Baron Partners Fund | Q3 2024

Baron Partners Fund® (the Fund) performed well in the third quarter, gaining 13.94% (Institutional Shares). This result significantly exceeded its benchmark, the Russell Midcap Growth Index (the Index), and the large-cap dominated Russell 3000 Index (the Market Index), which gained 6.54% and 6.23%, respectively.

Year to date, the Fund is now in positive territory, gaining 4.74%. While this return is reasonable in most nine-month periods, it does meaningfully trail both the Index and Market Index’s returns.

The Fund’s performance has stagnated over the prior three years, with an average annual return of 1.14%. However, the longer-term results remain excellent, with the Fund ranking in either the first or second percentile for its Morningstar category in each of the 5-, 10-, and 15-year periods.* Since its conversion to a mutual fund in 2003, the Fund’s annualized return of 16.54% is the top in its category and exceeds its Index’s return by 5.43%.

While we are very pleased with these long-term results, we are disappointed, although not alarmed, by the recent 3-year performance. The low turnover strategy implemented by the Fund has previously resulted in similar stretches. However, we have not only endured analogous periods throughout the Fund’s history, but also have typically emerged with strong absolute and relative performance in subsequent years. Although we offer no guarantee of continued success, we believe this trend will continue.

While we present the Fund’s absolute and relative returns over the SEC mandated periods, we believe it is also important to discuss how the Fund performed over the course of different market environments. The prior nearly two years have been exceedingly difficult for our style of investing, as long-term owners of quality growth businesses. This strategy typically holds a balanced portfolio of distinct types of quality growth businesses. Many investments were purchased when they were mid-cap companies that we believed would have the potential to become significantly larger over time. The U.S. economy has been challenged since the start of 2023. There have been high interest rates, high inflation, global unrest, and military conflicts. That macro backdrop had been harsh for the businesses held in the Fund. Customers at many service businesses had retreated causing revenue growth to moderate. Suppliers had increased prices causing margins to be pressured. Higher interest rates had increased financing costs and raised the discount on future earnings. Investors gravitated towards mega-cap companies with AI opportunities. These businesses are largely not held in the Fund.

We believe these phenomena are temporary and we are beginning to see signs of a more typical macro environment that is favorable towards our investment style. Inflation appears to have moderated. Interest rates were cut by 50 basis points, and the U.S. Federal Reserve Chair has indicated steady cuts will persist. The soft landing the government is attempting to orchestrate may just occur.

As a result, we believe that company fundamentals and opportunities will again drive stock prices rather than macro concerns and a singular mega trend. In the current period, we had large gains from a diverse set of companies. And only select companies declined in value due to company- specific results. Out of the Fund’s 21 holdings, only 2 public companies (The Charles Schwab Corporation and Birkenstock Holding plc) declined by more than 5%. On the other hand, 10 companies rose by more than 10% in the quarter. And this group of contributors excludes Space Exploration Technologies Corp. (SpaceX), the Fund’s second largest holding. SpaceX did not conduct a stock transaction in the current quarter and therefore its valuation remained constant. However, the company has continued to execute and grown the number of launches, satellites, and subscribers and made improvements on reusability.

The Fund’s largest holding, Tesla, Inc., appreciated 32% in the quarter. Investors are again looking at the company’s potential rather than the near- term impact of the current macro environment. Investors have become comfortable that the previous periods’ vehicle delivery shortfalls were the result of affordability (financing related) rather than desirability. Purchases improved in the quarter as the Chinese economy improved. Investors have increased confidence that new model introductions next year will again spur a meaningful increase in units. We do not believe other traditional original equipment manufacturers (that have historically made only internal combustion engines) can compete with the functionality and price of the upcoming models. Additionally, this dynamic company has remarkably improved on new services and products related to autonomous driving, robotics, and energy storage. We remain very optimistic about the future for Tesla.

But as mentioned, it was not only the Disruptive Growth companies that contributed to performance. The Fund had significant gains amongst many of its Financials businesses. MSCI Inc., Arch Capital Group Ltd., and FactSet Research Systems Inc. all had double-digit gains in the quarter. The largest gain in this group came from the financial technology company MSCI, which increased more than 21%. After a restrictive macro environment, the company is beginning to see its products resonate with prospective clients. Pent-up demand for new products has led to increased new contracts and lower cancellations.

