Baron Partners Fund: Latest Insights and Commentary

After selling off in March due to the U.S.-Iran conflict and disruptions in the Strait of Hormuz, U.S. equities rallied to new record highs during the second quarter, with most of the gains coming in April and May. Given narrow market breadth and concentrated position sizes in recent years, the gap in performance between the market cap-weighted S&P 500 Index and the equal-weighted version has reached extremes not seen since the dotcom bubble era (based on rolling three-year results). 

U.S. stocks saw a comeback after ending the prior quarter slightly down. The AI secular growth narrative was the principal driver of market returns, overshadowing uncertainty about a potential resolution to the U.S.-Iran conflict, shifting Federal Reserve rate expectations, and depressed consumer sentiment from high living costs, persistent inflation, and elevated borrowing rates. 

The S&P 500 posted one of its strongest quarterly profit prints in five years, thanks largely to the Magnificent Seven cohort, which reported blended earnings growth in excess of 60% (versus low double digits for other constituents in the Index). The other contributors were primarily Information Technology (IT) stocks—specifically companies that are perceived to be direct beneficiaries of AI capital spending and electrification and what the market has come to call “AI winners." 

Looking ahead, we remain focused on well-managed companies with durable competitive advantages and attractive growth prospects. While macroeconomic and policy uncertainty persist, we believe maintaining a disciplined, long-term perspective and emphasizing company fundamentals will be essential to navigating the evolving landscape.

CONTRIBUTORS

• Space Exploration Technologies Corp. (SpaceX) develops and launches advanced rockets, satellites, and spacecraft, with the long-term goal of making humanity multi-planetary. Shares rose as the company successfully completed the largest initial public offering in history, raising more than $85 billion. The proceeds are expected to accelerate growth across massive addressable markets, such as connectivity, launch, terrestrial and space infrastructure, and AI. Fundamental momentum was further reinforced by landmark compute hosting deals totaling tens of billions of dollars annually, including agreements with market leaders Anthropic and Google. SpaceX also announced its acquisition of Cursor, a premier enterprise AI-powered coding platform. Integrating Cursor’s technology, talent, and customer base provides another strategic stepping stone into the vast opportunities within AI applications and agentic systems. Lastly, the company conducted a successful test flight of the latest version of Starship, demonstrating meaningful advancements in rapid and full reusability. We believe these developments support sustained long-term revenue and profit growth well beyond current levels.
• Shares of global hotelier Hyatt Hotels Corporation increased in the second quarter as revenue per available room accelerated and management highlighted rising franchisee interest in its brands. As a result, the company is seeing strong growth in earnings and cash flow. Hyatt continues to have a robust balance sheet and is repurchasing shares, taking advantage of the stock’s significant valuation discount to peers despite having a similar mix of fee-based business. We believe Hyatt remains an attractive investment despite recent gains.

DETRACTORS

• CoStar Group, Inc. is the leading provider of information and marketing services to the commercial and residential real estate industries. Shares fell due to multiple compression driven by rising AI fears. The market has increasingly come to view AI as an existential risk for a growing number of industries, including software, business services, information services, and video games. While there is little evidence of any fundamental impact on these sectors, investors have largely adopted a “shoot first and ask questions later” approach, leading to significant stock price declines. We continue to own CoStar due to its enviable business model, differentiated data assets, and meaningful growth opportunities in providing enhanced real estate information, analytics, and marketplace offerings. The company also maintains a substantial cash balance, which we are hopeful will be used to aggressively repurchase shares at current depressed valuation levels.
• Syndicated research provider Gartner, Inc. detracted from performance due to multiple compression driven by rising AI fears.  The market has increasingly come to view AI as an existential risk for a growing number of industries, including software, business services, information services, and video games. While there is little evidence of any fundamental impact on these sectors, investors have largely adopted a “shoot first and ask questions later” approach, leading to significant stock price declines. We continue to own Gartner given its large addressable market, significant competitive advantage, and robust free cash flow generation, which we expect management to deploy toward share repurchases at depressed valuation levels.
• Shares of property and casualty (P&C) insurance software vendor Guidewire Software, Inc. declined after a handful of deals slipped from the fiscal third quarter into the fiscal fourth quarter. We believe this is purely a timing issue, with these deals having since closed in the current period. 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. We think the core-system opportunity alone represents nearly $20 billion of annual recurring revenue, or roughly 20 times Guidewire’s current size. In our view, AI will meaningfully expand this 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 adoption to accelerate over the coming year. Finally, we expect Guidewire to benefit from the same internal productivity enhancements AI is driving across enterprises, which should help it grow faster with lower costs and ultimately improve profitability.

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 Partners Fund (the Fund) was up 16.61% (Institutional Shares) in the second quarter, outpacing the Russell Midcap Growth Index’s (the Index) gain of 14.55% by 206 basis points. According to MSCI's Barra factor attribution, strong stock selection was enough to overcome material headwinds from style and industry factors mostly related to the AI trade. AI winners in the Semiconductors, Computers Electronics, and Semiconductor Equipment industries with elevated exposure to the Momentum and Beta factors drove the Index’s performance in the period, presenting headwinds to relative performance given the Fund’s underexposure to these factors.

