Baron Small Cap Fund: Latest Insights and Commentary

GDP growth is widely predicted to slow during 2025, reflecting weakening consumer demand and more cautious corporate spending. Consumer confidence has plummeted. The March 2025 inflation figure came in above the U.S. Federal Reserve’s target of 2%, as measured by the Consumer Price Index. The Fed has taken a wait-and-see approach as the effects of heightened U.S. policy uncertainty on growth, inflation, and employment play out. It left interest rates unchanged in its first meeting of the year.

Against this challenging backdrop, Baron Small Cap Fund declined in the first quarter. Investments within the Financials sector were the only material contributors in the period. Holdings within Industrials, Information Technology (IT), and Health Care were the top detractors. Top contributor The Baldwin Insurance Group, Inc. and third largest contributor Kinsale Capital Group, Inc. led positive returns within Financials. Depreciation within Industrials was led by top detractor Vertiv Holdings Co, while declines within IT were led by third largest detractor Gartner, Inc. Weakness within Health Care was led by contract research organization ICON Plc.

The second quarter may bring with it as much doubt and volatility as the first quarter, given continued elevated uncertainty around tariffs. After reaching a record high of more than $3.3 trillion in corporate profits in the fourth quarter of 2024, U.S. companies are scrambling to estimate the potential impact of the tariff war. As first quarter earnings season approaches, many observers expect businesses to offer weaker earnings guidance for the rest of the year or withdraw guidance completely.

We are closely monitoring current market conditions while staying focused on company fundamentals -- well-managed businesses with durable competitive advantages and compelling growth prospects at attractive prices -- as we believe this is the best way to generate alpha over the long term, although there are no guarantees.

CONTRIBUTORS

• Shares of insurance broker The Baldwin Insurance Group, Inc. rebounded from weakness in the prior quarter due to favorable operating trends and the relative stability of insurance stocks in a risk-off market. In the most recent quarter, the company reported strong results with 16% revenue growth, 38% EBITDA growth, and net leverage moderating to 4.1x. In 2025, management expects continued double-digit organic growth and margin expansion despite higher costs related to the California wildfires and the replacement of an insurance carrier for the homeowners insurance business. Management reaffirmed the goal of achieving $3 billion of revenue and 30% EBITDA margins within five years, implying a near-tripling of earnings. We continue to own the stock because we expect the company to continue gaining market share while expanding margins and reducing leverage over the next several years.
• Shares of property & casualty (P&C) insurance software vendor Guidewire Software, Inc. contributed to performance in the quarter. After a multi-year period, we believe Guidewire's cloud transition is substantially over, and 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. We also expect the company to shift R&D resources to product development from infrastructure investment, which will help drive cross-sales into its sticky installed base and potentially accelerate ARR over time. We are also encouraged by Guidewire’s subscription-based gross margin expansion, which improved by more than 1,000 basis points in its most recently reported quarter. We believe 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%.
• Specialty insurer Kinsale Capital Group, Inc. contributed to performance due to continued growth in the company’s end market and the relative stability of insurance stocks in a risk-off market. The company reported better-than-expected earnings in the most recent quarter despite slowing premium growth. Earnings per share grew 19% and return on equity remained elevated at 30% due to strong underwriting margins and higher investment income. Excess & surplus insurance market conditions remain favorable with recent state data indicating continued double-digit growth due to share gains from the standard market. 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.

DETRACTORS

• Shares of Vertiv Holdings Co, a provider of power, cooling and infrastructure solutions for data centers, sold off sharply during the quarter after the introduction of the surprisingly efficient DeepSeek AI app raised investor concerns that there would be less need for capital expenditures in the data center industry than projected and, accordingly, would slow Vertiv's growth rate. In addition, after strong outperformance in 2024, investor concerns that orders could slow in upcoming quarters as customers go through a digestion period of related spend caused a revaluation of the entire space. We remain investors. We believe Vertiv maintains its competitive advantage and will benefit from increased capital spend and the complexity roadmap related to new chip introductions, which will run hotter and require more advanced cooling solutions. We believe the stock is attractively valued in the context of the long-term growth potential.
• The Trade Desk is the leading internet advertising demand-side platform, enabling agencies to efficiently purchase digital advertising across PC, mobile, and online video channels. Shares fell on an earnings miss for the first time in 33 quarters. Since the most recent earnings report, we have done substantial research to test our investment thesis. We believe the miss was due largely to a reorganization in December and delays in its Kokai platform rollout, both of which we believe have since improved. While we monitor the competitive landscape as Amazon enters the market more meaningfully, we believe The Trade Desk still represents the best option for biddable Connected TV (CTV) inventory. It gained share against the incumbent Google in the last five years, even when Google charged low/no fees, and major companies like Netflix, Disney, and Spotify have opened their ad inventory to The Trade Desk. Its market remains large and underpenetrated, as the shift to CTV advertising is still in early stages. We believe The Trade Desk can grow its top line by high-teens to 20% year-over-year for years to come.
• Shares of Gartner, Inc., a provider of syndicated research, fell on uncertainty around the impact of government spending reductions on the business. We estimate U.S. federal exposure is about 5% of Gartner’s total research contract value, with about half from the Department of Defense and intelligence organizations and half from civilian agencies. While DOGE-driven cost scrutiny is high, we believe Gartner’s services deliver significant value to users, including the potential for hard dollar savings. The private sector business appears well positioned for sustained growth, and management is adept at exercising cost controls to sustain or enhance margins and free cash flow. The company’s balance sheet is in excellent shape, and we expect management to take advantage of this drawdown with aggressive share repurchases.

