Baron Discovery 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

• SiTime Corporation is a fabless semiconductor company that designs and sells microelectromechanical systems (MEMS) timing solutions and clock integrated circuits across consumer, communications, data center, automotive, and industrial end markets. MEMS-based solutions continue to gain share from traditional quartz-based products due to their smaller form factor, programmability, and robustness in harsh environments. Shares rose after the company reported better-than-expected results and guidance, driven by continued strong growth in data center products benefiting from the proliferation of AI. While investors expected revenue growth of approximately 50% for the year, the company guided to more than 80% growth, reflecting a step change as adoption of its differentiated offerings accelerates. With exposure to Apple’s internal modem and a growing presence across automotive, industrial, and aerospace and defense end markets, and expected contributions from the pending acquisition of Renesas' timing division, SiTime is well positioned to deliver sustained long-term growth. Strong operating leverage should further support earnings expansion and shareholder returns over time.
• Forgent Power Solutions, Inc. is a leading manufacturer of electrical distribution equipment used in data centers, the power grid, and industrial applications. The company specializes in low- and medium-voltage electrical equipment, with more than 90% of revenue derived from custom, engineered-to-order products, while larger competitors tend to focus on higher-voltage and more standardized offerings. Shares rose during the quarter as Forgent continued to deliver robust financial results and benefit from improving demand tied to AI infrastructure investment and grid modernization. The company is gaining share through its ability to provide customized solutions with industry-leading lead times and is still only beginning to penetrate the largest customers in its market. Forgent has invested heavily in manufacturing capacity and talent to support future growth, and we  believe the company is well positioned for years of revenue growth and margin expansion as it scales toward a manufacturing footprint capable of supporting roughly $5 billion of revenue, up from its current revenue run rate of roughly $1.2 billion.
• CareDx, Inc. sells diagnostic tests that detect early signs of organ transplant rejection for heart, kidney, and lung recipients. The stock contributed to performance as reimbursement concerns eased. Following a sharp decline in the second half of 2025 after the Centers for Medicare & Medicaid Services' (CMS) MolDX program proposed eliminating coverage for the HeartCare test and introducing a bundled reimbursement model, shares reached levels that we believed reflected a worst-case scenario. Since then, investors have gained confidence as the National Coverage Determination process has continued to facilitate dialogue between CMS and key stakeholders, allowing for further consideration of recent clinical data. The company also reported strong first-quarter results, with revenue increasing 39% and testing volume growing 17% year over year. Additionally, CareDx announced the divestiture of its laboratory products business and the acquisition of Naveris, expanding the company's growth opportunities through entry into the head and neck cancer testing market and reinforcing our positive long-term outlook for the business.

DETRACTORS

• Shake Shack Inc., the fast-casual burger chain, detracted from performance during the quarter. Shares fell sharply after the company reported weaker-than-expected first-quarter earnings, though we believe the reaction reflected poor communication and expectation-setting rather than any deterioration in the underlying business. Same-Shack sales grew 4.6%, including 1.4% positive traffic growth, marking the third consecutive quarter of positive traffic despite an estimated 240-basis-point weather headwind. Restaurant-level margin expanded 50 basis points to 21.2%. While EBITDA missed expectations, the shortfall was primarily attributable to the timing of accelerated pre-opening expenses, repair and maintenance costs, and elevated general and administrative spending. Although trends weakened in April, results rebounded in early May, with comparable sales increasing 8% and traffic rising 5%, driven by enthusiasm around menu innovation. We continue to view Shake Shack as a compelling long-term growth investment and believe the current valuation remains highly attractive relative to the strength of its business fundamentals.
• Karman Holdings Inc. is a best-in-class supplier of defense systems and components. Shares declined during the quarter as sentiment toward high-multiple small- and mid-cap defense companies weakened amid increased debate around the pace of defense budget growth in Washington and a reversal of the momentum-driven flows that had supported the sector earlier in the year. We retain conviction in Karman. New Chief Executive Officer Jon Rambeau has made a strong early impression and guided to organic growth above 20% for the foreseeable future. Long term, we expect Karman to grow well above its peers given its mission-critical content across several of the nation's flagship defense programs, which are expected to see substantial production increases over the coming years.
• Leading defense technology provider Kratos Defense & Security Solutions, Inc. declined during the quarter as sentiment toward high-multiple small- and mid-cap defense companies weakened amid increased uncertainty surrounding the pace of defense budget growth and a reversal in momentum-driven investor flows. We remain shareholders. The company continues to execute well, with strong visibility into additional contract wins across its core business and new opportunities emerging across previously nascent segments. We believe Chief Executive Officer Eric DeMarco has built one of the most innovative defense players and continue to see compelling long-term prospects for Kratos.

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 Discovery Fund (the Fund) posted a strong gain of 19.08% (Institutional Shares) for the second quarter yet trailed the Russell 2000 Growth Index (the Index) by 663 basis points. According to MSCI’s Barra factor attribution, stock selection was a modest tailwind in the period but was undone by style-related headwinds. Style factors were responsible for about 90% of the underperformance, with the primary culprit being significant underexposure to Momentum, which continued its sustained run of strong performance in the period, powered by investor excitement about AI. Underexposure to Beta was also detrimental given the factor’s favorable performance in a period of notable market strength. The Beta factor posted its best three-month performance on record during the period, with the factor’s performance rivaling prior sharp market rallies that followed bear markets, such as “Black Monday”, the dotcom collapse, the Great Recession, and the COVID pandemic. Many of the top contributors in the Index were what the market calls “AI winners” with elevated exposure to the Momentum and Beta factors. In other words, it was the AI winners that drove outsized factor performance, especially when it comes to Momentum and Beta, contributing to the Fund’s underperformance in the period. The remaining underperformance came from cash exposure in dramatic market rally and industry headwinds largely associated with being overexposed to lagging Aerospace and Defense stocks.

