Baron Durable Advantage Fund: Latest Insights and Commentary

U.S. equities were broadly higher in the third quarter, building on gains from the prior quarter. The S&P 500 Index and NASDAQ Composite set new record highs, most recently on September 22, and the Dow Jones Industrial Average ended the quarter at an all-time high. Small caps led the market recovery, with the Russell 2000 Index finally surpassing its previous record high achieved almost four years ago on November 8, 2021. Market volatility remained muted during the quarter as the CBOE Volatility Index (VIX) continued to trade in the mid-teens, well below its long-term average of around 20. 

The preeminent driver of market strength was the increased likelihood of Federal Reserve (Fed) rate cuts, prompted by signs of weakness in the labor market and the subsequent emergence of more dovish Fed commentary. Rate cut expectations rose in early August following a much weaker-than-expected July nonfarm payrolls report and significant downward revisions to prior numbers. Dovish Fedspeak intensified as the month wore on, with Chair Powell hinting a possible interest rate cut while delivering remarks at the Fed’s annual Jackson Hole conference. Similarly, Governor Waller continued to advocate for cuts while speaking at the Economic Club of Miami. The Fed eventually resumed its rate-cutting cycle at the September meeting, lowering its policy rate by 25 basis points to a range of 4% to 4.25%, after being on hold since its previous cut last December. Robust corporate earnings, narrowing trade uncertainties, a resilient consumer, increased M&A and IPO activity, and sustained AI optimism also contributed to market gains during the quarter. 

The Magnificent Seven complex dominated market returns for a second consecutive quarter, accounting for nearly two-thirds of the S&P 500 Index’s third-quarter gains. The group appreciated 15.5% in the period, outperforming all other securities in the Index, which were up 4.6%, by a double-digit margin. Tesla (+40.0%), Alphabet (+38.1%), Apple (+24.2%), and NVIDIA (+18.1%) posted the largest gains. Meta and Amazon were essentially flat in the period, trailing the broader Index. 

Most sectors closed higher in the period, with Information Technology, Communication Services, and Consumer Discretionary being the only sectors to outperform the broader market thanks to the heavy influence of the Magnificent Seven. Consumer Staples was the only sector to decline in the period, driven by broad-based weakness across a range of sub-industries, including distillers & vintners, personal care products, food retail, tobacco, and household products. Other laggards were Real Estate, Financials, Health Care, Industrials, Energy, and Materials. From a style perspective, small caps outperformed in the third quarter, rising more than 12% and narrowing the gap with mid- and large-cap stocks this year. Performance was mixed between growth and value, with growth stocks dominating in July, losing out to value in August, and rebounding in September. Despite recent volatility, growth generally remains ahead of value year to date, with the largest differential in the mid- and large-cap segments thanks to the heavy influence of Palantir and the broader Magnificent Seven. 

Beyond the U.S., emerging market (EM) equities meaningfully outperformed in September to finish ahead of their developed market counterparts for the quarter. The rally in Chinese equities was largely responsible for EM outperformance, with gains being driven by investor optimism about AI innovation, which bolstered Chinese technology and internet companies. Targeted government initiatives, easing trade tensions with the U.S., and significant domestic capital inflows also contributed to strength in China. Taiwanese and Korean equities also performed well in the period, overshadowing weakness in India, where equity markets were pressured by underwhelming corporate earnings and concerns about recently enacted U.S. tariffs. Foreign investor flows in Indian markets turned negative in the third quarter after being meaningfully positive in May and June. Performance in developed markets was held back by weakness in continental Europe (Denmark, Germany, Norway, Switzerland, France, and Sweden). European equities were hurt by weak corporate earnings, Trump tariff headwinds, and political instability, particularly in France, where the country’s prime minister resigned after losing a crushing confidence vote in parliament.

