Baron Focused Growth Fund | Q2 2024

Baron Focused Growth Fund® (the Fund) decreased 0.21% (Institutional Shares) in the second quarter. The Fund outperformed the Russell 2500 Growth Index (the Benchmark), which declined 4.22%. During the quarter, it became evident that the Federal Reserve’s (the Fed) restrictive policies over the past year were beginning to have their desired effect of slowing inflation, job growth, and employment. This cooling of economic growth led investors to believe the Fed could start cutting interest rates as soon as this fall. The result was gains in our Disruptive Growth investments, the valuations of which had been negatively impacted by higher interest rates and whose growth could accelerate in a lower interest rate and moderate inflationary environment. Included in this category of investments are Spotify Technology S.A., Tesla, Inc., FIGS, Inc., and Iridium Communications Inc.

Our Financials investments were also strong in the quarter. This is despite the expectation for lower future interest rates. Interactive Brokers Group, Inc. (IBKR) benefited from an acceleration in new client growth and trading revenue, while Arch Capital Group Ltd. saw continued growth in insurance premiums written and higher pricing due to strong demand for its property and casualty (P&C) insurance.

In the near term, we continue to believe that inflation will remain at or below historic 3% to 4% annualized levels and interest rates will approximate the rate of inflation. This has been the case since World War II. We believe that is a favorable environment for businesses that are growing significantly faster than the rate of inflation and the 7% nominal annualized growth rate of our economy.

The above stock price gains were offset by declines in our more economic- sensitive stocks, including FactSet Research Systems Inc., MSCI Inc., CoStar Group, Inc., Krispy Kreme, Inc., and Vail Resorts, Inc. These businesses were hurt by an elongation of the business sales cycle and concerns that their pricing power would be eroded by the decline in inflation. However, we believe as interest rates decline, business activity for these companies should accelerate. We continue to believe these businesses have strong competitive advantages with still underpenetrated growth opportunities ahead of them and robust balance sheets to fund their growth. We believe valuations are attractive at current levels, and we are starting to see an acceleration in insider buying activity, a key pillar that gives us stronger conviction in our investments.

The Fund has continued to generate strong returns with less than market risk. Over the trailing 3, 5, and 10 years, the Fund has captured 101%, 132%, and 111%, respectively, of the upside when the market increased. When markets declined, the Fund lost less with 80%, 90%, and 88% downside capture, respectively. The Fund’s Sharpe ratio, a measure of risk- adjusted return, was also higher than the Benchmark for each of these periods.

We believe these strong returns with downside protection are due to our research-based investment process. Our research enables us to identify and understand businesses’ competitive advantages, differentiation, long-term growth prospects, and exceptional people; and it allows us to invest in these businesses for the long term. As a result, the Fund has outperformed its Benchmark for the 3-, 5-, 10-, and 15-year periods, as well as since its inception on May 31, 1996. Since its inception as a private partnership 28 years ago, the Fund has increased 13.16% annually. This compares to an 8.04% annualized return for the Benchmark and a 9.64% annualized return for the Russell 3000 Index that measures the performance of the largest 3,000 U.S. companies.

The Fund’s outperformance versus the Benchmark in the second quarter was mostly driven by our Disruptive Growth investments. These businesses represented 34.9% of the Fund’s net assets and gained 9.1%, helping our returns by 305 bps in the quarter.

Spotify increased 18.9% in the quarter and helped performance by 98 bps. The company continues to improve its platform adding new products and making it more beneficial for the consumer. This has resulted in an increase in subscribers along with significant pricing power. The company has started to institute more regular price increases, which is accelerating its revenue and margin growth. Further, the company has been able to increase prices without increasing its churn rate. We believe the business should be able to improve gross margins from 26% to between 30% and 35% over time while continuing to add subscribers and generate strong top- and bottom-line growth. This should result in an increase in cash flow. Given strong cash flow conversion rates, we believe the company could initiate a return of capital program in the near future. We believe Spotify’s valuation remains attractive despite its recent stock price increase. Founder & CEO, Daniel Eck continues to own a 15% stake in this business

