Baron Discovery Strategy | Q4 2024

Baron Discovery Strategy was up 6.19% in the fourth quarter, outperforming the Russell 2000 Growth Index (the Benchmark). For the full year ended December 31, 2024, the Strategy was up 16.27%, outperforming the Benchmark by 1.13%. We were pleased with the outperformance, particularly given the difficult start that we had in the first half of the year. During this six-month period of underperformance, we remained consistent with our process and long-term focus. We did not view the underperformance as fundamentally driven. In our June 30, 2024 letter we wrote “we believe the downside moves [in our worst performing investments] are more technically related to macroeconomic factors and the trading environment and could reverse extremely quickly . . . “ Our belief proved to be prescient as the Strategy significantly outperformed in the second half of the year.

Nate Silver’s book On the Edge is a terrific exploration of some of the most important events, trends, and people in the recent past including AI, cryptocurrency, Silicon Valley venture capitalists, hugely successful entrepreneurs, and even financial villains. Silver, a professional political pollster and also a professional poker player, relates to the world in a construct that divides it into two key personality types, “Riverians” and “Villagers.” Riverians are gamblers, investors, entrepreneurs, and other risk takers who view their actions in terms of expected value (EV). EV simplistically is the value of a result being successful, multiplied by the probability that success occurs. If something has positive EV (+EV) after subtracting its costs, then it’s worth pursuing (at the most abstract level). Riverians are individualistic and calculating (sometimes to the extreme). By contrast, “Villagers” are more tribal and prize sticking to their community as the paramount way to achieve success (also sometimes to the extreme). Villagers (politicians, academics, journalists, and the like) are by nature more risk-averse. It will not surprise you to hear that your Strategy managers are Riverians by nature, and we strive to create what Silver calls “edge” via our style of long-term, fundamentally sound investing.

“Edge” is defined as consistently making +EV decisions (p. 22). It is important to understand that long-term actualized positive value does not mean that every investment or investment period is a guaranteed winner. Just that each investment is made with +EV at the outset. Pursuing this road requires a distinctive mixture of traits, including contrarianism (being critical of consensus thinking, not merely blindly defying the majority) (p. 25), risk taking (p. 221), a commitment to process versus using results as a goal (p. 221), with a long-term perspective (p. 226) based on experiential preparation (p. 232), and high-quality quantification of these experientially derived intuitions (p. 237). Sound familiar? It should. This is our daily process and it has allowed us to create long-term annualized returns for the Strategy since inception of 12.77% with outperformance (our annualized return above the market after fees) of 4.44%.

As Silver says, “it’s hard for anybody to have alpha. But not everybody is playing the same game. People have different incentives, and they may be following their incentives rationally, but it nevertheless creates profitable opportunities. . . It’s easier to achieve alpha at your objective when other people aren’t playing the same game. So be a conscientious contrarian – look for flaws in people’s incentives rather than their intelligence – and then seek out a place where your own incentives are well-aligned with your goals.” (p. 242). “Many times you can make a +EV bet just by being more patient than the next person. And it represents a comparative advantage because patience is an atypical trait in the United States.” (p. 259).

We are patient and we are playing the long-term game, which is contrary to most market participants (perhaps because their investors are driven by short-term performance or because they simply don’t have the patience). We also “eat our own cooking.” We have substantial investments in the Strategy which we have not sold, even when markets have been fearsome. This was particularly true in the first half of 2024 when as mentioned we were behind the market on a relative basis. Periods such as this set up big +EV opportunities, as emotions drive most investors to routinely sell quality investments at a discount due to fear. We are extremely proud of our long-term performance, particularly when every day the market seems to value “patience” less and less. Our contrarian outlook and measurement of “edge” over a longer-term horizon makes us different from most other Strategies and investors – we are playing a different game.

Shares of Axon Enterprise, Inc., the leading provider of tasers, body cameras, and other public safety solutions, rose after a robust quarterly earnings report. The company closed the quarter with record bookings and highlighted the 2025 launch of an AI bundle oriented around its innovative Draft One product (which automates the process of report writing for public safety officers). With eleven consecutive quarters of more than 25% revenue growth, Axon continues to find new areas of expansion as it pulls ahead of the competition and is on track to become the dominant provider of public safety solutions in the U.S., and, increasingly, in Europe.

Chart Industries, Inc. is a global leader in the design, engineering, and manufacturing of process and storage technologies and equipment for gas and liquid handling. Shares of Chart rose during the quarter as the company reported strong financial results, importantly with free cash flow ahead of investor expectations. The fundamentals for the business continue to be very strong, with record revenue, backlog, and margins every quarter in 2024 and a book-to-bill ratio above one. The stock had been “in the penalty box” for self-inflicted issues, with management setting too-high expectations and continuing to need to cut them back, but this quarter showed Chart has finally set more achievable expectations and we believe it is set up for strong execution into 2025. Chart is unique in its breadth of technology and solutions serving long-duration secular growth markets (liquid natural gas, hydrogen, carbon capture, water treatment, and more) with a mid-20% (and improving) EBITDA margin profile and with revenue growing double digits. As the company continues to grow and execute its operational excellence plan, we believe it will earn a more premium valuation, which combined with its strong earnings growth profile will drive significant near- and long-term upside in the stock.

