Baron Small Cap Fund | Q1 2025

Dear Baron Small Cap Fund Shareholder:

Baron Small Cap Fund^® (the Fund) was down 9.07% (Institutional Shares) in the first quarter, outperforming the Russell 2000 Growth Index (the Index) by 205 basis points. Small-cap stocks continued to meaningfully underperform larger market caps, so the Fund lagged the Russell 3000 Index, which fell 4.72% in the quarter.

Though our relative performance was good, it was a tough and unsatisfying quarter because we sustained losses on an absolute basis.

As shown in the charts below, the Fund has a strong long-term record, which compares favorably with the Index for almost all periods.

The quarter started off strong. The market rallied on optimism that the economic environment was improving because of the pro-business stance of the Trump administration (lower taxes, less regulation), moderating inflation expectations, and renewed focus on fiscal responsibility including efforts to reduce government spending and enhance efficiency. We had encouraging conversations with the executives who run the businesses of the companies in which we invest. One CEO proclaimed the “optimism is demonstrative,” as he explained that his clients were decisively moving forward with growth initiatives that had been on hold. We believed that growth was going to accelerate, that our companies would do better, and their stocks were cheap and had great upside, considering this outlook.

It didn't play out that way. The introduction of a Chinese AI app called DeepSeek shook up the picture for the rollout of AI infrastructure. Shares of the market leading tech stocks benefiting from the AI boom fell significantly. Corporate earnings results for the December quarter were uninspiring, and any sign of weakness caused major stock declines in a very skittish market. The Federal Reserve (the Fed) paused its consideration of rate cuts. And later in the quarter, Trump started to roll out his tariff plan. At first, there were targeted tariffs focused on certain industries and traditional U.S. trading partners. The levels were viewed as draconian, and the approach was seen as aggressive, unpredictable, and inflationary. The outlook for growth went from positive to negative, hurting growth stocks and small caps the most.

The Fund’s outperformance was due to stock selection (+4% effect) and tailwinds from style biases, notably lower exposure to the weak performing Beta factor and over-exposure to top performing Size factor (larger caps).

From a sector perspective, strong stock selection in Information Technology (IT), Consumer Discretionary, and Financials was responsible for most of the relative gains in the period. Strength in IT came mostly from insurance software vendor Guidewire Software, Inc. Bright Horizons Family Solutions, Inc., a corporate daycare provider, and The Cheesecake Factory, Inc., a multi-chain restaurant operator, led the way in the Consumer Discretionary sector. Within Financials, specialty insurer Kinsale Capital Group, Inc. and insurance broker The Baldwin Insurance Group, Inc. were up nicely in a down tape.

On the flip side, our underexposure to Health Care, namely strong performing pharmaceutical stocks, along with declines from food and animal safety products provider Neogen Corp. contributed to relative weakness in the sector. The Trade Desk, an internet advertising demand-side platform, fell sharply, negatively impacting performance in Communication Services.

The Fund had a weighted average beta of 0.78 entering the period, well below the Index. Historically, our lower beta, along with our tilt towards ‘quality’ growth stocks, are reasons why the Fund tends to outperform the Index in down markets, and that is what played out in the first quarter.

Shares of insurance broker The Baldwin Insurance Group, Inc. rebounded from weakness in the prior quarter due to favorable operating trends and the relative stability of insurance stocks in a risk-off market. In the most recent quarter, the company reported strong results with 16% revenue growth, 38% EBITDA growth, and net leverage moderating to 4.1x. For 2025, management expects continued double-digit organic growth and margin expansion, despite higher costs related to the California wildfires and the replacement of an insurance carrier for its homeowner’s insurance business. Management reaffirmed the goal of achieving $3 billion of revenue and 30% EBITDA margins within five years, implying a near-tripling of earnings. Even coming close to those aspirations would lead to great stock performance from current levels.

Shares of property and casualty (P&C) insurance software vendor Guidewire Software, Inc. contributed to performance in the quarter. We believe Guidewire's cloud transition is substantially over, and cloud will be the sole path forward, with annual recurring revenue (ARR) benefiting from new customer wins and migrations of the existing customer base to InsuranceSuite Cloud. We are encouraged by Guidewire’s subscription-based gross margin expansion, which improved by more than 1,000 basis points in its most recently reported quarter. 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%.