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) declined 9.07% (Institutional Shares) in the first quarter, outperforming the Russell 2000 Growth Index (the Index) by 205 basis points due to stock selection and tailwinds from style biases, notably lower exposure to the weak performing Beta factor and overexposure to the top performing Size factor (larger caps).

From a sector perspective, strong stock selection in Information Technology (IT), Consumer Discretionary, and Financials was responsible for most of the relative gains in the period. Strength in IT came from property and casualty (P&C) insurance software vendor Guidewire Software, Inc., whose stock price was up double digits for the quarter. After a multi-year period, we believe Guidewire's cloud transition is substantially over, and 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. We also expect the company to shift R&D resources to product development from infrastructure investment, which will help to drive cross-sales into its sticky installed base and potentially accelerate ARR over time. Additionally, we are also encouraged by Guidewire’s subscription gross margin expansion, which improved by more than 1,000 basis points in its most recently reported quarter.

Favorable stock selection in Consumer Discretionary was driven by gains from corporate daycare provider Bright Horizons Family Solutions, Inc. and full-service restaurant operator The Cheesecake Factory, Inc. Bright Horizons’ stock increased after reporting above-consensus guidance for fiscal year 2025. The company’s high-growth, high-margin Back Up Care segment has transformed the business and greatly enhanced growth prospects, with its $170 million in 2024 operating income alone exceeding the peak pre-pandemic income generated by Full Services. The Full Services segment continued its recovery, with enrollment growth more in line with pre-pandemic levels. Cheesecake Factory shares were lifted by solid fourth quarter earnings results. While management provided modest guidance to start the year, sales trends for the current quarter have been strong thus far. Fitness center operator Planet Fitness, Inc., regional gaming and entertainment company Red Rock Resorts, Inc., and premier insulation installer Installed Building Products, Inc. also contributed to relative gains in the sector.

Specialty insurer Kinsale Capital Group, Inc. and insurance broker The Baldwin Insurance Group, Inc., led the way in Financials, benefiting from strong financial results and the relative stability of insurers in a risk-off market. Kinsale reported better-than-expected earnings in the most recent quarter despite slowing premium growth. Earnings per share grew 19% and return on equity remained elevated at 30% due to strong underwriting margins and higher investment income. Excess & surplus insurance market conditions remain favorable with recent state data indicating continued double-digit growth due to share gains from the standard market. Baldwin reported 16% revenue growth, 38% EBITDA growth, and net leverage moderating to 4.1x. In 2025, management expects continued double-digit organic growth and margin expansion despite higher costs related to the California wildfires and the replacement of an insurance carrier for the homeowners insurance business. Management reaffirmed the goal of achieving $3 billion of revenue and 30% EBITDA margins within five years, implying a near-tripling of earnings.

Somewhat offsetting the above was stock-specific weakness in Health Care and Communication Services, where sharp declines from food and animal safety products provider Neogen Corp. and internet advertising demand-side platform The Trade Desk weighed heavily on performance. Lack of exposure to strong performing pharmaceutical stocks also contributed to the relative shortfall in Health Care. Neogen’s shares fell after the company lowered fiscal year 2025 guidance largely due to incremental FX headwinds. The company’s stock was also impacted by investor fatigue after two long years of M&A integration, leading to some relatively price-insensitive sellers, and concerns that the company could be impacted by tariffs. There will likely continue to be near-term volatility, but we retain long-term conviction, as we believe Neogen is a good company with solid industry tailwinds that is poised for strong performance post-merger integration.

Trade Desk’s stock price was pressured by an unusual earnings miss. We believe the earnings shortfall was due largely to a company reorganization in December and delays in its Kokai platform rollout, both of which we believe have since improved. While we continue to watch the competitive landscape as Amazon enters the market more meaningfully, we believe Trade Desk still represents the best option for biddable Connected TV (CTV) inventory. The company’s market remains large and underpenetrated, as the shift to CTV advertising is still in early stages. We believe Trade Desk can grow its top line by high-teens to 20% year-over-year for years to come.