Baron Small Cap Fund | Q3 2026

Baron Small Cap Fund (the Fund) was down 7.69% (Institutional Shares) in the third quarter, but that was 1.70% ahead of the Russell 2000 Growth Index (the Index), which fell 9.39%. Year to date, the Fund is down 4.30% while the Index is up 10.71%. For comparison, the Russell 3000 Index, which measures the performance of the overall U.S. equity market, was up 1.40% this quarter and is up 12.42% year to date. The Fund was tracking positively after July and August both in absolute and relative terms, but September saw the Index, and our Fund, sell off as interest rates spiked.

Despite underperformance this year, the Fund has compounded at 9.46% per year since inception, 2.60% ahead of the Index’s 6.86%.

The market was volatile and lopsided in the quarter. At the beginning of the quarter, the previously soaring AI and technology stocks declined sharply, because of extended valuation levels and concerns about the capital availability for the infrastructure build. Market leadership rotated, which we consider healthy and good for the Fund. Overlooked and laggard sectors, such as software and services stocks, acted well as the market broadened. High-quality small-cap stocks caught a bid.

The second half of the quarter was quite different, as macroeconomic development affected the market outlook. Tensions in the Middle East escalated, pushing oil prices above $100 per barrel for the first time since March. Inflation readings increased and remained well above the levels that the Federal Reserve is targeting. With the economy at full employment and GDP strong, the Fed decided to raise the Fed funds rate by 25 basis points, with anticipation of additional rate hikes to come. Interest rates continued to climb after the hike, with long-term Treasury yields approaching levels last seen in 2002. The 10-year Treasury yield added roughly 50 basis points for the month of September and over 100 basis points for the year.

The reaction to higher rates reversed the market trends. Investors worried that higher borrowing costs would slow the economy and weigh on equity valuations, triggering a sell-off that hit small-cap growth stocks especially hard. The Magnificent Seven and other AI-linked names returned to dominance and market breadth deteriorated.

The Fund’s relative outperformance was the result of good performance of certain sectors. For the quarter, stock selection in Information Technology (IT) was a standout. Our IT holdings rose 7.16%, while the Index’s IT sector stocks fell 12.81%, led by Intapp, Inc., Gartner, Inc., Everforth, Inc., and Guidewire Software, Inc., as software and services stocks recovered on earnings results and commentary that put to rest fears of a SaaS-apocalypse. Our stock selection in Financials and Health Care was also favorable, as we had some nice gainers amid a declining sector. The Baldwin Insurance Group, Inc. led our Financials stocks, and Neogen Corp., Hinge Health, Inc., and RadNet, Inc. performed well in Health Care. However, our Industrials and Consumer Discretionary stocks acted poorly, reacting negatively to higher rates or the sell-off in the AI trade. Vertiv Holdings Co, Legence Corp., Enpro Inc., and Mirion Technologies, Inc. were all marked down despite solid results and outlooks. Our aerospace & defense companies, Karman Holdings Inc. and Applied Aerospace & Defense, Inc., also showed great growth and bright prospects, but declined on fears that mid-term elections could affect future defense budget allocations. Our overweight in Consumer Discretionary was also a relative drag, as higher rates and spiking gas prices weighed on sentiment, hurting Red Rock Resorts, Inc. and Wingstop Inc. Not owning Energy stocks cost us a little. Still, stock selection was the primary driver of the Fund’s outperformance for the quarter.

The Fund is, and has been, underweight to Momentum and Beta. Both factors were out of favor this quarter, which helped our relative performance. Quality, by contrast, regained favor after a stretch of underperformance, which benefited the Fund given its higher-quality tilt. The Fund’s bias toward larger-cap companies within the small-cap universe also proved advantageous.

