Baron Discovery Strategy | Q1 2025

Baron Discovery Strategy was down 6.19% in the quarter, which was 4.93% better than Russell 2000 Growth Index. The market started off the year strong but began fading in mid-February when it became clear that the Trump administration was serious about enacting tariffs, which the market views as inflationary and likely to slow economic growth. The market’s decline accelerated after April 2nd when the actual tariff announcements were more sweeping than anticipated, leading to fears of a trade war and a global economic recession. While we are pleased with the relative outperformance during the quarter, we are dissatisfied with the overall direction of the market.

Following the recent market sell-off, investors are understandably asking, “What happens next?” At this stage, it is difficult to provide a great answer. The tariff announcements were only recently made and it is too early in the process with too many unknowns for us to assess their ultimate impact. Even so, market dislocations almost always allow us to find new investment opportunities. As long-term investors, our approach allows us to look through macroeconomic noise and focus on how our businesses can perform over a full economic cycle. We believe this market dislocation will be no different, and that many of the new investments we make today will be key contributors to helping the Strategy outperform in the future.

Investing in Reverse

Our investment process is designed to take advantage of market dislocations. We call this process “investing in reverse.” What this process entails is sitting down with each sector analyst on the investment team and asking one simple question: “removing current valuation, what are the companies in your particular subsector that best fit the criteria we look for in an investment (typically fast growing, high margin businesses with favorable long-term prospects)?” Those conversations lead to a “shadow list” of potential investments that we would like to own if the companies sell at attractive valuation levels. We call it “investing in reverse” because the majority of investors start their investment process by screening for valuation first and then, after narrowing it down to a select group of companies, use certain quality metrics (revenue and earnings growth, operating margins, and balance sheet leverage) to determine which stocks they should consider investing in. We do the reverse. We screen for companies that hit our quality criteria first and then we patiently wait for their stocks to get to the point where we believe we can make outsized returns.

This “shadow list” of ideas is constantly refreshed throughout the year. We track these companies closely. We listen to their earnings calls and meet with their management teams as frequently as possible. Because the companies are typically the fastest growing and have the highest margin, in a normal market environment these businesses trade at premium valuations that typically do not meet our investment return hurdle rate. During market dislocations, however, almost every stock trades lower. When the market indiscriminately sells off high-quality businesses alongside weaker ones, we are poised to make investments that have historically generated some of our highest returns. If history is any guide, this current dislocation will do the same.

Inari Medical, Inc. offers catheter-based devices to remove clots from venous thromboembolism (VTE). VTE is the third most common vascular condition in the U.S. after heart attacks and strokes and can be fatal if left untreated. Shares contributed to performance after Inari was acquired by Stryker Corporation in February for a 48.5% premium to its prior trading price.

Tempus AI, Inc. is an intelligent diagnostics and health care data company with two synergistic business units: Genomics and Data. Although shares have been volatile since its June 2024 IPO, we attribute these fluctuations to trading dynamics that do not reflect Tempus’ business fundamentals and have managed our position size accordingly, which was a key reason for the investment’s contribution this quarter. In the long run, we expect the company’s Genomics business (diagnostics for cancer treatment selection) to continue to grow rapidly as the market develops. The data generated from Tempus’ diagnostic tests also enhances its Data business, as Tempus combines its genomics data with clinical patient data from its oncology partners, to generate an enormous proprietary multimodal dataset. We believe that no one will be able to replicate the breadth and depth of this dataset, given Tempus’ enormous proprietary advantages. Tempus licenses its dataset to biopharmaceutical companies for use in designing smarter clinical trials and for identifying new drug targets.

Shares of Kratos Defense & Security Solutions, Inc., a disruptive defense technology provider, rose following a strong quarterly earnings report that demonstrated notable strength across multiple segments and guided to faster than baseline growth in fiscal 2026. We believe Kratos is increasingly well positioned to accelerate growth with its exposure to what are arguably the fastest growing segments of the defense ecosystem, including hypersonic missiles, solid rocket motors, and unmanned aircraft solutions. The company is hitting its stride and is making huge investments now to satisfy what it believes to be very visible future demand.

