Baron Small Cap Fund: Latest Insights and Commentary

U.S. equity markets were volatile during the quarter, as positive sentiment and strong performance in January were undermined by AI-related disruption fears and geopolitical tensions. Small and mid caps generated positive returns in the first quarter while large caps declined, a margin of outperformance for small and mid caps not seen since the COVID rally in late 2020 and early 2021. 

The year began with positive momentum for U.S. stocks, supported by easing inflation, resilient economic trends, strong corporate earnings, and investor optimism about the Trump administration’s stimulative economic strategy. Market sentiment began to shift in February, with the early catalyst being widespread losses across a range of industries due to fears about AI-driven disruption. Technology and software companies experienced notable pressure as investors worried AI agents could directly replace human-led business workflows. The sell-off worsened after the U.S. and Israel attacked Iran on February 28. Investors became concerned about the potential for sustained inflation and reduced economic growth from surging oil prices and supply chain disruptions. 

Against this backdrop, the dominant market trend was the continued rotation out of the Magnificent Seven, software, and other growth-oriented stocks. The Magnificent Seven complex declined 11.3%, accounting for about 90% of the cap-weighted S&P 500 Index’s losses. Microsoft (-23.3%), Tesla (-17.3%), Meta (-13.3%), Amazon (-9.8%), and Alphabet (-8.1%) suffered the largest losses. The non-Magnificent Seven stocks in the Index were down only 0.6% for the month. 

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

• Vertiv Holdings Co is a leading global provider of critical digital infrastructure solutions for data centers, communication networks, and commercial and industrial environments, with one of the broadest offerings in electrical and thermal management equipment and services within the data center infrastructure industry. Shares increased after Vertiv reported robust quarterly results, with fourth-quarter bookings well above expectations, driving backlog meaningfully higher and supporting stronger-than-expected growth into 2027. The company is benefiting from the industry’s shift toward integrated and modular solutions, which help alleviate labor constraints and accelerate deployment timelines at data centers. Vertiv is a leading provider of these solutions, backed by industry-leading servicing capabilities, and is also well positioned to support key technology transitions, including liquid cooling and direct current architectures. Combined with the company’s internal focus on margin improvement, this positioning should drive better-than-expected earnings growth and continued upside over the coming years.
• Cognex Corporation is a leading provider of machine vision solutions. Shares climbed during the quarter following a strong earnings report, with the company finally showing signs of a return to accelerated growth alongside material cost reductions initiated by the new management team. We believe Cognex is positioned to benefit from improving industrial conditions and has substantial latent operating leverage that could drive earnings to double over the next two to three years. We remain confident in Cognex’s position as the best-in-class provider of advanced machine vision solutions.
• RBC Bearings Incorporated is a proprietary aerospace and defense (A&D) and industrial solutions provider. Shares rose during the quarter as the company’s end markets are undergoing significant, sustained growth—from A&D, led by marine-related programs, to commercial original equipment manufacturers, driven by Boeing’s reaccelerated production ramp. As a best-in-class supplier, RBC is well positioned to meet this elevated level of demand, which should persist for the foreseeable future. Long term, we remain confident in the company’s ability to outgrow peers.

