Baron Opportunistic Small Cap Growth Strategy | Q2 2024

Baron Opportunistic Small Cap Growth Strategy (the Strategy) was down 6.42% in the second quarter of 2024, trailing the Russell 2000 Growth Index (the Benchmark), which was down 2.92%, and the broader Russell 3000 Index, which rose 3.22% in the quarter. After a strong first quarter, the Strategy’s performance is now essentially in line with Benchmark year to date, up 4.64% compared with the Benchmark up 4.44%. The Strategy is behind the Russell 3000 Index, which was up 13.56% in the first half of 2024, as large-cap stocks continued to significantly outperform small caps.

As shown in Table I below, the Strategy has outperformed the Benchmark for all relevant periods. Many of our investors have loyally supported us for over 26 years. We thank you for your confidence in us and are happy we have been able to do well for you. We are working hard in an effort to continue to outperform. We are confident we can do so.

The broader indexes and the technology-heavy NASDAQ Composite Index reached all-time highs in the second quarter, but the rally was very narrow and concentrated. The continued strong performance of the mega-cap Magnificent Seven was responsible for all the gains of the larger-cap indexes. Small-cap stocks declined. The market cheered signs of slowing inflation and continued resilient economic growth and earnings. Interest rates initially rose but declined as the quarter progressed, increasing the odds of rate cuts by the Federal Reserve (the Fed). The “goldilocks” scenario of declining inflation coupled with a solid economic environment led market participants to anticipate monetary policy easing and a soft landing (i.e., no recession).

Our Strategy’s losses this quarter were attributable to declines across multiple stock sectors. Some losses originated from company-specific concerns about near-term fundamentals, while others stemmed from broader macroeconomic or sector-specific factors. Our perceived interest rate-sensitive Consumer Discretionary and Industrials holdings (SiteOne Landscape Supply, Inc., Installed Business Products, Inc., Floor & Decor Holdings, Inc., and Trex Company, Inc.) declined as near-term housing industry trends weakened despite declining interest rates. Our Healthcare stocks underperformed primarily due to Inspire Medical Systems, Inc.’s earnings miss, raising concerns about the impact of GLP-1 drugs on its growth trajectory. Other large Healthcare holdings experienced declines, erasing some of the gains realized earlier in the year. Although operating results have been relatively strong, many of our Industrials stocks, including Chart Industries, Inc. and Dayforce, Inc., decreased amid concerns about a potential economic slowdown. Our Information Technology (IT) holdings were impacted by an unexpected earnings miss and reset by Sprout Social, Inc., as well as continued lackluster near-term growth from IT consulting holdings ASGN Incorporated, Endava plc, and Grid Dynamics Holdings, Inc. Our Consumer Discretionary holdings also underperformed due to declines from European Wax Center, Inc., which reported soft same-store sales, and DraftKings Inc., whose shares fell after an increased tax rate was imposed in one of its operating states. Our Financials holdings were negatively impacted by decelerating sales growth at Kinsale Capital Group, Inc., offsetting the gains from the first quarter’s strong performance.

Our winners this quarter were companies demonstrating robust fundamentals. Vertiv Holdings Co. reported exceptionally strong order growth, while Guidewire Software, Inc. showcased encouraging progress in transitioning insurance clients to the cloud. The Baldwin Insurance Group, Inc. exhibited strong momentum in improving its operating margins. Other winners experienced similar positive developments or market sentiment. Planet Fitness, Inc.’s planned membership price increase is anticipated to drive higher earnings.

Vertiv Holdings Co, a leading provider of critical digital infrastructure for data centers, contributed during the quarter. As an industry leader in data center cooling and power management, Vertiv is poised to benefit from AI- driven growth in data center spend. The NVIDIA partner network, strong industry relationships, and broad product portfolio that Vertiv maintains enables its participation in the creation of the technology roadmap for the future of the data center. In addition, Vertiv is investing in its capacity to serve this growing end market more effectively. The company also has an extensive global service network to aid customers as they grow. We believe the company has durable competitive advantages and a flexible balance sheet to benefit from the expected significant capital investment in data centers for years to come. Vertiv reported very strong results for the March quarter, with orders up 60%, which highlighted the strong demand it is seeing for its products. We sold some of our position into strength after the runup from the positive report, but still hold a major position in the Strategy as we see considerable upside in the shares over time.

Shares of property and casualty (P&C) insurance software vendor Guidewire Software, Inc. contributed to performance for the quarter. After a multi-year transition period, we believe the company’s cloud transition is substantially over. We believe that 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 Insurance Suite Cloud. We also expect the company to shift R&D resources from infrastructure investment to product development, which will help to drive cross sales into its sticky installed base and potentially accelerate ARR over time. We are also encouraged by Guidewire’s subscription gross margin expansion, which improved by more than 1,000 basis points in its most recently reported quarter. We believe that 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%.

