Baron Opportunistic Small Cap Growth Strategy | Q4 2024

Baron Opportunistic Small Cap Growth Strategy was down 0.98% in the fourth quarter of 2024. For the year, the Strategy was up 13.66%. The Strategy modestly trailed the Russell 2000 Growth Index (the Benchmark) for the quarter and the year, with the Benchmark up 1.70% in the quarter and 15.15% for the year. As small-cap stocks underperformed larger market caps, the Strategy lagged the Russell 3000 Index, which rose 2.63% in the quarter and 23.81% for the year. Though this year we did not beat the Benchmark, our long-term performance is well ahead, as shown in the table.

Like most years, 2024 was a year of many unexpected outcomes.

• Even after the Federal Reserve’s unprecedented series of interest rate hikes, the economy remained solid and avoided the much-anticipated recession.
• Stock market indexes gained nicely, with the S&P 500 Index finishing up 25%, well ahead of the predictions of most market prognosticators. This was the second year in a row of over 20% gains, which had not happened since the late 1990s. The strong returns were led by extraordinary performance of a small cohort of large-cap technology companies, which were propelled by strong earnings and excitement over AI. The rest of the market did okay but underperformed the broad indexes.
• The U.S. elections resulted in decisive victories for Trump and the Republicans, who secured majorities in both houses of Congress, which was unforeseen by most political pundits.
• The Federal Reserve pivoted and lowered the Fed Funds Rate only to result in significantly higher actual interest rates.

The fourth quarter had lots of twists and turns. Major highs and lows. The market was roughly flat in October before exploding higher in November in reaction to the election of Trump. The “Trump Rally” was predicated on exuberance about better economic growth spurred by the expected pro-business policies…lower interest rates, less regulation, fiscal responsibility, global security…. that the new administration espoused. These favored fiscal policies were coupled with a dovish Federal Reserve, which cut the Fed Funds Rates for the second time in November. The Federal Reserve hailed progress made in reducing inflation and easing labor conditions, and the market anticipated multiple future cuts in the offing. The stock market rally broadened significantly in November. Small-cap stocks rallied sharply and outperformed, after lagging greatly for the year, on the hopes of faster earnings growth and higher stock multiples.

The market gave back most of its gains in December. In spite of the Federal Reserve rate cuts of 100 basis points since mid-September, the interest rate for the important 10-year U.S. treasury bond rose approximately 100 basis points. The steepening of the yield curve and rise in rates was surprising. Economic reports indicated that activity remained solid and inflation readings were hotter than anticipated. Yields rose over fears of higher inflation fueled by faster growth, and the potential inflationary effects of suspected tariffs and border policies. Concerns about higher government deficits also contributed to higher actual rates. Small caps gave back their gains and underperformed. The market ended the year with a whimper, as the Federal Reserve signaled its plan to slow rate cuts.

Strategy performance this quarter was primarily driven by the operating results of our holdings, which is most often the case. We had many good stocks that posted strong results. But these were offset by companies whose earnings this quarter were below expectations. For the most part, we believe the shortfalls are temporary.

Our best performing sector was Industrials, our largest concentration. Vertiv Holdings Co, which is our biggest position, posted strong results and laid out an exciting outlook for continued multi-year growth, benefiting from the enormous capital investment in data centers to enable AI applications. Chart Industries, Inc., a leading domestic manufacturer and service provider, gained on the recognition that its outlook will be enhanced by the policies of the new administration. Our Information Technology (IT) stocks were a mixed bag. Both Intapp, Inc. and Grid Dynamics Holdings, Inc. rose meaningfully on improving business trends. But these gains were offset as Guidewire Software, Inc. gave up some of its gains for the year on profit taking, and ASGN Incorporated’s growth remains muted. Of our Consumer Discretionary holdings, shares of Red Rock Resorts, Inc. fell when the company reduced guidance because of capital projects that will disrupt operations for the next quarter or two. And our housing-related holdings (Installed Building Products, Inc., Trex Company, Inc., and Floor & Decor Holdings, Inc.) fell as interest rates rose, which likely will delay an expected rebound in those end markets. These losses were partially offset by gains in Planet Fitness, Inc., which has new and refreshing leadership and is raising membership pricing, and The Cheesecake Factory, Inc., which is increasing the pace of opening new restaurants. In Health Care, ICON Plc and Neogen Corp. both missed earnings estimates, and their shares fell, while HealthEquity, Inc. rose, benefiting from higher interest rates. Of our Financials holdings, The Baldwin Insurance Group, Inc. came back to earth as earnings missed Street expectations. Houlihan Lokey, Inc., a niche investment bank, rose nicely on anticipation of more active corporate finance activity.

