Baron Durable Advantage Fund: Latest Insights and Commentary

U.S. equity markets were volatile during the quarter, as positive sentiment and strong performance in January were undermined by AI-related disruption fears and geopolitical tensions. Small and mid caps generated positive returns in the first quarter while large caps declined, a margin of outperformance for small and mid caps not seen since the COVID rally in late 2020 and early 2021. 

The year began with positive momentum for U.S. stocks, supported by easing inflation, resilient economic trends, strong corporate earnings, and investor optimism about the Trump administration’s stimulative economic strategy. Market sentiment began to shift in February, with the early catalyst being widespread losses across a range of industries due to fears about AI-driven disruption. Technology and software companies experienced notable pressure as investors worried AI agents could directly replace human-led business workflows. The sell-off worsened after the U.S. and Israel attacked Iran on February 28. Investors became concerned about the potential for sustained inflation and reduced economic growth from surging oil prices and supply chain disruptions. 

Against this backdrop, the dominant market trend was the continued rotation out of the Magnificent Seven, software, and other growth-oriented stocks. The Magnificent Seven complex declined 11.3%, accounting for about 90% of the cap-weighted S&P 500 Index’s losses. Microsoft (-23.3%), Tesla (-17.3%), Meta (-13.3%), Amazon (-9.8%), and Alphabet (-8.1%) suffered the largest losses. The non-Magnificent Seven stocks in the Index were down only 0.6% for the month. 

Looking ahead, we remain focused on well-managed companies with durable competitive advantages and attractive growth prospects. While macroeconomic and policy uncertainty persist, we believe maintaining a disciplined, long-term perspective and emphasizing company fundamentals will be essential to navigating the evolving landscape. 

CONTRIBUTORS

• Monolithic Power Systems, Inc. (MPS) designs chips that deliver precise, safe, and efficient power to processors, memory, and sensors in electronic systems. With deep system-level expertise and highly integrated solutions, MPS has established a strong leadership position in power management. Shares rose during the quarter following raised full-year guidance and expectations for further upward revisions. The company is poised to benefit from two major secular trends: AI-driven data center redesigns and automotive electrification. AI is fueling exponential growth in data center power needs, forcing a fundamental rethink in how power is distributed. While server shipments are experiencing unprecedented growth, power content per system is also rising, creating a durable multi-year tailwind. At the same time, vehicles are shifting to centralized computing and higher-voltage architectures, significantly increasing the need for advanced power management content per vehicle. MPS’ leadership positions it to directly benefit from both the AI infrastructure buildout and long-term automotive electrification.
• Semiconductor giant Taiwan Semiconductor Manufacturing Company Limited (TSMC) contributed to performance as revenue growth exceeded expectations due to surging demand for AI chips. TSMC dominates the advanced semiconductor foundry market, controlling over 90% share of cutting-edge sub-7 nanometer (nm) nodes that power AI servers, flagship smartphones, and autonomous vehicles. The company benefits from a virtuous cycle in which its massive scale and profitability generate the capital necessary to fund industry-leading R&D and capex, in turn widening its technological moat and reinforcing its pricing power. As the ultimate "picks and shovels" provider of the AI era, TSMC remains insulated from the competitive dynamics of the AI chip design ecosystem. Whether hyperscalers develop custom accelerators or deploy merchant graphics processing units from companies like NVIDIA and AMD, nearly all advanced AI accelerators are manufactured exclusively at TSMC’s 3nm and 5nm nodes. We believe TSMC will deliver 20% earnings growth over the next several years, supported by secular AI-driven demand for leading-edge manufacturing capacity.
• CME Group, Inc. operates the world’s largest and most diversified derivatives marketplace. Shares rose due to higher trading volumes amid elevated market volatility. Average daily trading volume increased at a robust 22% pace during the first quarter, reflecting concerns over higher energy prices tied to the war in Iran, persistent inflation, and an uncertain outlook for interest rates. We continue to own the stock because we believe CME enjoys significant competitive advantages and should benefit from the growing adoption of exchange-traded derivatives and periodic spikes in market volatility.