PAR Technology Corporation is a leading software, hardware, and service provider to the restaurant industry. Shares of PAR rose during the quarter as it continued to deliver strong growth while reporting its first quarter of adjusted cash flow (EBITDA) profitability since embarking on its current strategy. The restaurant industry historically underinvested in technology, and PAR is building an all-in-one platform for enterprise restaurants to run the most critical portions of their technology stacks. PAR remains well positioned given limited competition, accelerating restaurant adoption of technology, and best-of-breed products. We believe PAR will deliver on its greater than 20% software revenue growth target for the next several years with possible significant upside if PAR closes some of its potential large customer deals. We further believe EBITDA margins will rapidly scale from this first profitable quarter as the company has maintained strong cost controls coincident with its growth. The company’s recent TASK and Stuzo acquisitions further strengthen the long-term opportunity as well, allowing for expansion into convenience stores and international markets and opening up opportunities with additional Tier 1 restaurants.

CareDx, Inc. is a diagnostic company that facilitates donor matches pre-organ transplant and rejection monitoring post-transplant. The market reacted poorly to the company’s Investor Day in October, with its preannouncement of quarterly results underwhelming expectations. And the stock was up over 100% in the prior quarter, leaving little room for disappointment. Short-term momentum shifts notwithstanding, our long-term investment thesis remains intact. We believe there is significant greenfield in the transplant diagnostics market alongside the backdrop of a cleaner reimbursement landscape.

Shares of Montrose Environmental Group, Inc., a leading environmental services firm, were down due to a multitude of issues and negative news flow. Previously, the stock came under pressure when the U.S. Supreme Court struck down the Chevron Doctrine in July, raising investor concerns about the authority of federal agencies to enforce environmental regulations that drive portions of Montrose’s business. In September, shares sank after a short report targeted the company. Finally, the perception that Montrose will fare worse under the incoming administration due to a reduced focus on regulation also hurt shares. Management has refuted all these points and met with investors to give confidence around their 2025 outlook. They noted the company grew under the prior Trump administration and paused acquisitions in the short term to demonstrate organic revenue growth and cash flow generation, which the short report claimed was lacking. We added to our position on weakness.

Floor & Decor Holdings, Inc. is a hard-surface flooring retailer with a long growth runway driven by double-digit unit growth as they consolidate the hard-surface flooring industry. The company has long-term, sustainable competitive advantages in its ability to source and price products versus both big box retailers and independents. Despite this positive long-term secular potential, the company’s shares can be highly sensitive to changes in interest rates over the short term as higher interest rates increase the risk of a prolonged housing recovery. As the year ended, rates on longer-dated maturities increased and, as a result, shares underperformed during the quarter due mostly to changes in interest rates. Despite this dynamic, demand for the company’s products appears to have stabilized and we believe once the housing market begins to recover, Floor & Decor will continue to be well positioned.

Our top ten positions comprised 28.2% of the portfolio, consistent with long-term levels. Our cash position was 3.9%, also in line with historical levels. The Strategy has significant capital loss carryforwards from prior years to offset current year capital gains.

We sold some of our investment in Axon Enterprise, Inc. as shares had run up significantly in the quarter due to an outsized earnings beat. This brought the position to approximately 5% of net assets during the day on November 8, 2024. After a total return of nearly 400% on our investment at December 31, 2024, we still own a 2.5% position in Axon (which we think is one of the best companies we have ever owned).

We reduced our position in Intapp, Inc. and sold out of Rexford Industrial Realty, Inc. to fund the purchases of Macerich and ServiceTitan, respectively.

We trimmed our investment in Advanced Energy Industries, Inc. to manage the position size to about 2%. We still believe the company has many opportunities to grow its state-of-the-art power management product set in semiconductor capital equipment, medical devices, and advanced industrial applications. Finally, we trimmed our position in ASGN Incorporated, as we found some higher return on invested capital ideas that we wanted to fund.

We believe that there is significant upside to our current portfolio given current valuations and the growth profiles of the companies in which we invest. Broadly, small capitalization markets have been worse than stagnant.

The Benchmark at December 31, 2024 was still 12% below its February 9, 2021 peak. This is incredible – a nearly four-year stretch at a standstill, when these companies are producing real and rapid fundamental growth. We have written at length about the relative valuation discounts in small versus large capitalization markets (see our third quarter investor letter for more details). And we are about to enter a period of time in which the country might get a step function of positive catalysts including increased deregulation, lower taxes, a serious effort to reduce the federal debt, and a return to more normalized energy policies. We believe that this confluence of factors should provide a powerful tailwind for small capitalization stocks.