Baron Discovery Strategy | Q2 2024
Performance
| Baron Discovery Strategy (net)2 | Baron Discovery Strategy (gross)2 | Russell 2000 Growth Index2 | Russell 3000 Index2 | |||||
|---|---|---|---|---|---|---|---|---|
| Three Months3 | (7.77)% | (7.55)% | (2.92)% | 3.22% | ||||
| Six Month3 | (3.56)% | (3.09)% | 4.44% | 13.56% | ||||
| One Year | 2.68% | 3.69% | 9.14% | 23.13% | ||||
| Three Years | (10.84)% | (9.96)% | (4.86)% | 8.05% | ||||
| Five Years | 7.10% | 8.16% | 6.17% | 14.14% | ||||
| Ten Years | 9.71% | 10.70% | 7.39% | 12.15% | ||||
| Since Inception (October 31, 2013)4 | 11.43% | 12.39% | 7.74% | 12.63% | ||||
Baron Discovery Strategy (net)2 | Baron Discovery Strategy (gross)2 | Russell 2000 Growth Index2 | Russel 3000 Index2 | |||||
|---|---|---|---|---|---|---|---|---|
| 2019 | 26.97% | 28.24% | 28.48% | 31.02% | ||||
| 2020 | 66.25% | 67.93% | 34.63% | 20.89% | ||||
| 2021 | 4.92% | 5.97% | 2.83% | 25.66% | ||||
| 2022 | (34.96)% | (34.32)% | (26.36)% | (19.21)% | ||||
| 2023 | 22.80% | 24.00% | 18.66% | 25.96% | ||||
For Strategy reporting purposes, the Firm is defined as all accounts managed by Baron Capital Management, Inc. (“BCM”) and BAMCO, Inc. (“BAMCO”), registered investment advisers wholly owned by Baron Capital Group, Inc. As of June 30, 2024, total Firm assets under management are approximately $40.9 billion. Gross performance figures do not reflect the deduction of investment advisory fees and any other expenses incurred in the management of the investment advisory account. Actual client returns will be reduced by the advisory fees and any other expenses incurred in the management of the investment advisory account. A full description of investment advisory fees is supplied in the Firm’s Form ADV Part 2A. Valuations and returns are computed and stated in U.S. dollars. Performance figures reflect the reinvestment of dividends and other earnings. The Strategy is currently composed of one mutual fund managed by BAMCO and a separately managed account managed by BCM. The Strategy invests mainly in small cap growth companies. BAMCO and BCM claim compliance with the Global Investment Performance Standards (GIPS®). To receive a complete list and description of the Firm’s strategies or a GIPS Report please contact us at 1-800-99BARON. GIPS® is a registered trademark owned by CFA Institute. CFA Institute does not endorse, promote or warrant the accuracy or quality of the report.
Performance data quoted represents past performance. Current performance may be lower or higher than the performance data quoted. Past performance is no guarantee of future results.
† The Strategy’s YTD 1-, 5- and 10-year historical performance was impacted by gains from IPOs and there is no guarantee that these results can be repeated or that the Strategy’s level of participation in IPOs will be the same in the future.
(1)With the exception of performance data, most of the data is based on a representative account. Such data may vary for each client in the Strategy due to asset size, market conditions, client guidelines, and diversity of portfolio holdings. The representative account is the account in the Strategy that we believe most closely reflects the current portfolio management style for the Strategy. Representative account data is supplemental information.
(2)The Russell 2000® Growth Index measures the performance of small-sized U.S. companies that are classified as growth. The Russell 3000® Index measures the performance of the largest 3,000 US companies representing approximately 96% of the investable US equity market, as of the most recent reconstitution. All rights in the FTSE Russell Index (the “Index”) vest in the relevant LSE Group company which owns the Index. Russell® is a trademark of the relevant LSE Group company and is used by any other LSE Group company under license. Neither LSE Group nor its licensors accept any liability for any errors or omissions in the indexes or data and no party may rely on any indexes or data contained in this communication. The Strategy includes reinvestment of dividends, net of withholding taxes, while the Russell 2000® Growth and Russell 3000® Indexes include reinvestment of dividends before taxes. Reinvestment of dividends positively impacts the performance results. The indexes are unmanaged. Index performance is not Strategy performance. Investors cannot invest directly in an index.
(3)Not annualized
(4)The Strategy has a different inception date than its representative account, which is 9/30/2013.
