Review and Outlook

as of 12/31/23

The fourth quarter contributed to a strong bounce-back year in 2023. The S&P 500 Index gained 11.69% during the quarter and 26.29% during the year, recapturing all its losses from the prior year. Brushing aside ongoing macro concerns including the Federal Reserve’s continuation of its historical tightening cycle, the recession debate, geopolitical uncertainties, and poor investor sentiment following a tough 2022, the index climbed steadily through the first half of the year. After a third-quarter dip driven largely by investor concerns that rates were going to stay “higher for longer,” lower inflation data and the shifting focus to rate cuts prompted a bull run in the last two months of 2023.

Baron Durable Advantage Fund increased in the fourth quarter. Holdings within Information Technology (IT), Financials, Communication Services, and Consumer Discretionary contributed the most to performance. No sector detracted. IT had a strong quarter, with gains in all portfolio positions, led by top contributor Microsoft Corporation. Positive returns within Financials were driven largely by rating agency and data provider S&P Global Inc., whose shares increased due to higher debt issuance amid more favorable market conditions. Third largest contributor Meta Platforms, Inc. drove appreciation within Communication Services. Increases within Consumer Discretionary were attributable to second largest contributor Amazon.com, Inc., the portfolio’s only holding within the sector.

One of the biggest surprises of 2023 was the highly anticipated recession in the U.S. that has not materialized. While some were in the camp of hard landing and others were in the camp of soft landing, not many were in the camp of no landing… could that remain the case in 2024? When will the Fed start cutting rates? How aggressive will it be? What are the implications of the upcoming elections (the S&P 500 has not declined in an election year since 1940)?

Though we have a view on many of these questions we do not have the answers. The range of outcomes continues to be extremely wide, creating a challenging environment for investors. But since we are not macro investors, we stick to focusing on well-managed, high-quality businesses with durable competitive advantages for the long term. We continue to speak with company management teams as often as we can, test our investment theses, look for disconfirming evidence and measure how well our businesses are performing fundamentally.

It is our belief that investing in great businesses at attractive valuations will enable us to earn excess risk-adjusted returns for our shareholders over the long term. We are optimistic about the prospects of the companies in which we are invested and continue to search for new ideas and investment opportunities.

Top Contributors/Detractors to Performance

as of 12/31/23

Contributors

  • Microsoft Corporation is a software company traditionally known for its Windows and Office products. Over the last eight years, it has built a $100 billion-plus cloud business, including Office 365, CRM product Dynamics 365, and infrastructure-as-a-service product Azure (including Azure AI services). Shares increased after posting strong quarterly results, with a material top line beat, upside across all three operating segments, and strong margin growth, despite ramping long tail investments behind AI. We remain confident that Microsoft is one of the best positioned companies in software with its vertically integrated software stack and broad sales distribution. We believe Microsoft will continue taking share across its business, driving durable, long-term, double-digit growth and best-in-class profitability.
  • Amazon.com, Inc. is the world’s largest retailer and cloud services provider. Shares of Amazon were up in the quarter. Reported results were better than consensus, with a significant beat in North American operating profit. We believe the AWS cloud division has many years ahead of growth, with recent customer optimizations attenuating. We also believe Amazon is well positioned in the short to medium term to meaningfully improve core North American retail profitability to above pre-pandemic levels, benefiting from its new regionalized fulfillment network and its growing margin-accretive advertising business. Longer term, Amazon has substantially more room to grow in e-commerce, where it has less than 15% penetration of the total addressable market. Amazon also remains the clear leader in the vast and growing cloud infrastructure market, with large opportunities in application software, including enabling generative AI workloads.
  • Shares of Meta Platforms, Inc., the world’s largest social network, were up in the quarter due to healthy topline growth and expense guidance that beat consensus, aided by a broader tech rally. Our industry checks have also validated advertiser adoption and satisfaction, with particular improvements in monetizing Instagram Reels and click-to-message ads. Meta continues to innovate in generative AI, with a leading AI research lab and the best open-source models to date; we are beginning to see Meta's core apps incorporate generative AI in the user experience. Meta is also the megacap tech company most focused on profitability. Core app engagement remains healthy, with video and Instagram Reels incremental to user time spent. Longer term, we believe Meta will utilize its leadership in mobile advertising, massive user base, innovative culture, leading generative AI research and potential distribution, and technological scale to perform, with further monetization opportunities ahead.