For the year, we had some great stocks and some clunkers. On the plus side, the following stocks rose over 50% for the year – Vertiv, Guidewire, Baldwin, The Trade Desk, Grid Dynamics, and Liberty Media Corporation – Liberty Live. Other significant holdings rose 30% or more – Kinsale Capital Group, Inc., Intapp, TransDigm Group Incorporated, Planet Fitness, Houlihan Lokey, Liberty Media Corporation – Liberty Formula One, Cheesecake Factory, Chart, HealthEquity, Clearwater Analytics Holdings, Inc., and Kratos Defense & Security Solutions, Inc. The biggest percentage losers of the year were Endava plc, Fox Factory Holdings Corp., Sprout Social, Inc., indie Semiconductor, Inc., Janus International Group, Inc., Neogen Corp., Holley Inc., DexCom, Inc., and European Wax Center, Inc. Some larger positions that were down and hurt performance were ICON, SiteOne Landscape Supply, Inc., ASGN Incorporated, Red Rock, and Cognex Corporation.

Vertiv Holdings Co, a critical digital infrastructure solutions provider for data centers, continued to perform well. With a leading market share in power and cooling applications for data centers, Vertiv is seen as a prime beneficiary of the AI-related data center buildout. At its November Analyst Day, Vertiv raised organic sales guidance to 12% to 14% CAGR for the next five years and gave guidance of 16% to 18% organic revenue growth for 2025. Vertiv also increased its target adjusted operating profit margin from 20% to 25%. While impressive on their own, these forecasts can prove conservative we think. With the stock up 141% in 2024, we have been trimming the stock into strength to manage position size but hold a large stake as we believe in its growth and that the stock is reasonably valued even after great appreciation the last two years.

Chart Industries, Inc. is a global leader in design, engineering, and manufacturing of process and storage technologies and equipment for gas and liquid handling. Business fundamentals remain solid, with record revenue, backlog, and margins every quarter in 2024 and a book-to-bill ratio above one, indicating resilient demand. 2025 guidance has already been set and looks achievable calling for 12% revenue and 18% EBITDA growth. Chart is unique in its breadth of technology and solutions capabilities, with an EBITDA margin profile of mid-20% and double-digit revenue growth in long-duration markets (LNG, hydrogen, carbon capture, water treatment, etc.). We believe the company will continue to grow and execute to earn the valuation it deserves. The company had issues hitting guidance last year, but we think that it is behind them.

Intapp, Inc. offers a software platform for professional services verticals such as private equity, legal, and consulting firms. Shares rose on strong quarterly results, with year-over-year revenue growth of 17% beating expectations and operating margins more than doubling compared to the same period last year. Management also reported a record pipeline for new deal activity, particularly in large enterprises, boosted further by demand for its new AI products. The favorable backdrop for M&A and capital markets deal activity created by the election outcome should also benefit Intappindirectly, as stronger deal activity typically leads to higher fees, hiring, and technology investment in its investment banking and private equity end markets.

Other holdings that rose over 25% in the quarter but added less to the overall returns were Grid Dynamics, John Bean Technologies Corporation, and Liberty Live.

ICON Plc is a leading contract research organization (CRO) that provides outsourced services to the biopharmaceutical industry. Shares fell on weak quarterly results and lowered 2024 guidance. Like other CROs, ICON is facing headwinds due to tighter management of R&D spend by pharmaceuticals, less biotechnology funding availability, a greater number of project delays and cancellations, and an industry shift in preferred business models from full to functional outsourcing. While we expect these headwinds will persist into at least the first half of 2025, we believe pharmaceutical R&D spend will continue to grow and global providers like ICON are well positioned to expand and gain share over time, returning to double-digit EPS growth. With the stock near all-time low valuations, we are holding.