Baron Discovery Strategy (the Strategy) fell 7.77% this quarter, underperforming the Russell 2000 Growth Index, which declined by 2.92%. Our ten worst-performing stocks accounted for 6.52% of negative performance and the lion’s share of negative attribution this quarter. While fundamental issues caused a thesis change in only one of these stocks, we believe macroeconomic factors and market conditions primarily drove the overall decline. These stocks could rebound rapidly, as evidenced by the significant rallies of several beaten-down technology stocks during the quarter’s final week. This demonstrates that momentum is a double-edged sword: declines due to technical factors can also be reversed. We have encountered numerous instances of stocks experiencing dramatic drops followed by substantial recoveries. Further details on these cases are provided later in the letter. This is an extremely volatile period in the markets, especially for small-cap stocks. Our strategy is to invest for the long term and, as a result, we do not trade around short-term volatility. We continue to remain confident in the long-term prospects of our portfolio companies. We both have significant personal investments in the Strategy to back that up.
Top Contributors to Performance
| Percent Impact | ||
|---|---|---|
| Silk Road Medical, Inc. | 0.73% | |
| CareDx, Inc. | 0.58 | |
| Nova Ltd. | 0.53 | |
| Guidewire Software, Inc. | 0.37 | |
| Montrose Environmental Group, Inc. | 0.28 | |
Apart from stock-specific issues, the style biases that most negatively impacted relative performance were momentum-related factors and market beta. Momentum is the tendency of stocks to continue their current direction. Market beta measures a combination of stock volatility (price fluctuation) and market correlation (how closely a stock or portfolio moves with the overall market). A higher portfolio beta indicates greater portfolio downside in a down market and more upside in an up market. The Strategy aims for a beta of approximately 1, meaning the Strategy’s excess returns should derive from stock selection, not market movements. The beta of the Strategy’s high-growth holdings remained elevated, primarily due to volatility rather than market correlation. This was especially pronounced in terms of “idiosyncratic volatility,” or events affecting individual stocks. In simpler terms, when individual companies faltered in the second quarter, stock prices plummeted, exacerbated by a declining overall market for small-cap growth stocks. Short sellers, who were highly active in the second quarter, contributed significantly to this. We believe these stock price movements reflect short-term trading trends rather than accurate valuations, and we see an enormous opportunity from this chaos.
The markets are currently in a very particular phase driven, on the one hand, by the excitement of some truly life-changing technologies such as AI and GLP-1 (glucagon-like peptide 1) weight loss drugs like Mounjaro and Ozempic and the fear of missing out on the stock upside related thereto, and on the other hand, the simultaneous conceit that these new modalities will disintermediate a vast swath of other companies. At the same time, the economy is in a very precarious position, somewhere between recession, stagflation, and “soft landing” perfection. The uncertainty of this economic overlay has enhanced the allure of “story investing” to the detriment of “stodgy” fundamental analysis. We are the stodgy ones.
We believe that the markets are overlooking incredible opportunities in small-cap growth stocks due to the relentless and narrow focus on new technologies and overall economic concerns. In our last letter, we discussed the fundamental disconnect between small-cap growth and large-cap valuations. This disconnect persists at near-record levels, with the forward P/E multiple of the S&P 500 Index exceeding that of the Russell 2000 Growth Index for over two years. Such a prolonged disparity is unprecedented in the past 25 years.
This letter aims to counter the prevailing market consensus on individual stocks we own. Many exceptional small-cap companies are trading at historically low valuations. Our Strategy holds a diversified portfolio of these companies, and we continue to employ our fundamental investing process to uncover high-quality investment opportunities at what we believe are fire-sale prices. Encouragingly, early signs of improvement are emerging. Softening inflation data may foreshadow a Federal Reserve rate cut, which would benefit smaller-cap stocks. Merger and acquisition activity has also increased, particularly in small-cap healthcare (two of our medical device companies were acquired in the past year). Chaos equals opportunity.
AI models are rapidly moving from objects of curiosity to levels of functionality that, just a couple of years ago, were believed to exist only in the realm of science fiction. We obviously do not invest in large-cap companies that produce AI hardware, which is where significant market attention is focused right now. Yet, we continue to look for exciting small-cap ideas in AI hardware. For example, we owned a small-cap AI-oriented semiconductor company in the second quarter called Astera Labs, Inc. Astera Labs manufactures analog semiconductors that facilitate improved communications within a motherboard (for example, between graphics processing units like what NVIDIA makes and central processing units made by companies like Intel), and between servers. We bought shares when the company went public, but due to the incredible hype surrounding hardware-based AI companies, the stock quickly doubled and exceeded what we believed was a reasonable long-term valuation (particularly given new competitive offerings on the horizon). Therefore, we sold our investment but continue to monitor its valuation closely for a potential re-entry point. We own Nova Ltd., a semiconductor capital equipment company that helps to enable the manufacture of high-end AI chips. Over the five-plus years Nova has been held in the Strategy, it has been one of the Strategy’s best investments, with appreciation in excess of 800%.
