Baron Discovery Fund: Latest Insights and Commentary

CONTRIBUTORS

• CareDx, Inc. provides diagnostic tests that detect early signs of organ transplant rejection in heart, kidney, and lung recipients. The stock contributed meaningfully to performance following the finalization of a highly favorable Local Coverage Determination (LCD) policy for molecular transplant testing. The company had previously faced reimbursement uncertainty while awaiting a final coverage decision from the Centers for Medicare & Medicaid Services (CMS) MolDX program that could have significantly limited reimbursement across its transplant testing portfolio. We believed the market was pricing in an overly severe outcome. Sentiment began to improve in the second quarter, and in the third quarter, CareDx received a best-case reimbursement outcome for its kidney, heart, and lung transplant tests. We believe this outcome validates our differentiated view and demonstrates how fundamental research and variant perception can generate exceptional investment returns.
• Tempus AI, Inc. is an intelligent diagnostics and health care data company with synergistic diagnostics and data businesses. Data generated through Tempus’ diagnostic testing enhances its data business, where the company combines genomic and clinical patient information from oncology partners to build a large proprietary multimodal dataset. Shares rose meaningfully during the quarter following better-than-expected earnings and full-year guidance. Management expressed strong confidence in the data business, citing a robust biopharma pipeline. Tempus also acquired Personalis, Inc., which specializes in minimal residual disease (MRD) testing to monitor cancer recurrence. We believe MRD testing represents a significant market opportunity and complements Tempus’ existing diagnostics and data platform.
• Dynatrace, Inc., a provider of AI-powered observability software, contributed to performance as investors increasingly recognized observability as a primary beneficiary of enterprise AI adoption. Agentic applications expand the number of services, dependencies, failure and security points, and amount of telemetry that must be monitored. Because Dynatrace prices based on consumption rather than seats, this added complexity translates directly into revenue. Management disclosed that customers running AI workloads consume at 1.5 times the rate of other customers, while the number of customers using Dynatrace to monitor AI and agentic workloads also grew sharply. Fundamentals reinforced the trend, with annual recurring revenue (ARR) of $2.14 billion growing 17% in constant currency, net new ARR increasing 66%, and guidance moving higher. We retain long-term conviction in Dynatrace, viewing observability as a durable picks-and-shovels opportunity within the AI build-out.

DETRACTORS

• 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 fell as sentiment weakened across the AI infrastructure market, despite financial results and guidance that beat expectations. Bookings reached $1.5 billion during the quarter, significantly exceeding the company’s current revenue run rate. Forgent is gaining market share through its ability to offer customized products with industry-leading lead times and remains in the early stages of its opportunity, having recently signed its first master services agreement (MSA) with a hyperscale customer. The company has invested heavily in capacity and personnel to support future growth. Given the strength of demand, Forgent has increased its planned manufacturing footprint to $5.8 billion, supporting our view that the company has many years of growth and margin expansion ahead.
• Loar Holdings Inc. is a specialized aerospace components manufacturer focused on highly engineered, mission-critical products. Shares declined amid growing negative sentiment toward the aerospace aftermarket as elevated fuel prices related to the Iran War weighed on the outlook. We expect Loar to outperform peers, supported by latent pricing power and a strong new product pipeline. The company has not fully utilized its pricing power in stronger market conditions, providing flexibility in a more challenging environment. We also expect new product growth to accelerate as customers increasingly seek out leading suppliers to solve complex problems.
• 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 declined amid increasingly negative sentiment toward the defense space and concerns about the potential implications of Democratic control of Congress following the midterm elections. We remain shareholders. As a leading provider of proprietary defense electronics solutions, Mercury is exposed to key national defense offerings. We expect accelerated growth as the programs Mercury supports ramp production considerably.

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) declined 4.16% (Institutional Shares) in the third quarter, outperforming the Russell 2000 Growth Index (the Index) by 523 basis points. According to MSCI's Barra factor attribution, stock selection and style factors contributed roughly equally to the outperformance. The largest style tailwind was the Fund's significant underexposure to Momentum, which gave back a portion of its strong first-half gains, adding approximately 230 basis points to relative results. This marked a sharp shift from the first half of 2026, when investors favored momentum “AI winner” stocks. In the third quarter, they sold those names and rotated into industries such as software and certain pockets of Health Care. Because the Fund is underweight both “AI winner” stocks and the Momentum factor, and overweight software, the shift helped it recover some of its year-to-date underperformance. The Fund also benefited from its overweight to the Size factor, as investors gravitated toward larger-cap stocks within the small-growth universe amid heightened market uncertainty.

Industry effects were a modest headwind, largely due to the Fund’s overexposure to Aerospace and Defense, which was among the worst performing industries in the period.

