Review and Outlook

as of 12/31/22

The stock markets posted solid gains in the fourth quarter, reversing the downward trend of the first nine months of 2022. The Russell 3000 Health Care Index advanced 11.54%. Putting aside ongoing caution from the Federal Reserve, investors seized on signs that elevated inflation appeared to be cooling, which suggested that the pace of tightening would slow. Overall strong corporate earnings results also helped boost the markets.

Within Health Care, different areas are often impacted differently by overall macro or sub-industry-specific conditions. Life sciences tools stocks continued to underperform due to declining COVID-related revenues, a weak funding environment for biotechnology customers, economic weakness in Europe, foreign currency headwinds, and COVID-related lockdowns in China. While some near-term headwinds may persist, we think the companies we own will benefit long term from secular growth drivers, pricing power, recurring revenues, high margins, and low capital intensity.

After two challenging years, we think small and medium-sized biotechnology stocks are positioned for better performance as interest rate hikes slow, stabilize, or even reverse, and we have increased our exposure to this area. New investments include Ascendis Pharma A/S, Rocket Pharmaceuticals, Inc., and Inhibrx, Inc.

By varying degrees, medical device companies continue to be impacted by nursing and staffing shortages resulting in constraints on procedure volumes. We think these headwinds will start to fade, and medical device companies will see increasing demand driven by an aging global population and a higher disease burden from chronic diseases. For the most part, our investments are in companies addressing non-elective procedures, which makes them less likely to be deferred in a recession.

Managed care companies benefited from low health care utilization, higher interest rates, and lack of exposure to foreign currency and global economic headwinds. We continue to think Medicare Advantage remains an attractive growth market. In addition, many managed care companies have growing health care services businesses, enabling them to capture more of the overall spending in health care.

We own select large-cap pharmaceutical companies, including Eli Lilly and Company. Lilly has several new drugs pending FDA approval or in the pipeline for obesity and Alzheimer’s disease. Importantly, it is not facing any significant near-term patent expirations. We think the company should be able to grow revenue and earnings at attractive rates at least through the end of the decade.

Overall, our long-term outlook for Health Care remains bullish. Innovation in the sector and the themes in which we have been investing are intact. We believe the portfolio includes competitively advantaged growth companies with pricing power, strong management, and excellent balance sheets.

Top Contributors/Detractors to Performance

as of 12/31/22

Contributors

  • Intuitive Surgical, Inc. sells the da Vinci robotic surgical system. The stock rose in response to solid third quarter financial results, highlighted by 20% procedure growth, well ahead of investor expectations. The company also completed another $1 billion accelerated share repurchase program, signaling management's and the board's view that the stock is a good buy. We continue to believe Intuitive Surgical has a long runway for growth as more procedures are performed using the da Vinci system.
  • Merck & Co., Inc. is a large cap pharmaceutical company with a deep heritage in drug discovery. Share gains were led by the continued growth of key asset Keytruda, the leading immune oncology agent used to treat a variety of cancers. Shares also benefited from increased investor interest as Merck proves its ability to scale its Gardasil vaccine that had previously been constrained by supply issues. We retain long-term conviction, as we expect Keytruda to solidify its position as the best-selling biopharmaceutical drug of all time.
  • AstraZeneca PLC is a global pharmaceutical company focused on oncology, respiratory, cardiovascular, and metabolism drugs. Shares increased given incremental positive news flow surrounding the oncology franchise at medical meetings and some mean reversion after lagging in the prior quarter. We retain conviction in AstraZeneca given its best-in-class growth profile among its pharmaceutical peers combined with its strong pipeline and commercial launch characteristics. We highlight Enhertu and Dato-Dxd as two new exciting near-term drug opportunities.

