Baron Growth Fund: Latest Insights and Commentary

U.S. equity markets managed gains in a period of heightened volatility, with the CBOE Volatility Index (VIX) briefly spiking above 50 for the first time in over five years before settling back below its long-term average of 20 by quarter end as tariff policy uncertainty and war in the Middle East failed to unnerve investors. Risk-off sentiment early in the quarter centered around President Trump’s “Liberation Day” tariff announcement, which Wall Street strategists viewed as more severe than expected and likely to slow economic growth, boost inflation, and increase the odds of a recession this year. On April 2, President Trump unveiled an unprecedented global tariff regime, placing a 10% baseline tax on imports from all countries, a 34% tariff on Chinese goods, a 25% tariff on all car imports, and a 20% tariff on EU goods. In retaliation, China imposed 34% tariffs on U.S. goods and the EU announced its own countermeasures. The S&P 500 Index fell more than 12% over the next four days, nearly entering bear market territory from its all-time high on February 19, 2025 (down almost 19%). Other prominent benchmarks, such as the NASDAQ Composite Index and Russell 2000 Index, officially entered a bear market in early April, declining more than 20% from their respective all-time highs reached late last year.

After bottoming on April 8, U.S. equities rebounded due to positive trade developments. On April 9, Trump announced a 90-day pause on most reciprocal tariffs to allow for negotiations. China was the only country excluded from the pause, with Trump instead raising tariffs on China to 145%, prompting Chinese officials to increase tariffs on U.S. goods to 125%. However, U.S. and Chinese officials eventually agreed to a de-escalation of tariffs on May 12, alleviating investor concerns and contributing to additional market gains. Other market catalysts were resilient corporate earnings amid tariff-driven pressures, dovish Federal Reserve commentary following muted May inflation, AI tailwinds from NVIDIA’s strong earnings results and Middle East deals, improving consumer sentiment, and a recent ramp in M&A and IPO activity. The sudden Israel-Iran war and subsequent involvement of the U.S. via the bombing of various Iranian nuclear sites threatened to upend market momentum, but a fragile ceasefire was quickly brokered, and the market resumed its advance to close the quarter at a record high.

The Magnificent Seven complex resumed its leadership role during the quarter, accounting for nearly 60% of the S&P 500 Index’s gains. The group appreciated more than 20% in the period, outpacing the Index, which was up 10.9%. NVIDIA (+45.8%), Microsoft (+32.7%), Meta (+28.2%), and Tesla (+22.6%) posted the largest gains. Apple (-7.5%) was the only member of the group to decline and trail the broader Index.

Sector performance mirrored the influence of the Magnificent Seven, as Information Technology, Communication Services, and Consumer Discretionary were among the top performing sectors. Industrials was the only other sector to outperform the Index, helped by strong gains from aerospace & defense companies. Health Care experienced a severe reversal of fortunes during the quarter, as the sector’s 7.2% decline wiped out all year-to-date outperformance versus the broad market. After trailing the S&P 500 Index by more than 50% over the prior two calendar years, Health Care was tracking ahead of the Index this year, outperforming by 750-plus basis points through the end of April. But that all changed in May and June when the sector trailed the Index by approximately 15%. Health Care performance was hampered by multiple factors, including regulatory uncertainty, particularly around drug pricing and Medicare Advantage reimbursement rates, federal investigations involving sector heavyweight UnitedHealth, disruption at the FDA and cancellations/delays of NIH grants for academic research, concerns about tariffs on the pharmaceutical industry, and renewed investor interest in AI-driven technology companies. Energy was another notable laggard, pressured by the sharp decline in oil prices during the quarter.

From a style perspective, small caps failed to lead the way in the market recovery during the quarter, trailing mid- and large-cap stocks. Small caps remain in negative territory this year, down 1.8%, while larger-cap stocks are up about 6%, having recovered all losses from early in the year. Growth stocks outperformed for a third consecutive month to finish the quarter ahead of value by between 400 and 1,400 basis points. The largest differential was in mid and large cap, where sizeable weights in Palantir/AppLovin and Magnificent Seven factored heavily into the strong showing for these growth benchmarks. Growth is now outperforming in most size segments this year, representing a meaningful turnaround from the end of March when value was ahead by a wide margin across the board.