We are huge believers in the practical uses of AI, and we have several investments in companies that adapt AI models to enhance their products and services. These include GitLab Inc., SentinelOne, Inc., and Couchbase, Inc., which were among our top detractors at one point in the second quarter. GitLab and SentinelOne recovered significantly in the last week of the quarter. As of the second quarter, the market has not yet been ready to reward AI companies beyond those providing “picks and shovels.” This led to all three of these companies trading at or near all-time low valuation levels during the quarter. Nevertheless, we believe that in the coming quarters, the market will broaden its level of interest from AI hardware to “adaptive AI” investments like GitLab, SentinelOne, and Couchbase. In that scenario, all three of these stocks have significant upside potential.
GitLab is a subscription software company that enables enterprise software developers to develop new software applications rapidly and securely for their firms. GitLab uses AI to help with code suggestions, check for holes in security, and automate collaboration among the many developers within an enterprise. GitLab recently launched a product called Duo that we believe will provide revenue upside for the company and enhance the competitiveness of its product offerings. SentinelOne is a cybersecurity company that provides endpoint protection (a much more advanced version of legacy “anti-virus” software) both at customers’ physical sites and in the cloud. It uses AI to detect anomalous behavior on the network and to automate the remediation of the security flaws that led to the intrusion. Both companies are recurring revenue entities with high gross margins (78% for SentinelOne and 90% for GitLab) and are growing rapidly (revenue growth of 25% or more). Yet both are trading at or near all-time low valuation levels. SentinelOne slightly beat full-year revenue guidance but guided to an operating loss that was $7.5 million worse than consensus, entirely accounted for by the increased operating expense pulled in from acquisitions – including PingSafe, which allows SentinelOne to scan cloud-based workloads without the need to install a software agent. This led to a one-day stock drop of as much as 31%, which we attribute purely to market skittishness. By the quarter’s end, SentinelOne’s shares had fully recovered. We believe the company can grow revenues by 25% from 2024 through 2028 and that free cash flow will go up over 10-fold in this period. We see the stock at least doubling from its current price. GitLab shares dropped 14.7% in the quarter despite raising full-year revenue and earnings guidance. This was partly due to a health issue with the CEO (cancer recurrence, which he believes is very treatable). We see GitLab revenues growing at a compounded rate of 26% through 2028, with free cash flow growing five-fold over current levels. Again, we see the stock doubling over this time.
One of our poorest performers in the quarter was Couchbase, which provides software enabling the creation of unstructured databases. Couchbase is enabling AI applications via new “vector” database modalities. Vector databases help sort data rapidly and efficiently. Couchbase raised its full-year revenue guidance and lowered its expected operating loss (we believe the company will be breakeven in 2025), yet shares dropped 30.6% in the quarter. The issue was that net new average recurring revenue was slightly lower than expected. In our opinion, this was due to the timing of contract signings throughout the year. We believe full-year guidance is still intact, and the company has already indicated a particularly good start to the second quarter. Revenue growth should compound at 20% from 2024 to 2028, with free cash flow growing meaningfully. The stock could triple over this time as it continues to execute. Chaos equals opportunity.
GLP-1 drugs (originally used to control type 2 diabetes) have become the biggest class of therapeutics in history with expected 2024 sales of close to $50 billion now that they are approved for weight loss. Sales of these drugs could climb to $100 billion in 2029. And it seems that every day studies uncover new benefits of the drugs, including reduction of sleep apnea and lowered risk of heart disease.
Fear of displacement by GLP-1 drugs has hurt Inspire Medical Systems, Inc., which treats sleep apnea with its proprietary medical devices. Inspire was a new purchase in the quarter, but our timing was unfortunate. A recent study called SURMOUNT-OSA that read out in June 2024 showed unexpectedly better sleep apnea control for obese patients who lost weight using GLP-1 drugs. This was slightly better than the preliminary study data released in April, upon which we based our initial investment. We discuss Inspire in more detail later in the letter.
We do have investments with positive exposure to GLP-1 trends, but the near-term macro environment has led to setbacks. Stevanato Group S.p.A manufactures specialized glass vials and cartridges used for injectable drugs. The company is a market leader in these high-value components. It is building out manufacturing capacity for what we believe will be significant volumes of components for GLP-1 drugs. Unfortunately, while investors waited for that capacity to come online, the company had excess inventory of other products in its distribution channel, leading to a 4.6% reduction in full-year 2024 revenue guidance. This modest reduction in guidance and the return of Franco Stevanato as CEO caused shares to drop 42.8%. Currently, shares trade at close to their lowest Enterprise Value to Sales (EV/Sales) multiple in years (about 4.3 times compared to an average of 5.5 times). Enterprise value combines the market value of the stock with net debt on the balance sheet to represent the cost to fully purchase the company. In addition, the stock trades at only 13 times next year’s cash flow (which we believe will double from 2024 to 2028 as new capacity ramps up). The company is most of the way through the capital expenditure needed to ramp up its plant capacity. Therefore, we believe that as inventory issues ease over the next couple of quarters and new products launch, we will see a nice recovery. Chaos equals opportunity.