Detractors

  • Opsens Inc. sells pressure-sensing guidewires for heart disease diagnostics, including a new guidewire for transcatheter aortic valve replacement procedures. The stock fell on slower growth than investors expected due to a challenging hospital procedure environment related to staffing shortages. The company also issued equity to bolster the balance sheet. We continue to believe Opsens' new Savvywire guidewire will drive revenue growth acceleration given the benefits it offers to patients.
  • ShockWave Medical, Inc. provides intravascular lithotripsy for the minimally invasive treatment of arterial plaque. Shares experienced a pullback given ShockWave's premium valuation, but the company continued to execute on its product for coronary artery disease in the U.S. It also received reimbursement coverage for coronary-related treatment in Japan and is in the early innings of launch in China. We think ShockWave has a differentiated technology serving a significant unmet need in arterial disease with potential to expand into treatment of heart valves.
  • Edwards Lifesciences Corp. is the leading provider of valves for patients with heart disease. Shares fell after the company's transcatheter aortic valve replacement (TAVR) business missed Street expectations again. Management attributed the sales shortfall to disruption from hospital staffing shortages, an issue that has an outsized impact on TAVR procedures because they are resource-intensive and require multiple specialists. We reduced the position due to increased uncertainty around the growth outlook.

Quarterly Attribution Analysis (Institutional Shares)

as of 12/31/22

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.

as of 12/31/22

Baron Health Care Fund (Institutional Shares) appreciated 9.08% in the fourth quarter, yet trailed the Russell 3000 Health Care Index by 246 basis points due to several factors, including cash exposure in an up market, adverse stock selection, and differences in sub-industry exposures.

Apart from cash, investments in biotechnology, health care equipment, and health care technology were mostly responsible for the relative shortfall during the quarter. Weakness in biotechnology was partly due to the underperformance of Inhibrx, Inc., a clinical stage biotechnology company with a pipeline of biologic therapeutic candidates developed using the company’s protein engineering expertise and proprietary single domain antibody platform. Inhibrx’s shares declined after we initiated a position in mid-October due to general small-cap biotechnology weakness into year end. Modest gains from our high-conviction positions in argenx SE and Vertex Pharmaceuticals Incorporated along with lower aggregate exposure to strong performing large-cap companies Gilead Sciences, Inc., AbbVie, Inc., and Amgen Inc. presented additional headwinds to performance. Negative stock selection in health care equipment was related to sharp declines from fiber optic sensors manufacturer Opsens Inc., intravascular lithotripsy leader ShockWave Medical, Inc., and transcatheter aortic valve replacement pioneer Edwards Lifesciences Corp. The Fund’s only remaining position in health care technology, physics-based drug discovery platform Schrodinger, Inc., weighed the most on performance. Schrodinger’s shares were down after management lowered guidance due to foreign currency headwinds, lower-than-anticipated adoption and scale-up by smaller biotechnology companies impacted by the capital markets environment, and uncertainty about the timing of year-end purchase decisions among the company’s largest customers.

These negative effects were somewhat offset by favorable stock selection in life sciences tools & services, pharmaceuticals, and managed health care along with higher exposure to outperforming health care distributors and lower exposure to lagging health care supplies. Strength in life sciences tools & services was driven by weighing instruments provider Mettler-Toledo International, Inc. and science and technology innovator Danaher Corporation, whose shares were up after reporting solid quarterly results and annual guidance despite headwinds from foreign exchange impacts. Positive stock selection in pharmaceuticals, owing largely to the outperformance of AstraZeneca PLC, was partly offset by the Fund’s underexposure to large-cap companies Pfizer Inc. and Merck & Co., Inc., whose shares were up 18.1% and 29.7%, respectively, in the period. AstraZeneca was the third largest contributor after benefiting from incremental positive news flow surrounding the company’s oncology franchise at medical meetings. Performance in managed health care was bolstered by Elevance Health, Inc., which operates as a health benefits company. Elevance’s shares rose in response to strong quarterly guidance and raised guidance driven by solid medical cost management, pharmacy benefit manager strength, and healthy enrollment growth.

as of 12/31/22

Yearly Attribution Analysis (for year ended 12/31/2022)

Baron Health Care Fund (Institutional Shares) was down 16.90% for the year, underperforming the Russell 3000 Health Care Index by 10.80% due to stock selection and, to a lesser extent, differences in sub-industry weights.

