Baron Small Cap Fund: Latest Insights and Commentary

U.S. equities were broadly higher in the third quarter, building on gains from the prior quarter. The S&P 500 Index and NASDAQ Composite set new record highs, most recently on September 22, and the Dow Jones Industrial Average ended the quarter at an all-time high. Small caps led the market recovery, with the Russell 2000 Index finally surpassing its previous record high achieved almost four years ago on November 8, 2021. Market volatility remained muted during the quarter as the CBOE Volatility Index (VIX) continued to trade in the mid-teens, well below its long-term average of around 20. 

The preeminent driver of market strength was the increased likelihood of Federal Reserve (Fed) rate cuts, prompted by signs of weakness in the labor market and the subsequent emergence of more dovish Fed commentary. Rate cut expectations rose in early August following a much weaker-than-expected July nonfarm payrolls report and significant downward revisions to prior numbers. Dovish Fedspeak intensified as the month wore on, with Chair Powell hinting a possible interest rate cut while delivering remarks at the Fed’s annual Jackson Hole conference. Similarly, Governor Waller continued to advocate for cuts while speaking at the Economic Club of Miami. The Fed eventually resumed its rate-cutting cycle at the September meeting, lowering its policy rate by 25 basis points to a range of 4% to 4.25%, after being on hold since its previous cut last December. Robust corporate earnings, narrowing trade uncertainties, a resilient consumer, increased M&A and IPO activity, and sustained AI optimism also contributed to market gains during the quarter. 

The Magnificent Seven complex dominated market returns for a second consecutive quarter, accounting for nearly two-thirds of the S&P 500 Index’s third-quarter gains. The group appreciated 15.5% in the period, outperforming all other securities in the Index, which were up 4.6%, by a double-digit margin. Tesla (+40.0%), Alphabet (+38.1%), Apple (+24.2%), and NVIDIA (+18.1%) posted the largest gains. Meta and Amazon were essentially flat in the period, trailing the broader Index. 

Most sectors closed higher in the period, with Information Technology, Communication Services, and Consumer Discretionary being the only sectors to outperform the broader market thanks to the heavy influence of the Magnificent Seven. Consumer Staples was the only sector to decline in the period, driven by broad-based weakness across a range of sub-industries, including distillers & vintners, personal care products, food retail, tobacco, and household products. Other laggards were Real Estate, Financials, Health Care, Industrials, Energy, and Materials. From a style perspective, small caps outperformed in the third quarter, rising more than 12% and narrowing the gap with mid- and large-cap stocks this year. Performance was mixed between growth and value, with growth stocks dominating in July, losing out to value in August, and rebounding in September. Despite recent volatility, growth generally remains ahead of value year to date, with the largest differential in the mid- and large-cap segments thanks to the heavy influence of Palantir and the broader Magnificent Seven. 

Beyond the U.S., emerging market (EM) equities meaningfully outperformed in September to finish ahead of their developed market counterparts for the quarter. The rally in Chinese equities was largely responsible for EM outperformance, with gains being driven by investor optimism about AI innovation, which bolstered Chinese technology and internet companies. Targeted government initiatives, easing trade tensions with the U.S., and significant domestic capital inflows also contributed to strength in China. Taiwanese and Korean equities also performed well in the period, overshadowing weakness in India, where equity markets were pressured by underwhelming corporate earnings and concerns about recently enacted U.S. tariffs. Foreign investor flows in Indian markets turned negative in the third quarter after being meaningfully positive in May and June. Performance in developed markets was held back by weakness in continental Europe (Denmark, Germany, Norway, Switzerland, France, and Sweden). European equities were hurt by weak corporate earnings, Trump tariff headwinds, and political instability, particularly in France, where the country’s prime minister resigned after losing a crushing confidence vote in parliament.