Repligen Corporation is another company benefiting from the massive growth in approvals of biologic drugs, including GLP-1s. It manufactures equipment used by drug companies to produce these drugs. Like other suppliers to the biologics industry, Repligen has experienced demand headwinds this year from Chinese buyers (now only 5% of sales), the loss of COVID-19 revenue (now insignificant), and a reduction in protein sales due to a lost customer and excess channel inventory. These challenges combined for approximately $75 million in lost revenues, or about an 11.5% headwind to 2024 sales. Sales were down 20% in 2023, as anticipated when we bought the stock in mid-2023. Unfortunately, shares fell after the well-regarded CEO, Tony Hunt, announced his resignation. Fortunately, Mr. Hunt has agreed to remain as Chairperson for at least three more years. The timing of this decision was poorly received by investors, given the challenging macro environment. We maintain our belief in Repligen’s long-term prospects and its newly appointed CEO, Oliver Loeillot. Mr. Loeillot has served as COO for nine months and was chosen by Mr. Hunt as his successor. We spoke with both men after the announcement and are confident Mr. Loeillot will continue executing the current strategy. Meanwhile, Repligen trades at its lowest valuation multiple in five years. Chaos equals opportunity.
Beyond the GLP-1s space, the Health Care sector has been challenging for small-cap stocks. Valuations have compressed significantly across all segments in which we invest. This is evident in diagnostics. For example, since 2021 (the COVID era), Veracyte, Inc., a specialty cancer diagnostic company, has seen its EV/Sales multiple contracts from around five to six times to approximately three and a half to four times. Veracyte has met or exceeded quarterly financial guidance since the third quarter of 2020 (prior to the peak of COVID) and has raised full-year guidance in most of those quarters.
We have increased our exposure to diagnostics companies, including existing positions in Veracyte and CareDx, Inc., which rebounded dramatically this quarter as the company re-accelerated its top-line growth. We added two new investments in the segment. First, we purchased shares of Exact Sciences Corporation after the stock fell from a recent peak of $100 per share to a low of $40 at the end of the second quarter. We will discuss our purchase rationale for Exact Sciences in detail below, but note that it is trading at about three times forward EV/Sales, its lowest level in five years. We also established a small initial position in Tempus AI, Inc., which went public in June 2024. This is another cancer diagnostics company with a unique database of its own, as well as third-party cancer testing and patient data surrounding testing results. The IPO did not perform well in the current environment, and within days, shares dropped as much as 38% from the initial offering price of $37 due to enormous short-selling activity. We viewed this as an opportunity and carefully added small purchases to the initial position at significantly lower prices. At one point, Tempus traded at four times next year’s EV/Sales, valuing the business more in line with slower-growing, “testing only” companies without recognizing the premium of its unique database asset. By the end of the quarter, Tempus had rebounded to the low $30s, and we realized a net profit on our investment. Chaos equals opportunity.
The Health Care sector was not entirely negative. Many of our Health Care holdings rebounded during the year, demonstrating the primacy of long term fundamentals over short-term market volatility. Silk Road Medical, a manufacturer of devices for minimally invasive carotid artery treatment, agreed to be acquired by Boston Scientific in June 2024, following Boston Scientific’s March 2024 acquisition of Axonics, Inc., another holding of ours. Silk Road declined by over 75% last year but has risen over 120% this year, with a 47.8% increase in the second quarter. Similarly, breast implant manufacturer Establishment Labs Holdings Inc. is up over 75% this year. We anticipate FDA approval soon, enabling the company to launch implants in the U.S. Establishment Labs fell over 60% last year. CareDx, Inc., the leading diagnostic testing lab for the organ transplant industry, has increased over 29% this year and 47.2% in the second quarter. This growth is attributed to the resumption of positive testing volume after a challenging period in 2023 caused by a proposed Medicare billing change. We believe these billing outcomes will be more favorable for CareDx than the market anticipates, which is why we re-initiated our investment strategy with purchases averaging under $10 per share earlier this year (shares closed the quarter at $15.53). This decision followed a 74% share price decline from the beginning of 2022 to the end of 2023. While owning these stocks in 2023 would have been painful, we are pleased with our decision to focus on the long-term outlook of these companies. It would have been easy to sell at the market bottom. Our process prevented this. Chaos equals opportunity.
