven given the group’s dominance in recent quarters and continued investor excitement surrounding their ability to gain from widespread adoption of AI.

Fund performance was driven by our semiconductor, consumer internet, digital advertising, cloud computing, and cybersecurity investments capitalizing on the AI inflection, including NVIDIA Corporation, Microsoft Corporation, Meta Platforms, Inc., Amazon.com, Inc., Advanced Micro Devices, Inc., Astera Labs, Inc., ASML Holding N.V., CrowdStrike Holdings, Inc., and The Trade Desk, as well as health care names Viking Therapeutics, Inc. (see discussion below regarding robust clinical data on its GLP-1/GIP combination weight loss medication) and Shockwave Medical, Inc., which agreed to be acquired by Johnson & Johnson in early April, but whose stock rose on reports of the deal. The primary detractors from Fund performance were our electric vehicle (EV) investments, including EV pioneer Tesla, Inc., fast follower Rivian Automotive, Inc., and automotive semiconductor supplier indie Semiconductor, Inc. As we address below, while our long-term conviction regarding the interconnected triangle of disruptions impacting the global transportation industry – electric battery propulsion, autonomous driving, and shared mobility – has not changed, we acknowledge the weak current trends in EV purchases and heightened uncertainty surrounding the leading EV vendors. Because of this uncertainty, during the quarter we decreased our exposure to the EV theme and reduced our Tesla portfolio weight. At bottom, I believe the portfolio’s strong quarterly performance, despite Tesla’s sharp decline, speaks to the power of diversifying across several industries and a multitude of innovation-driven secular growth themes.

As of this writing, the market has pulled back to start April, due to heightened concerns regarding inflation, interest rates, and the pace of anticipated Fed rate cuts, as well as fears regarding the potential for a wider conflict in the Middle East on growing tensions and military clashes between Israel and Iran. While the current retreat was triggered by macroeconomic and geopolitical anxieties, rather than any credible evidence prompting fundamental longer-term doubts, investors and traders have reduced exposure to recent AI winners, particularly across the semiconductor industry. To me, this feels like what’s commonly called a mid-cycle correction, as many of these stocks are just weeks away from all-time highs and a slew of exciting product announcements, and all our research reinforces our view that AI is the most significant advancement impacting our now-digital world since the advent of the internet itself. I believe the more accurate construction of the current setting is that we find ourselves just past the first upward inflection in a generational S-curve for AI adoption and economic impact. Before long, every digital interaction – whether with business software, consumer apps, robots, cars, etc. – will be AI powered. AI will make humans more productive doing their jobs, developing drugs, designing products, writing software, being creative, and more. I would encourage our investors and readers of this letter to stick with their long-term conviction and not get spooked by or try to time this short-term volatility⁵, and to consider increasing their investments across their favorite secular themes and durable-growth investment vehicles on this correction.

I will quickly reiterate some of the points made in my last letter. The secular trends we emphasize in the Fund – listed in the table just below – are real and intact. Other than the current pause in EV adoption – which we believe is primarily due to product launch gaps in Western markets – they are neither stopping nor slowing down. AI is real. Cloud computing is real. Digital media, entertainment, commerce are real. Health care advancements are real. Semiconductors powering every single digital or electronic device are real. The history of investing, no matter what era, has proven the wisdom of owning the dominant trends, owning the big winners. The market has historically underestimated the long-term growth potential for top companies in new and innovative verticals. Over the last four or five decades, as technology innovations forged disruptive trends and spurred the (post-industrial) computing revolution, the best investments are those companies, now household names, that grew faster for longer than most experts initially predicted. The market misjudged the growth that would be achieved by such disruptive developments as Microsoft’s Windows operating system, Google’s internet search engine, Amazon’s e-commerce platform, Apple’s iPhone, and Meta’s Facebook and Instagram social apps. These companies always looked expensive when valued based on then-current Street estimates; but they weren’t. They yielded great returns not because they were awarded premium multiples but because they crushed expectations on revenues, earnings, and cash flow. We believe the same thing will drive returns for the innovators and industry trends that populate our portfolio.

