Baron Generational Growth Fund: Latest Insights and Commentary

CONTRIBUTORS

• Shares of syndicated research provider Gartner, Inc. rallied amid multiple expansion across information services stocks. We believe Gartner’s contract value growth is poised to reaccelerate as the company enhances its product offering, retrains its sales force, and benefits from easier comparisons in its public sector end market. We also view Gartner as an underappreciated beneficiary of AI, as organizations increasingly seek guidance on the risks and opportunities presented by the technology. In addition, we expect earnings and free cash flow to grow meaningfully faster than revenue as Gartner expands margins and returns excess capital through share repurchases. Management is on pace to deploy nearly $2 billion of free cash flow toward share repurchases this year, which we estimate could reduce the company's share count by roughly 15% to 20%.
• FIGS, Inc., a direct-to-consumer health care apparel brand, contributed to performance following a strong second quarter. Net revenue grew 28.8% year-over-year, driven by higher order volumes and average order value. Growth was broad-based, with scrubwear revenue up 26.5%, non-scrubwear up 40.3%, and international sales up 67%. Active customers increased 13% to approximately 3.1 million, while revenue per active customer reached a record high. Profitability also improved, with adjusted EBITDA margin expanding 570 basis points to 18.6%, reflecting full-price selling, lower returns, and expense leverage. Management raised its full-year revenue growth outlook to approximately 20% from the 14% to 16% range. We retain strong conviction in FIGS' business model and the company's ability to gain market share in the attractive global health care apparel industry.
• FactSet Research Systems, Inc., a leading provider of investment management tools, contributed to performance. The stock rose following fiscal third-quarter results, with organic revenue and annual subscription value (ASV) growth both reaccelerating and FactSet completing its largest-ever quarterly share repurchase. Shares advanced again following fiscal fourth-quarter results, with record organic ASV, guidance for a return to margin expansion in fiscal 2027, and AI solutions bookings that more than doubled during the year. We retain long-term conviction in FactSet given its large addressable market, consistent execution across both new product development and financial results, and robust free cash flow generation.

DETRACTORS

• Red Rock Resorts, Inc., an operator of regional casino resorts serving the Las Vegas locals market, detracted from performance as investors grew concerned that higher interest rates, inflation, and oil prices could slow market growth. Despite ongoing construction disruption, the market continues to grow at a low-single-digit rate on an adjusted basis. Red Rock is gaining market share through ongoing property renovations while generating strong returns on invested capital. The company is deploying its significant cash flow into additional property investments to support future growth. Red Rock also maintains a strong balance sheet, which should improve further as new expansions come online through the remainder of 2026 and into 2027, supporting an acceleration in growth next year. The stock currently trades at a trough multiple, which we believe should expand as investors see growth reaccelerate.
• Specialty insurer Arch Capital Group Ltd. detracted from performance amid a cyclical softening in industry pricing. Quarterly premiums declined as the company deliberately pulled back from new business it viewed as inadequately priced, consistent with management’s “cycle management” approach of prioritizing profitability over volume. Rising interest rates are expected to weigh on book value growth in the near term by creating unrealized losses in the fixed income portfolio, though higher rates should benefit results over time through improved yields on new investments. Despite these headwinds, Arch reported quarterly earnings ahead of consensus expectations, with book value per share up 15%. We continue to own the stock given Arch's strong management team and our expectation for continued earnings and book value growth over time.
• Hotel franchisor Choice Hotels International, Inc. detracted from performance during the quarter amid concerns about higher inflation and interest rates, as well as uncertainty surrounding a leadership change. We retain conviction in the stock. We have known the new chief executive officer for years and remain positive on the transition. More broadly, we believe the business is at a positive inflection point that is not fully reflected in the stock’s current valuation. Revenue per available room is accelerating from a slower first half of 2026, a trend we expect to continue into next year. Combined with faster unit growth domestically and internationally and higher royalty rates supported by the tools Choice provides franchisees to manage occupancy and pricing, we believe these factors should drive improved earnings next year. The company also continues to generate strong cash flow, which it is using to reinvest in the business and repurchase shares at what management views as a meaningful discount to intrinsic value. We believe the stock’s trough valuation multiple has room to expand as the business reaccelerates next year.

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 Generational Growth Fund (the Fund) increased 2.13% (Institutional Shares) in the third quarter, outperforming the Russell 2000 Growth Index (the Index), which declined 9.39%, by 11.5%. About 80% of the relative strength was due to style-related tailwinds, notably lower exposure to the weak performing Momentum and Beta factors, as the market rotated away from semiconductors and other so-called AI winners that had dominated market performance over the first half of the year. Stock selection was responsible for the remainder of the outperformance, as the Fund's investments in high-quality businesses with durable competitive advantages and strong free cash flow generation held up well in a challenging period for small- and mid-cap stocks.