Specialty insurer Kinsale Capital Group, Inc. contributed to performance due to continued growth in the company’s end market and the relative stability of insurance stocks in a risk-off market. The company reported better-than-expected earnings in the most recent quarter, despite slowing premium growth. Earnings per share grew 19% and return on equity remained elevated at 30% due to strong underwriting margins and higher investment income. Excess & Surplus insurance market conditions remain favorable with recent data indicating continued double-digit growth due to share gains from the Standard market. We believe Kinsale is well managed and has a long runway for growth in an attractive segment of the insurance market.

Other holdings that rose over 10% in a difficult quarter but added less to the overall returns were Bright Horizons Family Solutions, Inc., Kratos Defense & Security Solutions, Inc., Waste Connections, Inc., and recent addition Karman Holdings Inc.

Shares of Vertiv Holdings Co, a provider of power, cooling, and infrastructure solutions for data centers, sold off sharply during the quarter after the introduction of the surprisingly efficient DeepSeek AI app raised investor concerns that there would be less need for capital expenditures in the data center industry than projected and, accordingly, would slow Vertiv's growth rate. In addition, after strong outperformance in 2024, investor concerns that orders could slow in upcoming quarters, as customers go through a digestion period of related spend, caused a revaluation of the entire space. We believe Vertiv maintains its competitive advantage and will benefit from increased capital spend and the complex roadmap related to new chip introductions, which will run hotter and require more advanced cooling solutions. We believe the stock is attractively valued in the context of its long-term growth potential.

The Trade Desk is the leading internet advertising demand-side platform, enabling agencies to efficiently purchase digital advertising across PC, mobile, and online video channels. Shares fell on an earnings miss for the first time in 33 quarters. We believe the miss was due largely to a company reorganization in December and delays in its Kokai platform rollout, both of which we believe have since improved. We believe Trade Desk still represents the best option for biddable Connected TV (CTV) inventory. We note Trade Desk gained share against the incumbent Google in the last five years, even when Google charged low/no fees, and major companies like Netflix, Disney, and Spotify have opened their ad inventory to Trade Desk. Its market remains large and underpenetrated, as the shift to CTV advertising is still in the early stages. We believe Trade Desk can grow its top line by high teens to 20% year-over-year for years to come.

Shares of Gartner, Inc., a provider of syndicated research, fell on uncertainty around the impact of government spending reductions on the business. We estimate U.S. federal exposure is about 5% of Gartner’s total research contract value, with about half from the Department of Defense and Intelligence organizations and half from civilian agencies. While Department of Government Efficiency-driven cost scrutiny is high, we believe Gartner’s services deliver significant value to users, including the potential for hard dollar savings. The private sector business appears well positioned for sustained growth, and management is adept at exercising cost controls to sustain or enhance margins and free cash flow. The company’s balance sheet is in excellent shape, and we expect management to take advantage of this drawdown with aggressive share repurchases.

Other stocks that declined over 20% this quarter were Chart Industries, Inc., ASGN Incorporated, Neogen Corp., Grid Dynamics Holdings, Inc., Ibotta, Inc., First Advantage Corporation, indie Semiconductor, Inc., Repay Holdings Corporation, and RadNet, Inc.

As of March 31, 2025, the Fund had $3.8 billion under management and owned 55 stocks. The top 10 holdings made up 40.6% of net assets. Turnover was 12.8%, as measured by a three-year average. The number of names in the portfolio is the lowest it's been in a while. This is because in times of stress in the markets, we normally focus on our highest conviction names and adjust the weightings or sell out of names in which we are less confident. Also, during the period, a couple of our holdings were acquired, and this was not offset, as is typically the case, by purchases of new issues, which delayed coming to market due to elevated investor uncertainty.

The Fund primarily invests in five sectors – Industrials, IT, Consumer Discretionary, Financials, and Health Care. We favor these sectors because these are the areas where we find special businesses that meet our high standards and investment criteria. They are also the sectors in which we have the most expertise, the deepest research effort, and most historical success with our investments.

The Fund’s sector exposures vary significantly from the Index. We are overweight Industrials (30.5% of net assets), IT (22.8%), Consumer Discretionary (14.9%), and Financials (12.9%) and significantly underweight Health Care (9.5%). These trends have been fairly consistent over time. This quarter, these allocations hurt our results, as IT and Consumer Discretionary were the weakest performing sectors in the Index, while Health Care outperformed. We have minimal investments in some of the other sectors in the Index, such as Energy, Utilities, Materials, and Real Estate.