Nova Ltd. is a semiconductor capital equipment company focused on the metrology (measurement) market. The stock rose during the quarter on the expectation that robust growth in chips for AI applications will drive accelerating adoption and growth across Nova’s product portfolio, including specifically high bandwidth memory, advanced packaging, and leading-edge chip production. Nova is the only supplier of materials metrology tools that are increasingly required for leading edge chips. Its superior capabilities in optical inspection tools are driving share gains, and it is also benefiting from adoption of its chemical metrology portfolio, which categorizes material qualities. We believe Nova is well positioned to continue outgrowing underlying wafer fabrication equipment industry trends.
Shares of property and casualty (P&C) insurance software vendor Guidewire Software Inc. contributed to performance for the quarter. After a multi-year transition period, we believe the company’s cloud transition is substantially complete. We believe that cloud subscriptions will be the sole path forward, with annualized recurring revenue (ARR) benefitting from new customer wins and migrations of the existing customer base to its InsuranceSuit Cloud product. We also expect the company to shift research and development 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. We are also encouraged by Guidewire’s subscription gross margin expansion, which improved by more than 10% in its most recently reported quarter. We believe that Guidewire will be the critical software vendor for the $2 trillion global P&C insurance industry, capturing 30% to 50% of its $15 to $30 billion total addressable market and generating margins above 40%.
Montrose Environmental Group, Inc., a leading environmental solutions provider (consulting, testing, and remediation), outperformed during the quarter. The company reported a solid quarter driven by strong organic growth benefiting from both secular trends and regulatory tailwinds. During the quarter, the EPA finalized the maximum contaminant levels for PFAS (a so-called “forever chemical”) in water supplies, which is expected to catalyze increased remediation spending. Montrose is likely to benefit due to its proprietary equipment for PFAS remediation. Enhancing organic growth prospects, Montrose sees a robust market for acquisitions and raised equity early in the quarter to capitalize on opportunities. We believe Montrose can generate over 20% cash flow growth annually for the next several years.
Top Detractors from Performance
| Percent Impact | ||
|---|---|---|
| SiteOne Landscape Supply, Inc. | –0.85% | |
| Stevanato Group S.p.A | –0.83 | |
| Kinsale Capital Group, Inc. | –0.80 | |
| Couchbase, Inc. | –0.80 | |
| Floor & Decor Holdings, Inc. | –0.61 | |
SiteOne Landscape Supply, Inc. is the largest distributor of wholesale landscape supplies in North America. SiteOne sells irrigation, hardscapes, agronomics, and nursery products to professional contractors through its network of branches for residential and commercial maintenance, upgrade/ repair, and new construction applications. Shares of SiteOne fell during the quarter as the company provided a negative intra-quarter update, with demand weaker than expected in upgrade/repair product categories and commodity deflation stronger than expected, which combined are likely to lead to lower full-year guidance when the company officially reports its second-quarter results. Despite the weaker-than-expected near-term results, we believe SiteOne remains well-positioned for the long term. It benefits from its investments in operational efficiency, technology, and product category management, allowing it to take a share of the fragmented wholesale landscape supplies distribution industry. It is also filling out its product offering and geographic footprint through consistent acquisition activity. We think that SiteOne can drive its EBITDA (adjusted cash flow) margins over time towards its 13% to 15% targeted range.
We discussed the reasons for Stevanato Group S.p.A’s underperformance earlier in the letter.
Following strong performance in the first quarter, specialty insurance company Kinsale Capital Group, Inc. gave back some of its gains in the June quarter. The company reported mixed first-quarter earnings, with earnings per share exceeding consensus estimates but with premium growth missing Street estimates. Gross premium growth slowed to 25% due to slower growth in property premiums (we estimate about 25% growth, down from 54% last quarter), while casualty premium growth likely remained steady at about 26%. We lowered our premium growth expectations for the full year and, with a more conservative loss ratio estimate, also lowered our earnings expectations. Nevertheless, the company’s return on equity remains best in class at 29%. At current levels, the valuation is also undemanding at about 21 times our 2025 earnings estimate. While we acknowledge the excess and surplus lines market (where Kinsale focuses) is slowing compared to the rapid growth we saw during and immediately after the COVID pandemic, we still believe Kinsale can grow premiums in the low teens for the foreseeable future. We believe it should grow earnings faster than that.
Floor & Decor Holdings, Inc. is a specialty retailer of hard-surface flooring and accessories in the U.S. While the company continues to open new stores and consolidate the hard surface flooring market through its large format stores with everyday low prices, the decline in housing turnover has put pressure on shorter-term sales trends. We maintain our long-term conviction. We view Floor & Decor as a differentiated, high-growth retailer offering a broader assortment of low-cost products than competitors. The company holds an 8% market share in the highly fragmented $21 billion U.S. hard-surface flooring market, and we believe it will continue to gain market share. We think the replacement of carpet with hard-surface flooring, which we see as a secular shift in the flooring industry, will aid growth. We believe Floor & Decor can continue to grow its store count in the 15% to 20% range annually.