Tesla increased 12.6% in the quarter, adding 98 bps to performance. The company designs, manufactures, and sells electric vehicles, related software and components, and solar and energy storage products. The stock increased as the core automotive segment accelerated sequentially. We believe lower interest rates will help sell more cars and halt the company’s continuous lowering of prices on its cars. In addition, the company’s energy storage business continues to grow sequentially. It almost doubled in the second quarter from first quarter levels. In time, business should add significantly to revenue and gross margins and help offset any margin degradation from its auto business. Tesla continues to generate sufficient gross profit to support a robust product development plan. The refreshed Model 3 and Y are also generating strong demand with improving unit-level economics. Lastly, Tesla should benefit from its eight-year, $10 billion investment in data and compute that will allow AI to “train” cars to drive with autonomous technology. Dojo, an AI “training” compute; autobidder, an automated energy trading platform; the Optimus, a human-like robot; and energy storage, we believe also provide opportunity. We believe Tesla is well positioned for further growth given its strong balance sheet and substantial cash.

The Fund’s Financials investments also contributed to performance.

IBKR, a global automated electronic broker, increased 10.0% in the quarter and helped performance by 40 bps. The company continues to take market share due to its strong automation and ability to operate in international markets with little competition. This is allowing the company to grow its new accounts, which have accelerated recently to almost 30% this year. The company has industry-leading margins of over 70% generating robust cash flow. It has significant cash on its balance sheet and is looking to deploy it towards acquisitions and continued growth. We continue to believe the company’s focus on the most sophisticated investors who trade a range of assets across different global markets is a key differentiating factor. The vast array of markets it serves and strong growth from countries outside the U.S. where low-cost brokerage is not well penetrated are key competitive advantages for the company. This allows the company to offer its clients the lowest cost trading due to its high level of automation, while also offering highly competitive rates on margin loans and paying its customers attractive yields on their uninvested cash balances. More than 80% of IBKR’s clients are non-U.S. citizens, and more than 80% of their investments are in U.S. stocks. The company has little direct competition serving this clientele. IBKR continues to hire software and computer engineers with a focus on automating many of the processes that competitors rely on employees to perform. With its low-priced offerings and leading range of capabilities, we believe IBKR is well positioned to continue its rapid pace of account growth from just under three million clients today. The company’s focus on automation should enable it to continue to be a low-priced provider while earning best-in-class margins, which we believe should lead to double-digit revenue and earnings growth.

P&C insurance software vendor Guidewire Software, Inc. was up 18.1% for the quarter, adding 85 bps to performance. After a multi-year transition period, we believe the company’s cloud transition is substantially complete. We believe that 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 should help drive cross-sales into its sticky installed base and potentially accelerate ARR over time. We are encouraged by Guidewire’s subscription gross margin expansion, which improved by approximately 1,050 bps 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%.

The above gains were partially offset by declines in our Real/Irreplaceable Assets investments that are more susceptible to a slowdown in the macroeconomic environment and penalized by high interest rates. These businesses represented 21.6% of the Fund and declined 9.1%, hurting performance by 237 bps. These stocks were dragged down by an expected slowdown in the domestic economy, hurting revenue and cash flow growth. However, we believe these businesses can continue to grow even faster in a declining interest rate environment. This is due to the fact they all have strong recurring revenue, fee-oriented businesses with significant pricing power. Their high client retention rates are helped by consumers’ desire to spend more on experiences over goods in the current post-COVID environment.

Shares of global ski resort operator Vail declined 18.2% in the second quarter and hurt performance by 93 bps. This was due to a slowdown in season pass sales and a disappointing ski season in Australia. However, we believe skiers have delayed buying season passes given poor snow conditions for the past two seasons, but still expect Vail to generate almost $950 million in season pass revenue this year. That represents s close to a third of 2023 revenue. An 8% increase in prices combined with a favorable year-over-year comparison should result in a double-digit increase in EBITDA with strong cash flow generation. The company is now trading at more than a 6% free cash flow yield, all of which is being returned to shareholders through dividends and share buybacks. We see valuation as unusually attractive and regard insider purchases by senior executives as reason to be optimistic about this investment.