Below is a partial list of the secular megatrends we focus on:

• Cloud computing
• Software-as-a-service (SaaS)
• AI
• Mobile
• Semiconductors
• Digital media/entertainment
• Targeted digital advertising
• E-commerce
• Genetic medicine/genomics
• Minimally invasive surgical procedures
• Cybersecurity
• EVs/autonomous driving
• Electronic payments
• Robotics

We continue to run a high-conviction portfolio with an emphasis on the secular trends cited and listed. Among others, during the first quarter we initiated or added to the following positions:

• Semiconductors: Broadcom Inc., Taiwan Semiconductor Manufacturing Company Limited, and Astera Labs, Inc.
• Digital Media: Spotify Technology S.A.
• Biotechnology/Pharmaceuticals: Arcellx, Inc. and Legend Biotech Corporation
• Autonomous Driving: Mobileye Global Inc.
• Real Estate Tech: CoStar Group, Inc.

NVIDIA Corporation sells semiconductors, systems, and software for accelerated computing, gaming, and generative AI. NVIDIA’s stock rose in the first quarter, driven by continued strong demand for its accelerated computing chips that stand at the epicenter of the generative AI revolution. NVIDIA closed 2023 with unprecedented revenue growth at massive scale, with a fourth quarter revenue run rate just shy of $90 billion, growing over 3.5 times year-over-year with operating margins of 67%. Importantly, NVIDIA disclosed that 40% of its data center business for fiscal year 2024 was from inferencing (which can be thought of as use of an AI application) and hinted that the fourth quarter level was likely even higher. This was received quite positively by investors as inferencing is viewed to be more sustainable than training, as well as evidence that NVIDIA’s customers are earning returns on their AI investments. Moreover, at its recent GTC developer conference, NVIDIA further cemented its lead as the AI platform company, announcing a number of new innovations, including its next-generation Blackwell AI superchip; significant die-to-die and chip-to-chip bandwidth improvements with its 5^th generation NVLink interconnection technology; it’s GB200 NVL72 computing system, where taking advantage of NVLink and software advancements, 72 Blackwell chips can act as one single massive GPU, yielding up to a 30 times improvement in inference performance compared to its Hopper generation of chips; and a new family of AI software called NVIDIA Inference Microservices, or NIMS, which make it easier for companies to build and scale generative AI workloads.

Viking Therapeutics, Inc. develops metabolic disease medicines with a focus on diabetes/obesity and MASH (metabolic steatohepatitis, i.e., fatty liver). Viking’s lead asset is VK2735, an injectable and oral version of a GLP-1/GIP combination weight loss medication that directly competes with well-known Eli Lilly products called Mounjaro and Zepbound. Viking’s second asset competes with Madrigal Pharmaceutical’s just approved MASH asset. Shares rose in late February when Viking announced positive top-line results from its Phase 2 clinical trial of VK2735. Both of Viking’s main assets appear to be more efficacious than their competitors in two exceptionally large revenue end markets. After a couple of decades of working on treatments for oncology and rare diseases, the pharmaceutical industry is shifting back to lower-priced/higher-volume primary care medications led by treatments for obesity, and Viking has the potential to be a notable player in this space. To size the potential obesity market, if 50 million people (one-third of the current U.S. addressable market) are treated at $2,000 per year, that would result in a $100 billion opportunity.

