Baron Health Care Fund: Latest Insights and Commentary

CONTRIBUTORS

• Shares of global pharmaceutical company Eli Lilly and Company increased on continued investor enthusiasm around GLP-1 drugs for diabetes and obesity. We remain shareholders. Eli Lilly's Mounjaro/Zepbound not only offers superb blood sugar control for diabetics but can drive 20%-plus weight loss and likely improve cardiovascular outcomes in both diabetic and non-diabetic obese patients. Eli Lilly is developing next generation drugs, including retatrutide, which drives approximately 25% weight loss, and orforglipron, a daily pill that produces approximately 15% weight loss. In the U.S. alone, there are 32 million Type 2 diabetics and an additional 105 million obese patients who we estimate would qualify for GLP-1 drugs. Although supply and access are limited near term, we think GLP-1 drugs will become standard of care for both diabetes and obesity and will become a $150 billion-plus category. We see Eli Lilly setting a high efficacy bar and capturing significant long-term market share. We think the adoption of GLP-1s will drive Eli Lilly to triple total revenue by 2030.
• Intuitive Surgical, Inc. manufactures the da Vinci Surgical System, a robotic surgical system used for minimally invasive procedures. The stock performed well due to excitement about the company's new robotic surgical system, the da Vinci 5, which offers enhanced imaging, force feedback, and other improvements. We continue to believe Intuitive has durable competitive advantages and will remain the market leader in robotic surgery. We think the company has a long runway for growth as more procedures are performed with the company's equipment.
• Boston Scientific Corporation is a global manufacturer of medical devices used in a broad range of interventional medical specialties. Shares increased during the quarter. We believe Boston Scientific can grow sustainably in the high single digits, driven by differentiated products in electrophysiology and structural heart devices. In particular, there has been increasing excitement around the emerging field of pulsed field ablation (PFA), where the company is well positioned. Traditionally, physicians have used temperature-based methods to disable heart tissue responsible for irregular heartbeats. Temperature-based methods may damage surrounding tissue, while PFA relies on electricity to damage aberrant tissue, and because different types of tissue have different electrical thresholds, the surrounding tissue can be selectively spared. Coupled with cost discipline and  more than 50 basis points of annual operating margin expansion, we believe Boston Scientific's double-digit EPS growth profile makes it a compelling name within the medical device universe.

DETRACTORS

• Rocket Pharmaceuticals, Inc. specializes in the development of gene therapies for rare genetic diseases outside of oncology. Currently these include Danon disease, Fanconi anemia, lysosomal acid lipase deficiency, and pyruvate kinase deficiency. The first three drug treatments are slated for commercial launch by 2025, which should generate substantial revenue. Shares detracted from performance after the FDA extended the priority review period by three months for the Kresladi gene therapy for leukocyte adhesion deficiency, potentially influenced by sluggish competitive gene therapy launches from Bluebird in sickle cell disease and BioMarin in hemophilia B. Given the lifesaving nature of Rocket's therapies and the high unmet need for each of these life ending diseases, we retain conviction in our investment.
• Arcellx, Inc. is a biotech company dedicated to the manufacturing of cell therapies for multiple myeloma. Shares fell on a lack of news in the quarter. There have been no fundamental new issues in the space over the past few quarters beyond the well-telegraphed dynamics around competitor programs scaling the complex manufacturing involved in cell therapy. The next significant news flow will occur later in 2024 when Arcellx releases updates with partner Kite from the pivotal Phase 3 trial of its iMMagine-3 treatment for multiple myeloma. This trial is widely expected to work and will be the penultimate event required before filing for FDA approval.
• DexCom, Inc. sells a continuous glucose monitoring device to help diabetics monitor their blood glucose levels.  Investors reacted negatively to DexCom's first quarter earnings report, which missed revenue estimates. In addition, year-over-year comparisons will be even tougher to beat in the yet-to-be-reported second quarter, and some investors appeared to interpret management commentary as trying to manage expectations due to the tougher comparisons and potential disruption from an increase in the sales force and reconfiguration of sales territories. We think these concerns are shortsighted and believe DexCom has a long runway for growth driven by increased adoption of its continuous glucose monitoring sensors.  We are also optimistic about the launch of Stelo, an over-the-counter glucose sensor for Type 2 diabetics who are not on insulin.  

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.

Baron Health Care Fund (the Fund) declined 2.55% (Institutional Shares) in the second quarter, trailing the Russell 3000 Health Care Index (the Index) by 153 basis points primarily due to active sub-industry/market cap weights. The Fund’s meaningfully lower exposure to strong performing large-cap stocks, specifically pharmaceutical giant Eli Lilly and Company, was a material headwind to performance as this group managed gains during the quarter. In contrast, small- and mid-cap stocks, where the Fund is significantly overweight, declined between 3% and 8% in the period, accounting for the remainder of the relative shortfall.