DETRACTORS

• Software leader Microsoft Corporation detracted from performance despite reporting slightly better-than-expected revenue, margins, and earnings per share, with cloud revenue up 24% year over year in constant currency and commercial bookings up 228%, driven by commitments from OpenAI and Anthropic. Two factors pressured shares. First, Azure growth of 38% year over year in constant currency was slightly below expectations, reflecting capacity allocation across first- and third-party applications. Management continues to emphasize that Microsoft remains capacity constrained and is optimizing usage for long-term value, prioritizing applications such as Microsoft 365 Copilot to support future adoption. Second, investors are focused on the company’s reliance on first-party models from OpenAI and Anthropic, which plan to expand into the broader enterprise software market and account for a meaningful portion of remaining performance obligations (with OpenAI representing roughly 45%). We believe Microsoft is well positioned over the medium to long term, though we see a need for continued improvement in the pace of innovation in Microsoft 365 Copilot and in advancing model capabilities.
• Meta Platforms, Inc., the world’s largest social network, detracted from performance. While Meta reported strong quarterly results and forward revenue guidance, management guided to 2026 operating expenses above Street expectations, raising concerns that it may be overspending on AI for less clear returns relative to competitors. Near the end of the quarter, Meta also lost a jury verdict finding that its design choices led to user harm. Additionally, broader ad budgets became more uncertain due to the conflict in Iran. While we continue to monitor the regulatory landscape, we believe the company can drive premium revenue and profit growth in the foreseeable future. Meta benefits from AI investments across its core business, driving improvements in content recommendations (with rising time spent) and in ad targeting and ranking (leading to higher conversions and better return on ad spend). Longer term, Meta’s leadership in mobile advertising, massive user base, innovative culture, leading generative AI capabilities, and technological scale position it well for continued strong performance, with additional monetization opportunities ahead in areas such as smart glasses and commerce.
• Amazon.com, Inc. is the world’s largest retailer and cloud services provider. Shares detracted from performance during the quarter after the company guided to $200 billion in fiscal year 2026 capital expenditures, above Street expectations. While we believe Amazon Web Services (AWS) revenue growth will accelerate meaningfully over the next two years, particularly as leading AI companies increase AWS usage, the path to returns on invested capital remains uncertain in the near term. The company continues to expand operating margins across core North American retail, AWS, and international retail, driven by improved cost discipline and operational efficiencies. Over the longer term, Amazon has substantial room for growth in e-commerce, where it has less than 15% penetration of its total addressable market. Amazon also remains the clear leader in the large and growing cloud infrastructure market, with significant opportunities in application software, including enabling generative AI workloads.

When reviewing performance attribution on our portfolio, please be aware that we construct the portfolio from the bottom up, one stock at a time. Each stock is included in the portfolio if it meets our rigorous investment criteria. To help manage risk, we are aware of our sector and security weights, but we do not include a holding to achieve a target sector allocation or to approximate an index. Our exposure to any given sector is purely a result of our stock selection process.

Baron Durable Advantage Fund (the Fund) declined 9.02% (Institutional Shares) in the first quarter, trailing the S&P 500 Index (the Index), which was down 4.33%, by 469 basis points. Despite strong stock selection, headwinds from industry and style factors contributed to the Fund’s underperformance in the period. According to MSCI’s Barra factor attribution, industry factors accounted for the vast majority of relative losses in the period, with the Fund’s underexposure to AI beneficiaries in the Computers Electronics, Semiconductor Equipment, Communications Equipment, and Electrical Equipment industries weighing heavily on relative performance. These segments posted strong gains in a period of general market weakness due to investor appetite for first-order AI beneficiaries, the "picks and shovels" technology, memory chips, and foundry services providers that have profited directly from the surge in AI development and capital expenditure. 

Additionally, notable overexposure to the weak performing Diversified Financials and Internet Software and IT Services industries hampered performance, with the latter facing particularly significant selling pressure due to investor fears that AI will disrupt these segments. The lack of exposure to various Energy-linked industries also proved costly due to the sharp rise in oil prices following the start of the Iran war in late February. From a style perspective, underexposure to certain value-oriented factors (Dividend Yield, Value, and Earnings Yield) and overexposure to the Growth factor proved costly given the meaningful rotation out of growth stocks during the period. Lastly, overexposure to the poor performing Beta factor and underexposure to the top performing Momentum factor hurt relative results. 

From a sector standpoint, poor stock selection in Financials coupled with being substantially overweight to this lagging sector accounted for about 40% of the relative losses in the period. Weakness in Financials was broad based, led by double-digit declines from alternative asset managers Apollo Global Management, Inc., Blackstone Inc., and Brookfield Corporation. Alternative asset managers generally faced pressure from concerns sweeping private and semi-liquid markets at large, including fears over credit quality, future fundraising, rising retail investor redemptions, software exposure within portfolio companies, and the impact of higher interest rates on monetizations and real estate values for balance sheet investments. We continue to view Apollo favorably and expect the fundamentals of Apollo’s business to remain strong given the breadth of its credit platform, much of which is investment-grade in nature. We see the company as a leading manager and expect fundraising, particularly from institutions, to remain largely unimpacted by recent headlines, supporting continued earnings growth for the stock. We view Blackstone as a best-of-breed global alternative asset manager, with a strong brand, global scale, long-term investment track record, full suite of products, and a proven executive team. Finally, we retain long-term conviction in Brookfield, given its strong asset management platform, which offers high earnings visibility, along with its global capital deployment capabilities.

Financial exchanges & data companies S&P Global, Inc. and Moody's Corporation also contributed to the relative deficit in Financials despite reporting solid quarterly results. The underperformance was driven by a weak full-year outlook from S&P Global, concerns about the impact of AI on their business models, and caution about a slowing credit cycle. We continue to own S&P Global and Moody’s because of their lengthy growth runways and significant competitive advantages.