CONTRIBUTORS

• Leading defense technology provider Kratos Defense & Security Solutions, Inc. contributed to performance following a strong earnings report and continued momentum across its business segments. Years of investment are beginning to pay off, with the company winning new contracts across multiple divisions. The current defense spending cycle appears to be in a generational upswing amid heightened global conflicts, and Kratos’ innovative solutions position it well to support the U.S. Armed Forces. The current administration’s openness to smaller, agile defense contractors further strengthens Kratos’ opportunity to secure larger awards, supporting our continued conviction in the company.
• Vertiv Holdings Co, a leading provider of critical digital infrastructure solutions for data centers, contributed to performance during the quarter. The company reported strong earnings and raised guidance, supported by robust momentum in the data center end market, particularly as increased AI-related activity drives elevated demand. We continue to hold Vertiv as we believe the company is well positioned to benefit from the ongoing buildout of AI data centers, especially through the adoption of liquid cooling technologies, which are increasingly necessary as data center energy intensity continues to rise.
• Red Rock Resorts, Inc. is a casino owner and operator focused on the Las Vegas Locals market. Shares rose during the quarter as investors reacted positively to incremental visitation from new customers and accelerating spend-per-visit trends, despite concerns about a market slowdown. The company continues to report strong visitation and robust slot and table game play, along with improving activity from uncarded and non-rewards customers. Red Rock is regaining business at its flagship resort following some initial cannibalization from the opening of its Durango property, with management expecting a full recovery next year and trends already improving faster than anticipated. The new property is generating robust returns, and performance across the company’s six core casinos has strengthened as the Las Vegas Locals market absorbs Durango and returns to its historical low-single-digit growth rate. Given the strength of the market, management continues to ramp up capital investment, which we believe should support ongoing revenue and EBITDA growth over the next several years.

DETRACTORS

• Gartner, Inc., a provider of syndicated research, detracted from performance following disappointing quarterly earnings. Contract value growth, a leading indicator of future revenue, decelerated by approximately 2%. We attribute most of the slowdown to ongoing cost cutting in the U.S. public sector, which represents about 5% of revenue, as well as more challenging business conditions in industries dependent on public-sector funding. In addition, companies with meaningful exposure to tariffs appear to be reducing costs, resulting in longer sales cycles and slightly higher client attrition. While the market expressed concern about the impact of AI on Gartner’s insights business, we see no evidence that this is negatively impacting its value proposition. The company continues to benefit from a vast and expanding set of proprietary data generated through hundreds of thousands of interactions with buyers, sellers, and technology consumers. Gartner bought back approximately $800 million worth of stock in July and August and authorized an additional $1 billion in September, and we expect the company to continue repurchasing shares aggressively to capitalize on the discounted valuation.
• Shares of insurance broker The Baldwin Insurance Group, Inc. fell after the company trimmed full-year guidance to reflect softer pricing for property insurance and slower business from construction customers. This mirrors the broader pullback in insurance stocks during the quarter amid expectations for a cyclical slowdown in industry pricing and premium growth. Management reaffirmed its goal of reaching $3 billion in revenue and 30% EBITDA margins within five years, implying that earnings could nearly triple. We remain shareholders and expect the company to continue gaining market share while expanding margins and reducing leverage over the next several years.
• Shares of specialty insurer Kinsale Capital Group, Inc. fell during the quarter amid concerns about moderating growth and a cyclical slowdown in the broader insurance industry. Nevertheless, Kinsale reported quarterly earnings that exceeded Street expectations, with 14% premium growth outside of large property policies, which face the most competition. Recent data from several state insurance commissioners also point to faster premium growth for the company in the third quarter. 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.

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) produced a modest gain of 0.54% (Institutional Shares) in the third quarter, meaningfully trailing the Russell 2000 Growth Index (the Index), which increased 12.19%. Over half of the relative losses stemmed from style-related headwinds, as the Fund was punished for being overexposed to the Earnings Quality factor, which suffered its worst three-month performance on record. We believe this is indicative of the low-quality nature of the market rally during the quarter, which was challenging given the Fund’s higher quality profile. Underexposure to the strong performing Momentum, Residual Volatility, and Beta factors also contributed to the relative shortfall in the period. The remaining underperformance came from stock-specific issues and active industry exposures.