From a sub-industry perspective, most of the underperformance was attributable to adverse stock selection in biotechnology together with higher exposure to the lagging life sciences tools & services sub-industry, which was down nearly 8% in the Index. Stock selection in biotechnology was a 200 basis point drag on performance, driven by sharp declines from small caps Rocket Pharmaceuticals, Inc. and Arcellx, Inc. Rocket specializes in the development of gene therapies for rare genetic diseases outside of oncology. Currently these include Danon disease, Fanconi’s anemia, LAD-I, and Pyruvate kinase disorder. The first three drug treatments should all commercially launch by 2025, generating substantial potential revenue for the company. In the near term, Rocket’s shares continue to be pressured by a three-month FDA delay to their initial commercial asset in LAD-1 and the added overhang of slow gene therapy launches from bluebird bio in sickle cell disease and BioMarin in hemophilia B. Given the life-saving nature of Rocket's therapies and the high unmet need for treatments and cures for each of these diseases, we retain conviction in our investment. Arcellx develops cellular therapies for multiple myeloma and is in the midst of pivotal clinical trials for its BCMA cell therapy, approval of which is expected by 2025. There have been no recent developments aside from the well-telegraphed dynamics around competitor programs scaling the complex manufacturing involved in cell therapy. The next significant event will occur later in 2024 when Arcellx is expected to release updates from the pivotal Phase 3 trial with partner Kite of its iMMagine-3 treatment for multiple myeloma. This trial is widely expected to succeed and is the penultimate event required before filing for FDA approval to begin commercial efforts within the next year.

Another source of weakness in the sub-industry was Viking Therapeutics, Inc., whose shares pulled back after increasing nearly 300% in the prior quarter. Viking develops metabolic disease medicines with focus on diabetes/obesity and MASH (metabolic steatohepatitis, i.e., fatty liver). The company’s lead asset is VK2735, an injectable and oral version of a GLP-1/GIP combination weight loss medication that directly competes with Lilly’s Mounjaro/Zepbound. Both of Viking's main assets appear to be more efficacious than their competitors' in two exceptionally large revenue end markets. Viking’s stock detracted as biotechnology specialists have leaned into an alternative mechanism for obesity called amylin inhibition and don't view the company as an attractive acquisition target (an opinion we disagree with). The recent rebalance of the well-known SPDR S&P Biotech ETF (XBI) also pressured Viking’s share price due to forced selling by many long/short strategies to reweight their positions.

Somewhat offsetting the above was solid stock selection in health care equipment, pharmaceuticals, and health care distributors, though these positive effects were somewhat offset by the Fund’s active weights in these sub-industries. Strength in health care equipment was driven by continued strong performance from global medical device manufacturer Boston Scientific Corporation and robotic surgical system leader Intuitive Surgical, Inc. Boston Scientific’s shares continued to benefit from increasing excitement around the emerging field of pulsed field ablation (PFA), where the company is well positioned. Traditionally, physicians have used temperature-based methods (either hot or cold) to disable heart tissue responsible for irregular heartbeats. Temperature-based methods may damage surrounding tissue, however. PFA, in comparison, relies on electricity to damage aberrant tissue, and because different types of tissue have different electrical thresholds, the surrounding tissue can be selectively spared. We remain positive about Boston Scientific because of the company’s differentiated products in electrophysiology and structural heart, double-digit EPS growth profile, proven track record of cost discipline, and consistent annual operating margin expansion. Intuitive’s stock performed well due to excitement about the company's new robotic surgical system, the da Vinci 5, which offers enhanced imaging, forced feedback, and other improvements.

Performance in pharmaceuticals and health care distributors was bolstered by solid gains from AstraZeneca PLC and McKesson Corporation, respectively. AstraZeneca is a global biopharmaceutical company with a focus on three main therapy areas based on its core competencies: oncology, cardiovascular and metabolic diseases, and respiratory illnesses. AstraZeneca’s shares increased given incremental positive news flow (LAURA, ADRIATIC, and DESTINY-Breast06 clinical trials) surrounding the oncology franchise. The company also published long-term guidance for the first time, projecting $80 billion in revenue by 2030, or 75% higher than 2023's $45.8 billion. This projection implies an annual growth rate of 8% over seven years, compared with the 5% to 7% targets set by GSK and Johnson & Johnson and the 5% target set by Novartis. McKesson is a leading distributor of pharmaceuticals and medical supplies and also provides prescription technology solutions that connect pharmacies, providers, payers, and biopharmaceutical customers. McKesson’s stock reacted positively to the company's fiscal year 2025 earnings guidance, which came in ahead of investor expectations. We continue to think McKesson can generate mid-teens earnings per share growth annually through organic growth, operating leverage, and share repurchases.