Lack of exposure to the top performing Energy sector and disappointing stock selection in Industrials, Communication Services, and Real Estate were other sources of relative weakness in the period. Within Industrials, double-digit losses from aerospace & defense companies HEICO Corporation and TransDigm Group Incorporated coupled with being underweight this better performing sector proved costly. HEICO, TransDigm, and other companies with aerospace aftermarket exposure were weighed down by concerns that higher oil prices stemming from the conflict in Iran could prompt airlines to retire older, less fuel-efficient aircraft in favor of newer models. Investors also worried that these retirements would release a greater supply of used serviceable material into the market, pressuring high-margin aftermarket pricing and volumes. We remain confident in HEICO’s ability to adapt to this environment, given the company’s time-tested strategy of compounding cash flow, driven by its commitment to long-term durable growth (both acquired and organic) and its unique, entrepreneurial culture. Since 1990 (when the current management team become involved), sales at HEICO have compounded at a 15% rate, and the company has completed over 95 acquisitions. Similarly, we retain conviction in TransDigm because of the company’s long track record of navigating similar conditions, and ability to deliver double-digit topline growth through the cycle. 

Performance in Communication Services and Real Estate was hindered by double-digit declines from dominate social network Meta Platforms, Inc. and real estate information and marketing services platform CoStar Group, Inc. Although Meta reported strong quarterly results and forward revenue guidance, shares fell as management guided to 2026 operating expenses above Street expectations, raising concerns that it may be overspending on AI for less clear returns relative to competitors. Near the end of the quarter, Meta also lost a jury verdict finding that its design choices led to user harm. Additionally, broader ad budgets became more uncertain due to the conflict in Iran. While we continue to monitor the regulatory landscape, we believe the company can drive premium revenue and profit growth in the foreseeable future. Meta benefits from AI investments across its core business, driving improvements in content recommendations (with rising time spent) and in ad targeting and ranking (leading to higher conversions and better return on ad spend). Longer term, Meta’s leadership in mobile advertising, massive user base, innovative culture, leading generative AI capabilities, and technological scale position the company well for continued strong performance, with additional monetization opportunities ahead in areas such as smart glasses and commerce.

CoStar’s shares fell due to multiple compression driven by rising AI fears. We continue to own CoStar given its differentiated data assets and significant growth opportunities in providing enhanced real estate information, analytics, and marketplace offerings. CoStar boasts an enviable business model with high levels of recurring revenue and meaningful cash flow generation potential. While near-term cash flow is obscured by elevated investment in Homes.com, we expect spending to moderate and cash flow to improve over the next several years. The company also maintains a substantial cash balance, which we are hopeful will be used to aggressively repurchase shares at current depressed valuation levels. 

Partially offsetting the above was strong stock selection in Information Technology (IT), where semiconductor holdings Monolithic Power Systems, Inc. (MPS) and Taiwan Semiconductor Manufacturing Company Limited (TSMC) were standouts. MPS designs chips that deliver precise, safe, and efficient power to processors, memory, and sensors in electronic systems. With deep system-level expertise and highly integrated solutions, MPS has established a strong leadership position in power management. Shares rose during the quarter following raised full-year guidance and expectations for further upward revisions. The company is poised to benefit from two major secular trends: AI-driven data center redesigns and automotive electrification. AI is fueling exponential growth in data center power needs, forcing a fundamental rethink in how power is distributed. While server shipments are experiencing unprecedented growth, power content per system is also rising, creating a durable multi-year tailwind. At the same time, vehicles are shifting to centralized computing and higher-voltage architectures, significantly increasing the need for advanced power management content per vehicle. MPS’ leadership positions it to directly benefit from both the AI infrastructure buildout and long-term automotive electrification.

TSMC shares rose as revenue growth exceeded expectations due to surging demand for AI chips. The company dominates the advanced semiconductor foundry market, controlling over 90% share of cutting-edge sub-7 nanometer (nm) nodes that power AI servers, flagship smartphones, and autonomous vehicles. TSMC benefits from a virtuous cycle in which its massive scale and profitability generate the capital necessary to fund industry-leading R&D and capex, in turn widening its technological moat and reinforcing its pricing power. As the ultimate "picks and shovels" provider of the AI era, TSMC remains insulated from the competitive dynamics of the AI chip design ecosystem. Whether hyperscalers develop custom accelerators or deploy merchant graphics processing units from companies like NVIDIA and Advanced Micro Devices, nearly all advanced AI accelerators are manufactured exclusively at TSMC’s 3nm and 5nm nodes. We believe TSMC will deliver 20% earnings growth over the next several years, supported by secular AI-driven demand for leading-edge manufacturing capacity.

Stock selection in IT was enhanced by having lower exposure to Index heavyweight Microsoft Corporation and other software stocks, which were down sharply due to concerns about AI-driven disruption to their business models.