Review and Outlook

as of 12/31/20

In the fourth quarter of 2020, equity markets marched higher, continuing their rally of the prior two quarters. Markets looked past an alarming spike in the number of COVID-19 cases and instead focused on positive news around vaccines, the U.S. election results, and continued monetary and renewed fiscal stimulus. However, the Health Care sector modestly lagged the broader market for the full year and the fourth quarter. While for the most part health care firms adapted well to pandemic conditions, certain sub-industries were more insulated than others from pandemic pressures. The drug and managed-care industries fared relatively better as patients continued to prioritize drug therapy and avoid costly elective surgeries that can weigh on managed-care margins. Demand is also returning for the device, dental, life sciences, and hospital industries following the pullback in the spring as trends reverse from the initial lockdown.

Against this backdrop, Baron Health Care Fund increased in the quarter. Holdings within the life sciences tools & services, biotechnology, and health care equipment sub-industries contributed the most to performance. Top contributor Pacific Biosciences of California, Inc., led positive performance within life sciences tools & services after its stock soared nearly 166%. The sub-industry had an impressive quarter, with all 12 investments advancing, including three holdings that increased by triple digits. Arrowhead Pharmaceuticals, Inc. and BridgeBio Pharma, Inc., respectively the second and third largest contributors, led gains within biotechnology. Zai Lab Limited, a leading China-based biotechnology company, was another noteworthy performer within the sub-industry. Although the fourth quarter was relatively quiet for Zai, shares continued their strong run alongside the Chinese health care indices. The health care equipment sub-industry had a solid quarter, with increases in 11 out of 14 holdings. With declines in the share price of four out of five holdings, including second largest detractor AstraZeneca PLC, pharmaceuticals was the only detracting sector.

We continue to think the Health Care sector will offer attractive investment opportunities over the next decade and beyond.  Health Care is one of the largest and most complex sectors in the U.S. economy, accounting for approximately 18% of GDP and encompassing a diverse array of sub-industries. Health Care is also a dynamic industry undergoing changes driven by legislation, regulation, and advances in science and technology. We think navigating these changes requires investment experience and sector expertise, which makes the Health Care sector particularly well suited for active management.

Top Contributors/Detractors to Performance

as of 12/31/20

Contributors

  • Pacific Biosciences of California, Inc. (PacBio) provides long-read DNA sequencing systems to help scientists conduct genetic analysis. Shares performed well for the quarter. We believe there is increasing excitement about the potential for its platform as it lowers sequencing costs and seeks to move beyond its current commercial niche. Recently appointed CEO Christian Henry previously served as CFO and Chief Commercial Officer at Illumina, Inc., and we think he is well-qualified to commercially execute on PacBio’s differentiated long-read platform.  
  • Arrowhead Pharmaceuticals, Inc. is a biotechnology company developing RNAi therapeutics for a long list of diseases.  Shares rose given a multitude of upcoming data readouts, a large financial deal with Takeda, and the prospect of increasing RNAi applications from just the liver to other tissue types (i.e., other diseases). We retain high conviction in Arrowhead and expect it to become a large multinational pharmaceutical company over time.
  • BridgeBio Pharma, Inc. is a diversified biotechnology company running a novel decentralized model of drug development focused on genetic medicine. During the period held, shares increased on news that GlaxoSmithKline had floated a $4.6 billion takeover offer for Eidos Therapeutics, of which BridgeBio owns 60%. We retain conviction in BridgeBio based on four upcoming critical data readouts that we think will help drive share performance.

Detractors

  • Vertex Pharmaceutical Incorporated is a pharmaceutical company best known for its commercial products targeting cystic fibrosis. Share weakness in the quarter was due to the negative initial readout of a pipeline asset targeting alpha one antitrypsin disease, an inherited disorder that increases the chance of lung and liver disease. Given Vertex's best-in-class growth profile and cash flow and upcoming catalyst flow, we retain long-term conviction in the name.
  • AstraZeneca PLC is a multinational pharmaceutical company developing drugs across multiple therapeutic areas such as oncology and respiratory diseases. Shares were impacted by news of AstraZeneca's joint development with Oxford University of a viral-based COVID-19 vaccine. Given a mixed data set due to an unforeseen error in dosing that occurred in the Brazilian market, the vaccine timelines slipped, hurting share performance. Our investment thesis on AstraZeneca is not dependent on COVID-19 but rather its best-in-class large-cap growth profile, and we retain conviction.
  • DexCom, Inc. sells a continuous glucose monitoring device for people with diabetes. The stock fell due to concerns about competition from Abbott Laboratories, which received regulatory approval to market its third generation Libre device in Europe. We continue to have conviction in DexCom based on the company's large addressable under-penetrated market and new product pipeline.