Portfolio Structure
| Year Acquired | Quarter End Investment Value (millions) | Percent of Net Assets | |||
|---|---|---|---|---|---|
| DraftKings Inc. | 2023 | $47.1 | 3.4% | ||
| CyberArk Software Ltd. | 2022 | 43.8 | 3.1 | ||
| Advanced Energy Industries, Inc. | 2019 | 43.0 | 3.1 | ||
| Axon Enterprise, Inc. | 2022 | 42.4 | 3.0 | ||
| Kratos Defense & Security Solutions, Inc. | 2020 | 38.9 | 2.8 | ||
| Montrose Environmental Group, Inc. | 2020 | 38.7 | 2.8 | ||
| Chart Industries, Inc. | 2022 | 36.1 | 2.6 | ||
| PAR Technology Corporation | 2018 | 35.3 | 2.5 | ||
| Texas Roadhouse, Inc. | 2022 | 34.3 | 2.5 | ||
| GitLab Inc. | 2022 | 33.7 | 2.4 | ||
Our top 10 holdings comprised about 28% of the Strategy’s net assets, consistent with long-term levels. Our cash position as of June 30, 2024 was 2.8%, also in line with historical levels. The Strategy has significant capital loss carryforwards from prior years to offset current year capital gains.
Recent Activity
| Year Acquired | Quarter End Market Cap (billions) | Net Amount Purchased (millions) | |||
|---|---|---|---|---|---|
| Inspire Medical Systems, Inc. | 2024 | $4.0 | $22.3 | ||
| Procore Technologies, Inc. | 2024 | 9.7 | 21.2 | ||
| Exact Sciences Corporation | 2024 | 7.8 | 20.9 | ||
| Tempus AI, Inc. | 2024 | 5.8 | 19.2 | ||
| Integer Holdings Corporation | 2024 | 3.9 | 18.4 | ||
We bought shares of Inspire Medical Systems, Inc., a medical device company that offers a treatment for moderate to severe obstructive sleep apnea called hypoglossal nerve stimulation. Obstructive sleep apnea (OSA) is a common sleep disorder caused by relaxation of the airway muscles and obstruction of the airway, which interrupts normal breathing during sleep. First-line therapy for OSA is continuous positive airway pressure (CPAP), which requires the patient to wear a mask, and an airflow generator delivers air pressure to the patient’s throat to keep the airway open. Compliance rates with CPAP are low because many patients find the mask cumbersome or cannot tolerate the pressure. Inspire offers a small surgically implantable device that delivers mild stimulation to the patient’s hypoglossal nerve, which causes the patient’s tongue to move forward and open the airway. Since receiving FDA approval in 2014, Inspire’s device has gained rapid adoption, growing from $8 million in sales in 2015 to an estimated $783 to $793 million in 2024. For context of the market opportunity for Inspire, there are 8 million CPAP users in the U.S., and only 24,000 Inspire procedures were done in 2023 (with 60,000 done since the product launched).
During the quarter, the stock came under pressure due to final data published in June from Eli Lilly and Company’s SURMOUNT-OSA trial. The trial showed that Lilly’s GLP-1 drug (tirzepatide) reduced OSA in adults with obesity by up to 62.8%, and up to 51.5% of participants met the criteria for disease resolution. In our view, Lilly’s tirzepatide and other GLP-1 medicines will have an impact on the OSA treatment paradigm. However, we think that even if some patients fall out of Inspire’s sales funnel after taking a GLP-1, many new patients will enter the funnel. This is because patients who have an extremely high body mass index (BMI) are not currently considered candidates for Inspire therapy, and if those patients lose enough weight with a GLP-1, they can become candidates for Inspire. We also think the total addressable market (TAM) opportunity for Inspire is large and underpenetrated. One of the principal investigators in the SURMOUNT-OSA study estimated that 1 billion people around the world have OSA. Inspire management has estimated its TAM to be at least 500,000 patients in the U.S. alone, and the company’s penetration rate is less than 10%. Finally, we also note that not everyone can tolerate a GLP-1 medicine (particularly the high doses used in the study), and to maintain the effect on OSA patients would need to stay on the drug forever. Given their high costs, insurance companies could place limits on their use. Inspire trades at a compelling valuation (under four times 2025 EV/Sales). Axonics and Silk Road were acquired for far higher multiples. This is too cheap for a company growing revenues rapidly (over 20%) in a hugely underpenetrated market with high (84%) gross margins. Given all these factors, we think Inspire offers a terrific investment opportunity.
