Baron Growth Fund: Latest Insights and Commentary

The upsurge was also marked by a change in leadership. Unlike recent quarters dominated by the Magnificent 7 megacap technology companies, gains were widespread. Buoyed by expectations of lower rates and steady growth, certain corners of the market, including small caps, real estate, and value stocks, led the rally. These segments also benefited from the rotation out of the Magnificent 7 into previously disfavored options.

The most recent economic data points to continued solid growth, with annualized GDP growth on track to increase by 1.3% to 2.5% in the third quarter. Inflation dipped to 2.5% in August, the lowest reading since February 2021. Unemployment ticked up but without the layoffs that tend to accompany a recession. Consumer spending remained solid, trending slightly up in August.

Baron Growth Fund increased in the quarter. Investments within Financials, Information Technology (IT), and Real Estate contributed the most. Financials has a strong quarter, with advances in all 11 holdings within the sector, led by top contributor MSCI Inc. and second largest contributor Arch Capital Group Ltd. Third largest contributor Gartner, Inc. led appreciation within IT. All four holdings within Real Estate increased, buoyed by the Fed’s interest rate cut. Industrials was the only detractor due to share price weakness in the portfolio’s two sector holdings.

Looking ahead, with much of the data pointing to a soft landing in which inflation retreats without a major economic slowdown, investors seem increasingly confident it can be achieved. Corporate earnings improved in the second quarter and third quarter consensus estimates show a broadening out from the mega caps, which bodes well for the economy. An increase in credit availability and lending activity as a result of lower rates should help boost investment activity by businesses and consumers alike.

Many investors are now focused on the upcoming U.S. presidential election. As the cliché goes, markets hate uncertainty. However, while the market does tend to have a short-term reaction to election outcomes, history shows the winning candidate or party has little long-term impact on returns. This is the view we take, and we are not concerned. As always, we remain focused on identifying and researching well-managed unique businesses with durable competitive advantages and compelling growth prospects and investing in them at attractive prices.

CONTRIBUTORS

• Shares of MSCI Inc., a leading provider of investment decision support tools, contributed to performance. The company reported solid Q2 earnings as both sales and cancellations rebounded from the prior quarter. During the quarterly call, management sounded quite upbeat about MSCI’s long-term prospects and noted that client engagement remained strong across the globe. While near-term macro uncertainty remains, 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.
• Specialty insurer Arch Capital Group Ltd. contributed to performance after reporting financial results that exceeded expectations. Operating return on equity was 20%, and book value per share rose 42% due to strong underwriting profitability and the establishment of a deferred tax asset at the end of last year. Shares likely benefited as well from a less active hurricane season and a market rotation away from banks during risk-off conditions in August. We continue to own the stock due to Arch’s strong management team and our expectation of significant growth in earnings and book value.
• Shares of Gartner, Inc., a provider of syndicated research, contributed to performance in the quarter. Gartner’s core subscription research businesses inflected higher in Q2, and we believe growth is poised to accelerate over the next several quarters. Longer term, we think Gartner will emerge as a key resource for companies evaluating the opportunities and risks of AI on its business, providing a tailwind to Gartner’s volume growth and pricing realization over time. Sustained revenue growth coupled with Gartner's focus on cost control should drive margin expansion and enhanced free cash flow generation, in our view. The company’s balance sheet is in excellent shape and can support aggressive repurchases and bolt-on acquisitions.

DETRACTORS

• West Pharmaceutical Services, Inc. manufactures components and systems for the packaging and delivery of injectable drugs. Shares fell on lower-than-expected financial results and reduced guidance for the year due to customer inventory destocking. Post-pandemic, customers have been using inventory they had stockpiled to meet elevated pandemic-era demand. West was also able to shorten the lead time needed to meet demand, giving customers confidence that they can safely reduce inventory. We believe the inventory-related issues are temporary and West remains a dominant player with competitive advantages in a growing market for injectable drugs. Management has stated that end-patient demand is in line with its expectations, market share shift is not occurring, and win rates on new molecules are strong. They expressed confidence that West can return to the long-term financial construct of 7% to 9% revenue growth with 100 basis points of operating margin expansion annually.
• Global ski resort company Vail Resorts, Inc. detracted from performance, as a result of a drop in the number of season passes sold and the normalization of the ski industry following the post-pandemic surge of visitors. We remain investors. With a captive high-end consumer base who is willing to pay a premium for its services, Vail enjoys significant pricing power. It plans to cut $100 million in costs over the next two years by leveraging synergies within the business, which should result in improved margins. The company uses its strong balance sheet and robust cash flow to invest in its resorts and cover its dividend, and it recently increased its share buyback program. We think shares are attractive at current valuations.
• Trex Company, Inc. is the leading manufacturer of composite decking materials for U.S. residential homes. The stock detracted after the company lowered full-year guidance due to softer-than-expected demand for select lower-priced deck products. We believe this softness is isolated and transitory and the multi-year prospects for Trex and composite decking remain bright. Composite continues to gain market share from wood, and Trex is meaningfully expanding capacity to meet future expected demand.

