Baron Small Cap Fund: Latest Insights and Commentary

U.S. equities delivered a steady finish to an otherwise turbulent year in the fourth quarter of 2025, with moderate gains across most indexes amid easing economic pressures and holiday-season stability. Large caps outperformed, while mid caps lagged and small caps delivered more modest advances. Market participation broadened beyond technology, with value stocks faring better than growth across all size segments. Multiple record highs were reached during the quarter, with the S&P 500 Index and Dow Jones Industrial Average peaking on December 24, the NASDAQ Composite reaching several all-time highs earlier in the quarter, and the Russell 2000 hitting a fresh peak on December 11. Volatility spikes in mid-October and mid-November proved short-lived, and the CBOE Volatility Index reached a 2025 low by late December, supported by resilient economic data.

Fourth-quarter gains were underpinned by moderating tariff impacts, robust corporate earnings, and continued monetary easing. Following a 25-basis-point rate cut in September, the Federal Reserve lowered rates twice more during the quarter, with additional 25-basis-point cuts in October and December. Investor sentiment reflected optimism, as Bank of America’s mid-December Global Fund Manager Survey showed the most bullish outlook in three-and-a-half years, with record-low cash levels and elevated allocations to equities and commodities, though concerns persisted around AI bubbles, private credit events, and elevated hyperscaler capital spending. While a prolonged government shutdown introduced some uncertainty, resilient labor market conditions and the absence of major inflation spikes helped support the rally.

The Magnificent Seven complex posted another positive quarter, rising 3.6%, though gains moderated meaningfully from prior quarters. The group outperformed the broader S&P 500 Index and accounted for nearly half of the Index’s gains. Performance within the group was mixed, led by Alphabet, which surged 28.8%, followed by Apple and Amazon. Tesla edged higher but trailed the broader market, while Meta, Microsoft, and NVIDIA declined during the period.

Looking ahead, we remain focused on well-managed companies with durable competitive advantages and attractive growth prospects. While macroeconomic and policy uncertainty persists, 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 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 rose during the quarter following robust financial results and broader strength across data center infrastructure companies, driven by rising expectations for data center capital spending and increasing electrical and thermal complexity tied to NVIDIA’s roadmap. We believe Vertiv is well positioned for growth over the next several years, supported by its broad product portfolio, unique service capabilities, and role as a preferred solutions provider to leading chip companies. In addition, the company’s internal focus on margin improvement should support better-than-expected earnings growth and continued upside over time.

• Clearwater Analytics Holdings, Inc., a provider of portfolio accounting and reporting software, contributed to performance. The company reported solid Q3 2025 earnings and raised 2025 guidance. Clearwater also announced that a consortium of private equity investors intends to acquire the company, which drove a sharp positive market reaction. We retain conviction and believe Clearwater has meaningful competitive advantages and the potential to compound revenue at attractive rates for several years. The company has an efficient business model that should drive 40%-plus adjusted EBITDA margins over time.

• JFrog Ltd. is a software platform that helps developers manage, secure, and release modern software applications. Its core products enable large companies to store and manage “binaries”—machine-readable files spanning open-source software packages, large language models, dependencies, and metadata—that allow applications to run securely in production. Shares rose as JFrog’s customers—many of whom are leveraging generative AI to improve developer productivity—built applications at faster rates throughout 2025, driving an increase in binary creation and platform usage. Customers also began signing larger, longer-term commitments and increasingly adopted JFrog’s cybersecurity suite to help prevent software supply chain breaches. These dynamics led to three consecutive quarters of revenue acceleration (Q3 sales grew 26% year over year, up from 23% in the prior year), margin expansion (trailing 12-month free cash flow margins of 28%, up 600 basis points year over year), and positive estimate revisions, driving strong stock price appreciation. We believe JFrog has a long runway for growth as the dominant platform for binary management in an industry accelerating due to AI adoption.

DETRACTORS

• ODDITY Tech Ltd. intends to transform the beauty and wellness market by using proprietary technology to sell and launch products exclusively online. Shares declined amid investor concerns around category strength following cautious commentary from industry peers, as well as credit card data indicating a potential deceleration at the company’s largest brand, Il Makiage. ODDITY is also launching its third platform, MethodIQ, which required incremental upfront marketing investment during the year. Management expects MethodIQ to ramp quickly and deliver strong financial results in the coming years. Overall, the business remains well positioned to achieve its full-year target of approximately 20% revenue growth at a 20% margin. ODDITY has demonstrated an ability to create innovative products and successfully launch new brands by leveraging its molecule formulation and marketing capabilities. We continue to own the stock given its attractive valuation relative to future earnings, strong cash flow generation, solid balance sheet, and long-term growth opportunity in a large, underpenetrated e-commerce category.