Neogen Corp. is a leading provider of food and animal safety products. Shares rose following better-than-expected fiscal fourth quarter results, including accelerating core organic growth, margin expansion, and the second-highest quarterly free cash flow in company history. Food Safety delivered its fastest growth since Neogen combined with 3M’s Food Safety business. Preliminary fiscal 2027 guidance also came ahead of expectations, while management reiterated that the Petrifilm manufacturing transition remains on track and the Genomics sale is expected to close on schedule, reducing debt levels with the proceeds. We maintain long-term conviction that this management team can execute the final stages of the 3M Food Safety integration, and set up the business for durable, more profitable growth.

Intapp, Inc. is a vertical software platform serving professional and financial services firms. Shares rose on strong fiscal fourth-quarter results, with cloud annual recurring revenue (ARR) growing 29% year-over-year, subscription revenue rising 27%, cloud net revenue retention holding at 123%, and non-GAAP operating margin expanding to 22.5%. The company signed a record number of cloud migrations and provided fiscal 2027 guidance above consensus. Shares also benefited from a recovery in sentiment and valuation multiples across application software. Intapp’s role is growing in compliance and conflicts management for major AI providers serving the legal industry, including Legora, Harvey, Anthropic, Microsoft, and OpenAI. We believe Intapp can scale to more than $1 billion in ARR by fiscal 2029, a 19% annual CAGR, while expanding profit margins.

The Baldwin Insurance Group, Inc. is a leading independent insurance distribution firm. Shares rose after the company announced on September 14 that it will be taken private by Sequence Holdings and Michael Dell’s family office in an all-cash transaction at $32.50 per share, an 88% premium to the closing price on June 17, before media reports of a potential deal. We think this is a good outcome for shareholders. The Fund invested in the IPO in 2019 when its market cap was under $1 billion, and the shares have appreciated 94% since then. With an expected first quarter of 2027 close, and the stock trading close to its take-out value, we trimmed our position.

Other holdings that rose over 30% in the quarter but added less to overall returns were Gartner, Inc., Everforth, Inc., Andersen Group Inc., The Cheesecake Factory Incorporated, and Grid Dynamics Holdings, Inc.

Vertiv Holdings Co is a global leader in critical digital infrastructure and services for data centers, including electrical and thermal management equipment. Shares declined as second-quarter organic growth came in slightly below guidance, even as management raised its full-year outlook (31% organic growth). Broader weakness in AI infrastructure stocks added further pressure to the price. Vertiv is benefiting from the industry’s shift toward modular solutions to alleviate field labor shortages, thanks to its broad product portfolio and large field service team. The company is also well positioned to support upcoming technology transitions, including liquid cooling and direct current architectures. We see meaningful long-term upside from strong organic growth, margin expansion, and complementary acquisitions, supported by a strong balance sheet.

Red Rock Resorts, Inc., an operator of regional casino resorts serving the Las Vegas locals market, detracted from performance as investors grew concerned that higher interest rates, inflation, and oil prices could slow market growth. Red Rock is gaining market share in its niche, as they continue to make significant investments to upgrade their existing properties. However, these investments are disrupting near-term results so reported profits this year are lower. We believe that Red Rock will earn high rates of return on these renovations and expansions. Management has successfully opened one new property (Durango) that is doing exceptionally well and has a pipeline of many additional casinos in the planning phase. We are excited about the long-term prospects of more than doubling the EBITDA of the business, which can be accomplished using its free cash flow. The stock currently trades at a trough multiple of depressed earnings and we expect accelerating profits, so the setup is favorable.

JBT Marel Corporation provides equipment and systems for the food processing industry, with particular exposure to poultry. Shares fell following temporary facility consolidation issues related to the Marel acquisition, leaving sales short of second quarter expectations. We believe the production inefficiencies are temporary, and consolidation should support higher margins going forward. Management anticipates strong first-half 2026 bookings to continue through the remainder of the year and into 2027. JBT Marel is extremely cheap on 2026 estimates, and we think continued growth along with synergy realization leading to higher margins can drive upside in the shares.

