Baron Small Cap 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

• Vertiv Holdings Co provides critical digital infrastructure solutions for data centers, communication networks, and commercial and industrial environments. The company is a leader in electrical and thermal management equipment and services, with one of the broadest product portfolios in the data center infrastructure industry. Shares increased during the quarter as Vertiv once again reported strong financial results amid rising expectations for future data center capital spending. Vertiv is benefiting from the industry's shift toward integrated and modular solutions that help alleviate labor shortages and accelerate deployment timelines, supported by its market-leading product portfolio and service capabilities. The company is also well positioned to support key technology transitions, including liquid cooling and direct current power architectures. Together with its ongoing focus on margin improvement, these opportunities should enable Vertiv to deliver earnings growth above market expectations, which should lead to continued strong upside over the coming years.
• Cognex Corporation is a leading provider of machine vision solutions. Shares rose during the quarter following a robust earnings report, with the company experiencing accelerating, broad-based growth driven by improving industrial conditions. This top-line momentum, combined with material cost-cutting efforts led by Chief Executive Officer Matt Moschner, is enabling significant earnings-per-share expansion. We expect this elevated level of growth to persist, supported by a meaningfully improved cost structure.
• Legence Corp. is a leading provider of engineering, installation, and maintenance services for mission-critical building systems, with a focus on complex heating, ventilation, air conditioning, process piping, and other mechanical, electrical, and plumbing (MEP) systems. Shares rose during the quarter, driven by a combination of strong underlying business momentum and continued enthusiasm around AI and data center construction, which remains a significant tailwind for the business. Quarterly results highlighted accelerating growth, with both revenue and cash flow more than doubling compared to the prior year. Additionally, the company's backlog reached a record high, providing excellent visibility into future growth. We remain long-term shareholders in Legence and are excited about the company's prospects.

DETRACTORS

• Planet Fitness, Inc., the leading high-value, low-cost gym operator, detracted from performance in the second quarter after the company lowered full-year guidance following weaker-than-expected member additions in the first quarter. Member growth was pressured by a combination of unfavorable weather, macroeconomic headwinds, increased competition in certain markets, and marketing changes that did not resonate with certain customer segments. As a result, management reduced its outlook for the year to reflect the lower membership base and paused previously announced price increases. Despite the disappointing results, Planet Fitness remains the category leader, with the scale advantages needed to capitalize on favorable long-term health and wellness trends. We continue to own the stock.
• 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.
• Everforth, Inc., formerly known as ASGN Incorporated, is a leading provider of IT consulting and staffing services. Shares fell after the company reported disappointing first-quarter results. Revenue, which was flat year over year, modestly missed consensus estimates, while EBITDA and earnings per share came in well below expectations due to weaker gross margins driven by business mix across both segments. The miss was particularly surprising given the strength of fourth-quarter bookings and management's more optimistic outlook coming out of 2025. Second-quarter guidance was also below Street expectations across the board. We believe commercial conversions are slowing and sales cycles are lengthening, particularly for higher-margin enterprise software projects, as customers pause to assess the implications of AI. Management has indicated that any recovery is likely to be gradual, making a return to organic growth in 2026 uncertain. On the positive side, expenses remain well controlled and there is no evidence of material pricing pressure. At less than 6 times EBITDA, we believe the stock is trading at or near a valuation trough and could rerate meaningfully as demand normalizes.

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) rose 12.57% (Institutional Shares) in the second quarter, trailing the Russell 2000 Growth Index (the Index), which appreciated 25.71%. The Fund underperformed by 13.14% for the quarter, with the shortfall being driven by a combination of style and stock-specific headwinds. According to MSCI’s Barra factor attribution, style biases were responsible for about two-thirds of the underperformance, with the primary culprit being underexposure to Beta in a period of notable market strength. The Beta factor posted in fifth best three-month performance on record in the period, with the factor’s performance rivaling prior sharp market rallies that followed bear markets, such as “Black Monday”, the dotcom collapse, the Great Recession, and the COVID pandemic.

Underexposure to Momentum was another material detractor, as the factor continued its sustained run of strong performance in the period, powered by investor excitement about AI. Many of the top contributors in the Index were what the market calls “AI winners” with elevated exposure to the Beta and Momentum factors. In other words, it was the AI winners that drove outsized factor performance, especially when it comes to Beta and Momentum, contributing to the Fund’s meaningful underperformance in the period. The remaining deficit was attributable to stock-specific issues, with the AI trade playing a prominent role given the three largest detractors were AI winners unique to the Index (Bloom Energy Corporation, Credo Technology Group Holding Ltd., and Sterling Infrastructure, Inc.).

From a sector perspective, investments in Information Technology (IT), Consumer Discretionary, Industrials, and Financials accounted for most of the relative losses in the period. A portion of the weakness in IT was due to poor stock selection in application software and IT consulting & other services, where P&C insurance software vendor Guidewire Software, Inc. and technology and digital engineering company Everforth, Inc. (formerly known as ASGN Incorporated) were material detractors. Both companies were impacted by the ongoing market rotation out of stocks perceived as “AI losers.” We believe this characterization is misplaced and that AI will ultimately be a significant tailwind for both businesses. 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.