CONTRIBUTORS

• Alphabet Inc. is the parent company of Google, the world’s largest search and online advertising company. Shares rose during the quarter on strength in the company’s core businesses, as well as in Google Cloud and Other Bets. Despite rising usage of AI competitors such as ChatGPT, both Google Search and YouTube delivered double-digit revenue growth year over year. Additionally, Google Search paid clicks increased compared to the prior year, Google's AI assistant Gemini reached the top spot on Apple’s App Store, and new AI-powered features for Chrome were announced. Cloud revenue growth also accelerated 32% year over year, driven by demand for AI cloud services. Meanwhile, the resolution of the Department of Justice’s antitrust case concerning Google Search was better than feared, lifting an overhang on the stock. Long term, we believe AI innovation could lead to strength in adjacent fields (e.g., travel) and in Google Cloud Platform’s cloud infrastructure business, though we continue to monitor competitive pressures in search and monetization.
• NVIDIA Corporation is a fabless semiconductor company specializing in compute and networking platforms for accelerated computing. The company's dominant position in AI infrastructure—with a comprehensive portfolio spanning GPUs, systems, software, and high-performance networking solutions—continues to drive strong performance. Shares rose during the quarter as investor confidence in AI infrastructure expansion grew. NVIDIA reported near-term visibility of tens of gigawatts in AI buildouts, with each gigawatt representing an estimated $35 billion total addressable market (TAM). During its last earnings call, the company announced that its long-term TAM expanded from $1 trillion to between $3 and $4 trillion, and more recently to $5 trillion. As AI infrastructure investment accelerates, NVIDIA’s leadership continues to strengthen through durable moats across compute silicon, networking, systems, software, and supply chain. We remain highly confident in AI’s potential to transform the global economy and in NVIDIA’s pivotal role as the leading enabler of that transformation, positioning it to capture significant long-term value in the AI era.
• Semiconductor giant Taiwan Semiconductor Manufacturing Company Limited (TSMC) contributed to performance during the quarter, driven by robust demand for AI chips. We retain conviction that TSMC’s technological leadership, pricing power, and exposure to secular growth markets—including AI and high-performance computing, automotive, 5G, and Internet of Things—will allow the company to sustain strong double-digit earnings growth over the next several years.

DETRACTORS

• Intuit Inc. is the leading provider of accounting software for small businesses and tax preparation software for individuals and professionals. Shares declined during the quarter after the company issued softer-than-expected revenue guidance for its Global Business Solutions segment, which management attributed to less aggressive QuickBooks pricing and slower growth in the Mailchimp marketing business. In addition, OpenAI announced a more advanced large language model, which the market perceived as a threat to application software broadly. Even so, quarterly results exceeded Street expectations, driven by continued expansion of QuickBooks into larger and more complex mid-market customers, faster adoption of TurboTax Live, and cyclical strength from Credit Karma. Management expects 12% to 13% revenue growth and 14% to 15% earnings-per-share growth in the next fiscal year. We remain shareholders given Intuit’s strong competitive position and numerous long-term growth opportunities.
• Shares of LPL Financial Holdings Inc., the largest independent broker-dealer in the U.S., fell during the quarter amid several near-term headwinds. Expectations for accelerated interest rate cuts weighed on sentiment, as LPL earns income from floating-rate client cash balances. However, the market’s long-term outlook on rates remains unchanged, leaving the firm’s cash earnings largely unaffected. LPL is also digesting its sizable acquisition of Commonwealth Financial Network, another independent broker-dealer. Although the deal could drive stronger growth over time, it currently offers limited near-term earnings upside and requires significant management attention to ensure a successful integration. While investor sentiment has cooled given the lack of immediate catalysts and expectations for lower rates, we believe LPL’s long-term fundamentals and earnings power remain intact. The stock continues to offer attractive value, in our view.
• Shares of S&P Global Inc., a leading rating agency and data provider, declined following cautious competitor commentary on market demand and margins. Industry bellwether FactSet Research Systems Inc. cited “tight client budgets” and a “challenging environment” on its quarterly earnings call, prompting a broad pullback in information services stocks, though management later clarified that these headwinds remain stable. FactSet also noted margin pressure from increased growth investments, which investors interpreted as a sign of a broader AI spending cycle that could weigh on margins across the sector. We believe these concerns are overstated and expect S&P Global to deliver solid results, supported by elevated debt issuance and a recovering capital markets backdrop. We continue to own the stock given the company’s long growth runway and significant competitive advantages.

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) appreciated 5.62% (Institutional Shares) in the third quarter, trailing the S&P 500 Index by 250 basis points principally due to disappointing stock selection. 

Financials was responsible for 95% of the underperformance in the period due to poor stock selection and, to a lesser degree, significantly higher exposure to this lagging sector. Stock-specific weakness in the sector was widespread, with independent broker-dealer LPL Financial Holdings Inc. and alternative asset manager Apollo Global Management, Inc. being among the top detractors due to shifting macroeconomic expectations, as both companies were perceived as near-term laggards in a declining interest rate environment. Given LPL earns income from floating-rate client cash balances, expectations for accelerated interest rate cuts weighed on sentiment. However, the market’s long-term outlook on rates remains unchanged, leaving the firm’s cash earnings largely unaffected. LPL is also digesting its sizable acquisition of Commonwealth Financial Network, another independent broker-dealer. Although the deal could drive stronger growth over time, it currently offers limited near-term earnings upside and requires significant management attention to ensure a successful integration. While investor sentiment has cooled given the lack of immediate catalysts and expectations for lower rates, we believe LPL’s long-term fundamentals and earnings power remain intact. The stock continues to offer attractive value, in our view.