From a sector perspective, Financials accounted for about half of the relative gains, owing to a combination of strong stock selection and significantly higher exposure to this better performing sector. Stock-specific strength was led by financial exchanges & data companies FactSet Research Systems Inc., Morningstar, Inc., and MSCI Inc. Solid earnings reports across the broader software and services universe helped dismantle the market's fear that AI would erode pricing power, compress margins, and displace incumbent platforms, and share prices across all three names benefited. FactSet shares advanced following fiscal third-quarter results that showed both organic revenue and annual subscription value (ASV) growth reaccelerating, alongside the company's largest-ever quarterly share repurchase. Shares rose again on fiscal fourth-quarter results, which delivered a record organic ASV for the year and AI-related ASV additions that more than doubled, with management guiding to a return to margin expansion in fiscal 2027. MSCI reported solid second-quarter results, with double-digit revenue growth and particular strength in the Index and Private Capital Solutions businesses. Management also expressed confidence in the pipeline for the back half of the year and in the traction of a large slate of recently launched products. Similarly, Morningstar reported solid results, with revenue and earnings exceeding expectations, organic revenue growth of 6.8%, and continued share repurchases. Results were strong across several of its key segments, including Wealth, Retirement, and Credit, which are largely asset-based and transactional businesses that are relatively well protected from AI-related disruption. 

Specialty insurers Arch Capital Group Ltd. and Kinsale Capital Group, Inc. also contributed a portion of the Financials-related gains. Despite posting modest declines in the period, Arch and Kinsale were meaningful contributors to relative performance given their large weights in a period of broad market weakness. Both companies continued to deliver solid financial results despite a cyclical slowdown in the property and casualty (P&C) insurance industry. We continue to own Arch because of its strong management team and our expectation of continued growth in earnings and book value over time. We remain Kinsale shareholders because we believe the company is well managed and has a long runway for growth in an attractive segment of the insurance market.

Favorable stock selection in Information Technology (IT) was another material driver of outperformance, led by double-digit gains in syndicated research provider Gartner, Inc. and P&C insurance software vendor Guidewire Software, Inc. After multiple quarters of significant share price weakness driven by AI-related fears and decelerating contract value growth, Gartner's stock rebounded sharply as the market began to appreciate the durability of its franchise. We have long believed the characterization of Gartner as an AI disruption victim was misplaced. The company has a vast and growing set of proprietary data, generated by hundreds of thousands of interactions with buyers, sellers, and consumers of technology. Its proprietary insights extend to corporate technology roadmaps, enabling Gartner to assess future trends. Its contract review program also delivers tangible return on investment for customers. Growth trends are improving as U.S. public sector headwinds abate and sales force productivity strengthens, and the company continues to repurchase shares aggressively at what we view as an attractive valuation. Taken together, we remain confident in Gartner's long-term outlook.

Like Gartner, Guidewire had been unjustly punished by the market for perceived AI disruption risk in prior periods. 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 and highly regulated, and the data underlying them is stored natively within Guidewire, which makes the system of record particularly critical and therefore highly valuable. We believe AI meaningfully expands the 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 that adoption to accelerate.

Solid stock selection in IT was enhanced by not owning semiconductors & semiconductor equipment stocks, which were down more than 20% the Index, adding 75-plus basis points of relative gains. 

Finally, strong stock selection in Consumer Discretionary coupled with lack of exposure to the lagging Industrials sector aided relative performance. The main standout in Consumer Discretionary was healthcare apparel brand FIGS, Inc., which delivered a strong second quarter. Net revenues grew 28.8% year-over-year, driven by more orders and higher average order value. Growth was broad-based: scrubwear revenue rose 26.5%, non-scrubwear rose 40.3%, and international sales grew 67% year-over-year. Active customers increased 13% to roughly 3.1 million, and revenue per active customer reached a record. Profitability inflected as well, with adjusted EBITDA margin expanding 570 basis points year-over-year to 18.6% on full-price selling, lower returns, and expense leverage. Management raised its full-year revenue growth outlook to approximately 20% from 14%–16%. We retain our strong conviction in FIGS.

Marginally offsetting the gains noted above was underexposure to Health Care, the Index's best-performing sector, driven by significant gains in life sciences tools & services and health care technology.