Insurance broker The Baldwin Insurance Group, Inc. reported first quarter organic revenue growth of 16%, and EBITDA margins expanded meaningfully year-over-year, leading to EBITDA growth of 29%. Margin improvement is expected to continue as the company leverages recent growth investments and focuses on efficiency after years of acquisitions. Also, during the quarter, the company refinanced a portion of its debt, resulting in lower borrowing costs and extended maturities. After a few years of subpar profit growth and the digestion of significant acquisitions, we believe Baldwin is now poised to show more consistent margin progression and free cash flow generation, and garner a higher multiple on compounding earnings.

Other stocks that rose over 15% in the quarter but contributed less to the overall performance of the Strategy were Loar Holdings Inc., Planet Fitness, Inc., and Exponent, Inc.

Shares of specialty insurer Kinsale Capital Group, Inc. gave back some gains from earlier this year after the company reported slower premium growth in the first quarter. Earnings beat Street expectations with 44% EPS growth and 43% growth in book value per share. However, investors focused on the slowdown in gross written premiums to 25% growth from 34% last quarter, reflecting tough comparisons and moderating growth in property insurance. We continue to own the stock because we believe Kinsale is well managed and has a long runway for growth in an attractive segment of the insurance market. Recall that Kinsale was one of our best performers last quarter, and we believe we can endure some volatility to achieve strong long-term returns.

SiteOne Landscape Supply, Inc. is the largest distributor of wholesale landscape supplies in North America. SiteOne sells irrigation, hardscapes, agronomics, and nursery products to landscapers through its network for residential and commercial maintenance, upgrade/repair, and new construction. Shares fell during the quarter after a negative intra-quarter update, with weaker-than-expected demand in upgrade/repair product categories and stronger-than-expected commodity deflation, which together will likely lead to lower full-year results. We believe SiteOne remains well positioned long term as its investments in operational efficiency, technology, and product category management enable it to continue taking share of the fragmented wholesale landscape supplies distribution industry and improve margins, while expanding its product catalog and geographic footprint through consistent M&A. We visited with the company at their headquarters in Atlanta during the quarter and came away with renewed respect for management and their execution. We believe in their journey to gain significant market share through acquisitions and organic growth and increase margins by about 50% over time, and we believe the stock is now very cheap because of the present softness in their sales.

Installed Building Products, Inc. (IBP) is a leading installer of insulation and complementary building products for U.S. residential homes. Shares fell on investor concerns that U.S. housing construction activity levels would slow due to the diminished ability of consumers to afford down payments and monthly mortgage payments, both of which are significantly higher than they were several years ago. We remain confident in our long-term investment thesis, as the U.S. housing market continues to grow, and IBP continues to execute on its multi-prong organic growth strategy, supplemented by highly accretive acquisitions. IBP has been able to unexpectedly grow its EBITDA very significantly over the last few years when single-family housing has been weak, so its outlook is bright as we expect to transition to a better macro environment. The stock has almost tripled off the bottom in 2022, and we have taken some profits along the way to manage the position size.

Other stocks that declined over 20% in the quarter but had less impact on our results were Sprout Social, Inc., Inspire Medical Systems, Inc., Floor & Decor Holdings, Inc., Trex Company, Inc., WEX Inc., Dayforce, Inc., Ibotta, Inc., European Wax Center, Inc., and Endava plc.

As of June 30, 2024, the Strategy had $4.5 billon in net assets and owned 60 stocks. The top 10 stocks in the Strategy made up 40.1% of net assets, which is down a bit from last quarter but still on the high end of our historic concentration. The turnover of the Strategy is down to 12.5% measured on a 3-year average basis. We suspect this will increase, as we are seeing an increase in IPOs, and we suspect that M&A activity will increase, as the capital markets return to a more normal state.

The Strategy’s investments are concentrated in four sectors, as has been the case for a while now. Industrials is the largest category and make up 27.5% of the Strategy’s net assets. IT is 22.1%, Consumer Discretionary is 15.8%, and Health Care is 11.4%. Compared to the Benchmark, we are notably overweight in Consumer Discretionary and Industrials, and significantly underweight in Health Care. The Benchmark was recently rebalanced, and our underweight position in Healthcare stocks is now even more pronounced due to the increased emphasis on biotechnology stocks, which we do not hold. This may result in some confusing relative performance in future quarters. However, this will not alter our management of the Strategy nor our avoidance of biotechnology stocks due to their binary and volatile nature.

Our approach is to invest in high-quality companies across various industry verticals that share similar characteristics: they are established or leading within their niche, exceptionally well-managed, and possess significant growth potential. Our deep and talented research team identifies and focuses on winning businesses suitable for long-term investment. This approach yields a diversified and balanced portfolio designed to thrive in most market conditions, demonstrating resilience during downturns and outperformance during upturns. Over the past three years, the Strategy’s upside capture has been 103%, with downside capture at 91%.