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) was up 11.15% (Institutional Shares) in the third quarter, outperforming the Russell 2000 Growth Index (the Index), which rose 8.41%, by 274 basis points. Active sector weights were entirely responsible for the Fund’s outperformance in the period, overshadowing adverse stock selection from investments in a handful of sectors.

Significantly higher exposure to the top performing Financials and Real Estate sectors added nearly 400 basis points of relative gains, accounting for the bulk of outperformance in the period. Lack of exposure to lagging Energy sector was another tailwind to performance, contributing approximately 70 basis points of relative gains.

Stock selection was positive in Information Technology and Communication Services thanks to double-digit gains from syndicated research provider Gartner, Inc. and mobile voice and data communications services vendor Iridium Communications Inc., respectively. Gartner’s core subscription research businesses inflected higher in the second quarter, and we believe growth is poised to accelerate over the next several quarters. Longer term, we think Gartner will emerge as a key resource for companies evaluating the opportunities and risks of AI on its business, providing a tailwind to Gartner’s volume growth and pricing realization over time. Sustained revenue growth coupled with Gartner's focus on cost control should drive margin expansion and enhanced free cash flow generation, in our view. The company’s balance sheet is in excellent shape and can support aggressive repurchases and bolt-on acquisitions.

While quarterly results mostly met expectations, Iridium’s shares rose after the company announced an increase in its debt target for the end of 2026, potentially allowing for over $700 million in buybacks and dividends beyond its initial plan. Iridium had previously committed to returning $3 billion to shareholders between 2023 and 2030. The acceleration, combined with a recent decrease in the share price, reduces execution risk and should provide support to the stock at its current valuation. Growth drivers remain intact, with management expressing confidence in its mid-term growth outlook, driven by stability in the satellite phone division, healthy demand within the consumer internet of things segment, growing traction with its aviation solutions, and dissipating headwinds within the maritime segment. Iridium also announced that its direct-to-device functionality will be added to the mobile industry standards, providing an opportunity for this service to be used by millions of devices globally, most likely starting in 2026. A successful integration with recent acquisition Satelles that allows Iridium to support customers in the positioning, navigation, and timing segment and offers a more reliable alternative to the maturing Global Positioning System was another positive for the stock.

Somewhat offsetting the above was disappointing stock selection in Health Care, Industrials, Consumer Discretionary, and Real Estate, which together were a 260-plus basis point drag on performance. Pharmaceutical packaging manufacturer West Pharmaceutical Services, Inc. was partly responsible for relative losses in Health Care after the company’s shares fell on lower-than-expected financial results and reduced annual guidance due to customer inventory destocking. Post-pandemic, customers have been using inventory they had stockpiled to meet elevated pandemic-era demand. Although we believe the inventory-related issues are temporary and West remains a dominant player with competitive advantages in a growing market for injectable drugs, we exited our position. Negative stock selection in Health Care was exacerbated by lack of exposure to biotechnology and pharmaceutical stocks, whose strong performance in the Index resulted in a 70 basis point drag on performance.

Weakness in Industrials came from wood-alternative decking and railing manufacturer Trex Company, Inc. and private battery developer and manufacturer Northvolt AB. Trex shares fell after the company lowered full-year guidance due to softer-than-expected demand for select lower-priced deck products. We believe this softness is isolated and transitory and the multi-year prospects for Trex and composite decking remain bright. Composite continues to gain market share from wood, and Trex is meaningfully expanding capacity to meet future expected demand. Northvolt’s share price was revalued significantly lower during the quarter due to significant production and funding challenges. The company’s main production facility has experienced a slower-than-expected ramp due to supply chain challenges, labor safety incidents, and lower-than-expected production yield. In addition, over the past few quarters, automobile manufacturers (OEMs) have been scaling back their short-to-mid-term electric vehicle production targets. Although demand remains healthy overall, the shift has reduced the immediate demand for batteries and muted funding incentives for battery production projects by OEMs and institutions. In light of these challenges, Northvolt announced a strategic review, resulting in a 20% workforce reduction and a halt to several key expansion initiatives. The company is now actively seeking funding to address its financial needs, aiming to stabilize and refocus its operations amid these unfavorable conditions.

Performance in Consumer Discretionary and Real Estate was hindered by the Fund’s sizeable positions in global ski resort operator Vail Resorts, Inc. and real estate data and marketing platform CoStar Group, Inc., whose share prices failed to keep pace with the Index during the quarter. Vail’s stock underperformed due to a drop in the number of season passes sold and the normalization of the ski industry following the post-pandemic surge of visitors. We remain investors. With a captive high-end consumer base who is willing to pay a premium for its services, Vail enjoys significant pricing power. It plans to cut $100 million in costs over the next two years by leveraging synergies within the business, which should result in improved margins. The company uses its strong balance sheet and robust cash flow to invest in its resorts and cover its dividend, and it recently increased its share buyback program. We think shares are attractive at current valuations.

CoStar’s shares were negatively impacted by deceleration in net new sales of Homes.com, its residential product offering. We remain encouraged by the website traffic growth and growing brand awareness for the platform, and we are optimistic that sales momentum will improve as the company builds out a dedicated residential sales force and enhances its customer targeting. We believe performance in CoStar’s non-residential business remains strong, and we expect to see better organic growth as the commercial real estate market improves and salespeople return to focus exclusively on a single product.