The two companies that moderately stumbled, Schwab and Birkenstock, are going through a transition that we believe will be successful. We believe Schwab had been too aggressive during COVID-19’s (COVID) extraordinarily low-rate environment. Believing the rapid increase in client cash during the pandemic would be retained, the company purchased long-dated bonds. The subsequent swift rise in rates and clients seeking higher yielding alternatives caused Schwab to increase its short-term borrowings to meet client needs. Net interest margin was pressured. Today, the company is unwinding these borrowings. It has been a slower process than anticipated with clients having lower idle cash levels. But organic asset growth has continued, and we believe the net interest margin will eventually rebound to more normalized levels. The timing, however, may be slightly extended beyond previously stated expectations.

Birkenstock continues to have very strong demand for its footwear products. Units sold and the average retail selling price have both increased. However, revenue slightly missed investors’ expectations. Consumers have shifted their shopping preference to physical locations rather than online. Birkenstock has a minimal owned store presence in the U.S., which is its largest market, and relies heavily on wholesale partners. The increase in wholesale distribution resulted in lower-than-anticipated gross profit. However, the company is making inroads in opening new stores in the U.S. that have historically had high returns on investment. We are pleased with the high demand and ability to take market share in the wholesale channel. And we believe more stores will meaningfully improve profitability in the future.

We remain pleased with the portfolio’s composition and the execution of the businesses held. A more normalized macro environment, in our opinion, should be beneficial for the Fund.

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.

Tesla, Inc. designs, manufactures, and sells fully electric vehicles, related software and components, and solar and energy storage products. The stock contributed because of accelerated growth in the energy unit, growing expectations that Tesla will soon launch new vehicle models, and increasing investor confidence in its potentially lucrative AI initiatives. Despite macroeconomic challenges, delivery data in major markets like China showed improvement in the quarter, while declining interest rates could enhance demand and profitability in the coming quarters. Tesla has also launched operations at its advanced computing center in Texas, rolled out improved version of its software-enhanced driving solution, and announced plans to provide an important update on its AI projects in early October. These investments and product releases are enhancing Tesla’s leadership position in real world AI and investor confidence that Tesla will benefit from these large and attractive growth opportunities.

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 property and casualty (P&C) insurance software vendor Guidewire Software, Inc. advanced after subscription gross margins improved by more than 1,000 basis points in its most recently reported quarter. After a multi-year transition period, we believe the company’s cloud transition is substantially over. We believe cloud will be the sole path forward, with annual recurring revenue (ARR) benefiting from new customer wins and migration of the existing customer base to InsuranceSuite Cloud. We also expect Guidewire to shift R&D resources to product development from infrastructure investment, which should help drive cross-sales into its sticky installed base and potentially accelerate ARR over time. We believe 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 Charles Schwab Corporation detracted from performance following a weak second quarter update. The broker-dealer generates significant earnings from net interest income on idle client cash. Clients have been moving cash into higher-yielding money market funds, forcing Schwab to utilize external sources of funding to support its balance sheet. Although this funding, which is more costly than other liabilities on the balance sheet, is intended to be temporary, the company made little progress in reducing its reliance on it, which disappointed the market. While the timing of earnings growth has been pushed out, we think Schwab will eventually pay down these funds and enter an earnings growth phase as its normal earnings algorithm comes to the fore.

Birkenstock Holding plc is a global footwear brand that has been making its distinctive style of sandals since 1774. Shares fell on a slight miss in quarterly revenue due to a demand mix shift away from the direct-to-consumer channel, which grew only 14%, and into the wholesale channel, which expanded 23%. The change was the result of a shift in consumer preference toward in-person shopping, prompting them to purchase shoes from Birkenstock’s wholesale partners due to the company’s limited retail presence of just 64 stores. We remain investors. Broad-based quarterly revenue growth of 19% pointed to continued strong demand across different product lines and geographies with high levels of full price sell through, as well as market share gains. We see a long growth runway for Birkenstock, supported by retail, geographic, and category expansion.