Microsoft Corporation is the world’s largest software and cloud computing company. Microsoft was traditionally known for its Windows and Office products, but over the last five years, it has built a $135 billion run-rate cloud business, including its Azure cloud infrastructure service and its Office 365 and Dynamics 365 cloud-delivered applications. The stock contributed to performance because of continued strong operating results and investor enthusiasm regarding Microsoft’s leadership across the secular megatrends of AI and cloud computing. In Morgan Stanley’s first quarter 2024 CIO Survey, we continued to see the strength and attractiveness of Microsoft’s product portfolio among its customer set: (1) Microsoft is the “clear beneficiary” that is “poised to gain the largest incremental share of the GenAI budget” on both a one-year and three-year basis; (2) Microsoft remains the leading vendor “expected to gain an incremental percentage of IT budgets in 2024 and over the next three years” as “workloads shift to the cloud;” and (3) Microsoft Azure ranks as the preferred cloud vendor today and is expected to extend its lead over the next three years for both platform-as-a-service and infrastructure-as-a-service use cases. For the December quarter, Microsoft again reported better-than-expected financial results, highlighted by Microsoft Cloud growing 23% in constant currency and Azure revenue growing 28% in constant currency, flat sequentially from the September quarter, bolstered by ramping AI revenue contributing six points of growth (vs. guidance of increasing contribution and three points last quarter). March quarter guidance came in-line with consensus, but the company provided higher guidance for the two most important segments, Productivity and Business Processes and Intelligent Cloud, on the back of continued strong trends across Microsoft Cloud, Azure, and AI. We remain confident that Microsoft is one of the best-positioned companies across the overlapping software, cloud computing, and AI landscapes, with its vertically integrated technology stack and broad sales distribution. We believe Microsoft will continue taking share across its business, driving durable, long-term, double-digit growth and best-in-class profitability.

Tesla, Inc. designs, manufactures, and sells EVs, autonomous driving software and charging services, and solar and energy storage products. Despite commencing deliveries of the highly anticipated Cybertruck, its first pickup truck that boasts innovative technologies and a space-age look and feel, the stock underperformed as Tesla’s core automotive segment remained under pressure. In the first quarter, Tesla delivered only 386,000 units, down 8.5% year-over-year, well below expectations of 420,000 to 440,000 deliveries. Near-term challenges stem from a complex mix of macroeconomic and interest rate headwinds (higher rates increase the monthly cost of car ownership for most consumers), temporary factory closures, escalating competition in China, and Tesla’s price adjustments in 2023. Like many investors, we viewed recent trends as more of a temporary perfect storm resulting from the fusion of these factors and a product launch gap, which we expected to close when Tesla launched is lower-priced, next-gen vehicle, sometimes referred to as Model 2, opening large mass-market price segments to the company. However, a couple of weeks ago, Reuters reported that Tesla was planning to cancel the Model 2 vehicle and would instead prioritize its robotaxi operations. CEO Elon Musk denied the accuracy of this report, but then announced that Tesla would hold a robotaxi unveiling on August 8. These events increased uncertainty regarding the company’s near-term growth prospects, its strategic priorities, its product-launch cadence, its capital spending needs, and short- and mid-term earnings dynamics. We continue to anticipate that significant growth opportunities will mature in the coming years, either with: (1) the introduction of a lower-priced vehicle, which should enable Tesla to significantly increase its delivery volumes; and/or (2) rapid advancements in commercialization of autonomous driving technology, which should yield new open-ended revenue opportunities and materially improve profitability and returns on invested capital. Balancing our confidence in Tesla’s long-term prospects and technological leadership against the current uncertainties, we decided to trim our position to a level we deemed more appropriate under the current circumstances as we seek more clarity on these issues.

Shares of Rivian Automotive, Inc., a U.S.-based EV manufacturer, detracted from performance. Despite substantial improvements in production and delivery volumes in 2023 as well as improved unit economics, Rivian’s business remains constrained by its limited scale, negative gross margins, and elevated cash outflows. Additionally, Rivian expects to temporarily shut down its production facilities for upgrades, impeding anticipated production growth in 2024. Compounding these challenges is the potential for demand constraints, which may not keep pace with production. Nevertheless, the recent unveiling of Rivian’s mass-market products, the R2 and R3, garnered enthusiastic responses, as evidenced by over 68,000 pre-orders within the first 20 hours post-launch, but the company does not expect to begin production of the R2 models until 2026. In a strategic move, management opted to produce the R2 in Rivian’s existing facility, deferring the construction of a new factory. This decision should help reduce mid-term capital expenditure obligations while ensuring higher utilization of the current production facility in Normal, IL.

