Baron Durable Advantage Fund: Latest Insights and Commentary

After selling off in March due to the U.S.-Iran conflict and disruptions in the Strait of Hormuz, U.S. equities rallied to new record highs during the second quarter, with most of the gains coming in April and May. Given narrow market breadth and concentrated position sizes in recent years, the gap in performance between the market cap-weighted S&P 500 Index and the equal-weighted version has reached extremes not seen since the dotcom bubble era (based on rolling three-year results). 

U.S. stocks saw a comeback after ending the prior quarter slightly down. The AI secular growth narrative was the principal driver of market returns, overshadowing uncertainty about a potential resolution to the U.S.-Iran conflict, shifting Federal Reserve rate expectations, and depressed consumer sentiment from high living costs, persistent inflation, and elevated borrowing rates. 

The S&P 500 posted one of its strongest quarterly profit prints in five years, thanks largely to the Magnificent Seven cohort, which reported blended earnings growth in excess of 60% (versus low double digits for other constituents in the Index). The other contributors were primarily Information Technology (IT) stocks—specifically companies that are perceived to be direct beneficiaries of AI capital spending and electrification and what the market has come to call “AI winners." 

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

• Taiwan Semiconductor Manufacturing Company Limited (TSMC) is the world's largest contract chipmaker and the leading manufacturer of advanced logic semiconductors used in modern AI accelerators. Shares rose during the quarter as investors increasingly recognized that TSMC, rather than any individual chip designer, sits at the center of the AI supply chain. High-performance computing now represents the majority of TSMC's business. AI demand is consuming so much leading-edge capacity that smartphone and PC production is increasingly shifting to older technology nodes, reversing a dynamic that defined the foundry industry for much of the past decade. Management also raised its full-year outlook and increased capital spending to support demand that remains well above available supply. We retain long-term conviction in TSMC and view its leading-edge manufacturing monopoly, pricing power, and 2-nanometer technology roadmap as durable advantages that support multi-year earnings power.
• Alphabet Inc., the parent company of Google, contributed to performance as the market increasingly recognized its unique position in the AI buildout. Alphabet is the industry's most vertically integrated AI player, with ownership across every layer of the stack, including custom Tensor Processing Unit (TPU) silicon, global cloud infrastructure, the Gemini foundation models, and distribution across 13 products with more than 1 billion users each. This full-stack ownership is translating into strong demand. Google Cloud revenue grew 63% year over year and backlog surged nearly 300% to roughly $460 billion, prompting management to raise 2026 capital expenditure guidance and signal a significant further increase in 2027. Search revenue grew 19% year over year as AI features drove record query volumes, demonstrating that generative AI is expanding, rather than eroding, the core franchise. Capital access has itself become a competitive moat, allowing Alphabet to fund supply aggressively and outbid peers for scarce compute. We maintain strong conviction, viewing Alphabet's vertical integration and balance sheet strength as durable advantages in a multi-year build cycle.
• Monolithic Power Systems, Inc. (MPS) is a semiconductor company that designs power management chips that regulate and distribute power within electronic systems. Shares rose during the quarter as investors increasingly recognized the company's important role in the AI buildout. As AI accelerators draw more power at higher densities, delivering that power efficiently has become increasingly valuable, driving higher dollar content for MPS’ products within AI servers. The company's AI server power business nearly doubled, and because its solutions are deeply integrated into server platforms, they are difficult to displace mid-cycle, creating a durable competitive position that we believe remains underappreciated by investors. We retain long-term conviction in MPS and view its rising power content per AI server, sticky design wins, and expanding capacity as key drivers of multi-year earnings power.

DETRACTORS

• CME Group, Inc. operates the world’s largest and most diversified derivatives marketplace. Shares fell due to a slowdown in trading activity, reflecting tough comparisons against the prior year and easing market volatility following the escalation of the U.S.-Iran conflict in March. This cyclical softening was exacerbated by concerns about emerging competition from crypto-native perpetual futures markets, as well as uncertainty following the announcement that long-time Chief Executive Officer Terry Duffy will step down next year. 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.
• Intuit Inc. is the leading provider of accounting software for small businesses and tax preparation software for individuals and tax professionals. Shares fell due to modest underperformance in the TurboTax segment, where revenue grew 7%, falling short of expectations for 8% growth. Management acknowledged volume losses among lower-income filers who traded down to cheaper alternatives, fueling investor anxiety about competition and potential AI-driven disruption. Negative sentiment was further compounded by a 17% workforce reduction, which some investors interpreted as a defensive move to protect margins and a signal of demand challenges. Despite headwinds in certain parts of the business, overall growth remains robust, with management expecting earnings growth of 18% this year and mid-teens growth over the coming years.
• Shares of LPL Financial Holdings Inc., the largest independent broker-dealer in the U.S., fell during the quarter due largely to market-driven concerns. With continued improvement in frontier AI models, investors worried that automated cash management could erode the client sweep balances that generate spread income, a meaningful contributor to LPL's revenue and margins. This narrative weighed on the stock even as the underlying business continued to perform well. LPL posted better-than-expected first-quarter results, guided to improving recruiting momentum, and made progress integrating Commonwealth Financial Network, which it acquired in 2025. LPL's cash balances are actively managed by advisors, meaning there is little excess cash left for an AI tool to optimize. Cash held in client accounts is primarily used for trading, taxes, and fees. The company has also communicated that it is exploring options to reduce its reliance on sweep cash revenue, and we expect a change in the model over the next 12 to 18 months. Consequently, we view the recent weakness as a sentiment overhang rather than a deterioration in the company's long-term earnings power. We remain shareholders.

