Baron Discovery 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

• Leading defense technology provider Kratos Defense & Security Solutions, Inc. contributed to performance following a strong earnings report and continued momentum across its business segments. Years of investment are beginning to pay off, with the company winning new contracts across multiple divisions. The current defense spending cycle appears to be in a generational upswing amid heightened global conflicts, and Kratos’ innovative solutions position it well to support the U.S. Armed Forces. The current administration’s openness to smaller, agile defense contractors further strengthens Kratos’ opportunity to secure larger awards, supporting our continued conviction in the company.
• Mercury Systems, Inc. designs, manufactures, and markets high-performance embedded digital signal and image processing systems, mission systems, and software for Tier-1 defense contractors worldwide. Shares rose during the quarter following another strong earnings report, reflecting the material progress made since CEO Bill Ballhaus began restructuring the company in 2023. Mercury continues to deliver meaningful margin expansion and is benefiting from a generational increase in defense spending across the ecosystem, particularly among the nation’s flagship defense programs, for which it is serves as a mission-critical supplier of electronic components and solutions. We continue to expect accelerating growth and further margin expansion in the years ahead.
• Shares of Karman Holdings Inc., a best-in-class supplier of defense systems, rose during the quarter as the company continued to benefit from a generational increase in defense spending. Demand was especially strong across the nation’s flagship defense programs, where Karman is a mission-critical supplier of components and solutions, as well as in emerging segments such as hypersonics, where the company is a leading player. Karman is arguably one of the most important suppliers in the defense industry, given its focus on technically complex systems for a customer base composed largely of prime contractors, enabling margins more than double the peer average. We continue to expect elevated growth and incremental margin expansion as the company solidifies its irreplaceable position in the defense supply chain.

DETRACTORS

• PAR Technology Corporation is a leading global provider of software, systems, and service solutions to the restaurant industry. Shares fell during the quarter after the company lowered its full-year growth outlook to 15% from 20%, reflecting a weaker-than-expected first half driven by soft macroeconomic conditions and deliberate rollout delays for certain customers. These delays were strategic, allowing PAR to focus on securing contracts with several large enterprise restaurant chains currently in late-stage negotiations, at least one of which could meaningfully expand the company’s scale. Despite the slower start to the year, management remains confident in achieving 20% annual recurring revenue growth over the next 12 months, supported by a strong pipeline of contracted and prospective customers, including its ongoing rollout with Burger King. As more enterprise-scale restaurants upgrade their technology stack, we believe PAR is well positioned to capture outsized share as the leading cloud-based platform in the industry. Strong software revenue growth combined with rapidly scaling profitability should drive meaningful long-term performance.
• Inspire Medical Systems, Inc. is a medical device company offering a treatment option called hypoglossal nerve stimulation for patients with moderate-to-severe obstructive sleep apnea. Shares fell during the quarter as management lowered 2025 financial guidance, citing several factors behind the slower-than-expected rollout of Inspire 5, the company’s next-generation device. These included delays onboarding centers to a new patient management platform, a postponed Medicare reimbursement code that did not take effect until July 1 due to a software update, patients deferring procedures in anticipation of Inspire 5’s availability, and management’s decision to pause marketing efforts and new center expansion. In addition, management noted anecdotal reports of some patients delaying procedures to try GLP-1 medications. ​We exited our position.
• Wingstop Inc. is a fast-casual restaurant chain known for its cooked-to-order chicken wings and wide flavor variety, operating a highly franchised model across the U.S. and abroad. Shares fell during the quarter amid softening sales momentum. While the company reported better-than-expected quarterly results over the summer, subsequent market data indicated weakening sales trends as the quarter progressed. We attribute this to a broader slowdown in industry spending that has affected Wingstop’s customer base. Despite these short-term headwinds, we maintain conviction in Wingstop’s long-term growth prospects. The company’s asset-light, franchised business model and best-in-class unit economics should continue to support double-digit unit growth for the foreseeable future. We also believe Wingstop’s technology initiatives to reduce order times will drive improved sales and that the company will benefit from continued growth in marketing and brand awareness.

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’s (the Fund) extended streak of outperformance came to an abrupt halt in the third quarter, as the Fund relinquished all relative gains from the first half of year. The Fund appreciated 2.85% (Institutional Shares) in the September quarter yet meaningfully trailed the Russell 2000 Growth Index (the Index) by 934 basis points. About half of the relative losses stemmed from style-related headwinds, as the Fund was punished for being overexposed to the Earnings Quality factor, which suffered its worst three-month performance on record. The Fund’s underexposure to the strong performing Momentum, Residual Volatility, and Beta factors also contributed to the relative shortfall in the period. The remaining underperformance came from active industry exposures and a few stock-specific issues. 

From a sector perspective, poor stock selection in Information Technology (IT), Health Care, and Consumer Discretionary contributed the vast majority of relative losses in the period. Stock-specific weakness in IT was a 500-plus basis point drag on performance, as declines from several of the Fund’s software holdings proved costly owing partly to broader uncertainty around the impact of AI on the software space. Restaurant foodservice technology provider PAR Technology Corporation was the largest detractor after the company lowered its full-year growth outlook to 15% from 20%, reflecting a weaker-than-expected first half driven by soft macroeconomic conditions and deliberate rollout delays for certain customers. These delays were strategic, allowing PAR to focus on securing contracts with several large enterprise restaurant chains currently in late-stage negotiations, at least one of which could meaningfully expand the company’s scale. Despite the slower start to the year, management remains confident in achieving 20% annual recurring revenue growth over the next 12 months, supported by a strong pipeline of contracted and prospective customers, including its ongoing rollout with Burger King. As more enterprise-scale restaurants upgrade their technology stack, we believe PAR is well positioned to capture outsized share as the leading cloud-based platform in the industry. That being said, we decreased the position size given the macroeconomic headwinds the company is facing. Other material detractors in software were observability software platform Dynatrace, Inc., digital banking solutions provider Alkami Technology Inc., professional services software provider Intapp, Inc., and investment management software platform Clearwater Analytics Holdings, Inc. 