From a sector perspective, poor stock selection in Information Technology was responsible for 50% of the relative losses in the period, with syndicated research provider Gartner, Inc. being the primary culprit. Gartner was a material detractor after reporting disappointing quarterly earnings. Contract value growth, a leading indicator of future revenue, decelerated by approximately 2%. We attribute most of the slowdown to ongoing cost cutting in the U.S. public sector, which represents about 5% of revenue, as well as more challenging business conditions in industries dependent on public-sector funding. In addition, companies with meaningful exposure to tariffs appear to be reducing costs, resulting in longer sales cycles and slightly higher client attrition. While the market expressed concern about the impact of AI on Gartner’s insights business, we see no evidence that this is negatively impacting its value proposition. The company continues to benefit from a vast and expanding set of proprietary data generated through hundreds of thousands of interactions with buyers, sellers, and technology consumers. Gartner bought back approximately $800 million worth of stock in July and August and authorized an additional $1 billion in September, and we expect the company to continue repurchasing shares aggressively to capitalize on the discounted valuation.

Widespread weakness in software also contributed to the relative deficit in IT, partly reflecting a broader pullback in software stocks as investors weighed potential AI-related disruption across the industry. The largest detractors were property and casualty (P&C) insurance vendor Guidewire Software, Inc., professional services software provider Intapp, Inc., and restaurant foodservice technology provider PAR Technology Corporation. Guidewire’s stock pulled back modestly following strong performance earlier in the year. After a multi-year transition period, we think Guidewire’s cloud migration is largely complete. We believe cloud will be the sole path forward, with annual recurring revenue (ARR) benefiting from new customer wins and migrations of the existing customer base to InsuranceSuite Cloud. This progress is best exemplified by Guidewire’s landmark 10-year agreement with Liberty Mutual, the fifth-largest U.S. insurer with $45 billion in direct written premiums, to migrate its entire on-premise deployment of ClaimCenter and adopt PolicyCenter in the cloud. The deal should also help drive adoption among other Tier 1 carriers—now that Liberty Mutual has fully embraced the cloud, others are likely to follow. We believe that Guidewire will be the critical software vendor for the global P&C insurance industry, capturing 30% to 50% of its $15 billion to $30 billion total addressable market and generating margins above 40%.

Intapp’s stock price declined because a portion of the company’s customer base is transitioning from on-premise licenses to cloud contracts. While this shift is positive over the long term, as cloud customers typically spend more, it may pressure near-term GAAP revenue. Intapp nevertheless delivered strong fiscal fourth-quarter results, highlighted by record bookings, AAR growth up 20% year over year, and trailing 12-month free cash flow margins of 24%. Robust product demand, particularly for Intapp’s AI suite, integrated into 35% of DealCloud sales during the quarter, gave management confidence to issue solid fiscal 2026 guidance and launch a $150 million repurchase program. We continue to believe Intapp has a long runway for growth and margin expansion as its deal management, compliance, and collaboration solutions continue to gain share. We are encouraged by the company’s expansion into adjacent verticals like real estate, which meaningfully broadens its addressable market.

PAR’s shares fell after the company lowered its full-year growth outlook to 15% from 20%, reflecting a weaker-than-expected first half driven by soft macroeconomic conditions and deliberate rollout delays for certain customers. These delays were strategic, allowing PAR to focus on securing contracts with several large enterprise restaurant chains currently in late-stage negotiations, at least one of which could meaningfully expand the company’s scale. Despite the slower start to the year, management remains confident in achieving 20% ARR growth over the next 12 months, supported by a strong pipeline of contracted and prospective customers, including its ongoing rollout with Burger King. As more enterprise-scale restaurants upgrade their technology stack, we believe PAR is well positioned to capture outsized share as the leading cloud-based platform in the industry. Strong software revenue growth combined with rapidly scaling profitability should drive meaningful long-term performance.