Beyond the U.S., developed and emerging market (EM) equities were up double digits for the quarter, benefiting from the significant allocation shift away from U.S. equities early in the period. Despite modest underperformance in June, developed Europe was a standout for the quarter, bolstered by sharp gains in the Netherlands, Spain, Ireland, Germany, Italy, Finland, and Sweden. Securities in Israel, Hong Kong, Australia, and Canada also contributed to strength in developed markets. EM equities were lifted from semiconductor-related strength in Taiwan and Korea (SK hynix). Solid gains in Mexico and Brazil also contributed to EM outperformance, as investors were relieved about the relatively less punitive tariff approach announced by the U.S. administration.

CONTRIBUTORS

• Shares of veterinary diagnostics leader IDEXX Laboratories, Inc. contributed to performance for the quarter after reporting better-than-expected financial results. Foot traffic to veterinary clinics in the U.S. remains under pressure, which has continued to hamper aggregate revenue growth. Despite macroeconomic challenges, IDEXX’s excellent execution has enabled the company to maintain strong performance. We believe competitive trends are outstanding, and we expect new proprietary innovations and field sales force expansion to be meaningful contributors to growth in 2025. We see increasing evidence that long-term secular trends around pet ownership and pet care spending have structurally accelerated, which should help support IDEXX’s long-term growth rate.
• Shares of property and casualty (P&C) insurance software vendor Guidewire Software, Inc. contributed to performance on strong fiscal Q3 2025 financial results and an upward revision to full-year guidance. After a multi-year transition, we think Guidewire’s cloud migration is largely complete. We believe cloud will be the sole path forward, with annual recurring revenue (ARR) benefiting from new customer wins and migrations of the existing customer base to InsuranceSuite Cloud. We also expect the company to shift R&D resources from infrastructure investment to product development, which should help drive cross-sales into its sticky installed base and potentially accelerate ARR growth over time. We are further encouraged by Guidewire’s subscription-based gross margin expansion, which improved by more than 600 basis points in the most recently reported quarter. We believe Guidewire will be the critical software vendor for the global P&C insurance industry, capturing 30% to 50% of its $15 billion to $30 billion total addressable market and generating margins above 40%.
• Red Rock Resorts, Inc. is a casino owner and operator focused on the Las Vegas Locals market. Shares rose during the quarter as the market returned to growth following the successful absorption of Red Rock’s Durango property, which opened in December 2023. This recovery is expected to accelerate the return of customers to Red Rock’s other casino resorts and fully offset prior cannibalization by mid-2026. Red Rock is currently renovating and expanding its three core assets. While these projects may cause some near-term construction disruption, we expect them to drive stronger earnings growth next year and generate attractive returns on capital. The resulting increase in cash flow should support further casino development, debt reduction, and additional dividend payments. The stock trades at a discount to its historical average, which we find attractive given the company’s growth prospects and improving balance sheet.

DETRACTORS

• Specialty insurer Arch Capital Group Ltd. gave back some of its gains from earlier in the year, following slower growth and broader weakness across insurance stocks during the second quarter. In the first quarter, premium growth came in below forecasts and slowed relative to the prior quarter due to rising competition and lower pricing in certain business lines. Even so, earnings beat expectations due to stronger underwriting margins and lower tax rates. We continue to own the stock due to Arch’s strong management team and our expectation of significant growth in earnings and book value over time.
• Choice Hotels International, Inc. is a global franchisor of economy and midscale hotels across a portfolio of well-known brands. Shares fell during the quarter as investors focused on slowing revenue-per-available-room (RevPAR) growth. However, management has steadily reduced Choice’s exposure to RevPAR fluctuations by expanding higher-margin, non-RevPAR fee income as it leverages the company’s 70-million-member loyalty database to secure additional partnerships with credit card companies, timeshare operators, and casinos. Choice is also adding higher-revenue units at a low single-digit rate, with a focus on larger room sizes, premium royalty rates, and RevPAR levels that exceed the current portfolio. We expect revenue growth to accelerate as a robust pipeline of new projects come online and Choice captures synergies from its Radisson Americas acquisition by increasing traffic to those properties and narrowing the royalty-rate gap between Radisson and legacy Choice brands. With a strong balance sheet, Choice is well positioned to return capital to shareholders through dividends and share repurchases.