Shares of Red Rock Resorts, Inc., an owner and operator of casinos in the Las Vegas Locals market, declined 7.7% in the second quarter and hurt performance by 35 bps. This was due to slower-than-expected growth in the Las Vegas Locals market and greater-than-expected cannibalization of its casinos from the opening of its new Durango casino late last year. The Durango casino is generating strong results that should enable Red Rock to meet its projected 20% return on invested capital, pay down debt, and return to its targeted leverage ratio of 3 times by the end of next year. We believe the new casino combined with continued market growth should generate high single-digit growth in EBITDA and double-digit free cash flow growth over the coming years. Red Rock currently has over 300 acres of gaming-entitled land to develop. Its margins remain above pre-pandemic levels, despite increasing wage costs, thanks to strong incremental margins on revenue generated from its new resort.

Global hotelier Hyatt Hotels Corporation declined 4.7% in the quarter and hurt performance by 29 bps. The disappointing share price performance was due to a deceleration in growth in revenue per available room as a result of modestly slower leisure bookings. However, the company continues to increase its business transient and group bookings, which are now pacing 7% ahead of 2023 levels. These bookings are half of its business today. Robust mid-single-digit growth in units and modest margin expansion should lead to double-digit growth in EBITDA this year. In addition, Hyatt continues to sell assets in its bid to become a more asset-light business. It also has one of the strongest balance sheets in its industry today. All of the above should generate significant free cash flow that Hyatt can use to accelerate share buybacks. Hyatt has repurchased more than 80 million shares since its IPO in 2009! It now has just 100 million shares outstanding. Yet, despite 85% of Hyatt’s cash flow generated by fees, its stock still trades at a discount to peers.

Sources: FactSet PA, Baron Capital, and FTSE Russell.

* Individual weights may not sum to displayed total due to rounding.
** Represents the blended return of all share classes of the Fund.

Space Exploration Technologies Corp. (SpaceX) is a high-profile private company founded by Elon Musk. Its primary focus is on developing and launching advanced rockets, satellites, and spacecrafts, with the ambitious long-term goal of enabling human colonization of Mars. SpaceX is generating significant value with the rapid expansion of its Starlink broadband service. The company is successfully deploying a vast constellation of Starlink satellites in low Earth orbit, reporting substantial growth in active users, and regularly deploying new and more efficient hardware technology. Furthermore, SpaceX has established itself as a leading launch provider by offering highly reliable and cost-effective launches. SpaceX capabilities extend to strategic services such as crewed space flights. Moreover, SpaceX is making tremendous progress on its newest rocket, Starship, which is the largest, most powerful rocket ever flown. This next-generation vehicle represents a significant leap forward in reusability and space exploration capabilities. We value SpaceX using prices of recent financing transactions.

Tesla, Inc. manufactures electric vehicles, related software and components, and solar and energy storage products. The stock contributed as Tesla continued to drive vehicle manufacturing costs lower, accelerate the launch of new models, and invest heavily in its lucrative AI initiatives. Shareholders reaffirmed the CEO’s compensation plan, alleviating personnel and legal uncertainties. Despite material operational complexities resulting in significant shutdowns of key manufacturing facilities and lower sales volume, Tesla presented better-than-expected margins in the quarter. It expects to launch a lower cost model as soon as late 2024, which should result in accelerated revenue growth, reduced manufacturing costs, and increased factory utilization. The company continued to advance its autonomous driving capabilities, expanding its already significant data centers and developing its humanoid robot Optimus.

Spotify Technology S.A. is a leading global digital music service, offering on-demand audio streaming through paid premium subscriptions and an ad-supported model. Shares of Spotify were up, largely attributable to impressive beats in gross margin and operating margin as well as the announcement of subscription price hikes. Given the strong value proposition of the product, Spotify is beginning to exercise its pricing power following last year’s initial price increases that saw minimal churn. Users continue to grow at a healthy pace despite the pricing impact. Spotify also continues to innovate on the product side, with early trials of generative AI features and the addition of new verticals like audiobooks, which have seen solid early adoption. On the cost side, Spotify is on a path to structurally increase gross margins, aided by its high-margin artist promotions marketplace, increasing contribution by its podcast division, and growth of the margin-accretive advertising business. We still view Spotify as a long- term winner in music streaming with potential to reach more than one billion monthly active users.

