Baron Opportunity Fund (BIOIX)

Portfolio Commentary

Review and Outlook (for quarter ended 3/31/2013)

The stock market opened the year with a strong first quarter. The market cheered the New Year’s Eve compromise averting the fiscal cliff, and the rally continued, spurred on by the Fed’s easy money policy, a gradually improving U.S. economy, better-than-feared fourth quarter earnings, and strong money flows into U.S. equity markets.

Many of the Fund’s investments performed well during the quarter. Top contributors included e-commerce leaders HomeAway, Inc. and Shutterfly, Inc., and the world’s leading real estate services firm, CBRE Group. Information Technology (IT) holdings were also top performers, particularly Guidewire Software, Inc., Gartner, Inc., ANSYS, Inc., CoStar Group, Inc., and Acxiom Corp.

Even so, the Fund’s significant weighting to IT and Telecommunication Services negatively impacted performance. First quarter IT spending was weak, impacted by the annual re-setting of IT budgets and global macro-economic concerns. A number of well-known tech companies reported or pre-announced poor results to start the year. While this has had a short term negative impact on performance of the Fund, we are not making any major changes to the portfolio. Our experience tells us that technology spending can be lumpy, particularly in the first quarter of the year, after the year-end budget flush and as budget priorities for the current year are being set. We remain confident that the technology themes in which we are investing are intact, that these themes will drive outsized growth, and that our portfolio companies are not only benefiting from these growth themes, but are taking market share within them. Consequently, we have taken advantage of the broad weakness in IT stocks to selectively add to certain positions in the portfolio.

Amounting to just under 9% of the portfolio, the Fund’s Health Care stocks declined about 2.5% in aggregate due to stock price declines for Edwards Lifesciences Corp., Intuitive Surgical, Inc., Illumina, Inc., and Masimo Corp. While we decided to exit our Intuitive Surgical position, neither the short-term price movements in any of these stocks, nor anything we learned during the quarter altered our opinion that minimally-invasive surgical procedures and better diagnostics (including DNA-based testing) will continue to be meaningful secular growth drivers in the Health Care space. In fact, Illumina recently reported a strong first quarter, driven by adoption of its DNA sequencing technology and its dominant competitive position in the market.

We invest in higher growth, often innovative businesses that are benefiting from powerful secular growth themes. Our portfolio holdings are growing their top lines at about twice the rate as the companies that make up our benchmark. Our investments also tend to have higher free cash flow margins and thus faster free cash flow growth. We sometimes pay higher multiples for these faster-growing businesses, and we accept slightly more volatility, but we believe over time our strategy will yield higher risk-adjusted returns for our investors.

While we strive to outperform in every period, we acknowledge periods of underperformance are unavoidable. We attempt to use those periods to improve the portfolio by taking advantage of compelling opportunities when they present themselves. We believe the best approach to long-term investing is to pursue a consistent and proven strategy. We remain focused on identifying businesses with powerful secular growth drivers, predictable and/or recurring revenue streams, sustainable competitive advantages, strong balance sheets, positive operating cash flows, and products and services that we expect to remain in high demand and critical to customers.

Top Contributors/Detractors to Performance

Contributors (for quarter ended 3/31/2013)

• HomeAway, Inc. was up 47.7% in Q1. HomeAway is the #1 firm in online vacation rentals with over 700,000 paid listings. Performance in Q1 was due to strong Q4 results, where the company beat Street expectations and showed an acceleration in its revenue-per-listing metric.

• Shutterfly, Inc. is the leading provider of personalized photo-based products. Shares of Shutterfly were up 47.9% in Q1 due to strong Q4 results and an equally strong outlook for 2013. The company benefited from greater market share gains relative to its competitors, and improving margins from its new manufacturing facilities. The company is also making significant progress in its enterprise business.

• Shares of Guidewire Software, Inc., a leading provider of core systems software to the global P&C insurance industry, outperformed in Q1 after reporting significantly better than expected financial results. We believe that Guidewire is emerging as the gold standard in terms of P&C core systems functionality, as evidenced by its near perfect retention rates, growing installed base, and accelerating adoption of its complete suite of offerings.

Detractors (for quarter ended 3/31/2013)

• Agrinos AS declined 46.3% in Q1. Agrinos is a green technology company with a unique microbial product that enhances crop yields. Performance in Q1 was weak because a delay in receivables collection led to a change in accounting policy, with no revenue booked for Mexico in Q4. We continue to hold Agrinos because we believe it has disruptive technology and exciting long-term growth prospects.