Detractors

  • Shares of specialty insurer Arch Capital Group Ltd. gave up some gains in the fourth quarter after solid performance for most of the year. We believe the share price weakness was primarily due to a sector rotation away from defensive stocks to more speculative stocks following a decline in interest rates. Company fundamentals remained strong, with net premiums written growing 23%, operating ROE expanding to 25%, and book value per share rising 30% in the third quarter. Management expects favorable market conditions will persist. We continue to own the stock due to Arch’s experienced management team and our expectation of solid growth in earnings and book value.
  • LPL Financial Holdings Inc. is the largest independent broker-dealer in the U.S. Shares detracted in the quarter as the market's expectations for the number of interest rate cuts in 2024 increased. LPL invests idle client cash in both floating and fixed rate contracts. Rate cuts could reduce LPL's revenue and earnings from its floating rate contracts. LPL's interest rate exposure has also made it a favored stock for short-term traders to gain exposure to higher interest rates. We believe some of the stock weakness was a result of these investors reducing their stake as rates look set to fall. On a long-term basis, LPL's execution continues to be strong as it gains share among advisors and wins large enterprise deals.
  • The Estee Lauder Companies Inc. is a leading manufacturer, marketer. and retailer of prestige beauty products globally. Shares were challenged in the fourth quarter after management cut the company’s outlook for the fiscal year ending 6/30/24. This downward revision was mainly driven by a worsening outlook in China, business disruptions in Israel and other parts of the Middle East, and worsening FX headwinds. Lauder’s disproportionate exposure to the Chinese consumer and the travel retail channel in Asia relative to peers continues to place pressure on both growth and margins. We exited our position.

Quarterly Attribution Analysis (Institutional Shares)

as of 12/31/23

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 12/31/23

Baron Durable Advantage Fund (Institutional Shares) gained 13.94% in the fourth quarter, outperforming the S&P 500 Index by 225 basis points due to active sector weights and, to a lesser degree, stock selection.

Lack of exposure to the lagging Energy sector together with favorable stock selection in Information Technology (IT), Consumer Discretionary, and Communication Services were the main drivers of outperformance in the period. Within IT, higher exposure to strong performing semiconductor stocks via positions in Monolithic Power Systems, Inc., Taiwan Semiconductor Manufacturing Company Limited, and NVIDIA Corporation aided performance. Strength in the sector also came from software companies Intuit Inc. and Microsoft Corporation, whose shares were up 22.4% and 19.3%, respectively, in the period. Intuit is the leading provider of accounting software for small businesses and tax preparation software for individuals and tax professionals. The company reported quarterly financial results that exceeded Street expectations, with 15% revenue growth and 49% EPS growth. Intuit is benefiting from the sale of higher-value services and is well positioned to capitalize on increasing adoption of artificial intelligence (AI) given its vast data sets. The company recently launched Intuit Assist, a generative AI-powered digital assistant that improves productivity and unlocks valuable insights for customers. Microsoft is a software company traditionally known for its Windows and Office products. Over the last eight years, the company has built a $100 billion-plus cloud business, including Office 365, CRM product Dynamics 365, and infrastructure-as-a-service product Azure (including Azure AI services). Microsoft was the top contributor after posting strong quarterly results, with a material top-line beat, upside across all three operating segments, and strong margin growth, despite ramping long tail investments behind AI.