CoStar Group, Inc. is a provider of marketing and data analytics services to the real estate industry. Shares detracted from performance in the quarter along with the broader software sector. Most software companies experienced a slowdown in new sales activity in early 2024, leading to guidance reductions and multiple compression. We believe CoStar shares were also impacted by concerns that the company’s second quarter financial results will show a deceleration in net new sales of its residential product following outstanding first quarter performance. We remain encouraged by traction in CoStar’s residential offering although recognize that progress may not be linear. CoStar began to monetize its new Homes.com platform in February. We believe early momentum can be amplified by the recent NAR class action settlement, which has the potential to disrupt the residential brokerage industry and enhance the return on investment for brokers advertising on Homes.com.

Doughnut chain Krispy Kreme, Inc. detracted during the quarter alongside the broader peer group, with small cap names being hit harder than their larger counterparts. Other company-specific concerns may also have pressured share prices, including the Federal Reserve’s delay in the timing of rate cuts given Krispy Kreme’s high leverage, weaker-than-anticipated credit card data, concerns around the strength of consumer sentiment, uncertainty around the company’s ability to execute on its partnership with McDonald’s, and holding company JAB’s announced plans to diversifying outside of consumer. We remain investors. The expected sale of Insomnia cookies should alleviate leverage issues, the credit card data is not an accurate metric as it does not include its growing wholesale sales, and we do not believe JAB intends to sell down its position in the near future. We see a strong growth opportunity and potential for outsized shareholder returns as Krispy Kreme expands its network and prepares for the expanded McDonald’s partnership.

Shares of global ski resort operator Vail Resorts, Inc. declined in the second quarter due to a slowdown in season pass sales and a disappointing ski season in Australia. We retain conviction. Vail has said that it believes skiers are delaying buying season passes given poor snow conditions for the past two seasons, and it still expects to generate almost $950 million in season pass revenue this year, representing close to a third of 2023 revenue. An 8% increase in prices combined with a favorable year-over-year comparison should result in a double-digit increase in EBITDA with strong FCF generation. The company is now trading at more than 6% FCF yield, all of which is being returned to shareholders through dividends and share buybacks.

We remain steadfast in our commitment to long-term investing in competitively advantaged growth businesses. We believe these investments are an effective way to protect and increase the purchasing power of your savings. Wars, pandemics, financial panics, higher-than-normal inflation, and interest rate increases can cause significant market declines, but when these negative influences abate, interest rates stabilize and decline, stock prices in the past have increased substantially. We believe this will happen again, although the timing remains uncertain.

As of June 30, 2024, The Fund owned 29 investments. The Fund’s average portfolio turnover for the past three years was 22.5%. This means the Fund has an average holding period for its investments of over four years. This compares to the average mid-cap growth mutual fund that typically turns over its entire portfolio every 17 months. From a quality standpoint, the Fund’s investments have stronger sales growth; higher EBITDA, operating, and free-cash-flow margins; and stronger returns on invested capital than the Benchmark. We believe these metrics help limit risk in this focused portfolio and are why the portfolio has generated strong risk-adjusted returns over time.

While focused, the Fund is diversified by sector. The Fund’s weightings are significantly different than those of the Benchmark. For example, we are heavily weighted to Consumer Discretionary businesses with 38.7% of net assets in this sector versus 13.5% for the Benchmark. We have no exposure to Energy, Materials, or Utilities. We believe companies in these sectors can be cyclical, linked to commodity prices, and/or have little if any competitive advantage. This compares to the Benchmark that had 9.0% exposure to these sectors. We also have lower exposure to Health Care stocks at 3.1% for the Fund versus 19.7% for the Benchmark. The performance of many stocks in the Health Care sector can change quickly due to exogenous events or binary outcomes (e.g., biotechnology and pharmaceuticals). As a result, we do not invest a large amount in these stocks in this focused portfolio. In Health Care, we invest in competitively advantaged companies that are leaders in their industries such as our positions in IDEXX Laboratories, Inc., the leading provider of diagnostics to the veterinary industry and Illumina, Inc., the leader in DNA sequencing instruments and consumables. The Fund is further diversified by investments in businesses at different stages of growth and development.

Disruptive Growth firms accounted for 34.9% of the Fund’s net assets. On current metrics, these businesses may appear expensive; however, we think they will continue to grow significantly and, if we are correct, they have the potential to generate exceptional returns over time. Examples of these companies include electric vehicle leader Tesla, Inc., commercial satellite and launch company Space Exploration Technologies Corp., and audio streaming service provider Spotify Technology S.A. These companies all have large underpenetrated addressable markets, are well-financed with significant equity stakes by these founder-led companies, giving us further conviction in our investment.