Stocks that fell more than 30% in the quarter but had less impact on overall performance were Applied Aerospace & Defense, Inc., Legence Corp., Wingstop Inc., indie Semiconductor, Inc., and Karman Holdings Inc.

As of September 30, 2026, the Fund had approximately $2.4 billion under management and owned 51 stocks. The Top 10 holdings accounted for 36.3% of the Fund's net assets.

The Fund is primarily invested in five sectors: Industrials (30.7% of net assets versus 15.8% for the Index), IT (20.8% versus 20.0%), Consumer Discretionary (13.7% versus 8.7%), Health Care (13.1% versus 29.3%), and Financials (10.2% versus 9.7%). We are well overweight Industrials and Consumer Discretionary, roughly in line in IT and Financials, and meaningfully underweight Health Care because we do not own biotechnology stocks, which are 14.8% of the Index. We also own no Energy stocks, which are 5.6% of the Index. We build the Fund stock by stock, bottom up, and these weightings are the outcropping of our team's research to find the best investment opportunities for the long term. They are not a reflection of how we feel about near-term expectations for sectors or the pace of economic growth.

We remain committed to being long-term investors and holding onto our winners. 39% of our assets are invested in companies we have owned for more than 10 years and another 29% in stocks we have owned between 5 and 10 years. Those long-held positions, which make up 68% of the Fund, have compounded at 17.2% per year since we bought them, versus 9.5% for the Index. 33% of our assets are in stocks that have appreciated more than five times since we purchased them, including 16% that have appreciated more than ten times, and another 25% have more than doubled. That means 58% of the Fund's assets are in stocks that have at least doubled. We also continue to buy small and sell large. The positions we initiated or added to in the quarter had a weighted average market capitalization of $3.6 billion, squarely in the small-cap range, while the 18 positions we trimmed had a weighted average market capitalization of about $12.3 billion.

Stock performance this year has been heavily influenced by the market’s perception of how AI will affect the future of individual companies. In our view, these judgments are often sweeping generalizations, and we frequently see things differently, a view we believe will play out over time. Still, these perceptions have driven large swings in stock prices and valuations during the year, so we would like to explain how they have affected our portfolio.

We have classified our holdings as “AI Haves,” “AI Have Nots,” and “Other.” Our portfolio is built from the bottom up, one name at a time, through fundamental research. Yet, our holdings are increasingly being impacted by wide sweeping macro themes and trades, and less on a micro, company-specific basis.
 

The Fund returned 3.67% in the first half of this year on the strength of AI Haves. This group comprised 18.7% of the Fund on average and rose a remarkable 87%. These companies are beneficiaries of the AI build-out, including Vertiv Holdings Co, Legence Corp., and Enpro Inc. (on the semiconductor side) and JFrog Ltd. (more written code is stimulating demand). Dragging down performance was the 19.7% of the portfolio that traded as if it were AI Have Nots, including companies tied to IT consulting (Everforth, Inc., Gartner, Inc., and Grid Dynamics Holdings, Inc.), application software (PAR Technology Corporation, Intapp, Inc., Guidewire Software, Inc.), and services to corporate employers (Bright Horizons Family Solutions, Inc.). Together, these AI Have Nots fell 28.2% through June. Other stocks, which made up the remaining 60% of the Fund, declined 1.1%. As a reminder, the Index was exceptionally strong in the first half of the year, led by semiconductors and other AI infrastructure and energy beneficiaries with high measures of Momentum and Beta.

In the third quarter, those trends reversed, with semiconductors, momentum, and beta all trading lower. Our AI Haves, which averaged 18.8% of the Fund, were off 21.9%. Our AI Have Nots, with an average weight of 20.3%, were up 15.8%, as our software and employment service holdings rebounded. Strong company results and positive government data threw cold water on the thesis that these companies would be disintermediated by AI.