Shares of insurance broker The Baldwin Insurance Group, Inc. gave back some gains (up 61% in 2024) due to weaker financial results and an expected earnings headwind from the loss of an insurance partner. The company reported healthy14% organic revenue growth and modest margin expansion yet missed the Street’s more bullish expectations, which led to a modest cut to full-year EBITDA guidance. In addition, it disclosed the need to replace an insurance partner in 2025, resulting in a 3% to 5% headwind to earnings. Rising interest rates also weighed on shares due to an elevated leverage profile consisting primarily of variable rate debt. We continue to own the stock, as we expect Baldwin to gain market share while expanding margins and reducing leverage over the next several years. It is a neat, fast- growing business that we believe is on the path to being a more important distinctive player in its space.

Installed Building Products, Inc. installs and delivers insulation and complementary building products for the U.S. residential and non-residential construction markets. Shares detracted on broader investor concerns that growth had stalled in its core residential market, with buyers facing headwinds, including crimped affordability (as mortgage rates continued to rise). We view these headwinds as somewhat temporary and remain optimistic about the company’s multi-year, multi-pronged growth strategy of organic and acquisitive growth.

Other stocks that declined over 20% this quarter were Neogen, Janus, Bright Horizons Family Solutions, Inc., Exponent, Inc., Fox Factory, and Americold Realty Trust.

As of December 31, 2024, the Strategy had $4.3 billion in net assets and owned 57 stocks. The top 10 holdings made up 40.4% of net assets. Turnover was 11.5% as measured by a three-year average. The portfolio is somewhat more concentrated, and turnover is lower than usual. Though we are comfortable with these levels, we expect to be more active in adding new names to the Strategy as the IPO and capital markets revert to historical levels.

The Strategy primarily invests in five sectors—Industrials, IT, Consumer Discretionary, Financials, and Health Care. These are the areas where we have been able to find special/unique companies that have the business characteristics that we favor—leaders in their niches, strong growth record and opportunities, proven management teams, durable competitive advantages, and reasonable valuations. We have deep research teams in these sectors and great expertise and understanding of these industries to identify and follow the companies we own and seek to invest in.

We like to invest in businesses that can compound the value of their business at double-digit rates. This growth is often predicated on multiple levels—organic growth, margin expansion, accretive acquisitions, and utilization of free cash flow. We invest at trading multiples that we think are reasonable, if not cheap. Ideally the multiples can expand over time and add to the returns we get from the growth in earnings/value. We do not invest in businesses that are not growing sufficiently. We do not like to invest in businesses that are not yet profitable. We do not invest in stocks that we think are cheap with the main premise of the investment being multiple expansion. To simplify…we are long-term growth investors, in high-quality special companies, that we think are reasonably valued. It is this approach that has generated the Strategy’s Benchmark-beating long-term performance.

Because we have this distinct approach, the resultant portfolio is very different than the Benchmark to which we are compared and most other strategies in our space. Looking at the sectors we invest in and comparing it to the Benchmark, the Strategy is well overweight in Industrials, overweight in IT, Consumer Discretionary, and Financials, and significantly underweight in Health Care. This is not by design, but the outgrowth of our process and the business characteristics we favor. We do not own any stocks in the Energy or Utilities sectors and have very modest holdings in Real Estate and Materials, all in contrast to the Benchmark. The significant difference in sector weightings means the Strategy is unlikely to track the Benchmark, which is fine with us.

The other major difference in our approach is our long-term perspective and holding period. We have learned over the years that special companies can produce strong results and be great stocks for long periods of time. The best thing for us to do is be shareholders for the long term and benefit from their success. Not to sell too soon. To keep position size and market cap in consideration, but to stay invested in these wonderful companies. And, when we look for new investments, to have this same perspective and seek out extra special small companies that we can invest in for the long term and benefit as they prosper.