Indie Semiconductor, Inc. is a fabless designer, developer, and marketer of automotive semiconductors for advanced driver assistance systems and connected car, user experience, and electrification applications. Shares fell during the quarter as the company guided revenue growth for 2024 below Street expectations as its customers digest excess inventory in the early parts of the year. While indie conservatively still expects to be growing at a healthy 25%-plus year-over-year growth rate, well above the industry and peers, investors are concerned the inventory digestion could last longer into 2024 than initially expected despite management confidence in a strong second half of 2024 driven by over 20 new projects layering in through the year across various automakers and applications. Despite the near-term softening, we believe indie remains well positioned for growth over the medium and long term supported by its $6.3 billion design win backlog (versus $220 million in 2023 revenue), and its large program ramps in 2025, including a marquee radar-related rollout, the biggest program in the company’s history. We believe indie can continue to significantly outpace the broader industry and approach $1 billion in revenue by 2028 with premium margins, all supported by its contracted visibility.

We invest in secular growth and innovative businesses across all market capitalizations, with the bulk of the portfolio landing in the large-cap zone. Morningstar categorizes the Fund as U.S. Large Growth. As of the end of the first quarter, the largest market-cap holding in the Fund was $3.1 trillion and the smallest was $1.3 billion. The median market cap of the Fund was $41.0 billion, and the weighted average market cap was $986.5 billion.

To end the quarter, the Fund had $1.3 billion in net assets. We had investments in 47 unique companies. The Fund’s top 10 positions accounted for 54.0% of net assets.

Fund flows were modestly positive for the quarter, which we consider satisfactory given that actively managed peers in the Large Growth category have experienced meaningful outflows in recent months.

During the quarter we initiated a position in Broadcom Inc., a global technology leader that designs, develops, and supplies a broad range of semiconductor and infrastructure software solutions. Broadcom’s semiconductor-solutions business focuses on complex digital, mixed-signal, and analog products across a variety of end-markets, while its software products help customers plan, develop, automate, manage, and secure applications across various platforms. Historically, Broadcom’s semiconductor business has been a market leading franchise with high margins and market-level growth, but the emergence of AI-related demand has spurred stronger growth across its portfolio. Broadcom’s AI-related revenue has grown from less than 5% of its semiconductor business to an expected 35% in its fiscal 2024, as its industry-leading Ethernet switch silicon business and, more importantly, its custom accelerated compute solutions, primarily Google’s tensor processing unit but with two additional hyperscale customers ramping as well, have grown significantly. Broadcom partners with its consumer-internet hyperscale customers to specifically tailor chip solutions to power their stable, large-scale workloads, offering significant savings on both upfront capex and energy consumption. In its software business, Broadcom recently closed the acquisition of VMware and is implementing its well-honed strategy of removing excess costs to drive incremental cash flow and significant earnings accretion, but with VMware it is also investing in the product and upgrading customers from license to subscription models for the complete offering, creating a significant growth opportunity in the coming years. We believe the market underestimates both the growth opportunity from its custom accelerator business and the accretion and growth it will drive from the VMware acquisition. Combined, we believe these tailwinds will lead to strong earnings growth and a sustainable re-rating in the stock’s valuation. The company will continue to use its significant free cash flow to pay a growing dividend and buy back shares over time.