DETRACTORS

• Planet Fitness, Inc., a leading franchiser and operator of low-cost fitness centers, detracted from performance after the company issued disappointing 2026 guidance that came in below investor expectations, weighed down by a combination of one-off factors and a slow start to the year. Despite this short-term earnings softness, we maintain our conviction in Planet Fitness. During the quarter, the company continued to benefit from both health and wellness trends and internal improvements under new leadership. Same-store sales grew 5.7%, EBITDA increased 12%, earnings per share rose 18.6%, and gym openings exceeded expected. Longer term, we believe Planet Fitness will benefit from ongoing initiatives to improve member experience and franchisee returns and remains well positioned to gain share in the secularly attractive fitness industry.
• Syndicated research provider Gartner, Inc. detracted from performance as valuation multiples compressed amid rising concerns around AI. Investors have increasingly viewed AI as a potential existential risk across a widening range of industries—including software, business services, information services, and video games—despite no evidence of any fundamental impact to these sectors. This “shoot first and ask questions later” dynamic has driven meaningful share price declines across the group. Against this backdrop, shares of Gartner came under pressure after the company reported contract value growth that was just 0.5% below expectations, underscoring the dramatic valuation compression at play. We continue to own Gartner given its large addressable market, significant competitive advantages, and robust free cash flow generation, which we expect management to deploy toward share repurchases at depressed valuation levels. We also view Gartner as an AI beneficiary, as it can leverage emerging tools to extract deeper insights from its vast trove of proprietary data and deliver it to customers in chatbot-type formats that meaningfully enhance its value proposition.
• Shares of property and casualty (P&C) insurance software vendor Guidewire Software, Inc. declined during the quarter amid concerns about the disruptive impact of AI, which weighed broadly on software stocks. We retain conviction in Guidewire and believe its fundamentals remain robust. The company's cloud sales are accelerating, with annual recurring revenue benefiting from new customer wins, expansions, and migrations of its existing customer base. The ongoing shift away from on-premise deployments, along with strong customer references from insurers such as Liberty Mutual, The Hartford, and Sompo, should further accelerate customer migration to the cloud. Additionally, Guidewire is ramping investment in product development, which should facilitate cross-selling into its sticky installed base. AI should act as a tailwind, helping the company accelerate product releases, create products that were previously out of reach, and reduce the cost of customer implementations (a historical impediment to adoption). We believe these dynamics position Guidewire for sustained growth over the long term.

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 Small Cap Fund (the Fund) fell 7.90% (Institutional Shares) in the first quarter, trailing the Russell 2000 Growth Index (the Index), which was down 2.81%, by 509 basis points. About two-thirds of the underperformance was due to the adverse impact of active industry weights, led by overexposure to the lagging Insurance Brokers and Reinsurance and Hotels, Leisure and Consumer Services industries. Lower exposure to AI beneficiaries in Semiconductors, Communications Equipment, Computers Electronics, and Semiconductor Equipment also hampered performance, as these industries managed strong gains against a backdrop of general market weakness. The Fund’s overexposure to certain software and services related industries (Internet Software and IT Services and Software) also weighed heavily on performance, as these segments faced significant selling pressure due to investor fears that AI will disrupt their businesses. Lastly, lack of exposure to the Energy-linked industries (Oil and Gas Equipment and Services, Oil Gas and Consumable Fuels, and Oil and Gas Exploration and Production) that were up sharply alongside the price of oil in the period also hampered performance. Most of the remaining underperformance came from style factors, with the main culprit being underexposure to Momentum, whose performance remained strong to begin 2026.

On a sector level, investments in Information Technology (IT), Consumer Discretionary, Consumer Staples, and Financials weighed the most on relative performance. IT holdings were responsible for over half of the relative losses in the period, detracting approximately 280 basis points. Most of the weakness came from being overexposed to application software and IT consulting & other services stocks, which were pressured by the AI disruption narrative that gained steam following Anthropic's release of specialized sector-specific plugins for Claude Cowork. The plugins, which enable AI to function as domain-specific analysts across legal, finance/accounting, sales/marketing, and customer support, caused investors to worry that AI agents could directly replace expensive human-led, subscription-based business workflows.

Property and casualty (P&C) insurance software vendor Guidewire Software, Inc. and syndicated research provider Gartner, Inc. were the top detractors in application software and IT consulting & other services, down 25.6% and 37.3%, respectively, for the period. We retain conviction in Guidewire and believe its fundamentals remain robust. The company's cloud sales are accelerating, with annual recurring revenue benefiting from new customer wins, expansions, and migrations of its existing customer base. The ongoing shift away from on-premise deployments, along with strong customer references from insurers such as Liberty Mutual, The Hartford, and Sompo, should further accelerate customer migration to the cloud. Additionally, Guidewire is ramping investment in product development, which should facilitate cross-selling into its sticky installed base. AI should act as a tailwind, helping the company accelerate product releases, create products that were previously out of reach, and reduce the cost of customer implementations (a historical impediment to adoption). We believe these dynamics position Guidewire for sustained growth over the long term.