As of the end of 2024, about three-quarters of the Strategy’s assets were in stocks we have held for five years or more, which includes a third of the portfolio in stocks we have held 10 years or more. As a group, these stocks (36 in total) have been held for a weighted average of 10.3 years and have produced an annualized total return of 24.2%. Many of our long-term holdings have been what we call “big winners.” 39.4% of the Strategy’s net assets are in stocks that have appreciated five times or more. And this includes 10 stocks which make up 23.1% of the Strategy that have gained over 10 times since their initial purchase. So, we believe in our approach because it has succeeded, and we believe it will continue to succeed in the future.

Buying small-cap stocks and holding successful investments for the long term does result in a higher market cap for the Strategy as compared to the Benchmark and most competitive strategies. We believe it is worth it as it is the essence of our approach and has led to strong returns that benefit our investors. Yet we do monitor and are attentive to the overall market cap of the Strategy. We keep it in check by buying only small caps and trimming our larger-cap holdings. In the fourth quarter of 2024, we bought or increased stocks with a weighted average market cap of $3.5 billion and sold or trimmed stocks with a weighted average market cap of $26.0 billion.

We enter the new year with competing narratives and an uncertain outlook…. which is often the case. The optimistic view is that the Trump administration will be good for business and good for stocks. The economy seems to be poised to grow faster. It is expected that tax rates will be cut, that the regulatory hurdles will be substantially eased, and that animal spirits will be unleashed, and more decisive actions will be taken by business leaders after years of hesitancy and the remnants of the COVID-19 hangover. There is excitement around efforts to reduce government spending and costs (DOGE) and be more fiscally responsible, all which could lead to an outlook for lower government deficits down the road. And maybe stronger American leadership can calm geopolitical tensions and further unleash a sort of “golden age” led by technological advances and American ingenuity. Sounds almost too good to be true…. but it is a real possibility and would be very bullish.

The counter is that stocks have performed very well for the last couple of years and valuations are higher. That much of the above enthusiasm is already reflected in stock prices. And, importantly, that interest rates have risen significantly. If interest rates continue to rise and stay high, that would be an obstacle to future growth and also be a negative for investor psyche and stock valuations. Rates have risen because of concerns about the reacceleration of inflation…. which could be caused by higher economic growth and/or government policy (tariffs, immigration) and/or concern about government deficits. As we go to press, the recent blowout employment report has fueled the flames of stronger growth and caused interest rates to surge.

It’s complicated. It always is. Our view as of now is more positive than not. These higher rates are a negative and will probably be a headwind for the market for now. But, from our discussions with the managements of our holdings and other conversations with business executives, we hear that inflation continues to dissipate and also that the pace of business growth, while muted, is on the verge of improving, but higher interest rates could slow that improvement. Though the inversion of the yield curve is a return to more normal conditions, we still think that interest rates will decline from here in conjunction with present economic conditions and modest inflation, which would be a boon for growth and stocks.

It is well chronicled how small-cap stocks have underperformed larger caps and are relatively cheap and under owned. But one must acknowledge that the outperformance of the large technology stocks is the result of the extraordinary growth of those companies. Small caps will do better as their growth accelerates, which we believe is in the offing (though higher interest rates are a hinderance). And, as always, the performance of our Strategy will be primarily determined by the results of the companies in which we invest and their longer-term outlooks.

We have worked continually on building a portfolio of special companies. Businesses that we believe are unique and have significant competitive advantages. Businesses that are very well managed by executives that we respect and believe in. To generalize, we believe our holdings will grow faster in the future as the economic environment improves and growth initiatives play out. That they are reasonably valued, if not on the cheap side, so offer great upside in the near and long term. We are excited about the prospects for strong returns.

I would like to thank assistant PM David Goldsmith for his yeoman’s work in helping me manage the Strategy. David is exceedingly capable and continues to take on greater and broader responsibilities. I am thrilled he is my partner. And I commend the terrific research team of Baron Capital. My fellow portfolio managers are top notch, and our industry analysts are experts in their fields. We all work together to produce strong results for this Strategy and all the Baron Strategies, which I am pleased to say we have so far succeeded in doing and I believe will continue to do.