• Liquidity Services, Inc. brings efficiencies through auctions to a large, but fragmented, reverse supply chain industry consisting of returns, damaged goods, and capital asset sales. Shares of Liquidity Services were down during the period held. We sold our position after the company reduced its outlook for 2013, after having just reduced expectations for Q4. Guidance was lowered based on its greater level of investment in the business and slower first half retail sales by the company’s suppliers.

• Shares of Polypore International, Inc. partially retreated from their Q4 run up of 31.5%. Although the lead-acid battery separator business (about 50% of revenues) did well in Q4, sales of separators for lithium-ion (LiON) batteries were lower than expected for both consumer and vehicle applications. We believe the revenue decline associated with LiON battery separators has troughed, and with its capacity expansion, the company should see significant upside earnings leverage as electric vehicles gain penetration.

Quarterly Attribution Analysis (for quarter ended 3/31/2013)

When reviewing performance attribution on our portfolio, please be aware that we construct the portfolio from the bottom up, one stock at a time. Each stock is included in the portfolio if it meets our rigorous investment criteria. To help manage risk, we are aware of our sector and security weights, but we do not include a holding to achieve a target sector allocation or to approximate an index. Our exposure to any given sector is purely a result of our stock selection process.

The Baron Opportunity Fund (Institutional Shares) gained 8.94% in the first quarter, yet underperformed the Russell Midcap Growth Index by 257 basis points. During the quarter, the Fund’s unfavorable stock selection and, to a lesser extent, relative sector weights detracted from relative performance.

The Fund’s investments in the Financials and Consumer Discretionary sectors were the primary contributors to relative performance for the quarter. Favorable stock selection within the Financials sector was mostly attributable to outperformance of the Fund’s two holdings in the sector, CBRE Group, Inc. and Artisan Partners Asset Management, Inc. Shares of CBRE Group, a leading commercial real estate services company, outperformed in the quarter due to strong year-end operating results, an optimistic outlook from management, and its favorable valuation. Shares of Artisan Partners, an investment management firm with over $75 billion in assets under management, rose sharply following its IPO late in the quarter. Strength in the Consumer Discretionary sector was mainly attributable to outperformance of two of the Fund's Internet retail investments, HomeAway, Inc. and Shutterfly, Inc. Shares of both HomeAway and Shutterfly rose more than 45% in the quarter after reporting better than expected quarterly results.

The Fund’s holdings within the Information Technology (IT), Health Care, and Consumer Staples sectors were the largest detractors from relative performance. Within IT, a combination of unfavorable stock selection and the Fund’s meaningfully larger exposure to the underperforming sector, hampered relative results. Weakness in the sector was largely attributable to underperformance of the Fund’s investments in the Internet software and services and system software sub-industries. The largest detractors from relative performance were Internet software and services holdings Liquidity Services, Inc. and Rackspace Hosting, Inc. Shares of both companies declined after reporting weaker than expected earnings results due to greater levels of investment in their respective businesses. As a result, the Fund exited its position in both companies. Another detractor in IT was RealPage, Inc., an application software company which markets a comprehensive suite of property management software and analytical tools for the rental housing industry. The company’s shares declined in the quarter as financial results and 2013 guidance fell short of expectations.

Within Health Care, underperformance of the Fund’s three investments in the health care equipment sub-industry, Masimo Corp., Intuitive Surgical Inc., and Edwards Lifesciences Corp., and the Fund’s larger exposure to this lagging segment were the primary drivers of underperformance. Masimo, a medical diagnostics company, was the largest detractor from relative results in the sector. While Masimo reported respectable quarterly results, investors were disappointed in sales of its new Rainbow monitoring products, sending the company’s shares lower. Another detractor in the sector was Illumina, Inc., a leading provider of genetic analysis tools, including DNA sequencing instruments and consumables. Shares of Illumina declined after Roche’s CEO said the companies could not reach an agreement on price and Roche was abandoning its efforts to acquire Illumina. Our investment thesis has not been contingent upon Illumina being acquired. Within Consumer Staples, underperformance of the Fund’s only holding in the sector, Whole Foods Market, Inc., and the Fund’s lower exposure to the outperforming sector, hurt relative results. Whole Foods, which operates the largest chain of natural food supermarkets in the country, was a new addition to the Fund during the quarter.

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