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) rose 13.64% (Institutional Shares) in the second quarter, modestly trailing the S&P 500 Index (the Index), which rose 15.20%, by 156 basis points. Despite tailwinds from industry and style factors, disappointing stock selection served as the primary cause of underperformance. Many of the top stock-specific detractors were names not held in the Fund that performed exceptionally well in the period, such as Micron Technology, Inc., Advanced Micro Devices, Inc. (AMD), and Eli Lilly and Company.

From a sector perspective, poor stock selection in Financials coupled with being notably overweight this lagging sector accounted for most of the underperformance in the period. The bulk of the losses came from being meaningfully overexposed to the lagging financial exchanges & data sub-industry via sizable positions in CME Group, Inc., S&P Global Inc., MSCI Inc., and Moody's Corporation. Financial exchanges & data stocks were down double digits in the Index, with the overexposure causing an almost 300 basis point drag on relative performance. The sub-industry faced headwinds on multiple fronts, including slowing trading activity due to easing market volatility, concerns that AI could disrupt many financial data companies, and a weak outlook for debt issuance given rising interest rates and geopolitical volatility in the Middle East.

Another material detractor in the sector was independent broker-dealer LPL Financial Holdings Inc., whose shares fell largely due to market-driven concerns. With continued improvement in frontier AI models, investors worried that automated cash management could erode the client sweep balances that generate spread income, a meaningful contributor to LPL's revenue and margins. This narrative weighed on the stock even as the underlying business continued to perform well. LPL posted better-than-expected first-quarter results, guided to improving recruiting momentum, and made progress integrating Commonwealth Financial Network, which it acquired in 2025. LPL's cash balances are actively managed by advisors, meaning there is little excess cash left for an AI tool to optimize. Cash held in client accounts is primarily used for trading, taxes, and fees. The company has also communicated that it is exploring options to reduce its reliance on sweep cash revenue, and we expect a change in the model over the next 12 to 18 months. Consequently, we view the recent weakness as a sentiment overhang rather than a deterioration in the company's long-term earnings power. We remain shareholders.

Stock selection in Information Technology (IT) was another material drag on relative performance, owing partly to disappointing performance from Intuit Inc., the leading provider of accounting software for small businesses and tax preparation software for individuals and tax professionals. Intuit’s shares fell due to modest underperformance in the TurboTax segment, where revenue grew 7%, falling short of expectations for 8% growth. Management acknowledged volume losses among lower-income filers who traded down to cheaper alternatives, fueling investor anxiety about competition and potential AI-driven disruption. Negative sentiment was further compounded by a 17% workforce reduction, which some investors interpreted as a defensive move to protect margins and a signal of demand challenges. We exited our position to redeploy capital to other ideas.

Poor stock selection in IT was exacerbated not owning several AI winners in the semiconductors and technology hardware storage & peripherals sub-industries that were up triple digits in the period, namely Micron, AMD, Intel Corporation, Sandisk Corporation, Seagate Technology Holdings PLC, Western Digital Corporation, and Dell Technologies, Inc. Not having exposure to these seven names was a 400-plus basis point drag on relative performance, overshadowing strong performance from a handful of the Fund’s own AI beneficiaries (Taiwan Semiconductor Manufacturing Company Limited, Monolithic Power Systems, Inc., Lam Research Corporation, and Amphenol Corporation). 

Somewhat offsetting the above was limited exposure to the lagging Energy, Consumer Staples, Utilities, Health Care, and Materials sectors. Solid stock selection in Industrials, Communication Services, and Consumer Discretionary contributed another 180-plus basis points of relative gains. Specialized electronic and mechanical components manufacturer Arxis, Inc., global technology company Alphabet Inc., and e-commerce and cloud computing leader Amazon.com, Inc. led the way in these sectors. The Fund participated in Arxis’ successful initial public offering during the quarter. We view Arxis as a next-generation compounder that builds on the models established by TransDigm Group Incorporated and Amphenol. We expect high-single-digit or better organic revenue growth, with incremental margin expansion supporting low-teens EBITDA growth. Mergers could add five percentage points to annual EBITDA growth, resulting in a mid- to high-teens CAGR over a full cycle. This should enable Arxis to compound value at above-market rates over time.

Alphabet’s stock performed well as the market increasingly recognized its unique position in the AI buildout. Alphabet is the industry's most vertically integrated AI player, with ownership across every layer of the stack, including custom Tensor Processing Unit silicon, global cloud infrastructure, the Gemini foundation models, and distribution across 13 products with more than 1 billion users each. This full-stack ownership is translating into strong demand. Google Cloud revenue grew 63% year over year and backlog surged nearly 300% to roughly $460 billion, prompting management to raise 2026 capital expenditure guidance and signal a significant further increase in 2027. Search revenue grew 19% year over year as AI features drove record query volumes, demonstrating that generative AI is expanding, rather than eroding, the core franchise. Capital access has itself become a competitive moat, allowing Alphabet to fund supply aggressively and outbid peers for scarce compute. We maintain strong conviction, viewing Alphabet's vertical integration and balance sheet strength as durable advantages in a multi-year build cycle.

Amazon’s shares rose as the market has increasingly recognized that the shift to AI is a durable tailwind for large-scale cloud platforms, and Amazon Web Services (AWS) is a primary beneficiary. AWS revenue growth accelerated for a fifth straight quarter to 28% year-over-year as enterprises accelerated workload migration, and management pointed to a substantial contracted backlog underpinning future growth. Amazon's investment in custom AI chips appears to give it a multi-year cost advantage, reinforcing the durability of its cloud franchise, while the core retail business continued to gain share and expand margins. 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.