From a sector perspective, investments in Information Technology (IT) and Consumer Discretionary accounted for most of the relative losses in the period. A portion of the weakness in IT was due to poor stock selection in application software, where property and casualty insurance software vendor Guidewire Software, Inc. and construction management software provider Procore Technologies, Inc. were material detractors. Guidewire and Procore underperformed as investors continued to rotate out of software names amid ongoing AI uncertainty. We believe AI will ultimately be a meaningful tailwind for both businesses. Guidewire’s InsuranceSuite platform serves as the core system of record for insurance carriers, functioning as the single source of truth for the policies an insurer writes, the claims it processes, the premiums it collects, and the payments it makes. Insurance policies are complex, highly regulated, and stored exclusively in digital form within Guidewire, which makes the system of record particularly critical and therefore highly valuable. We believe the core system opportunity alone represents nearly $20 billion of annual recurring revenue, or roughly 20 times Guidewire’s current size. In our view, AI meaningfully expands this opportunity by enabling automation and intelligence on top of the core system of record. Guidewire is already bringing new AI enabled capabilities to market and signing customers, and we expect adoption to accelerate over the coming year. Finally, we expect Guidewire to benefit from the same internal productivity enhancements AI is driving across enterprises, helping the company support faster growth with lower costs and ultimately improving profitability.

Procore is the leader in a large and under-digitized market, yet the company still has a relatively modest market share. Its existing customer base provides significant room for expansion, with new customers and adjacent growth levers such as the international markets and fintech representing additional opportunities for growth. Procore's competitive edge is derived from its unified platform and collaborative pricing model that drives network effects across the construction industry. We retain conviction in the durability of Procore's growth opportunity and believe that its competitive positioning remains strong. We see meaningful potential for future margin expansion.

Weak stock selection in IT was exacerbated by having lower exposure to semiconductor stocks, which were up 100% in the Index, detracting 75-plus basis points from relative performance.

Within Consumer Discretionary, higher exposure to this lagging sector coupled with declines from fast-casual burger chain Shake Shack Inc. and luxury casino operator Wynn Resorts, Limited hampered performance. Shake Shack’s shares fell sharply after the company reported weaker-than-expected first-quarter earnings, though we believe the reaction reflected poor communication and expectation-setting rather than any deterioration in the underlying business. Same-Shack sales grew 4.6%, including 1.4% positive traffic growth, marking the third consecutive quarter of positive traffic despite an estimated 240-basis-point weather headwind. Restaurant-level margin expanded 50 basis points to 21.2%. While EBITDA missed expectations, the shortfall was primarily attributable to the timing of accelerated pre-opening expenses, repair and maintenance costs, and elevated general and administrative spending. Although trends weakened in April, results rebounded in early May, with comparable sales increasing 8% and traffic rising 5%, driven by enthusiasm around menu innovation. We continue to view Shake Shack as a compelling long-term growth investment and believe the current valuation remains highly attractive relative to the strength of its business fundamentals.

Wynn’s stock was pressured by increasingly difficult second-half comparisons in Macau, where growth is expected to moderate as the market laps a strong prior-year recovery. Sentiment was further weighed down by the ongoing conflict in the Middle East, which added uncertainty around the timeline and risk profile of the Wynn Al Marjan Island development in the UAE. We continue to view Wynn as the premier operator across the premium mass and VIP segments, supported by an unmatched luxury brand and meaningful long-term optionality from its entry into a new regulated gaming market. We remain shareholders but are closely monitoring Macau's growth trajectory amid increasingly difficult comparisons and the geopolitical backdrop surrounding the UAE development.

Somewhat offsetting the above was favorable stock selection in Health Care along with limited exposure to the lagging Energy and Materials sectors, which added 300-plus basis points of relative gains. Performance in Health Care was bolstered by a combination of higher exposure to life sciences tools & services stocks, which were up more than 50% in the Index, and robust gains from Establishment Labs Holdings Inc. and Veradermics, Incorporated. Establishment Labs sells next-generation Motiva breast implants designed to offer meaningful safety improvements and aesthetic benefits compared to competing products. Shares increased in the second quarter, driven by continued strong adoption of Motiva in the U.S. breast augmentation market and anticipation of the upcoming launch in the U.S. breast reconstruction market. Additionally, concerns related to consumer spending and the company's silicone supply agreement, which weighed on the stock last quarter, eased meaningfully. Positive momentum was further amplified by the company's official inclusion in the Russell 2000 Index, which generally increases institutional visibility and drives index-related buying. We believe Establishment Labs can capture a leading share in the U.S. over the next several years, driving strong revenue growth, improving profitability (with free cash flow expected to turn positive in 2026), and meaningful long-term value creation.

Veradermics is a dermatologist-founded, late clinical-stage biopharmaceutical company developing VDPHL01, an extended-release oral minoxidil tablet for pattern hair loss. In April, the company reported solid Phase 3 data in male pattern hair loss. The drug demonstrated robust hair growth with up to 63% of male patients reporting improved hair coverage compared to just 13% on placebo. We await data from a second Phase 3 study of VDPHL01 in male pattern hair loss and the first clinical data from a Phase 2 study of VDPHL01 in female pattern hair loss patients, both expected in the second half of 2026. If VDPHL01 is U.S. Food and Drug Administration (FDA) approved, we think it will be uniquely positioned as the first FDA-approved oral treatment in several decades for a condition affecting 80 million Americans.