Global ski resort company Vail Resorts, Inc. detracted from performance, as a result of 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.

We seek to invest in businesses we believe can double in value within five or six years. We invest for the long term in a focused portfolio of appropriately capitalized, well-managed growth businesses at attractive prices across market capitalizations. We attempt to create a portfolio of no more than 30 securities diversified by GICS sectors, but with the top 10 positions representing a significant portion of net assets. These businesses are identified by our analysts and portfolio managers using our proprietary research. We think these well-managed businesses have sustainable competitive advantages and strong, long-term growth opportunities. We use leverage to enhance returns, which increases the Fund’s volatility.

As of September 30, 2024, we held 21 investments. The median market capitalization of these growth companies was $18.5 billion. The top 10 positions represented 88.6% of total investments. Leverage was 15.2%.

The long-term absolute and relative performance of the Fund has been very good. The Fund has returned 16.54% annualized since conversion to a mutual fund on April 30, 2003, exceeding the Index by 5.43% per year.

The Fund’s performance has also exceeded the Index over the prior 5-, 10-, and 15-year periods. In addition to viewing the Fund’s returns over these various trailing annual periods, we believe it is helpful to understand how the Fund has performed over economic cycles.

The Fund has appreciated considerably in good times…

There have been two distinct periods over the life of the Fund with significant economic growth. The nearly 8-year period from the Fund’s inception through the Internet Bubble (1/31/1992 to 12/31/1999) and the more recent 11-year period Post-Great Recession to the start of the COVID Pandemic (12/31/2008 to 12/31/2019). During both periods, the Index had strong returns; however, the Fund’s returns were even better. The Fund’s annualized return during the most recent robust economic period was 17.44% compared to the Index’s 16.84%. The Market Index had an annual return of 14.70% during that time.

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 retained value in challenging times…

We believe what especially sets the Fund apart from other growth funds is its historic ability to outperform in more challenging economic periods. The nine-year period from the Internet Bubble collapse through the Great Recession (12/31/1999 to 12/31/2008) saw lower returns for the Fund. It had annualized returns of 1.54%. However, the Index declined substantially. A $10,000 hypothetical investment in the Fund at the start of this period would have been worth $11,479 after those nine years. A $10,000 hypothetical investment in a fund designed to track the Index would be worth only $6,488, more than a 35% cumulative decline. The Fund preserved (and slightly grew) capital during this difficult economic time because its investments in a diverse set of high-quality growth businesses could weather the environment and enhance their competitive positioning.

The COVID pandemic and its lingering macroeconomic issues have caused excessive market volatility. Over the course of three years, there were two sizable market corrections during which most major indexes fell more than 25%. But the Fund has performed admirably in both protecting and growing clients’ capital. During the COVID pandemic and its aftermath (12/31/2019 to 12/31/2022), the Fund had an annualized return of 23.65%. The Index’s annualized return was significantly lower at only 3.85%.

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.

Since the COVID pandemic and subsequent market downturn ended, the Fund has performed well on an absolute basis. However, its relative returns are more mixed. While the Fund has exceeded the Index’s returns, it has trailed the Market Index. As discussed in prior sections of this letter, we believe the Fund’s holdings are poised to perform well again on both an absolute and relative basis. Since December 31, 2022, the Fund has an annualized return of 26.20% compared to the Index’s annualized return of 22.24%.

Over the longer term, positive returns in difficult environments and better than market returns in good times have been rewarding for clients. A $10,000 hypothetical investment at the inception of the Fund on January 31, 1992, would have been worth $949,135 on September 30, 2024. That same $10,000 hypothetical investment in a fund designed to track the Index would now be worth $230,564, only approximately 24% of what it would have been worth if invested in the Fund.

Thank you for joining us as fellow shareholders in Baron Partners Fund. We continue to work hard to justify your confidence and trust in our stewardship of your hard-earned savings. We remain dedicated to giving you the information we would want if our roles were reversed. We hope this letter enables you to make an informed decision about whether this Fund remains an appropriate investment.

Respectfully,