Performance in Health Care was hindered by double-digit losses from obstructive sleep apnea treatment pioneer Inspire Medical Systems, Inc. and transplant diagnostics company CareDx, Inc. Inspire’s shares fell after management lowered 2025 financial guidance, citing several factors behind the slower-than-expected rollout of Inspire 5, the company’s next-generation device. These included delays onboarding centers to a new patient management platform, a postponed Medicare reimbursement code that did not take effect until July 1 due to a software update, patients deferring procedures in anticipation of Inspire 5’s availability, and management’s decision to pause marketing efforts and new center expansion. In addition, management noted anecdotal reports of some patients delaying procedures to try GLP-1 medications. We exited our position.

CareDx’s stock fell sharply after the Centers for Medicare & Medicaid Services’ Molecular Diagnostics (MolDX) Program issued a draft coverage decision that would significantly limit reimbursement for CareDx’s tests. In particular, the proposal introduces a bundled payment model and recommends testing at a lower frequency than what has been supported by clinical studies and medical societies. The draft also removes coverage for HeartCare, CareDx’s dual test combining donor-derived cell-free DNA and gene expression profiling, despite robust data demonstrating clinical benefit. In our view, the draft decision does not reflect current medical evidence or best clinical practice, and we are hopeful that some restrictions will be revised in the final determination. We believe CareDx shares already reflect a worst-case scenario and could rerate meaningfully with any improvement in reimbursement policy.

Disappointing stock selection in Health Care was exacerbated by having limited exposure to biotechnology and pharmaceutical stocks, which were up 21.2% and 32.7%, respectively, in the Index. Lower exposure to these sub-industries accounted for about a third of the relative losses in the sector.

Weakness in Consumer Discretionary was broad based, led by double-digit declines from fast-casual restaurant chain Wingstop Inc. and online sportsbook and gaming operator DraftKings Inc.

Wingstop’s shares fell during the quarter amid softening sales momentum. While the company reported better-than-expected quarterly results over the summer, subsequent market data indicated weakening sales trends as the quarter progressed. We attribute this to a broader slowdown in industry spending that has affected Wingstop’s customer base. Despite these short-term headwinds, we maintain conviction in Wingstop’s long-term growth prospects. The company’s asset-light, franchised business model and best-in-class unit economics should continue to support double-digit unit growth for the foreseeable future. We also believe Wingstop’s technology initiatives to reduce order times will drive improved sales and that the company will benefit from continued growth in marketing and brand awareness.

DraftKings stock was pressured by unfavorable sports outcomes over the first four weeks of the NFL season. The company has missed expectations in each of the past two NFL seasons, and the weak start to the 2025 season has intensified debate around predictability of sportsbook margins. We believe these outcomes will normalize over time. DraftKings has made significant progress in improving profitability over the past several years, driven by a shift in bet mix toward higher-margin parlays, and we expect this upward margin trend to continue over the long term. The stock also faced pressure from the rapid growth of sports event–contract markets, which some view as a potential competitive threat. However, adoption so far appears concentrated in states where sports betting remains illegal, and we believe that, given the choice, bettors will prefer regulated platforms with broader offerings. Looking ahead, we expect DraftKings to generate significant free cash flow over the next year, supporting share repurchases at what we view as attractive valuation levels.

Somewhat offsetting the above was solid stock selection in Industrials and Communication Services along with lower exposure to the lagging Financials sector, which added 350-plus basis points of relative gains. Strength in Industrials was driven by the Fund’s aerospace & defense holdings, namely Kratos Defense & Security Solutions, Inc., Mercury Systems, Inc., and Karman Holdings Inc., whose shares were bolstered by strong earnings releases amid heightened defense spending. Environmental services company Montrose Environmental Group, Inc. also performed well in the sector after reporting strong growth and raising full-year guidance, driven by both organic expansion and increased emergency response revenue. The results boosted investor confidence in Montrose’s long-term outlook for 7% to 9% organic growth, supported by rising client demand for services that help manage environmental risks, and eased concerns that the business could face pressure in the current political environment. In addition, the company completed the redemption of its preferred convertible instrument in early July, enhancing balance sheet transparency. We remain shareholders and believe management’s ongoing initiatives to highlight organic growth and free cash flow generation will help unlock value in the stock.

Performance in Communication Services was aided by Liberty Media Corporation - Liberty Live, a tracking stock for Liberty Media Corporation's interest in Live Nation Entertainment, Inc., the world's largest live entertainment company. Liberty Live’s shares increased following a strong second-quarter earnings release that showed healthy growth across all segments. We believe the combination of strong category demand, expanding global artist supply, owned venue development, and margin expansion provides a solid backdrop for long-term adjusted operating income (AOI) growth. Concert segment margins continue to expand consistently, driven by scale, operational efficiencies, and the shift toward owned and operated venues. We also believe the historically loss-leading promotion segment is becoming a fundamentally stronger business. Additionally, management is investing in promotion talent internationally to support the company’s expanding footprint. Overall, we remain optimistic about Liberty Live’s ability to deliver double-digit AOI growth over the long term.