We initiated an investment in Procore Technologies, Inc. during the quarter. Founded in 2002, Procore provides cloud-based construction management software that helps general contractors, subcontractors, and asset owners manage every step of the construction process. Procore’s product suite includes project execution (storing and updating blueprints, designs, work orders, and project schedules in a single system of record), pre-construction (managing bids, permitting, and approvals), workforce management (scheduling worker hours and recording safety compliance), financial management (budgeting and invoicing), and data analytics. Together, these products help contractors execute projects more efficiently, plan more accurately, avoid costly rework, improve worker safety, and generate better margins. This has led to exceptionally low customer churn.
Procore serves a large and growing addressable market – annual construction volume exceeds $2 trillion in the U.S. alone – that is still in the early innings of digitization and technology adoption. The company has a leading market share in the sector, with more than 16,500 construction firms and asset owners using its software to manage billions of dollars of annual project volume. Yet Procore is still only 12% penetrated in terms of U.S. construction volume and 2% penetrated internationally. We believe the company has several competitive advantages that will drive further share capture and strong growth. First, Procore is the only cloud-native technology vendor that addresses all stages of the project life cycle with a single, integrated interface and data model. Second, Procore was the first vendor to price its platform using a “take-rate” model, charging a percentage fee against its customers’ total construction volume. Compared to seat-based license models offered by many competitors, this approach has encouraged far more industry practitioners to trial and use Procore products. As of last year, over 500,000 collaborator companies were interacting with its product, driving a strong pipeline for new customer wins.
We see a long runway for growth through new customer additions and expansion in existing accounts. The company has maintained low to mid-double-digit revenue expansion rates for existing customers by managing more project volume and by cross-selling additional product modules. Recent product innovations like Procore Pay (managing payments for the various vendors and subcontractors on a given project) and geospatial mapping (for larger civil engineering projects) should improve the company’s wallet share over time. Procore’s cash flow is positive today, and its margins have been increasing meaningfully over the past two years. We think the business can continue to grow at a healthy rate while further expanding free cash flow margins to north of 20% as it benefits from market share capture, higher take rates, and operating leverage. This should lead to good earnings growth and bode well for the stock long term.
Exact Sciences Corporation has the best-in-class non-invasive colorectal cancer (CRC) diagnostic test. It is a stool-based test called Cologuard, which produces two billion in revenue (over 70% of the company’s 2024 revenue). Cologuard is second in accuracy only to having a colonoscopy, which is the gold standard in diagnostics. However, many people dislike the discomfort of colonoscopy preparation and the invasive nature of the procedure. Exact Sciences is also the market leader in breast cancer recurrence testing with its Oncotype DX genetic test, used by 90% of U.S. oncologists due to its robust clinical evidence. We initiated an investment strategy in the stock in the low $40s during the second quarter. Shares peaked at $158 in 2021 and traded as high as $100 in July 2023.
Exact Sciences’ stock price has declined due to several factors. First, the surprise FDA advisory committee recommendation in favor of competitor Guardant Health’s blood-based CRC test in June 2024 has caused uncertainty. The test’s final label remains undisclosed. Second, the company’s increased marketing expenses, exceeding expectations, have raised concerns about profit margin compression. We believe the threat posed by blood-based tests is overstated. These tests are significantly less accurate than stool tests for detecting early-stage CRC. Cologuard demonstrates superior sensitivity compared to blood tests, particularly for stage 1 cancer and advanced adenomas. Should Guardant’s test receive full FDA approval, its label will likely highlight the inferiority of blood-based tests in early-stage CRC detection compared to stool tests and colonoscopies. Additionally, blood-based tests are more expensive to operate due to their reliance on NGS technology, whereas Cologuard employs the cost-effective PCR method.
Reimbursement for blood tests remains uncertain. If they achieve reimbursement equivalent to Cologuard for a three-year interval, profitability may be limited. Furthermore, annual testing due to lower accuracy, combined with lower reimbursement, could render blood tests unprofitable. We support Exact Sciences’ decision to increase marketing spending to compete effectively with blood tests and capitalize on the substantial greenfield CRC opportunity. This strategy will bolster the company’s salesforce, enabling the promotion of additional pipeline products such as Cologuard Plus, Oncodetect, and potentially Exact Sciences’ own blood-based CRC test.
The CRC testing market is vast, with approximately 110 million eligible individuals in the U.S. Currently, 35 million remain unscreened, representing a potential market of 12 million Cologuard tests on a three-year cycle. Colonoscopy covers about 50 to 60 million eligible individuals, while stool tests, including Cologuard and FIT, account for the remainder. Cologuard holds a significant advantage over FIT in terms of accuracy.