Many of our Other stocks declined in the third quarter on concerns about higher interest rates and fuel prices, which weighed on our housing-related investments and consumer names. We also saw weakness in our aerospace & defense names, as the ongoing Iran conflict could affect global air travel and the upcoming midterm elections could change the political landscape and defense budgets. This move lower was most evident in September, coinciding with the mid-September Fed rate decision, as the market narrowed and small caps suffered the largest declines.

In the third quarter, we initiated one new position and added to seven existing holdings. The Fund initiated or increased positions with a weighted average market cap of $3.6 billion. On the last day of the quarter, we participated in the IPO of Accelevation Holdings Corp.

Accelevation designs, manufactures, and installs mission-critical infrastructure and power products for data centers. The company has grown from a single product generating $3 million in revenue in 2021 to what we believe will be close to $1 billion in revenue this year across multiple products serving the industry’s biggest customers signifying just how rapidly the company has innovated and scaled production. Over the next several years, Accelevation will derive the majority of its revenue from its “SkyBridge” family of modular infrastructure systems, large customized pre-fabricated steel frame structures with wiring/liquid-cooling conveyance systems already attached that take expensive labor and complexity out of the field and into a controlled factory setting saving costs and accelerating timelines.

The company today is the basis of design for multiple Google, Oracle, and Microsoft data centers while also in the early innings of penetrating neocloud and colocation customers. They have more than 800 field service personnel that install their solutions, meaning there is truly one source of accountability to customers, an advantage versus peers who use traditional engineering, procurement, and construction (EPC) firms and contractors.

As of the end of the second quarter of 2026, Accelevation’s backlog was $1.1 billion, and its quarterly annualized bookings were over $2.5 billion. Combined with growing demand for modular infrastructure and power products in data centers, this positions the company to sustain a rapid pace of growth in the coming years. We believe margins will improve over time as the company scales into its large manufacturing footprint, which can support more than $5 billion of revenue, continues to gain wallet share by launching new products, and expands into higher-margin commercial and industrial markets. With valuation under 8 times 2027 EBITDA for a company that could double its revenue in each of the next two years, we see meaningful upside in the stock.

The Fund’s largest sale was the full exit of The Cheesecake Factory Incorporated, which we first purchased in 2001 when it was a $1.3 billion company. With the stock rising 40% in the quarter and more than doubling this year, we felt the current valuation was finally reflecting the core brand’s unique positioning and consistent results, as well as prospects for its fast-growing secondary brands, namely Flower Child. Over the 25 years (!) since our initial purchase, the stock returned 9.6% annualized, exceeding the return of the Index’s Consumer Discretionary sector over that period, with outsized returns over the past three and five years.

In keeping with past practice, we trimmed The Baldwin Insurance Group, Inc. as the shares moved toward the take-private price to redeploy the proceeds to other investments with higher potential returns.

The market is off to a weak start in the fourth quarter. Geopolitical tensions remain elevated, energy prices are high, and interest rates have risen significantly, with investors expecting additional tightening from the Fed. AI stocks are under pressure, as AI frontier model developers face potential legal liability for future safety issues and the AI infrastructure buildout faces pressures from higher cost of capital.

We do not believe higher interest rates will cause a recession. Though there are pockets of weakness, the economy remains strong and resilient. For the most part, the businesses of our holdings remain strong, and we expect earnings to accelerate after a few years of slower-than-normal growth. Their stocks trade at cheap valuations, and we see the potential for outsized returns.

Small-cap stocks have been out of favor for years now, and we believe the pendulum will swing back. We also believe “High Quality” stocks will return to favor and outperform. The management teams of our holdings share this view, as the chart below, which shows heightened share repurchase activity, illustrates.

We continue to rely on our long-held approach of buying and holding exceptional small-cap companies for the long term. We have a strong investment team of more than 40 professionals focused on this effort. Although our process is presently out of favor, it has served us well for decades. We expect our holdings to deliver excellent results, which should translate into strong performance for their stocks and for the Fund.

Sincerely,