Quarterly Attribution Analysis (Institutional Shares)

as of 12/31/20

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 12/31/20

Baron Health Care Fund (Institutional Shares) gained 17.09% in the fourth quarter and meaningfully outperformed the Russell 3000 Health Care Index by 701 basis points primarily due to favorable stock selection. The Fund also benefited from exposure to smaller-cap stocks, which significantly outperformed their larger-cap counterparts as the market rallied during the quarter.

Investments in life sciences tools & services, biotechnology, and health care technology contributed the most to relative performance. Stock selection in life sciences tools & services accounted for nearly two-thirds of the Fund’s outperformance, driven by long-read DNA sequencing systems provider Pacific Biosciences of California, Inc. The company was the top contributor due to increasing excitement about the potential for its platform as it lowers sequencing costs and seeks to move beyond its current commercial niche. Seer, Inc., which develops innovative solutions that act as a gateway to the proteome, also performed well after the company’s December IPO was well received by investors. Higher exposure to life sciences tools & services stocks, which were up nearly 15% in the index, also added value. Strength in biotechnology came from RNAi therapeutics developer Arrowhead Pharmaceuticals, Inc. and genetic disease-focused company BridgeBio Pharma, Inc. Performance in the sub-industry was also bolstered by biotechnology company Zai Lab Limited, which is focused on bringing transformative medicines for cancer, autoimmune, and infectious diseases to patients in China. Zai’s shares continued to move higher as investors believe the company is well positioned to become a leader in the delivery of drugs to the Chinese health care market. The Fund’s largest position in health care technology, Schrodinger, Inc., added the most value. Schrodinger’s shares rebounded following the announcement of a multi-year, multi-target agreement with Bristol-Myers Squibb Company. We believe the deal provides highly favorable economics and further validates the company’s physics-based computational platform for drug discovery.

Cash exposure in a sharp up market and underperformance of investments in managed health care and pharmaceuticals detracted the most from relative results. Weakness in managed health care was related to the underperformance of for-profit health insurance company Humana Inc. The company’s shares were flat for the quarter due to the overhang of health care policy uncertainty as investors waited for the outcome of the Georgia Senate runoff which determined the final balance of power in the Senate. Negative stock selection in pharmaceuticals, coming from AstraZeneca PLC and Sanofi, was mostly offset by the Fund’s meaningfully lower exposure to this lagging sub-industry. AstraZeneca was the second largest detractor given a setback in the company’s vaccine timeline, while Sanofi’s shares pulled back as the company’s turnaround story is still in process.

as of 12/31/20

Yearly Attribution Analysis (for year ended 12/31/2020)

Baron Health Care Fund (Institutional Shares) appreciated 47.72% for the year and significantly outperformed the Russell 3000 Health Care Index by 28.38% due to favorable stock selection and, to a lesser extent, relative sub-industry weights and a bias towards strong performing smaller-cap stocks.

Investments in biotechnology, health care equipment, life sciences tools & services, and health care technology and significantly lower exposure to poor performing large-cap pharmaceutical stocks added the most value. Stock selection in biotechnology accounted for over a third of the Fund’s outperformance in the period, led by triple-digit gains from Acceleron Pharma Inc., Immunomedics, Inc., and Zai Lab Limited. Acceleron was the third largest contributor on an absolute basis, while shares of Immunomedics were up sharply for the period held after the company agreed to be acquired by Gilead Sciences, Inc. for $21 billion. Zai’s shares benefited from the company’s in-licensing deal with Regeneron and commercial launch of ovarian cancer treatment Zejula in China. Immunology company argenx SE also performed well following the company’s successful Phase 3 trial in Myasthenia Gravis, where the data quality all but ensures regulatory approval and commercial launch over the next 12 months. Most of the Fund’s health care equipment holdings outperformed in the period, led by Inspire Medical Systems, Inc., which sells an implantable neurostimulation device to treat obstructive sleep apnea, and DexCom, Inc., which sells a continuous glucose monitoring device for people with diabetes. Inspire Medical’s stock price more than doubled due to continued progress securing insurance coverage for its sleep apnea therapy, while DexCom’s shares were up after quarterly sales exceeded Street expectations due to continued strong demand for the company’s device. Performance in the sub-industry was also bolstered by sharp gains from ShockWave Medical, Inc., CryoPort, Inc., and Inari Medical, Inc. Life sciences tools & services holdings outperformed after appreciating nearly 100% as a group, with long-read DNA sequencing systems provider Pacific Biosciences of California, Inc. leading the way. Pacific Biosciences was the top contributor given investor enthusiasm surrounding the appointment of new CEO Christian Henry, a well-regarded former executive at Illumina. Favorable stock selection in health care technology was driven by Schrodinger, Inc., which develops state-of-the-art chemical simulation software for use in pharmaceutical, biotechnology, and materials research. Schrodinger was the second largest contributor as investors increasingly recognized it as a unique and competitively advantaged business.

Cash exposure in the sharp market rally over the last nine months of the year weighed the most on relative results.

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.