We continue to own Gartner given its large addressable market, significant competitive advantages, and robust free cash flow generation, which we expect management to deploy toward share repurchases at depressed valuation levels. We also view Gartner as an AI beneficiary, as it can leverage emerging tools to extract deeper insights from its vast trove of proprietary data and deliver it to customers in chatbot-type formats that meaningfully enhance its value proposition.

Performance in Consumer Discretionary and Consumer Staples was hindered by sharp losses from fitness center franchiser and operator Planet Fitness, Inc. and beauty and wellness consumer technology company ODDITY Tech Ltd., respectively. Planet Fitness shares dropped after company issued disappointing 2026 guidance that came in below Street expectations, weighed down by a combination of one-off factors and a slow start to the year. Despite this short-term earnings softness, we maintain our conviction in Planet Fitness. During the quarter, the company continued to benefit from both health and wellness trends and internal improvements under new leadership. Same-store sales grew 5.7%, EBITDA increased 12%, earnings per share rose 18.6%, and gym openings exceeded expected. Longer term, we believe Planet Fitness will benefit from ongoing initiatives to improve member experience and franchisee returns and remains well positioned to gain share in the secularly attractive fitness industry.

ODDITY’s stock plummeted after a recent Meta algorithm update proved incompatible with the company’s “Try Before You Buy” model, steering ads toward low-intent audiences. Because the model’s higher return rates skewed the algorithm, customer acquisition costs rose from $60 to $75 to over $100 to $150. Management spent several weeks diagnosing the problem before concluding it stemmed from the auction layer rather than the creative content fed into the algorithm. By the time the cause was identified in late January, ODDITY had already entered its peak first-quarter acquisition window with unit economics that made new customer acquisition unprofitable. As a result, the company pulled back on growth marketing. With no firm timeline for resolving the algorithm issue, we sold our position.

Specialty insurer Kinsale Capital Group, Inc. was the principal detractor in Financials due to concerns about moderating growth amid a cyclical slowdown in the P&C insurance industry. In the most recent quarter, gross premium growth slowed because of a drop in large property business, where competition and pricing pressure are most acute. Nevertheless, Kinsale reported quarterly earnings that exceeded Street expectations, driven by higher earned premiums, very low catastrophe losses, and favorable reserve development. We continue to own the stock because we believe Kinsale is well managed and has a long runway for growth in an attractive segment of the insurance market.

Somewhat offsetting the losses above was strong stock selection in Industrials along with the benefit of being overweight this better performing sector, one of only three to manage gains in the Index. Critical digital infrastructure leader Vertiv Holdings Co and proprietary aerospace and defense (A&D) and industrial solutions provider RBC Bearings Incorporated led the way in the sector. Vertiv was the top overall contributor after reporting robust quarterly results, with fourth-quarter bookings well above expectations, driving backlog meaningfully higher and supporting stronger-than-expected growth into 2027. The company is benefiting from the industry’s shift toward integrated and modular solutions, which help alleviate labor constraints and accelerate deployment timelines at data centers. Vertiv is a leading provider of these solutions, backed by industry-leading servicing capabilities, and is also well positioned to support key technology transitions, including liquid cooling and direct current architectures. Combined with the company’s internal focus on margin improvement, this positioning should drive better-than-expected earnings growth and continued upside over the coming years.

RBC’s stock rose during the quarter as the company’s end markets are undergoing significant, sustained growth—from A&D, led by marine-related programs, to commercial original equipment manufacturers, driven by Boeing’s reaccelerated production ramp. As a best-in-class supplier, RBC is well positioned to meet this elevated level of demand, which should persist for the foreseeable future. Long term, we remain confident in the company’s ability to outgrow peers.