Performance in Consumer Discretionary and Communication Services was bolstered by the Fund’s sizeable positions in retailer and cloud services provider Amazon.com, Inc. and leading social network Meta Platforms, Inc., respectively. Amazon’s shares were up after the company reported results were better than consensus, with a significant beat in North American operating profit. We believe the AWS cloud division has many years ahead of growth, with recent customer optimizations attenuating. We also believe Amazon is well positioned in the near term to meaningfully improve core North American retail profitability to above pre-pandemic levels, benefiting from its new regionalized fulfillment network and its growing margin-accretive advertising business. Similarly, Meta reported healthy top-line growth and expense guidance that beat consensus. Our industry checks have also validated advertiser adoption and satisfaction, with particular improvements in monetizing Instagram Reels and click-to-message ads. Core app engagement remains healthy, with video and Instagram Reels incremental to user time spent. Meta continues to innovate in generative AI, with a leading AI research lab and the best open-source models to date, and we are beginning to see Meta's core apps incorporate generative AI in the user experience.

Other tailwinds to performance came from solid stock selection in Consumer Staples and Health Care coupled with lower exposure to these underperforming sectors. Discount warehouse Costco Wholesale Corporation and life sciences tools & services leader Agilent Technologies, Inc. led the way in these sectors. Costco’s shares rose after the company’s quarterly results featured top- and bottom-line beats to consensus estimates, expanding gross margins, healthy e-commerce sales, and strong membership renewal rates. The company also announced its fifth one-time special dividend in 11 years. Agilent’s stock bounced back after management provided commentary about stabilizing trends in the life sciences tools space on its latest quarterly call. The company faced challenges from customer inventory destocking, biopharmaceutical funding constraints, and slowing growth in China during the year and those headwinds appear to be abating, bolstering shares of Agilent and other life sciences tools names during the quarter.

Cash exposure in a rapidly advancing market and stock selection in Financials were the only material detractors in the period. Disappointing stock selection in Financials, owing largely to declines from specialty insurer Arch Capital Group Ltd. and premier independent broker-dealer LPL Financial Holdings Inc., was somewhat offset by the Fund’s significantly higher exposure to this better performing sector. Arch gave back a portion of its strong performance from earlier in the year, given a market rotation away from defensive securities to more speculative stocks following a decline in interest rates. Company fundamentals remained strong, with net premiums written growing 23%, operating ROE expanding to 25%, and book value per share rising 30% in the third quarter. Management expects favorable market conditions will persist. We continue to own the stock due to Arch’s experienced management team and our expectation of solid growth in earnings and book value. LPL’s shares detracted as the market's expectations for the number of interest rate cuts in 2024 increased. LPL invests idle client cash in both floating and fixed rate contracts. Rate cuts could reduce LPL's revenue and earnings from its floating rate contracts. LPL's interest rate exposure has also made it a favored stock for short-term traders to gain exposure to higher interest rates. We believe some of the stock weakness was a result of these investors reducing their stake as rates look set to fall. On a long-term basis, LPL's execution continues to be strong as it gains share among advisors and wins large enterprise deals.

as of 12/31/23

Yearly Attribution Analysis (for year ended 12/31/2023)

Baron Durable Advantage Fund (Institutional Shares) posted a significant gain of 45.51% for the year, outperforming the S&P 500 Index by a wide margin due to stock selection and, to a lesser extent, differences in sector weights. Style biases also aided performance, specifically the Fund’s overexposure to stocks with higher betas and growth rates given these factors rebounded after being out of favor in 2022.