Adverse stock selection in Financials, Consumer Discretionary, Industrials, and Health Care was responsible for the remainder of the underperformance in the period. Relative losses in Financials were attributable to insurance-related holdings The Baldwin Insurance Group, Inc., Kinsale Capital Group, Inc., and Accelerant Holdings, whose share price performance was hampered by concerns about moderating growth and a cyclical slowdown in the broader insurance industry. We remain shareholders.

Stock selection in Consumer Discretionary was a drag on performance owing to declines from corporate daycare provider Bright Horizons Family Solutions, Inc. and low-cost fitness center franchisor and operator Planet Fitness, Inc. Bright Horizons shares declined despite reporting solid second-quarter earnings results. Investors remain cautious about the slower pace of Full Service enrollment recovery post-Covid and potential macro-related risks to new client wins and family retention. We remain constructive on the company’s long-term prospects and believe its rapidly growing, high-margin Back-Up Care business is an underappreciated asset with the potential for multi-year double-digit revenue growth, supporting structurally higher margins for Bright Horizons over time. 

Planet Fitness shares fell due to elevated expectations going into the company’s latest earnings report. While Planet Fitness delivered strong results, with revenue and profits exceeding forecasts, management only reiterated full-year guidance, which disappointed investors. Guidance also reflected caution regarding the macroeconomic environment and uncertainty related to the nationwide rollout of online membership cancellations. Despite these near-term concerns, we retain long-term conviction in Planet Fitness. We believe the company remains well positioned for strong revenue growth as franchisees open new locations and benefit from secular shifts toward health and wellness. We continue to view Planet Fitness’ asset-light, high-margin franchise model favorably.

Stock-specific weakness in Industrials, driven by losses from engineered aerospace components supplier TransDigm Group Incorporated and automotive services provider Driven Brands Holdings Inc., was somewhat offset by higher exposure to better performing aerospace & defense companies. TransDigm’s stock declined due to a temporary destocking issue with a key customer in the company’s original equipment manufacturers channel. The company expects growth in that channel to resume by year end, as broad-based improvements across the aerospace supply chain indicate the issue is largely behind them. We continue to believe TransDigm can compound earnings at an elevated rate relative to peers, supported by its best-in-class portfolio of proprietary aerospace and defense components and increasingly robust end-market tailwinds.

Driven Brands shares declined despite solid second-quarter results, as investor sentiment was pressured by macroeconomic concerns about consumer spending. We retain conviction. Driven Brands’ Take 5 quick lube segment, which generates the majority of profits, continued to perform well, with revenue up nearly 15% and EBITDA up 10%. Despite macroeconomic uncertainty, the company should remain relatively well insulated given the needs-based nature of most of its services. We also believe Driven Brands is better positioned following the sale of its Car Wash business and that shares remain attractive at current levels.

Lastly, performance in Health Care was hindered by obstructive sleep apnea treatment pioneer Inspire Medical Systems, Inc., whose stock fell 42.8% in the period. Management lowered 2025 financial guidance, citing several factors behind the slower-than-expected rollout of Inspire 5, the company’s next-generation device. These included delays onboarding centers to a new patient management platform, a postponed Medicare reimbursement code that did not take effect until July 1 due to a software update, patients deferring procedures in anticipation of Inspire 5’s availability, and management’s decision to pause marketing efforts and new center expansion. In addition, management noted anecdotal reports of some patients delaying procedures to try GLP-1 medications. ?We think these issues are temporary and addressable. Management expects revenue growth to re-accelerate in 2026. The stock trades at a depressed valuation, in our view, for a company with Inspire’s financial profile (mid-80% gross margins, profitable and cash flow positive, with a strong balance sheet) and an underpenetrated large addressable market. Losses from Health Savings Account custodian HealthEquity, Inc. and glucose monitoring device leader DexCom, Inc. also hampered performance in the sector.