The Fund's holdings have generally higher growth rates, are more profitable, and have lower betas when compared to the Index holdings. The active share of the Fund has generally been above 90%, meaning the Fund relies on its stock picks and does not hug the Index.

During the quarter, we continued our approach of investing in small-cap stocks and trimming our larger market cap holdings. We bought or increased stocks with a weighted average market cap of $4.0 billion and sold or trimmed stocks with a weighted average market cap of $19.3 billion. Our “size score” as measured by Morningstar has declined.

With tariffs being such a flashpoint, we have examined our holdings based on revenue exposure to the U.S. versus non-U.S. The basic premise is that companies with greater domestic sales would be less affected...though this is imperfect because it doesn't take into consideration cost or supply-chain issues. For 30% of our assets under management, all revenues are domestic; 22% of our net assets generate 75% to 100% of revenues inside the U.S., and another 33% of assets generate 50% to 75% of revenues domestically. For a modest percentage of the Fund, a little over 10%, 50% of sales are outside the U.S. Interestingly, this group of stocks performed the worst on average this quarter.

During the quarter, we bought shares of RadNet, Inc., the largest owner and operator of fixed-site, freestanding diagnostic imaging centers in the U.S, with 399 locations. The company’s imaging centers offer multi-modality imaging services, including magnetic resonance imaging (MRI), computed tomography (CT), positron emission tomography (PET), nuclear medicine, mammography, ultrasound, diagnostic radiology (X-ray), and other related procedures. The company develops leading positions in regional markets to leverage operational efficiencies and contracting benefits with health plans. Currently, the company has a strong regional presence in California, Maryland, New York, and New Jersey.

RadNet is benefiting from several secular growth trends. The aging population is driving increased demand for diagnostic imaging services. Payors are steering volume to less costly outpatient providers like RadNet, away from higher cost hospitals, and patients prefer the experience of care in an outpatient setting over a hospital. New technology is driving higher demand for more advanced imaging modalities like MRI, CT and PET, all of which generate higher revenue and margin per procedure for RadNet.

In addition, we think RadNet is well positioned to lead the transformation of the radiology field with AI and radiology software products. RadNet’s emerging Digital Health business offers AI algorithms for enhanced cancer detection, allowing for earlier and more accurate diagnosis and preventive screening. The company has the largest repository of imaging data from its imaging centers, which it can use to train and re-train its algorithms, providing a competitive advantage. The company’s newly launched DeepHealth OS cloud-native operating system helps operate all aspects of the radiology service line, from scheduling and patient preparation to technologist workflow to interpretation and referral management. RadNet is investing for growth in this business, which we think can grow 30% per year and scale at very high incremental margins. Over time, AI will enable RadNet to lower costs in its own imaging centers in a material way, driving margin expansion.

Finally, RadNet is well capitalized with cash on the balance sheet for accretive acquisitions. RadNet purchases other independent imaging center operators that are not as well capitalized to make investments in new technology or lack scale to contract at favorable rates with payors. RadNet is also expanding through health system joint ventures, including with Cedars Sinai, MemorialCare, Dignity Health and Adventist Health. Additionally, the company intends to use acquisitions to bolster its offerings in the Digital Health business.

We think the stock is attractively valued on current estimates based on the growth characteristics of the imaging center business alone and does not reflect the upside potential from the Digital Health business or future acquisitions.

We purchased shares of PAR Technology Corporation, a leading software, hardware, and service provider to the foodservice industry. PAR is building an all-in-one software and service platform for enterprise restaurants and convenience stores to run the most critical portions of their technology stacks. Historically, the company was known as a hardware supplier to large QSR restaurant chains, but since CEO Savneet Singh took the role in late 2018, he has made software the primary focus of the business through organic investment and M&A. The company has added several complementary software pieces around its core point-of-sale software product (less than $10 million in software revenue when Savneet took over) to build a unified technology platform offering integrated solutions and data insights supporting $275 million in ARR today growing 20% or more annually.