From a sector perspective, stock selection in Health Care and Information Technology (IT) added more than 950 basis points, the vast majority of relative gains. Strength in Health Care was largely driven by higher exposure to life sciences tools & services stocks, including sizable positions in CareDx, Inc., Tempus AI, Inc., and Repligen Corporation.  The sub-industry staged a broad-based recovery after several difficult years marked by post-pandemic destocking, weak demand from China, and cautious biopharmaceutical R&D budgets. Biopharmaceutical funding rebounded to its highest quarterly total since late 2021, clinical pipeline activity continued to expand, and a long-awaited bioprocessing and lab-instrument replacement cycle gained traction. As a result, many of our holdings and several industry bellwethers beat expectations and raised full-year guidance during the quarter.

Another standout in the sector was Heartflow, Inc., a commercial-stage medical technology company whose AI platform turns coronary CT scans into non-invasive diagnostics for coronary artery disease. Shares surged during the quarter after the company reported strong second-quarter results and raised its outlook. Plaque-activated accounts are accelerating, and reimbursement coverage continues to run ahead of plan. We retain conviction given Heartflow's scale advantage in an underpenetrated market and potential to expand its addressable market as asymptomatic screening trials begin enrolling.

Within IT, gains were concentrated in systems software, which added more than 325 basis points, as our cybersecurity holdings Rubrik, Inc., Netskope, Inc., SentinelOne, Inc., and Dynatrace, Inc. rebounded sharply. Investors increasingly recognized that frontier AI is a driver of demand for security and monitoring rather than a threat to these businesses. Agentic applications expand the number of services, dependencies, and failure and security points, while also generating far more telemetry that must be secured, monitored, and analyzed. AI-enabled attackers are also raising the speed and sophistication of threats, forcing enterprises to invest in stronger defenses, and the need to protect and recover data used by AI models adds to demand. Together, these dynamics lengthen the runway for spending on the platforms that secure and observe enterprise infrastructure. Fundamentals reinforced the trend, with the group reporting solid results and, in many cases, raised guidance during the quarter.

Partially offsetting these gains was weakness in Industrials and Consumer Discretionary. Within Industrials, the Fund’s higher exposure to aerospace & defense stocks, which were down 20% in the Index, detracted roughly 100 basis points from relative performance. Aerospace & defense came under pressure from two distinct sources. In commercial aerospace, sentiment toward the aftermarket deteriorated as elevated fuel prices related to the Iran war weighed on the industry outlook. In defense, sentiment weakened broadly, as investors grew concerned about the potential implications of Democratic control of Congress following the November mid-term elections. These pressures weighed on Loar Holdings Inc., Karman Holdings Inc., and Mercury Systems, Inc., which together were the principal detractors and responsible for more than half of the losses in Industrials. We believe the sell-off in our aerospace & defense holdings is overdone and remain constructive on their fundamentals. 

Stock selection contributed to the shortfall in Industrials, owing mostly to poor performance from Forgent Power Solutions, Inc., a leading manufacturer of electrical distribution equipment used in data centers, the power grid, and industrial applications. Shares fell as sentiment weakened across the AI infrastructure market, despite results and guidance that beat expectations and bookings of $1.5 billion in the quarter, well above the company’s current revenue run rate. Forgent specializes in custom, engineered-to-order low- and medium-voltage equipment (more than 90% of revenue), where larger competitors tend to focus on higher-voltage, more standardized products. It is gaining share through industry-leading lead times and is still early in its opportunity, having recently signed its first master services agreement with a hyperscale customer. Given the strength of demand, Forgent has increased its planned manufacturing footprint to $5.8 billion, supporting our view that it has many years of growth and margin expansion ahead.

Within Consumer Discretionary, the Fund's restaurant stocks were especially costly, led by declines from Wingstop Inc., a franchisor of wing-focused restaurants, and Jersey Mike’s Subs, Inc., a franchisor of fast casual, submarine-style sandwich restaurants. Wingstop detracted from performance as weakness among its core lower-income customers weighed on results. Domestic same-store sales fell 7.5% year over year in the second quarter as transactions declined, and management responded by lowering its full-year outlook to a same-store sales decline of 4% to 6%. We sold our position during the quarter and reallocated the proceeds into other restaurant companies, including Jersey Mike’s, where we saw better upside potential.

We initiated a position in Jersey Mike’s, one of the largest and fastest-growing limited-service restaurant brands in the U.S., with nearly 3,400 stores, nearly all franchised, and $4.3 billion in 2025 system sales. The brand pairs a premium, made-to-order product with a simple, efficient operating model and ranked number one in quick-service customer satisfaction in the American Customer Satisfaction Index for 2026. The unit economics are compelling: new stores cost about $515,000 to build, and with average unit volumes of $1.4 million, franchisees earned roughly 42% cash-on-cash returns in fiscal 2025. A strong owner-operator culture and a $200 million national ad fund would be very difficult for a competitor to replicate at scale.

We expect systemwide sales to keep growing at a double-digit pace over the next several years, following 18% annual growth from 2021 to 2025. Growth should come from 8% to 10% annual unit growth toward a long-term potential of 7,500 U.S. stores, 20 consecutive years of positive same-store sales, and a capital-light model with adjusted EBITDA margins above 50%. We believe the shares are very attractively priced and offer the opportunity for strong appreciation from here.