We reestablished a position in Spotify Technology S.A., a leading global digital music service, offering on-demand audio streaming through paid premium subscriptions and an ad-supported free option. Spotify was among the originators of paid streaming music after the downloads/Napster era, with the Spotify App launching broadly in the early 2010s. Since then, streaming music has grown at an over 20% annualized pace, and Spotify has been the leading streaming music service globally (and in the U.S.) with over 600 million total monthly active users. Spotify has a strong user experience and has developed its product considerably over the last decade, especially with algorithmic recommendations and expansion into categories like podcasting. While we have monitored Spotify for some time due to its product leadership and large market potential, we believe the last few months have represented a meaningful positive inflection point for the company. Firstly, Spotify continues to prove that its market is far from completely mature – subscriber net adds accelerated in 2023, even as the product has been well known for years, thanks to targeted marketing in newer countries and the strengthening product value. Next, Spotify’s gross margin profile continues to improve. In the past, we had some caution around Spotify’s position as a lower gross-margin technology business, due to its reliance on the catalogs from the Big 3 music labels. Now, there is a clearer medium-term path to 30% gross margins with the rise of Spotify’s artist promotions marketplace, continued adoption of its margin-accretive advertising business, podcasting becoming more profitable, and audiobooks with a pathway to becoming accretive to gross margins. Beyond gross margins, Spotify has recently become much more serious about operating discipline, with 2024 expected to be its first meaningfully profitable year after operating losses in 2021 and 2022. Next, Spotify demonstrated its ability to achieve price increases while seeing minimal churn, demonstrating the pricing power in their product and the broader streaming music industry. Finally, Spotify has continued to innovate with its product roadmap, with the introduction of audiobooks and features like AI DJ, differentiating it from other music streaming providers. Going forward, we believe Spotify has more room to grow in the areas we listed above. We continue to view Spotify as a long-term winner in music streaming with the potential to reach over 1 billion monthly active users, as Spotify continues to increase its global market share and music listening habits mature internationally. We believe improving the value proposition for subscribers through audiobooks and other features will continue to differentiate the product, and that the cadence of price hikes will increase (as suggested by recent news reports). On profitability, we expect meaningful gross margin and operating expansion in the next few years as Spotify’s current efforts begin to be reflected in the numbers. Over time, we believe Spotify’s increasing global share will give it further leverage in negotiations with its partners.

During the first quarter, we initiated a position in Taiwan Semiconductor Manufacturing Company Limited, the world’s leading semiconductor foundry. Morris Chang founded Taiwan Semi in 1987 as the world’s first dedicated semiconductor manufacturer, called a foundry. Until then, semiconductor chips were both designed and manufactured by the same company, which Intel still does today. Taiwan Semi disrupted the industry by positioning itself purely as a contract manufacturer. This new business model proved to be successful and paved the way for the emergence of fabless semiconductor innovators, such as NVIDIA and AMD, which only focus on designing chips while outsourcing the manufacturing. Though many other foundry competitors have emerged over the last few decades, Taiwan Semi has outcompeted them all with superior technological execution and operating efficiency. Today, Taiwan Semi controls approximately 60% of the foundry market and has a near monopoly in manufacturing the world’s most advanced chips. Taiwan Semi enjoys high barriers to entry, given the increasing cost and technological complexity of semiconductor manufacturing and its long-term, sticky customer relationships. We believe Taiwan Semi will sustain strong double-digit earnings growth for years to come, with rapidly growing demand for advanced chips for AI and high-performance computing, and continued market share gains driven by its superior technology, reliability, and customer service. We expect Taiwan Semi to continue spinning the virtuous cycle of its scale advantage: higher market share yields higher profits, which funds more research and development and higher capital spending, which enables further technological differentiation and increased capacity, resulting in more market share, and so on. We are aware of the geopolitical risks concerning China but consider the likelihood of a military conflict over Taiwan to be a low-risk tail event.

We sold the remainder of our Alphabet Inc. position because, as we wrote in prior letters, we believe the advent and adoption of AI-based services present a hard-to-measure risk to Google’s virtual search monopoly.

We slightly trimmed our investment in NVIDIA Corporation, but it remains our second largest holding and our largest overweight position versus the Benchmark. We spread this capital around several of our other semiconductor investments, including Broadcom and others shown in the Review and Outlook section above.

We also exited our investments in Endava plc and Dynatrace, Inc. during the period.

I remain confident in and committed to the strategy of the Fund: durable growth based on powerful, long-term, innovation-driven secular growth trends. We continue to believe that non-cyclical, durable, and resilient growth should be part of investors’ portfolios and that our strategy will deliver solid long-term returns for our shareholders.

Sincerely,