• Shares of property and casualty (P&C) insurance software vendor Guidewire Software, Inc. declined during the quarter following strong gains earlier in the year, as the broader software sector came under pressure. 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 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 $2.5 trillion global P&C insurance industry, capturing 30% to 50% of its $15 billion to $30 billion total addressable market and generating margins above 40%.

• Cognex Corporation is a leading provider of machine vision solutions. Shares declined during the quarter following weaker-than-expected forward guidance that suggested continued growth but less acceleration than investors had anticipated. Cognex is an especially short-cycle player that is highly sensitive to changes in the broader industrial economy, which is currently operating below normalized levels. An expansion in industrial production is needed for growth to reaccelerate meaningfully. We retain conviction in the stock. Cognex’s competitive moat remains strong, positioning it to benefit enormously once the cycle turns upwards.

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 1.56% (Institutional Shares) in the fourth quarter, trailing the Russell 2000 Growth Index (the Index), which increased 1.22%, by 278 basis points due to the negative impact of relative sector weights. 

Investments in Health Care, Financials, and Consumer Staples weighed the most on relative results. Within Health Care, lack of exposure to biotechnology and pharmaceutical stocks, which rose 26.1% and 24.1%, respectively in the Index, detracted nearly 300 basis points from relative performance. Double-digit losses from medical device outsource manufacturer Integer Holdings Corporation also hampered relative results. Shares of Integer declined sharply after the company lowered its 2025 guidance during third-quarter earnings and provided preliminary 2026 and 2027 outlooks that fell well below expectations. Management attributed the shortfall primarily to three customer new product launches that meaningfully underperformed expectations, resulting in limited near-term reorder activity. While Integer now expects minimal growth contribution from these products, management continues to target a return to 7% to 8% organic growth beginning in 2027 as newer programs ramp. Although shares appeared undervalued relative to the longer-term growth outlook, we found it difficult to underwrite the undisclosed new products and the expected growth reacceleration. As a result, we exited the position.

Within Financials, losses from specialty insurer Kinsale Capital Group, Inc. and global investment bank Houlihan Lokey, Inc. weighed the most on relative results. Shares of Kinsale fell during the quarter due to concerns about moderating growth amid a cyclical slowdown for the property and casualty insurance industry. While third-quarter revenue growth improved sequentially, the pace of improvement was more modest than suggested by monthly data from state insurance commissioners. 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. 

Houlihan Lokey’s shares declined due to a softer outlook for the restructuring business. Lower interest rates and improving macroeconomic conditions have tempered new restructuring activity, which represents 20% to 25% of the company’s revenue. However, these same conditions are driving strong growth in Houlihan Lokey’s pro-cyclical M&A and valuation advisory businesses. Quarterly results exceeded Street expectations, with 15% revenue growth and 26% earnings per share growth. Favorable capital markets conditions are supporting improving corporate confidence and increased deal-making activity. We continue to own the stock given Houlihan Lokey’s diversified service offering, leading market positions, and long runway for growth.

Beauty and wellness industry transformer ODDITY Tech Ltd. hampered performance in Consumer Staples. Shares declined amid investor concerns around category strength following cautious commentary from industry peers, as well as credit card data indicating a potential deceleration at the company’s largest brand, Il Makiage. ODDITY is also launching its third platform, MethodIQ, which required incremental upfront marketing investment during the year. Management expects MethodIQ to ramp quickly and deliver strong financial results in the coming years. Overall, the business remains well positioned to achieve its full-year target of approximately 20% revenue growth at a 20% margin. ODDITY has demonstrated an ability to create innovative products and successfully launch new brands by leveraging its molecule formulation and marketing capabilities. We continue to own the stock given its attractive valuation relative to future earnings, strong cash flow generation, solid balance sheet, and long-term growth opportunity in a large, underpenetrated e-commerce category.