From a sector perspective, favorable stock selection in Communication Services contributed most relative gains thanks to the Fund's large position in rocket, satellite, and spacecraft manufacturer Space Exploration Technologies Corp. (SpaceX). The company completed the largest initial public offering in history during the quarter, raising more than $85 billion. The proceeds are expected to accelerate growth across massive addressable markets, such as connectivity, launch, terrestrial and space infrastructure, and AI. Fundamental momentum was further reinforced by landmark compute hosting deals totaling tens of billions of dollars annually, including agreements with market leaders Anthropic and Google. SpaceX also announced its acquisition of Cursor, a premier enterprise AI-powered coding platform. Integrating Cursor’s technology, talent, and customer base provides another strategic steppingstone into the vast opportunities within AI applications and agentic systems. Lastly, the company conducted a successful test flight of the latest version of Starship, demonstrating meaningful advancements in rapid and full reusability. We believe these developments support sustained long-term revenue and profit growth well beyond current levels.

Stock selection in Consumer Discretionary was another value add but was partly offset meaningfully higher exposure to this lagging sector. Global hotelier Hyatt Hotels Corporation led the way in the sector. The company’s shares increased in the second quarter as revenue per available room accelerated and management highlighted rising franchisee interest in its brands. As a result, the company is seeing strong growth in earnings and cash flow. Hyatt continues to have a robust balance sheet and is repurchasing shares, taking advantage of the stock’s significant valuation discount to peers despite having a similar mix of fee-based business. We believe Hyatt remains an attractive investment despite recent gains.

Partially offsetting the above was disappointing stock selection in Information Technology (IT), Financials, and Real Estate, where AI-driven disruption remained an overhang for several of the Fund's holdings. A portion of the weakness in IT was attributable to double-digit losses from syndicate research provider Gartner, Inc. and property and casualty (P&C) insurance software vendor Guidewire Software, Inc. Both companies underperformed as investors continued to rotate out of stocks perceived as at risk of being disrupted by AI. We believe this characterization is misplaced and that AI will ultimately be a significant tailwind for both companies.

We continue to own Gartner given its large addressable market, significant competitive advantage, and robust free cash flow generation, which we expect management to deploy toward share repurchases at depressed valuation levels. We believe AI will be a powerful tailwind for Gartner for three key reasons. First, every company is struggling to assess AI’s risks and opportunities, and Gartner offers the most comprehensive, cost-effective service to help businesses navigate this transformation. Second, Gartner generates vast amounts of proprietary data and AI will enable the company to convert this data into deeper insights and deliver it in more intuitive, easy-to-consume formats. Lastly, AI integration will drive internal efficiencies, streamline operations, and boost Gartner's long-term operating margins.

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, highly regulated, and stored exclusively in digital form within Guidewire, which makes the system of record particularly critical and therefore highly valuable. We believe the core system opportunity alone represents nearly $20 billion of annual recurring revenue, or roughly 20 times Guidewire’s current size. In our view, AI meaningfully expands this 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 adoption to accelerate over the coming year. Finally, we expect Guidewire to benefit from the same internal productivity enhancements AI is driving across enterprises, helping the company support faster growth with lower costs and ultimately improving profitability.

Poor stock selection in IT was exacerbated by having minimal exposure to AI winners in semiconductors, semiconductor materials & equipment, and technology hardware storage & peripherals, which were up sharply in the Index, accounting for about half of the losses in the sector.

Within Financials, financial exchanges & data companies MSCI Inc., Morningstar, Inc., and FactSet Research Systems Inc. contributed to relative weakness due to ongoing concerns that generative AI could disrupt their businesses. We maintain long-term conviction because all three companies have strong, "all-weather" franchises underpinned by proprietary data assets and we believe they remain well positioned to benefit from numerous secular tailwinds in the investment community.

Discount brokerage house The Charles Schwab Corporation and specialty insurer Arch Capital Group Ltd. also contributed to losses in the sector. Schwab’s shares detracted from performance because improving frontier AI models caused investors to grow concerned that AI-powered cash optimization tools could erode the sweep cash balances that generate spread income, a meaningful contributor to the company's revenue and margins. These concerns weighed on the stock even though the underlying business performed well, with strong net new asset growth and rising trading volumes. Schwab already offers clients a range of higher-yielding cash alternatives, allowing rate-sensitive balances to move within the platform. Most remaining sweep cash is operational and used for trading, settlement, and fees. Moreover, most yield-seeking balances were already relocated during the last rate-hiking cycle, and sweep cash has since stabilized and grown, suggesting clients have largely optimized their cash allocations. Cash yield is not the primary basis on which Schwab competes; clients choose the firm for its scale, low costs, and breadth of services and advice. We view the market's reaction as a sentiment-driven overhang rather than a reflection of any meaningful deterioration in the company's long-term earnings power.

Arch’s stock failed to participate in the market rally during the quarter, reflecting a rotation away from resilient insurance stocks as market volatility eased. Soft pricing trends in the insurance industry also pressured shares. Rates for property insurance are falling due to strong profitability and elevated capital levels following last year’s benign hurricane season. This cyclicality is normal, and we continue to own the stock due to Arch’s strong management team and our expectation of continued growth in earnings and book value over time.

Real estate information and marketing services platform CoStar Group, Inc. hampered performance in the Real Estate sector. Like other software and services peers in the Fund, CoStar's shares remained under pressure due to multiple compression driven by rising AI fears. We continue to own CoStar due to its enviable business model, differentiated data assets, and meaningful growth opportunities in providing enhanced real estate information, analytics, and marketplace offerings. The company also maintains a substantial cash balance, which we are hopeful will be used to aggressively repurchase shares at current depressed valuation levels.