While there is a lot of competition in the small and medium-sized business portion of the market, there are significantly less competitors serving enterprise chains, with the two largest players being legacy incumbents with poor reputations when it comes to innovation and service. Enterprise foodservice is playing “catch-up” in adopting new technology, and we anticipate spend to ramp in coming years. PAR’s strong reputation, modern platform purpose built for enterprise brands, and product and integration breadth give it a strong competitive positioning, as reflected by a customer list that includes many of the largest restaurant and c-store brands in the world (Burger King, Dairy Queen, and Arby’s).

We believe PAR will continue to grow its software revenues 20%-plus per year over the next several years, driven by wins with new restaurant brands and cross-sell of its product portfolio to existing customers. PAR just reported two consecutive quarters of adjusted EBITDA profitability driven by very strong operating leverage, and we expect the company to continue to deliver strong incremental margins as it grows revenue in excess of the required investment in its R&D or sales and marketing needed to scale its business. As profitability and cash flow ramp rapidly in the coming years (estimating over 25% EBITDA margins), combined with further accretive bolt-on and/or meaningful acquisitions, we see significant upside in the stock over time.

During the quarter, we exited three positions and two of our companies were acquired.

Aspen Technology, Inc. was acquired by Emerson Electric Co. ending a successful 9-plus year investment (21.4% annualized return). We believe the future remains bright for that business, so we were sad to see it go. Also, we sold the remaining portion of our holdings in big winner Altair Engineering Inc. that is also being acquired.

We trimmed our positions in Vertiv Holdings Co and Guidewire Software, Inc. at attractive prices to deploy those proceeds to new smaller-cap ideas.

We sold out of WEX Inc. as its end markets outlook has diminished, lowering our view of the company’s long-term growth profile. Ibotta, Inc. has struggled as a public company with sales growth and earnings lower than expected. Their solution and brand engagement needs tweaking, which will take some time, so we decided to step to the sidelines during this transition. We sold the remnants of our SBA Communications Corp. holding to fund growthier names after the stock moved higher as interest rates fell. We purchased this position in 2004, and it has been a great holding for the Fund, generating over $350 million in total profits (21.9% annualized return).

We are writing this report in the middle of April, having just gone through extremely tumultuous times. Tariffs were imposed, and levels announced were higher, shockingly so, than anticipated. The market sold off dramatically on many concerns – the soundness of the policy itself, a surge in inflation, business disruption, a protracted trade war/period of geopolitical tension, and, most important, the risk of a recession. The Trump Administration favors a move away from decades of globalization and a reordering of the system of global trade, and investors went catatonic.

Subsequently, the administration yielded and stepped off the ledge, by pausing the implementation of tariffs while it individually negotiates deals with trading partners. This was well received, and the markets rallied from levels that were oversold with bearish sentiment at the peak. However, the conflict with China escalated, with far ranging repercussions, and an amicable resolution anytime soon seems unlikely.

The tariff shock has resulted in a period of maximum uncertainty. Consumers' confidence is lower. Business leaders are freezing decisions. They crave certainty. This is precisely the opposite of what we were hearing just a couple of months ago and points to slower growth. Also, there are concerning knock on effects, with the U.S. dollar moving lower and long duration interest rates moving higher, both negatives for the economy and market. Plus, the Fed is in a tough position determining the path of interest rates, since slower economic growth seems to be clouded by higher inflation expectations. We will see where this all shakes out but expect continued volatility given the murkiness of the road ahead.

During times of market and macro volatility, we rely on our experience and process. This usually results in staying invested in the special companies we have invested in and riding out the storm. We believe we own a portfolio of high quality, well managed, and high performing businesses. We are closely following the evolving policy, but, as mentioned earlier in the letter, it is unpredictable, so we don’t spend a lot of time making predictions. Instead, we are even more closely in contact with our businesses, focusing on their fundamentals and competitive advantages and will adjust the portfolio appropriately if need be. Stocks presently trade at discount valuations to our present near- and longer-term estimates of corporate earnings and value, but this is also a time of great uncertainty about the outlook. We appreciate you hanging in there with us as we do our best to manage the Fund for your benefit. We have been here before and have historically done a good job mitigating the results of such challenging environments, which has helped us achieve long-term outperformance. We are following the same playbook now, and we expect this time to be no different.

Thanks for your investment in the Fund and confidence in our investment team and approach.