Baron Health Care Fund®: Navigating the Complex and Rapidly Changing Health Care Landscape

The COVID pandemic spurred investor interest in a sector – Health Care – that for years had flown under the radar, viewed largely as a not-very-exciting, defensive, value-oriented sector.

In fact, well before the onset of the pandemic, the Health Care sector had been growing and transforming for years. Over the past decade, the number of health care companies in the Russell 3000 Index has increased to 519. Health Care now comprises nearly 12% of the index by weight. The industry is evolving on multiple fronts, driven by population demographics, governmental policies and regulations, trends in health care insurance, and revolutionary advances in technology and diagnostics and treatment of disease. We think the reinvigorated investor, societal, and governmental focus on health care brought on by COVID, coupled with the scientific breakthroughs achieved in the development of the vaccines and elsewhere, will only serve to accelerate many of these long-term trends.

Baron Health Care Fund

Six-plus years ago, we launched Baron Health Care Fund to capture the attractive growth opportunities we were seeing and leverage our long investment experience in the sector. The Fund has been run by Portfolio Manager Neal Kaufman and Assistant Portfolio Manager Josh Riegelhaupt since its April 30, 2018, inception. Neal and Josh are backed by four additional research analysts covering Health Care as well as the rest of our 45 investment professionals.

The sector is a fertile hunting ground for skilled stock pickers, as it is unusually complex, comprised of 10 sub-industries ranging from massive, long-established managed health care companies to tiny, high-growth, high-risk biotechnology startups. The fact that, over the last decade, Health Care experienced the biggest dispersion of any sector, presenting some of the best and the worst returns in the market, speaks to its complexity. We believe the transformative secular trends impacting health care coupled with its breadth and diversity create a competitive advantage for stock pickers like us with an expert understanding of the medical science, technology, and regulatory landscapes involved.

As seen below, our approach has produced solid longer-term results to date. Since its launch, the Fund has outperformed its primary benchmark, the Russell 3000 Health Care Index, by 177 basis points annualized. The Fund’s five-year upside capture of 103.73% and downside capture of 95.48% are also strong.

A Differentiated Approach to Health Care

Baron Health Care Fund takes a distinct approach to investing in health care. While we can invest across all market caps and geographies, we hold just 30 to 60 stocks at any one time, fewer than the 510 holdings in its primary benchmark or the 76 stocks in the average fund in Morningstar’s health care category. The Fund’s top 10 holdings represent 52.3% of the portfolio, reflecting the high conviction of its managers.

At the same time, the Fund is well diversified across sub-industries, with a focus on equipment and life sciences tools companies, pharmaceuticals, biotechnology, and managed health care. Its relatively higher growth, smaller market cap makeup also distinguishes us from many of our competitors and the benchmark.

A balanced approach to risk

To help manage risk, we seek to balance the portfolio among high growth, biotech, and stable growth or earnings compounders.

Weights for each category are typically around 25% in high growth, 25% in biotech, and 50% in stable growth or earnings compounders. Note that we view these weights as guidelines, not rigid mandates, and they may shift somewhat depending on the opportunity set and the market environment.

High growth

These are higher risk/return companies typified by revenue growth of 15% or more that we believe will lead to dramatic future earnings growth. This category includes newer businesses with novel products or services. Yet they are not venture businesses. We invest only in companies with fully formed business strategies.

DexCom, Inc. is a high-growth stock we own. DexCom provides a continuous glucose monitoring (CGM) device for patients with diabetes to help them monitor their blood glucose levels. As CGM continues to rapidly replace finger sticks in the U.S. and abroad, DexCom’s system is differentiated in that it offers exceptional features and functionality. This market leader recently launched its seventh generation sensor called the G7, a smaller, disposable, lower cost sensor. We believe DexCom can continue to generate attractive growth, driven by continued penetration into the insulin intensive market and expansion into new markets, including the much larger non-insulin intensive, gestational diabetes, and hospital markets, among others.

Biotech

Even among high-growth health care stocks, biotechs present a unique challenge. For one, their growth – and in some cases, their very survival – is dictated by binary catalysts, usually the greenlighting of a drug by the FDA. Equally as important, in addition to all the other research we do into potential investments, biotechs require an expert understanding of and deep dive into the clinical and scientific data associated with the drugs being developed. Josh, who is the assistant portfolio manager of Baron Health Care Fund and covers biotech and pharma, holds a PhD in genetics and molecular biology from Rockefeller University. Yet Josh says that considering the amount of research he has done to evaluate prospective and existing investments in this area, he has probably “learned three [additional] PhDs worth of material” in his 14 years as an analyst and now portfolio manager. Within biotech, we have a preference for platform companies in which the drugs being developed are potentially applicable to more than one disease.

Argenx SE is developing antibodies for the treatment of autoimmune disorders and cancer. Argenx’s main product, efgartigimod, which treats a rare muscle weakness disorder, has potentially broad applicability in ameliorating overactive antibody-based diseases. The stock has appreciated significantly in the time we have held it, and we expect it will continue to ramp as the company proves its product’s effectiveness in multiple auto-antibody disorders.