Partially offsetting the losses above was strong stock selection in Industrials and Information Technology (IT). Within Industrials, outperformance of critical digital infrastructure leader Vertiv Holdings Co and sharp gains from Legence Corp., a leading provider of engineering, installation, and maintenance services for mission-critical building systems, added the most value. Shares of Vertiv rose during the quarter following robust financial results and broader strength across data center infrastructure companies, driven by rising expectations for data center capital spending and increasing electrical and thermal complexity tied to NVIDIA’s roadmap. We believe Vertiv is well positioned for growth over the next several years, supported by its broad product portfolio, unique service capabilities, and role as a preferred solutions provider to leading chip companies. In addition, the company’s internal focus on margin improvement should support better-than-expected earnings growth and continued upside over time.

Legence shares increased following a strong first earnings report after the company’s initial public offering in September. While Legence benefited from robust data center activity, strong performance was not limited to that end market, with the company also delivering solid growth across technology, life sciences and healthcare, education, and government projects. Legence also announced its acquisition of The Bowers Group, a leading mechanical contractor in the Northern Virginia and Washington, D.C. metro area, which we believe will enhance its regional service capabilities and add to its overall growth profile. We continue to hold shares of Legence and believe the company is well positioned to benefit from ongoing tailwinds tied to data center construction, digital infrastructure investment, reshoring and onshoring of manufacturing, energy efficiency initiatives, and other related trends.

Strength in IT came from software companies Clearwater Analytics Holdings, Inc. and JFrog Ltd., two of the Fund’s largest absolute contributors in the period. Shares of Clearwater, a provider of portfolio accounting and reporting software, contributed to performance after the company reported solid Q3 2025 earnings and raised 2025 guidance. Clearwater also announced that a consortium of private equity investors intends to acquire the company, which drove a sharp positive market reaction. We retain conviction and believe Clearwater has meaningful competitive advantages and the potential to compound revenue at attractive rates for several years. The company has an efficient business model that should drive 40%-plus adjusted EBITDA margins over time.

JFrog is a software platform that helps developers manage, secure, and release modern software applications. Its core products enable large companies to store and manage “binaries”—machine-readable files spanning open-source software packages, large language models, dependencies, and metadata—that allow applications to run securely in production. Shares rose as JFrog’s customers—many of whom are leveraging generative AI to improve developer productivity—built applications at faster rates throughout 2025, driving an increase in binary creation and platform usage. Customers also began signing larger, longer-term commitments and increasingly adopted JFrog’s cybersecurity suite to help prevent software supply chain breaches. These dynamics led to three consecutive quarters of revenue acceleration (Q3 sales grew 26% year over year, up from 23% in the prior year), margin expansion (trailing 12-month free cash flow margins of 28%, up 600 basis points year over year), and positive estimate revisions, driving strong stock price appreciation. We believe JFrog has a long runway for growth as the dominant platform for binary management in an industry accelerating due to AI adoption.

Yearly Attribution Analysis (for year ended 12/31/2025)

Baron Small Cap Fund (the Fund) fell 0.66% for the year, underperforming the Russell 2000 Growth Index (the Index), which increased 13.01%, by 13.67%. More than 50% of the underperformance was due to style-related biases as the Fund was punished for being overexposed to the Earnings Quality factor, which suffered one of its worst performing periods in the last nine months of the year. Underexposure to the strong performing Momentum factor also contributed to the relative shortfall in the period. The remaining underperformance came from stock-specific issues and active industry exposures.

On a sector level, weakness in IT detracted the most from relative results, driven by syndicated research provider Gartner, Inc. Shares of Gartner declined in response to 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.

Staffing firm ASGN Incorporated, outsourced software developer Grid Dynamics Holdings, Inc., and professional services platform Intapp, Inc. also hampered performance in the sector. Shares of ASGN declined amid ongoing macroeconomic uncertainty, as customers remained cautious with spending and hesitant to initiate new IT projects without greater clarity on the economic outlook. We continue to believe ASGN is well positioned to meet the IT needs of its clients as demand normalizes over time. Grid Dynamics fell during the period due to expectations for a near-term slowdown and concerns that management’s outlook for the second half of the year was overly optimistic. We continue to own the stock based on our view that Grid Dynamics offers differentiated capabilities and has a long runway for growth. Shares of Intapp declined in the period, reflecting a broader pullback in software stocks as investors weighed potential AI-related disruption across the sector. Additionally, a portion of Intapp’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, annual recurring revenue 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. 