Apart from interest rate-related headwinds, Apollo’s shares suffered because of dampened investor sentiment toward alternative asset managers in general owing to concerns that private equity firms may struggle to monetize existing investments, which could weigh on carried interest revenues and slow new capital deployment. Fears of weakness in consumer credit further contributed to the selloff across alternative asset managers. We believe Apollo is less exposed to these risks than peers, given its large insurance business and investment approach that emphasizes rigorous purchase-price discipline, which helps keep cost basis low. Apollo’s skew toward higher-quality, investment-grade credit should also help insulate its balance sheet from stress at the lower end of the credit spectrum. While the stock will likely trade with credit markets in the near term, we view Apollo as a differentiated asset manager with strong secular tailwinds that support multi-year earnings growth.

Financial data providers S&P Global Inc., Moody's Corporation, and MSCI Inc. also weighed on performance, hurt by a combination of industry-wide AI concerns, cautious commentary from several financial data and software peers, and factor rotation as investors shifted from high-quality, defensive names to higher-growth stocks. We remain investors in these high-quality businesses. 

Most of the remaining underperformance came from disappointing stock selection in Consumer Discretionary and Industrials, where high-quality casual dining chain Texas Roadhouse, Inc. and aerospace manufacturing company TransDigm Group Incorporated were the top detractors. Texas Roadhouse shares were pressured by concerns about rising beef costs and their potential impact on near-term margins. Beef is one of Texas Roadhouse’s largest inputs, and prices have risen sharply this year. Importantly, the company continues to deliver strong sales growth due to its high-quality food offerings, generous portion sizes, and focus on labor and service. While margins may temporarily compress, we expect them to recover as beef prices moderate. We believe Texas Roadhouse’s long-term emphasis on value is a key competitive advantage and a primary reason the company has consistently gained market share. Weak stock selection in Consumer Discretionary was exacerbated by not having exposure to electric vehicle manufacturer Tesla, Inc., whose share price increased 40% during the period, accounting for about half of the relative shortfall in the sector. 

TransDigm’s stock declined due to a temporary destocking issue with a key customer in the company’s original equipment manufacturer channel. The company expects growth in that channel to resume by year end, as broad-based improvements across the aerospace supply chain indicate the issue is largely behind them. We continue to believe TransDigm can compound earnings at an elevated rate relative to peers, supported by its best-in-class portfolio of proprietary aerospace and defense solutions and increasingly robust end-market tailwinds.

Partially offsetting the above was strong stock selection in Information Technology, where semiconductor holdings Taiwan Semiconductor Manufacturing Company Limited (TSMC), Monolithic Power Systems, Inc. (MPS), and Broadcom Inc. were the standouts. TSMC’s stock price was bolstered by robust demand for AI chips, while MPS shares rose following better-than-expected earnings and management’s outlook for a stronger second half, particularly in its largest segment, Enterprise Data, which includes power modules for AI processors. Broadcom’s stock increased after management provided strong business visibility into next year. The company continues to execute with its key customer, Google, is on track for volume production with two additional customers (likely Meta and ByteDance), and recently secured a fourth customer (likely OpenAI) with orders worth $10 billion next year. We retain long-term conviction in all three companies given their unique positions within the AI ecosystem. 

Solid stock selection in Health Care and lower exposure to the lagging Consumer Staples sector also contributed to relative performance. Strength in Health Care came from Thermo Fisher Scientific Inc., a life sciences company that offers instruments and consumables for research, tools for bioproduction, specialty diagnostics, and contract research and manufacturing services. Thermo Fisher’s shares rebounded alongside other life sciences stocks following a difficult stretch of performance in which the industry was hurt by multiple headwinds, including regulatory uncertainty, particularly around drug pricing, cancellations/delays of National Institutes of Health grants for academic research, biotechnology funding constraints, and concerns about tariffs on the pharmaceutical industry. We retain conviction as Thermo Fisher is dominant across multiple end markets and its scale gives it resilience. Once the macroeconomic environment stabilizes, we expect the company to resume organic growth in the high single-digit range and deliver double-digit earnings-per-share growth.