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 Growth Fund (the Fund) relinquished the entirety of its outperformance from the prior quarter as the Russell 2000 Growth Index (the Index) rebounded during the second quarter. The Fund rose 0.86% (Institutional Shares) in the period, trailing the Index, which appreciated 11.97%, by 11.11%. The shortfall was mostly style-related, with the Fund’s underexposure to higher beta stocks proving especially damaging given the Beta factor experienced one of its best three-month periods of performance in the last 25 years. The only time Beta performed better was the initial market rally coming out of the COVID downturn. 

From a sector perspective, stock selection in Financials was responsible for approximately 70% of the underperformance in the period, driven by declines from insurers Arch Capital Group Ltd., Kinsale Capital Group, Inc., and Primerica, Inc. Specialty insurers Arch and Kinsale reported premium growth below expectations and slowed from the prior quarter due to lower pricing in certain business segments. We maintain conviction as we believe both companies are well managed and have significant growth potential. Primerica detracted from performance as market volatility and lower equity prices weighed on expectations for sales growth and asset-based fees. Cost-of-living pressures also continued to impact new policy sales and client retention in the life insurance business. We remain investors because we expect earnings growth to persist, as Primerica provides much-needed financial advice to underserved middle-income households.

Financial data providers MSCI Inc. and FactSet Research Systems Inc. also weighed heavily on performance. MSCI’s shares failed to keep pace with the broader sector despite reporting solid quarterly earnings and reiterating 2025 guidance. We retain long-term conviction as MSCI owns strong, “all weather” franchises and remains well positioned to benefit from numerous secular tailwinds in the investment community. FactSet’s stock experienced some volatility following the announcement that longtime CEO Phil Snow will retire later this year. Remarks on a recent earnings call emphasized that this was a personal decision unrelated to company performance. The company reported better-than-expected fiscal Q3 earnings, and management remained upbeat about prospects for the remainder of fiscal 2025. We continue to own the stock given its large addressable market, strong execution across both new product development and financial results, and robust free cash flow generation.

Poor stock selection in Information Technology (IT) and Consumer Discretionary accounted for most of the remaining underperformance. Weakness in IT came from the Fund’s meaningful position in syndicated research provider Gartner, Inc., whose shares declined as reductions in government spending negatively impacted the company’s public sector business. We estimate U.S. federal exposure accounts for about 5% of Gartner’s total research contract value, with about half from the Department of Defense and intelligence organizations, and half from civilian agencies. While federal budget scrutiny remains high, we believe Gartner’s services deliver significant value to users, including the potential for hard dollar savings. The private sector business appears well positioned for sustained growth, and management is adept at exercising cost controls to support margins and free cash flow generation. The company’s balance sheet is in excellent shape, and we expect management to take advantage of this drawdown through aggressive share repurchases.

Performance in Consumer Discretionary was hindered by modest declines from hotel franchisor Choice Hotels International, Inc. and global ski resort operator Vail Resorts, Inc. Choice Hotels shares were pressured by investor concerns about slowing revenue-per-available-room (RevPAR) growth. However, management has steadily reduced Choice Hotels’ exposure to RevPAR fluctuations by expanding higher-margin, non-RevPAR fee income as it leverages the company’s 70-million-member loyalty database to secure additional partnerships with credit card companies, timeshare operators, and casinos. We retain conviction. With a strong balance sheet, Choice Hotels is well positioned to return capital to shareholders through dividends and share repurchases. Vail’s stock declined modestly on investor concerns about slowing visitation levels and the potential impact on early season pass sales for the upcoming ski season. The return of former CEO Rob Katz added uncertainty about the company’s future strategic direction, further pressuring shares. We remain investors. We view Katz’s return positively and expect his emphasis on guest experience, pricing, and targeted acquisitions to reignite growth. Combined with a well-covered mid-single-digit dividend yield and a strong balance sheet that supports strategic growth through M&A, reinvestment in the portfolio, and share repurchases, we see an attractive long-term opportunity and the potential for multiple expansion from multi-year lows.

Apart from stock selection, minimal exposure to the better performing Industrials sector and higher exposure to the lagging Real Estate sector detracted another 260-plus basis points from relative results.

Somewhat offsetting the losses above was significantly lower exposure to the lagging Health Care sector, which added 150-plus basis points of relative gains. Within Health Care, underperformance from biotechnology and pharmaceutical stocks caused the sector to trail the broader Index. Lack of exposure to the lagging Energy and Consumer Staples sectors contributed another 70-plus basis points of relative gains.