Baron WealthBuilder Fund | Q1 2024

Baron WealthBuilder Fund^®’s (the Fund) performance in the first three months of 2024 was below our expectations. While the Fund increased 4.87% (Institutional Shares), it trailed both its primary benchmark, the S&P 500 Index (the Index), and the MSCI ACWI Index (Global Index), which were up 10.56% and 8.20%, respectively. The Morningstar Aggressive Allocation Category Average (the Peer Group) increased 7.28% in the quarter.*

The Fund has made little progress in the past three years. Its results in 2024’s first quarter contributed to the Fund’s three-year return trailing the Index’s. Over the past three years, the Fund’s annualized return was 0.80% compared to the Index’s annualized return of 11.49%. 

Since inception, however, the Fund’s absolute performance is good while its relative performance is more in line with the Index. The Fund’s annualized return since its inception is 13.10%. This compares to the Index’s annualized return of 13.37%, while the Global Index had an annualized return of 8.92%.

This in-line performance since inception was achieved despite the Fund’s strategy facing considerable headwinds. Baron Capital’s consistent investment philosophy and process has not changed since the Firm’s founding in 1982. This Fund provides clients with broad exposure to our strategies. We favor small- and mid-cap sized growth companies since we believe they offer the greatest long-term return potential. Our long-term investment horizon enables the Fund to benefit when companies in which we are shareholders achieve their long-term strategic objectives. We have historically owned growing businesses that often penalize their short-term earnings by making ongoing investments to become larger businesses. As a result of these capital investments, these businesses often appear more highly valued than the broad market. Although our long- term strategy has periodically led to short-term underperformance, we believe it has enabled our Firm to achieve exceptional performance over extended periods. But these businesses have been out of favor over the life of the Fund. Since the Fund’s founding, the Russell 2000 Growth Index has appreciated 6.89% compared to the Russell 1000 Growth Index, which appreciated 17.04%. 70.7% of the Fund’s investments are in, small- and mid-sized companies, as defined by Russell.

Despite this headwind, the Fund is ranked as the number one fund in its Morningstar category since its inception.

The significant reason for the Fund’s underperformance this quarter stemmed from our underlying investment in Tesla, Inc. Baron Capital has had a 10-year investment in the company, and it is the largest underlying position held at the Firm and within the Fund. Tesla’s shares fell 29.3% during the period and detracted 2.32% from the Fund’s first quarter results. Although Tesla has contributed importantly to the Fund’s performance since its inception, on occasion it has detracted from quarterly performance. In previous instances when Tesla’s shares have underperformed during a discrete period, they have shortly afterwards reflected the strong growth of its underlying business and the stock has appreciated considerably. We believe that will be the case again, although we cannot guarantee it. 

A significant decline also occurred at the end of 2022. In that instance, investors had become concerned about a host of external factors. Investors believed company founder, visionary, and CEO Elon Musk was distracted by his acquisition of Twitter. They also believed a weak Chinese economy that was emerging from COVID-19 (COVID) and U.S. government policies would curtail sales of Tesla vehicles. These fears proved to be overblown. As the company achieved milestones in the succeeding year, the stock subsequently doubled over the next 12 months. 

Today, investors are again concerned. They believe there is increased competition from Chinese automakers who are supported by a protectionist government. They worry about product-level margins after announced price cuts. They are skeptical about the company’s ability to achieve Full Self Driving (FSD) and the feasibility of Tesla’s Robotaxi. And they debate if a mass appeal vehicle can be produced at scale and profitably.

Just like in late 2022, we believe investors’ concerns are overblown. Electric vehicle (EV) competition will always be present. The Chinese automakers make a good, value product. But we believe Tesla’s offering is superior and will garner a meaningful market share within China. We also believe the Chinese OEM advantage will be minimized outside of its home market because of tariffs. We are already seeing traditional internal combustion engine (ICE) manufacturers scrap their EV plans as plant conversions are too costly and their technology is inferior. They have instead attempted to fight for market share in the outdated ICE category.

We also believe a lower cost Tesla product will eventually be introduced and gain wide acceptance. Timing is uncertain, however, as the company attempts to develop both the new lower cost vehicle and fully autonomous vehicles in parallel. We have experienced Tesla’s FSD versions and believe they are close to achieving success. While the combination of these two feats may extend the timeline, we believe it meaningfully improves profitability and solidifies Tesla’s competitive advantage. Additionally, other ongoing projects within Tesla (e.g., battery packs, energy storage, humanoids, database, software, AI compute, distributed inference) make the company a lot more dynamic than when we first invested in 2014.

We remain focused on Tesla’s ability to achieve its mission of accelerating the world’s transition to sustainable energy rather than on how much it earns in any given quarter. After extensive and frequent meetings with Tesla executives and engineers, manufacturing and technology consultants, and competitors, we have increased confidence in Tesla’s ability to accomplish its mission.