Health Care investments were also a drag on relative results for the year. Within Health Care, lower exposure to this lagging sector along with losses from Contract Research Organization (CRO) ICON plc, food and animal safety products provider Neogen Corp., and obstructive sleep apnea treatment pioneer Inspire Medical Systems, Inc. detracting the most from relative results. ICON’s shares were hurt by soft earnings results marked by persistent volatility in the clinical development market. Bookings lagged as clients deferred decisions, tightened R&D budgets, and canceled or delayed projects, prompting management to lower 2025 guidance and remove two next-generation COVID-19 vaccine studies with uncertain timelines. We retain conviction. Neogen reported weak fiscal Q3 2025 earnings, lowered its fiscal 2025 guidance, and announced that CEO John Adent would step down in 2025. The stock was also impacted by investor fatigue after several long years of M&A integration, leading to some relatively price-insensitive sellers. We expect near-term volatility to persist but retain long-term conviction, as we believe Neogen benefits from solid industry tailwinds and is poised for strong performance as it works through merger-related integration.

Inspire Medical Systems’ shares declined double-digits in period after 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.

Financials investments also materially detracted from relative results. Weakness in Financials came from insurance broker The Baldwin Insurance Group, Inc.  and specialty insurer Kinsale Capital Group, Inc. Baldwin’s stock price fell after the company issued an incrementally slower growth outlook for the commercial insurance brokerage segment. Management reaffirmed their goal of achieving $3 billion of revenue and 30% EBITDA margins within five years, implying a near-tripling of earnings. We remain investors because we expect the company to continue gaining market share while expanding margins and reducing leverage over the next several years. Kinsale’s shares detracted after reporting premium growth below Street expectations and slowed from the prior quarter due to lower pricing for large property policies. Nevertheless, earnings beat expectations due to better underwriting margins, more favorable reserve development, and smaller catastrophe losses. 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.

Lastly, Communication Services investments detracted from relative results, driven by higher exposure to this underperforming sector coupled with losses from internet advertising demand-side platform The Trade Desk. Shares of The Trade Desk fell after reporting in-line earnings relative to conservative guidance amid a strong quarter for peers in digital advertising. The company’s total addressable market remains large and underpenetrated, but advertisers may take longer to shift towards biddable programmatic CTV advertising and could be drawn to lower fees offered by competitors. We continue to monitor the competitive landscape, particularly as Amazon enters the market more meaningfully with its rapidly improving DSP offering. While growth may moderate slightly going forward, we believe The Trade Desk’s margin profile and long-term prospects remain defensible, particularly given the stock’s lower valuation.

Somewhat offsetting the losses above were the Fund’s investments in Industrials and Consumer Discretionary. Within Industrials, higher exposure to this better performing sector along with strong performance from defense technology provider Kratos Defense & Security Solutions, Inc. and critical digital infrastructure leader Vertiv Holdings Co. aided relative results. Kratos contributed to performance during the period amid growing momentum across the business. We believe Kratos is well positioned for accelerated multi-year growth, as prior investments in high-growth areas of defense—such as hypersonics, drone engines and small missile engines, space, microwave electronics, and unmanned systems—are translating into larger contract awards. Demand is being driven by increased funding from the Department of Defense and other global militaries. In our view, the current operating environment has never been better, and few companies are as well-equipped as Kratos to deliver the advanced solutions required for modern warfare. Vertiv’s stock rose on solid quarterly earnings results. 

Favorable stock selection in Consumer Discretionary came from regional gaming and entertainment company Red Rock Resorts, Inc. and premier insulation installer Installed Building Products, Inc. (IBP). Shares of Red Rock performed well in 2025 as the company's new Durango casino continued to grow the market and the company was able to backfill its other casino resorts more quickly than management expected.  As a result, the company was able to grow earnings while using the increased cash flow to accelerate its capital expenditures and fund new project expansions at the Durango as well as other resorts including Sunset Station and Green Valley Ranch. Shares of IBP increased after the company reported strong quarterly results and provided an optimistic outlook for the remainder of 2025. We remain shareholders, as we believe IBP will continue to outperform the broader housing market through share gains, cross-selling initiatives, and accretive acquisitions.