Exact Sciences has a substantial greenfield opportunity of 15 million tests, translating to $7.5 billion in annualized revenue. This, combined with the company’s existing $2 billion, yields a total potential revenue of $9.5 billion. The upcoming launch of Cologuard Plus in 2025 is expected to increase accuracy, reduce costs, and command higher reimbursement. This could generate an additional $600 million in high-margin revenue on the existing test base and $2.25 billion on new tests, bringing the total potential to over $12 billion.
At our current valuation, Exact Sciences trades at a historically low EV/Sales multiple of three times for 2025. Considering the company’s mid-teens top-line growth and low 30% cash flow growth, we anticipate at least doubling our investment over the next five years.
We established a position in Tempus AI, Inc., an intelligent diagnostics and healthcare data company. Tempus operates two synergistic business units: Genomics and Data & Other. Within Genomics, Tempus provides diagnostic tests, primarily for cancer treatment selection. The company’s labs sequence the tumor’s genome and transcriptome to help oncologists select optimal treatments for individual patients. We believe the cancer treatment selection sequencing market is underpenetrated and primed for rapid growth, with Tempus well-positioned as a leader. Genomics testing data also contributes to Tempus’ value as a data company.
Tempus has amassed a substantial (over 200 petabytes) proprietary multimodal dataset combining clinical patient data with genomic testing data from both Tempus and other providers. This dataset includes approximately 7.7 million clinical records, over 1 million imaging records, about 900,000 matched clinical and molecular dataset profiles, and nearly 1 million sequenced samples. Beyond powering intelligent diagnostics, Tempus licenses this data to biopharmaceutical companies for designing smarter clinical trials and identifying potential drug targets. Tempus collaborates with 19 of the top 20 pharmaceutical companies and has announced nine-figure deals with three. We believe this proprietary dataset is unique with significant barriers to entry and offers substantial value to biopharmaceutical research and development.
We initiated a position in Integer Holdings Corporation, the largest medical device outsourcer (MDO) manufacturer. Integer designs and manufactures components, sub-assemblies, and full devices for a range of companies, including the five largest med-tech firms. This is an attractive business with high barriers to entry and switching costs. Developing new med-tech devices and components is time-consuming and expensive, and Integer is often a preferred supplier for customers. Compared to other MDOs, Integer boasts differentiated capabilities, particularly in battery technology, the most comprehensive offering in its space, and strong customer relationships. Customers prioritize speed-to-market, scalability, and product quality, all areas where Integer excels. Larger customers also seek to consolidate vendors, benefiting Integer’s comprehensive offering. The company is involved in several promising med-tech launches, including neurostimulation, pulsed-field ablation, and structural heart, positioning it for faster-than-market growth. In addition to organic revenue growth, Integer actively pursues acquisitions to expand its technological capabilities and manufacturing scale. This strategy should drive approximately 10% annual top-line growth.
Year Acquired | Market Cap When Acquired (billions) | Market Cap When Sold (billions) | Net Amount Sold (millions) | ||||
|---|---|---|---|---|---|---|---|
| Axonics, Inc. | 2020 | $1.1 | $3.4 | $37.7 | |||
| Boyd Gaming Corporation | 2021 | 7.3 | 4.8 | 28.6 | |||
| Smartsheet Inc. | 2022 | 4.5 | 5.2 | 22.5 | |||
| Allegro MicroSystems, Inc. | 2020 | 0.4 | 5.3 | 15.9 | |||
| Astera Labs, Inc. | 2024 | 9.3 | 10.8 | 12.3 | |||
We sold our position in Axonics, Inc. after Boston Scientific agreed to acquire it. We sold our investment in Allegro MicroSystems, Inc. based on what we view as a high valuation and ongoing difficulties for the automotive industry. We have automotive semiconductor exposure via our holding in indie Semiconductor, Inc., which is growing far faster than Allegro, is trading at a lower valuation, and has visibility to a huge multi-billion-dollar pipeline supporting our estimates for years to come. We exited our position in Boyd Gaming Corporation as we believe the company will experience challenging macro conditions for an extended period (this was our only top 10 detractor that we believe missed our thesis expectations). We sold our position in Smartsheet Inc. during the quarter to allocate the capital to higher conviction ideas.
Outlook
The second quarter was certainly challenging for us. We hope that the details we have provided in this letter offer a meaningful, substantive update on some of the major crosscurrents in the market. We are in a period of rapid technological change in nearly every industry. The Strategy is embracing this change and is finding investments that we believe will benefit from it over the next few years. Until the economy fully recovers, volatility will continue to be a standard feature of the investment landscape, particularly in small caps. When investors do finally sense recovery is near, we believe the market (and our investments) will rebound rapidly, following the historical context of small-cap performance. We own significant holdings in the Strategy because we are confident this will occur and that we will reap the rewards.
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