But the Fund is diversified across market caps, sectors, and geographies. Our small-and mid-cap Baron Funds performed well on an absolute basis, however, they generally trailed their indexes. The shortcoming largely stems from what is not owned in these funds, rather than what is owned. This is particularly true for our small-cap offerings. With inflation appearing contained by some metrics, investors believe the interest rates have peaked and their appetite for risk has increased. As explained in depth in the Baron Discovery Fund and Baron Growth Fund letters, Super Micro Computer, Inc. and MicroStrategy Incorporated, generated over 50% of the Russell 2000 Growth Index’s total return in the period. These companies are not owned in the Underlying Funds, and do not meet our criteria for investment. Super Micro Computer has limited recurring revenue and poor free-cash-flow conversion. MicroStrategy has made a significant investment in Bitcoin and its stock’s value is closely tied to the cryptocurrency rather than in its business operations. Steadier growth businesses that we favor lagged in such an environment. While our larger-cap portfolios performed better on an absolute basis and modestly exceeded their respective benchmarks, they too faced headwinds because of the investment environment. Out of the five top stock-specific detractors, four were from those that were underweight in the Fund.

We encourage you to read the various Baron Funds’ quarterly letters to gain a deeper understanding of the underlying holdings and strategies that constitute the Fund.

*Not annualized.

†Performance is calculated from the time the Fund was added to Baron WealthBuilder Fund: Baron Durable Advantage Fund – 3/13/2018; Baron Global Advantage Fund – 1/9/2018; Baron FinTech Fund – 2/27/2020; Baron Health Care Fund – 10/18/2018; and Baron Real Estate Income Fund – 5/17/2021.

Performance data quoted represents past performance. Past performance is no guarantee of future results. The indexes are unmanaged. The index performance is not Fund performance; one cannot invest directly in an index.

The Fund is a compilation of our Baron Funds and provides broad equity exposure. All Underlying Baron Funds follow a consistent investment philosophy and process. We do not try to mimic the indexes, and we do not alter our strategy to coincide with short-term macro events that we regard as unpredictable. We remain focused on underlying business Fundamentals.

We believe small- and mid-cap growth stocks offer attractive return potential relative to their risk over the long term. Small- and mid-cap businesses represent 70.7% of the Fund (compared to only 16.8% for the Index). While our small- and mid-cap growth investments have been successful over our Firm’s 42-year history, these styles are occasionally out of favor. Today’s environment is one of those times. Large-cap growth companies outperformed small-cap growth companies in the year and in many instances over the last decade. Since the Fund’s inception over six years ago, the one-year rolling monthly returns of the Russell 1000 Growth Index have outperformed the Russell 2000 Growth Index 77% of the time, including five out of the past six calendar years.

Rather than only examining the Fund’s performance over a quarter or a year, we believe it is equally important to understand how the Fund has performed over the course of an economic cycle. The COVID and subsequent Macro-Induced Market Rotation periods have been very difficult for small- and mid-sized growth companies. Investors have favored larger-cap, value-oriented businesses that are deemed safer during a time of uncertainty. We believe this offers a great opportunity for long-term investors to invest in small- and mid-cap growth businesses at attractive prices. Markets first peaked in late February 2020 before rapidly dropping as the economy braced for COVID. It recovered quickly, followed by another sizable drop based on macroeconomic factors. Over the three years of COVID ended 12/31/2022, the Russell 2000 Growth Index, a small-cap growth index, gained only 1.96% on a cumulative basis. The Russell Midcap Growth Index fared better with a cumulative 3-year return of 12.00%. With that backdrop, the Fund performed better and appreciated 28.11%. We believe protecting and growing clients’ assets during this challenging period positions long-term investors well for meaningful appreciation once the macro landscape changes. Table III provides a more complete look at how the Fund and various indexes performed during the pandemic and its aftermath.

We do not yet know if the challenges caused by COVID will persist. Volatility has remained high, but we are hopeful that interest rate increases, policy factors, and COVID hangovers are ending. Global conflict has increased, and geopolitics remains uncertain. But growth stocks have recently begun to outperform value stocks. Perceived safer large caps have continued to perform better than smaller companies. So far, we are optimistic that companies will again be valued on their Fundamentals rather than on macroeconomic concerns. We have started to see the performance of some individual securities diverge. This divergence of returns, we believe, should favor growth investors. Given our weightings, the Fund’s performance has trailed the Index since the start of this cycle. However, the Fund’s return has continued to meaningfully exceed small-cap growth indexes.

Performance data quoted represents past performance. Past performance is no guarantee of future results. The indexes are unmanaged. The index performance is not Fund performance; one cannot invest directly in an index.
 

Source: FactSet SPAR. Except for Standard Deviation and Sharpe Ratio, the performance-based characteristics above were calculated relative to the S&P 500 Index.

Thank you for joining us as fellow shareholders in the Fund. We continue to work hard to justify your confidence and trust in our stewardship of your hard-earned savings. We remain dedicated to providing you with the information we would like to have 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,