As previously discussed (please refer to last quarter’s report for details), the Strategy’s market capitalization is elevated due to the success of our small- cap investments, which have substantially grown, and our practice of retaining “winners” to participate in their long-term business and stock appreciation. We aim to moderate market capitalization by exclusively acquiring small-cap companies and reducing positions in our larger market cap holdings. In the recently concluded quarter, the weighted average market capitalization of our new purchases, encompassing both new ideas and additions to existing positions, was $2.8 billion. Our sales and reductions had a weighted average market capitalization of $16.3 billion. Our ownership in the peak positions of our larger market cap stocks remains minimal, and these stocks continue to perform exceptionally well. Many of these holdings have been part of our portfolio for 15 years or more, and we firmly believe in their contribution to our returns and core strategy.

We initiated a position in Ibotta, Inc. in its April IPO. Ibotta offers cashback rewards on various purchases through its Ibotta Performance Network (IPN) and direct-to-consumer app. Ibotta partners with retailers (e.g., Family Dollar and Kroger) who want to offer loyalty programs and earn money from brands (e.g., Nestle and Unilever) who want to offer digital cashback rewards on their products. For example, brands find these cashback rewards useful as a measurable way to attract customers away from private label brands and launch new items. Ibotta gets paid on a measurable basis, averaging $0.80 per cashback redemption. In total, Ibotta serves over 2,400 brands and, through its third-party retailer network, reaches over 200 million potential end consumers (“redeemers”). Given the scalability of offering online rewards across its platform, Ibotta has a highly profitable and cash flow generative model, with 70% incremental margins in its third- party business.

Ibotta was founded in 2011 as a direct-to-consumer app in a highly competitive space. In 2021, Ibotta began powering cashback rewards programs with the IPN for large third-party retailers, which is a much faster growing space and is already half of Ibotta’s revenue today. To date, Ibotta has credited American consumers with $1.8 billion in cash rewards through its network. With the IPN, Ibotta competes in a very large, digital total addressable market, and we believe that Ibotta, which enables effective return on brand spending, has significant room to grow from a base of $320 million in revenue in 2023.

Competitively, Ibotta is the clear leader in providing consumer rewards/ incentives for large retailers, with more meaningful scale, better technology, and sharper focus than legacy competitors. We believe it would be very difficult to replicate Ibotta’s relationships with 2,400 brands and 85 retailer point-of-sale integrations offering item-level transaction data. We also believe this is a market where there should be a winner that takes most/all, and we believe Ibotta is on track to be that winner. While this shift will take time, Ibotta’s deep partnership with Walmart should be a catalyst. Ibotta has signed an exclusive multi-year deal to power all cashback rewards for Walmart, which we believe will expand its redeemer base substantially and attract other retailers who look to follow Walmart’s lead.

At the end of May, Ibotta reported their first quarter as a public company: revenue grew 52% year-over-year to $82 million and adjusted EBITDA 28%. However, Ibotta’s second quarter guidance was a bit soft (versus expectations), which we believe is because Walmart and other retailers are still ramping and remain far from maturity. With the stock trading down, we find Ibotta’s valuation attractive and added to our initial position.

We initiated a position in Loar Holdings Inc. as part of the company’s IPO. Founded in 2012, Loar is a niche aerospace parts manufacturer with an 85% proprietary portfolio and over half of revenue focused on the high margin aftermarket channel. Loar’s business comprises roughly 15,000 products with around 1,400 employees and 12 manufacturing locations. We believe Loar can grow revenue 10% organically supplemented by a disciplined acquisition strategy that has allowed the integration of 16 acquisitions over the past 12 years. This exceptionally strong M&A franchise has been integral to the 38% sales and 46% EBITDA CAGR since inception. Given secular aerospace tailwinds, strength of the business model, and a management team with over a decade of proven success, we see a long runway of growth ahead for the company to compound EBITDA organically in the mid-teens with a potential double-digit addition from M&A.

We added to our position in Driven Brands Holdings Inc. on the belief that the stock price does not reflect the quality of the underlying assets and the ability of management to unlock this value with portfolio restructuring.

We decreased our holdings in Vertiv Holdings Co to manage the position size after the stock’s 83% ascent year-to-date. We have sold about half of our peak position in Vertiv over the last year as the stock has been a tremendous success and we need to manage the Strategy’s market cap. We trimmed Installed Building Products, Inc. into strength, as mentioned before. We sold out of Mercury Systems, Inc. after years of disappointing operational issues and unclear timing of improved financial results. We trimmed European Wax Center, Inc. this quarter as business has slowed and key performance indicators have deteriorated.

Thanks for your interest in the Strategy.