Review and Outlook

as of 09/30/23

The quarter began with a steady dose of good news, and July continued the market rally from the first six months of the year. Inflation slowed to around 3%, while growth and economic activity remained surprisingly strong. The probability of a soft landing was steadily increasing. That sentiment soured, however, as the prospects of continued high rates seemed more likely. Investors shifted assets into fixed income to take advantage of yields at levels not seen in more than 15 years. Adding to this possible “higher for longer” interest rate scenario, $90/barrel oil prices, the auto workers strike, the prospect of a government shutdown, and increasing geopolitical uncertainty set the context for a market pullback. The S&P 500 Index declined 3.27% in the period.

Baron Durable Advantage Fund declined modestly in the quarter. Communication Services and Financials investments contributed to performance. Information Technology, Industrials, and Consumer Discretionary positions declined the most. Meta Platforms, Inc. and Alphabet, Inc., respectively the top and third largest contributors, drove positive performance within Communication Services. Appreciation within the Financials sector was led by alternative asset manager Blackstone Inc. and specialty insurer Arch Capital Group Ltd. Weakness within IT was led by Microsoft Corporation and Monolithic Power Systems, Inc., respectively the top and second largest detractors. E-commerce behemoth Amazon.com, Inc. drove declines within the Consumer Discretionary sector.

We believe stock prices have two components to them: business fundamentals, which can be measured by revenues, earnings, and ultimately cash flows, and then a multiple that investors are willing to pay for those fundamentals. During the September quarter, our analysis suggests that at the portfolio level, the fundamentals of our businesses continue to improve with revenue and profit expectations rising, while the multiples of how much investors are willing to pay for these profits have taken another leg down, making our companies even more attractive in our view.

The businesses we own tend to have no financial leverage and are capital light – meaning that higher rates would not have a direct negative impact on their businesses. They are leaders in their industries and should benefit from customer consolidation of key vendors. They have what we believe are great management teams and offer critical solutions, which makes them sticky and gives them pricing power. We are optimistic about the long-term prospects of our investments and continue to search for new ideas while remaining patient and investing only when we believe target companies are trading at attractive prices relative to their intrinsic values.

Top Contributors/Detractors to Performance

as of 09/30/23

Contributors

  • Shares of Meta Platforms, Inc., the world’s largest social network, were up this quarter, driven by impressive reacceleration of advertising revenue as a result of strong adoption of newer advertising products like Instagram Reels and broader improvement in the digital advertising market. Our industry checks have also validated advertiser adoption and satisfaction. Meta continues to innovate in generative AI (GenAI), with a leading AI research lab and the best open-source models to date; we are beginning to see Meta's core apps incorporate GenAI in the user experience. Meta is also the mega-cap tech company most focused on profitability, including >20% layoffs and reductions in its datacenter and office footprint. 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 GenAI research and potential distribution, and technological scale to continue to grow, with further monetization opportunities ahead.
  • Intuit Inc. is the leading provider of accounting software for small businesses and tax preparation software for individuals and tax professionals. Shares increased after the company reported financial results that exceeded Street expectations, with 13% revenue growth and 22% EPS growth in the recently completed fiscal year. Management provided favorable guidance for the next fiscal year that demonstrated confidence in the business momentum despite macroeconomic uncertainty. Intuit is benefiting from the sale of higher-value services and is well positioned to capitalize on increasing adoption of artificial intelligence given the company’s vast datasets. We continue to own the stock due to Intuit’s strong competitive position and numerous growth opportunities.
  • Alphabet Inc. is the parent company of Google, the world’s largest search and online advertising company. Shares of Alphabet were up this quarter, reflecting solid performance as well as continued product innovation in generative AI (GenAI) that boosted investor sentiment after high initial doubt around ChatGPT competition. We believe Alphabet has a fundamentally strong business model and massive scale, particularly in the core assets of Search, YouTube, and the Google ad network, as well as top talent in its engineering division. We continue to closely monitor the quickly changing innovations relating to GenAI and the potential implications on consumer behavior around Search, including the shift to chatbot form. We believe GenAI innovation could lead to stronger products in adjacent fields (e.g., travel) and a continued healthy cloud infrastructure business in Google Cloud Platform.