Core Growth investments, steady growers that continually invest in their businesses for growth and return excess free-cash-flow to shareholders, represented 23.9% of net assets. An example would be CoStar Group, Inc., a marketing and data analytics provider to the real estate industry. The company continues to add new services in commercial and residential real estate, which have grown its addressable market and enhanced services for its clients. This has improved client retention and cash flow. CoStar continues to invest its cash flow in its business to accelerate growth, which we believe should generate strong returns over time.

Companies that own what we believe are Real/Irreplaceable Assets represented 21.6% of net assets. Vail Resorts, Inc., owner of the premier ski resort portfolio in the world, Hyatt Hotels Corporation, upscale lodging brand, and Red Rock Resorts, Inc., the largest player in the Las Vegas Locals casino gaming market, are examples of companies we believe possess meaningful brand equity and barriers to entry that equate to significant pricing power over time.

Financials investments accounted for 18.1% of the Fund’s net assets. These businesses generate strong recurring earnings through subscriptions and premiums that generate highly predictable earnings and cash flow. These businesses use cash flows to continue to invest in new products and services, while returning capital to shareholders through share buybacks and dividends. These companies include Arch Capital Group Ltd., FactSet Research Systems Inc., and MSCI Inc.

As of June 30, 2024, the Fund’s top 10 holdings represented 58.5% of net assets. Many of these investments have been successful and were purchased when they were much smaller businesses. We believe they continue to offer significant appreciation potential, although we cannot guarantee that will be the case.

The top five positions in the portfolio, Space Exploration Technologies Corp., Tesla, Inc., Arch Capital Group Ltd., Spotify Technology S.A., and Hyatt Hotels Corporation all have, in our view, significant competitive advantages due to irreplaceable assets, strong brand awareness, technologically superior industry expertise, or exclusive data that is integral to their operations. We think these businesses cannot be easily duplicated and have large market opportunities to penetrate further, which enhances their potential for superior earnings growth and returns over time.

In the second quarter, we increased our positions in Vail Resorts, Inc. and Shopify Inc., two companies we believe were trading at attractive valuations and should see accelerated growth in the years ahead. We increased our position in Vail as the stock declined in the quarter due to external factors that were out of the company’s control. We believe assuming normal winter weather, the company should grow its earnings at a double-digit rate next year. Its season pass sales should still grow this year and help the company lock in close to a third of its revenue before the season even starts. We still believe the company has significant pricing power given no new ski supply, which enables the company to generate strong free cash flow. The company is trading over a 6% free cash flow yield, a level we deem attractive.

Shopify declined in the quarter due to an increase in product and marketing investments the company is currently making to increase its already strong competitive advantages. While this will hurt current profitability, we believe it is the right decision and should result in strong returns on invested capital, especially as competitors shy away from investments in their own businesses.

We believe the shares of many of our portfolio investments already reflect overly pessimistic earnings estimates for this year. Investors obviously remember operating declines during the 2008/2009 Global Financial Crisis and are pricing in similar declines today. If we do not go into a deep recession this year, or if the slowdown and expected decline in earnings are not as bad as feared, we see significant near-term upside in the portfolio. We continue to believe our stocks are cyclically depressed, not secularly challenged, and see further upside over the next 12 to 18 months. So far, most of our portfolio holdings have not experienced a slowdown in sales or earnings growth, and their outlooks remain strong. In addition, we believe that even if a downturn were to occur, our portfolio companies would still be operating above pre-pandemic levels. These businesses’ balance sheets have been strengthened since COVID-19, and we believe they remain well positioned to weather a downturn should one occur. We find the current risk/reward inherent in our portfolio holdings attractive at current levels.

Thank you for investing with us in Baron Focused Growth Fund. We continue to work hard to justify your confidence and trust in our stewardship of your family’s hard-earned savings. We also continue to try to provide you with information we would like to have if our roles were reversed. This is so you can make an informed judgment about whether Baron Focused Growth Fund remains an appropriate investment for your family.

Respectfully,