Exact Sciences Corporation is a cancer diagnostics company. Its flagship product is Cologuard, a stool-based screening test for colorectal cancer (CRC). Shares detracted from performance in the quarter due to fears of competitive blood-based CRC tests which may launch in 2025. While these tests cost more than Cologuard, they are somewhat more convenient for patients. However, blood-based tests do not have the same level of pre-cancer sensitivity as Cologuard, and Cologuard is significantly better at detecting pre-cancerous growths called Advanced Adenoma. Moreover, Exact Sciences is developing its own blood-based tests that we anticipate will be as accurate as competitor tests but will cost significantly less than those tests as it uses a different type of analytics to get its results. So, either way, we believe Exact Sciences will win. It also has a huge channel presence in CRC which will enable it to be successful in both fecal and blood-based CRC testing. In addition, with 60 million Americans not receiving any CRC screening at all, there is ample opportunity for multiple players to win.

Indie Semiconductor, Inc. designs automotive semiconductors for advanced driver assistance (ADAS), in-cabin features, and other applications. Shares fell during the quarter on a miss in forward revenue guidance due to an inventory correction in the broader automotive semiconductor industry that was exacerbated by continued automotive macroeconomic uncertainty. We retain conviction. Revenue growth continued to outperform peers, and the company is winning new sockets in future platforms. Indie remains well positioned over the medium and long term, supported by its $7.1 billion strategic backlog and its radar, vision, and other programs that will ramp through 2025 and more meaningfully into 2026. We believe indie will return to outsized growth by the end of 2025 and will significantly outpace the broader industry on its path to $1 billion in revenue by the end of this decade supported by contract visibility. As its product mix shifts to ADAS, its margins should meaningfully improve as well.

Montrose Environmental Group, Inc., a leading environmental solutions company, detracted from performance during the quarter. This was due to concerns that the Environmental Protection Agency (EPA) under the Trump administration will reduce enforcement of environmental regulations that require the type of consulting, testing, remediation and monitoring that Montrose provides. We believe these concerns are misguided, and that given its current high single-digit multiple of cash flow, Montrose is hugely underpriced. Montrose’s business is driven by state regulations as well as contaminants that have a long-regulated history with bipartisan support (including from the current EPA Administrator). Montrose has successfully grown through both Democratic and Republican administrations (including the first Trump administration), and the company believes the Trump administration’s initiatives on cost efficiency, U.S. manufacturing, and domestic energy production could create large new opportunities for the company.

We exited our positions in Reddit, Inc. and AAON, Inc. as both stocks had exceeded our long-term price targets.

Inari Medical, Inc. was acquired by Stryker Corporation in February. We sold our investment in ASGN Incorporated as we grew concerned about the company’s ability to continue to rapidly grow its IT consulting business in the current environment, and we believe that the placement side of the platform still faces meaningful cyclical and structural challenges. We sold our small position in Maravai LifeSciences Holdings, Inc. after it failed to gain traction on a turnaround geared toward replacing its dependence upon COVID vaccines.

We will miss our investment in Axon Enterprise, Inc. Axon is a truly fantastic company, with an incredible management team, and has been one of the best investments we have ever made. Our rationale in selling our investment was two-fold. First, we believed at the time we sold that valuation had exceeded our long-term estimates. Second, the company’s market capitalization at over $50 billion had become too large for our small-cap mandate. The Strategy’s investors reaped huge returns from Axon. Our initial investment in January 2022 was made when the company traded at $128 per share, with our last sale at over $700 per share. This is exactly the type of company we want to find, and we believe it benefits our investors that we have the flexibility to hold companies even as they become mid-caps as long as the overall market cap in the Strategy remains in the small-cap domain.

While there is currently a lot of macroeconomic noise, we will stay focused on investing for the long term. Market dislocations have historically created fantastic opportunities to invest in fast-growing companies with favorable long-term prospects. We anticipate being able to take advantage of the current market dislocation to make new investments at attractive long-term valuations. We look forward to providing updates on these new investments over the coming quarters.

The case for small-cap growth stocks remains strong. As seen in the charts below, valuations remain inexpensive and investor allocation to small cap growth is at the lowest levels in the last decade (a contrarian indicator). While the timing is difficult to predict, we believe these trends will eventually revert to their long-term averages. When that happens, it will be a tailwind for the performance of small-cap growth stocks.