Detractors

  • Microsoft Corporation is a software company traditionally known for its Windows and Office products. Over the last five years, it has built a $60+ billion cloud business, including its infrastructure-as-a-service Azure business, Office 365, and Dynamics 365 (Microsoft's CRM offering). The stock detracted from performance after providing guidance for FQ1 2024 that was shy of investor expectations. While Microsoft is continuing to see better performance in Azure for the third straight quarter and slightly better quarter-over-quarter trends captured in its guidance, the rate of improvement specifically in AI-related workloads marked a near-term disappointment. Looking at the big picture, we remain confident that Microsoft is well positioned to leverage AI over the medium to long term. Over time, we expect Microsoft to continue to infuse Open AI across the entire product portfolio, driving strong value for customers and enabling monetization via the company's masterful pricing and packing capability.
  • Monolithic Power Systems, Inc. is a fabless high-performance analog and power semiconductor company serving diverse end markets across the semiconductor industry. The company, a relatively small player in the industry, leverages its deep system-level and applications knowledge, strong design experience, and innovative process technologies to provide highly integrated, energy-efficient, cost-effective, and easy-to-use monolithic products to its customers. Shares declined during the quarter on investor concerns around demand. While near-term growth drivers such as GPU power and automotive design wins were not large enough to offset weakness in other end markets like notebooks, industrial, and CPU power, the company should return to delivering growth 10% to 15% above the broader industry as the demand environment improves. The company continues to expand its addressable market and drive strong revenue gains by taking advantage of areas where its competition has failed to innovate. It has also started to sell more integrated, higher-ASP modules as opposed to discrete products, generating additional above-market appreciation.
  • Shares of rating agency and data provider S&P Global Inc. gave back some gains from earlier this year due to investor concerns that rising interest rates will weigh on future debt issuance and asset-based fees. Management also removed their 2026 target for revenue from the ESG segment due to a more uncertain regulatory landscape and political climate. On a positive note, S&P Global reported strong second quarter financial results, with 7% adjusted revenue growth and 11% EPS growth as ratings issuance returned to growth for the first time in six quarters. Management maintained full-year guidance as a more favorable outlook for the Ratings and Indices segments offset slower growth in the Market Intelligence segment. We continue to own the stock due to the company's long runway for growth and significant competitive advantages.

Quarterly Attribution Analysis (Institutional Shares)

as of 09/30/23

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 09/30/23

Baron Durable Advantage Fund (Institutional Shares) was down slightly in the third quarter, outperforming the S&P 500 Index by 272 basis points due to stock selection and, to a lesser extent, differences in sector weights.

Stock selection was positive across most sectors where the Fund had investments, led by those in Financials, Information Technology (IT), Communication Services, and Consumer Discretionary. Within Financials, meaningfully higher exposure to this better performing sector coupled with gains from specialty insurer Arch Capital Group Ltd. and alternative asset manager Blackstone Inc. accounted for about half of the outperformance in the period. Arch’s shares rose after reporting results that beat consensus expectations amid favorable industry conditions. For fiscal second quarter, net premiums written grew 28%, underwriting margins remained strong, and net investment income more than doubled. The operating ROE exceeded 20%, and book value per share grew 18%. Pricing trends in the property & casualty insurance market remain favorable, and higher interest rates are driving higher investment yields. Blackstone’s stock was up on the back of strong fundraising in a tough macroeconomic environment, moderating redemptions in its Blackstone Real Estate Income Trust retail fund vehicle, and momentum from its milestone AUM of $1 trillion. Investment decision support tools provider MSCI Inc., derivatives marketplace CME Group, Inc., and independent broker-dealer LPL Financial Holdings Inc. also contributed to relative gains in the sector.

Strength in IT was partly driven by the outperformance of Intuit Inc., the leading provider of accounting software for small businesses and tax preparation software for individuals and tax professionals. Intuit was the second largest contributor after reporting financial results that exceeded Street expectations, with 13% revenue growth and 22% EPS growth in the recently completed fiscal year. Management provided upbeat guidance for the next fiscal year that demonstrated confidence in the business momentum despite macroeconomic uncertainty. The Fund also benefited from its lack of exposure to benchmark heavyweight Apple Inc., whose shares were down double digits in the period, contributing approximately 65 basis points of relative gains.

Within Communication Services, the Fund’s overexposure to social network Meta Platforms, Inc. and search and online advertising leader Alphabet Inc. accounted for most of the outperformance in the sector. Meta was the largest contributor as advertising revenue rebounded thanks to strong adoption of newer advertising products like Instagram Reels and broader improvement in the digital advertising market. Alphabet was another top contributor, reflecting solid performance as well as continued product innovation in generative artificial intelligence that boosted investor sentiment after high initial doubt around ChatGPT competition. Retailer and cloud services provider Amazon.com, Inc. led the way in the Consumer Discretionary sector after reporting solid quarterly results, with Amazon Web Services growth and overall operating profit coming in ahead of Street expectations.

Lack of exposure to the top performing Energy sector was the only material detractor in the period, offsetting a portion of the above-mentioned gains.

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.