Stable growth or earnings compounders

This category is constructed to help dampen volatility by offsetting holdings in other parts of the portfolio that may have higher beta. This category is also typically not as correlated to the market as the other two. These holdings might be more yield- or asset-oriented and generate solid free cash flow growth.

UnitedHealth Group Incorporated is the nation’s leading health care franchise. Our investment allows us to participate in the strong secular growth of health care. We believe UnitedHealth has a uniquely diversified portfolio and complementary set of skills, services, and expertise that will allow it to deliver higher quality health care at lower cost to its members and customers. It uses its significant free cash flow to fund acquisitions and $5 billion in annual technology, research, and innovation investments, which serve to reinforce the company’s competitive moat.

Focus on investable themes

To find the most promising companies within health care, we typically search for and analyze what we believe to be defined, long-term growth themes. We then apply Baron Capital’s time-tested research-intensive, fundamental, bottom-up approach to invest for the long term in companies that we believe benefit from durable competitive advantages, excellent management, and secular growth opportunities, at an attractive valuation. We do not make a bet on an entire space. Instead, we determine who the competing businesses are and whether we think there is a potential winner.

The following investment themes help illustrate our approach.

• Anti-Obesity Medications
• Innovative New Drugs
• Technology-Enabled Drug Development
• Minimally Invasive Surgery
• Diabetes Management
• Tools Providers to Life Sciences Companies
• Animal Health

Anti-Obesity Medications

Without question, the biggest development in health care in 2023 was the exploding popularity of GLP-1 drugs to treat obesity. While earlier generations of GLP-1s, used to treat Type 2 diabetes, had only a limited impact on weight loss, the newest generation (Ozempic/ Wegovy and Mounjaro/Zepbound) has been shown to reduce body weight by 15% to 20%, with few major side effects or safety concerns seen to date. We estimate a $150 billion opportunity in the U.S. alone and expect top 10 holding Eli Lilly and Company to capture a meaningful share of that market with its drug Mounjaro/Zepbound and its pipeline of next generation GLP-1s. We view Lilly as a unique company with a compelling growth profile, strong competitive advantages, and a top-rated management team. Its R&D productivity is well above the industry average, and it has first mover advantage, clinical expertise, manufacturing capabilities, and payer relationship advantages in the diabetes and obesity market.

Innovative New Drugs

We have investments in companies developing innovative new drugs to treat a diverse array of diseases. In addition to argenx, Rocket Pharmaceuticals, Inc., is specializing in gene therapies for rare genetic diseases outside of oncology and has a rich pipeline of targets including Danon disease, Fanconi anemia, lysosomal acid lipase deficiency, and pyruvate kinase deficiency.

Technology-Enabled Drug Development

The use of technology to help speed drug development and improve efficiencies is a relatively new area with massive growth potential, in our view. We recently invested in Tempus AI, Inc., an intelligent diagnostics and health care data company. Tempus has two synergistic business units: Genomics and Data & Other. Within its Genomics business, Tempus provides diagnostic tests, particularly for cancer treatment selection. We think the cancer treatment selection sequencing market is underpenetrated and poised for rapid growth, and Tempus is well positioned as one of the leaders in this field. Tempus has also amassed a huge (over 200 petabytes) proprietary multimodal dataset that combines clinical patient data (including clinical records, imaging data, etc., mostly from two-way collaborations with health systems) with genomic testing data from the Genomics business. In addition to using this data to power more intelligent diagnostics, Tempus also licenses it to biopharmaceutical companies, who use it to design smarter clinical trials and identify potential new drug targets. Tempus is expanding its platform beyond oncology to other areas such as cardiovascular disease, which should expand its market over time.

Minimally Invasive Surgery

Less invasive surgery is less traumatic for the patient, enabling a faster recovery and in many cases resulting in cost savings to the system. We have a number of investments in this growing space, including robotic surgery pioneer Intuitive Surgical, Inc.

Diabetes Management

The prevalence of diabetes is staggering, with over 400 million people globally with diabetes, yet this number is expected to keep climbing. The International Diabetes Federation estimates that 629 million people could have diabetes by 2045. We have investments in innovative medical technology companies that help patients better manage their diabetes. We own DexCom, which, as discussed above, provides a device that allows diabetics and caregivers to monitor insulin levels by smartphone.

Tools Providers to Life Sciences Companies

We like businesses that provide products and services to life sciences companies because they can benefit from the growth in life sciences without the risk inherent in drug development. Our investments in life sciences tools providers include Thermo Fisher Scientific Inc., Bio-Techne Corporation, and Mettler-Toledo International, Inc.

Animal Health

Growth in pet ownership and spending on pets, and, on the flip side, increased consumption of animal protein and focus on food safety all bode well for the animal health industry. In addition, compared with drug development for humans, the animal health industry is characterized by lower regulatory barriers, faster and less costly R&D, less generic competition, and lower third-party reimbursement risks. We have investments in Zoetis Inc., which develops and sells medicines for pets and food producing animals; and IDEXX Laboratories, Inc., the leading provider of diagnostic instruments and assays used for pet care in veterinarian offices.

Conclusion