Stock selection was positive across most sectors where the Fund had investments, led by those in Communication Services, Financials, Consumer Discretionary, and Information Technology (IT). Favorable stock selection in Communication Services was responsible for about a third of the outperformance in the period, driven by strong performance from social network Meta Platforms, Inc., whose shares nearly tripled over the course of the year. Meta was the largest contributor due to accelerated revenue growth, driven by continued engagement growth and better monetization, and significant cost discipline moves. This combination led to materially increased earnings power, which we expect to continue. We believe Meta has executed past the privacy issues it has been facing and is seeing meaningful traction in the monetization of Instagram Reels and click-to-message ads. Meta should also benefit from the advent of generative artificial intelligence (AI), both in core and adjacent opportunities. Search and online advertising leader Alphabet Inc. was the other contributor in the sector, reflecting healthy top-line results, a better environment for technology stocks, and improving investor sentiment about Google's positioning in generative AI following competitor ChatGPT's rollout in November 2022.

Strength in Financials, related mostly to outstanding performance from alternative asset manager Blackstone Inc., was somewhat offset by the Fund’s meaningfully higher exposure to this lagging sector. Blackstone’s shares were up in response to strong fundraising, moderating redemptions in its BREIT retail funds vehicle, an improved capital deployment outlook with ample dry powder, and maintenance of its assets under management. We retain conviction in Blackstone given its strong brand, unmatched fundraising track record, and durable fee stream underpinned by long-term or perpetual capital. Rating agencies/data providers Moody's Corporation and S&P Global Inc. also contributed to gains in the sector due to rebounding debt issuance and stronger equity markets. Performance in Consumer Discretionary was bolstered by Amazon.com, Inc., the world’s largest retailer and cloud services provider. Amazon’s stock benefited from materially improving overall operating profit and a better backdrop for technology stocks throughout much of the year.

A significant portion of the gains in IT came from the Fund’s higher exposure to semiconductor stocks, which were up triple digits in the index. The Fund’s overweight position in semiconductors via large positions in NVIDIA Corporation and Monolithic Power Systems, Inc. contributed almost 400 basis points of relative gains. Software was another area of strength in IT, helped by notable gains from Intuit Inc. and Microsoft Corporation. Intuit’s shares increased after reporting strong financial results throughout the year that exceeded Street expectations despite ongoing economic uncertainty. Intuit is benefiting from the sale of higher value services and is well positioned to capitalize on increasing adoption of AI given its vast data sets. Microsoft’s stock rallied due to investor excitement over generative AI. The company is executing at a high level, navigating a challenging macro backdrop while investing in long-term growth. Microsoft’s proven ability to innovate is only getting stronger with continued enhancements across the portfolio including Power Apps, Security, and, more recently, Azure OpenAI. Over time, we expect Microsoft to continue to infuse Open AI across the entire product portfolio via embedded "Co-Pilots" in each market segment, driving strong value for customers and enabling monetization via the company's masterful pricing and packing capability.

Cash exposure in a rebounding market coupled with adverse stock selection in Health Care were the only material detractors in the period, offsetting a portion of the above-mentioned gains. Weakness in Health Care was broad based, led by declines from science and technology innovator Danaher Corporation, life sciences tools leader Thermo Fisher Scientific Inc., and diversified health and well-being company UnitedHealth Group Incorporated. Danaher and Thermo Fisher were among the top detractors after their shares declined alongside other life sciences tools stocks because of multiple headwinds, including a slowdown in capital spending among pharmaceutical customers, slowed growth in China, lack of funding and spending among pre-commercial biotechnology companies, and inventory destocking among bioprocessing customers. We view these headwinds as temporary and remain positive about their long-term growth prospects. UnitedHealth underperformed alongside other managed care companies early in the year after facing utilization concerns, which ultimately didn't bear out. An additional overhang in the second half of the year involved worries about reimbursement headwinds and slower Medicare Advantage growth in 2024. Nonetheless, UnitedHealth should deliver 13% EPS growth in 2023, and we believe it has guided to an initially conservative 11% growth in 2024, which bracketed consensus. We have high conviction in UnitedHealth, as a leader in the shift to value-based care reimbursement facilitated by its Optum Health division employing 130,000 doctors and advanced practice clinics across 2,700 sites, and focused on building out ancillary services, including community and home-based care, to better manage costs and support growth.

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.