Investments in pharmaceuticals, life sciences tools & services, biotechnology, and other health care-related companies accounted for much of the underperformance in the period. Weakness in pharmaceuticals was partly due to the underperformance of U.K.-based veterinary drugs manufacturer Dechra Pharmaceuticals PLC, whose shares suffered as animal health stocks were impacted by challenging comparisons following a surge in business activity during the pandemic. Additionally, high-multiple growth stocks like Dechra were particularly punished given higher interest rates and a more challenging global macroeconomic environment. The Fund’s meaningfully lower exposure to strong performing large-cap pharmaceutical companies such as Merck & Co., Inc. and Johnson & Johnson detracted an additional 160-plus basis points from relative performance. Within life sciences tools & services, higher exposure to this lagging sub-industry together with sharp declines from life sciences tools developer Bio-Techne Corporation, global contract research organization ICON Plc, and non-invasive prenatal testing leader Natera, Inc. hampered performance. Bio-Techne and ICON were among the top detractors after their shares pullback following strong performance the year prior, while Natera’s stock plummeted in early March thanks to disappointing quarterly results and a short report alleging aggressive sales practices. We sold our shares as the inflection point to profitability will take longer to materialize, resulting in heavier cash burn rates than we originally expected. Within biotechnology, underperformance of RNA interference medications developer Arrowhead Pharmaceuticals, Inc. and lower exposure to this better performing sub-industry weighed the most on performance. Arrowhead’s shares came under pressure early in the year due to a lack of near-term catalysts to drive news flow and the absence of new disclosures regarding targeting tissues beyond the liver. Health care-related companies Alexandria Real Estate Equities, Inc. and Warby Parker Inc. were responsible for about a tenth of the relative shortfall in the period. Life sciences REIT Alexandria declined for the period held as investors grew concerned that financial duress among certain biotechnology companies could ultimately lead to rent delinquencies and less demand for the company’s real estate. Shares of eyewear brand Warby Parker were down for the period held due to difficult market conditions for newly public companies as well as weaker-than-expected quarterly results owing to heightened COVID-related disruptions early in the year.

Partially offsetting the above was favorable stock selection and positive allocation effect in the health care distributors sub-industry coupled with cash exposure in a down market. Strength in health care distributors came from McKesson Corporation, whose shares outperformed due to solid financial performance and the ongoing rotation into stocks that trade at lower multiples of earnings.

Investors should consider the investment objectives, risks, and charges and expenses of the investment carefully before investing. The prospectus and summary prospectuses contain this and other information about the Funds. You may obtain them from the Funds’ distributor, Baron Capital, Inc., by calling 1-800-99BARON or visiting www.BaronFunds.com. Please read them carefully before investing.

The performance data quoted represents past performance. Past performance is no guarantee of future results. The investment return and principal value of an investment will fluctuate; an investor's shares, when redeemed, may be worth more or less than their original cost. The Fund’s transfer agency expenses may be reduced by expense offsets from an unaffiliated transfer agent, without which performance would have been lower. Current performance may be lower or higher than the performance data quoted.

Risks:All investments are subject to risk and may lose value.

The discussion of market trends is not intended as advice to any person regarding the advisability of investing in any particular security. The views expressed on this page reflect those of the respective writer. Some of our comments are based on management expectations and are considered “forward-looking statements.” Actual future results, however, may prove to be different from our expectations. Our views are a reflection of our best judgment at the time and are subject to change at any time based on market and other conditions and Baron has no obligation to update them

Portfolio holdings are subject to change. Current and future portfolio holdings are subject to risk.

The index performance is not fund performance; one cannot invest directly into an index.