Everforth’s stock fell after the company reported disappointing first-quarter results. Revenue, which was flat year over year, modestly missed consensus estimates, while EBITDA and earnings per share came in well below expectations due to weaker gross margins driven by business mix across both segments. The miss was particularly surprising given the strength of fourth-quarter bookings and management's more optimistic outlook coming out of 2025. Second-quarter guidance was also below Street expectations across the board. We believe commercial conversions are slowing and sales cycles are lengthening, particularly for higher-margin enterprise software projects, as customers pause to assess the implications of AI. Management has indicated that any recovery is likely to be gradual, making a return to organic growth in 2026 uncertain. On the positive side, expenses remain well controlled and there is no evidence of material pricing pressure. At less than 6 times EBITDA, we believe the stock is trading at or near a valuation trough and could rerate meaningfully as demand normalizes.

Disappointing stock selection in IT was exacerbated by having minimal exposure to semiconductor stocks, which were up 100% in the Index, accounting for about a third of the losses in the sector.

Within Consumer Discretionary, higher exposure to this lagging sector coupled with share price losses from fitness center franchisor and operator Planet Fitness, Inc. and corporate-sponsored childcare provider Bright Horizons Family Solutions, Inc. weighed heavily on performance. Planet Fitness shares fell after the company lowered full-year guidance following weaker-than-expected member additions in the first quarter. Member growth was pressured by a combination of unfavorable weather, macroeconomic headwinds, increased competition in certain markets, and marketing changes that did not resonate with certain customer segments. As a result, management reduced its outlook for the year to reflect the lower membership base and paused previously announced price increases. Despite the disappointing results, Planet Fitness remains the category leader, with the scale advantages needed to capitalize on favorable long-term health and wellness trends. We continue to own the stock.

Despite reporting first-quarter results that modestly beat expectations, Bright Horizons stock declined after management lowered its outlook for the Full-Service Center-Based segment, as anticipated improvements in 2026 occupancy are now likely to be pressured by previously undisclosed enrollment weakness in Australia. Management believes the challenges in Australia, including childcare market saturation and heightened labor qualification requirements, can be managed through reducing staff and overhead over time. We think investors are too focused on the legacy Full-Service Center-Based business and that the company’s high-growth, high-margin Back-Up Care segment is being undervalued by the market. As this imbalance becomes more widely recognized, we think Bright Horizons should see multiple expansion off its current historic lows.

Performance in Industrials was hindered by SiteOne Landscape Supply, Inc., the largest distributor of wholesale landscape supplies in North America. The company sells irrigation, hardscapes, agronomics, and nursery products to professional contractors through its branch network for maintenance, upgrade/repair, and new construction applications. SiteOne shares fell during the quarter as investors worried about the impacts of the Iran war and a potential reduction in demand given rising commodity prices. Despite this, we believe the company remains well positioned to continue outgrowing its markets and expand margins as it harvests benefits from its ongoing initiatives and investments in improving underperforming branches, operational efficiency, technology, and product category management to continue differentiating itself from the fragmented wholesale landscape supplies distribution industry. The company also remains focused on filling out its product offering and geographic footprint through consistent M&A. Strong organic growth supported by the share gains combined with M&A will drive EBITDA margins towards the 13%-plus long-term targeted range over time from below 10% today, leading to meaningful upside in the stock over time. Higher exposure to lagging aerospace & defense stocks via sizable positions in TransDigm Group Incorporated, Karman Holdings Inc., and Kratos Defense & Security Solutions, Inc. also contributed to the shortfall in Industrials.

Stock-specific weakness in Financials was driven by modest losses from specialty insurer Kinsale Capital Group, Inc. and leading global investment bank Houlihan Lokey, Inc. Kinsale’s stock was pressured by concerns about moderating growth amid a cyclical slowdown in the P&C insurance industry. The company reported mixed quarterly financial results, with strong profitability but slowing growth. We remain shareholders because we believe Kinsale is well managed and has a long runway for growth in an attractive segment of the insurance market. 

Houlihan Lokey’s shares fell due to mixed financial results and a cyclical slowdown in mid-market M&A activity. The company reported quarterly results that missed Street expectations due to delayed closings on two large restructuring deals and extended M&A timelines amid geopolitical uncertainty related to the Iran conflict and volatility in the software sector. Nevertheless, management maintained an optimistic outlook, supported by a record backlog and pipeline entering fiscal 2027. We continue to own the stock given Houlihan Lokey’s diversified service offerings, leading market positions, and long runway for growth.

Somewhat offsetting the above were favorable impacts from having limited exposure to weak performing securities in the Energy and Materials sectors, which added approximately 175 basis points of relative gains. The Fund also benefited from not owning biotechnology stocks within Health Care, as the segment trailed the broader Index in the period.