Review and Outlook

as of 03/31/24

The bull market that started at the end of October of 2023 kept running throughout the first quarter of 2024. Even the renewed threat of "higher for longer" interest rates did not put a check on equity performance. Within the small cap growth universe, overall performance was somewhat distorted due to the historic increase in the share prices of Super Micro Computer and MicroStrategy, which together accounted for 52% of the Russell 2000 Growth Index’s gains. This event was an extreme statistical outlier which is highly unlikely to be repeated, in our view.

Against this backdrop, Baron Discovery Fund increased in the quarter. Consumer Discretionary, Industrials, and Financials investments contributed the most. Information Technology (IT) and Real Estate holdings detracted. Second largest contributor DraftKings, Inc. led gains within Consumer Discretionary. Appreciation within Industrials was led by Axon Enterprise, Inc. Shares of Axon, which makes the TASER and other public safety solutions, rose during the quarter following a strong earnings report and fiscal year 2024 guidance that beat consensus estimates. Top contributor Kinsale Capital Group, Inc. drove increases within the Financials sector. Weakness within IT was led by top detractor Endava plc. Rexford Industrial Realty, Inc., an industrial warehouse REIT and the sector’s only holding, drove declines within Real Estate.

We remain bullish on the prospects for 2024. The tailwinds for small cap outperformance remain firmly in place. First, fundamentals for our portfolio investments are intact and (in our opinion) continue to improve. Small cap stocks have attractive valuations both on an absolute basis (forward price/earnings ratios are at the lower end of a 25-year historic range) and relative to large cap stocks (the persistence and magnitude of lower small cap valuations versus large cap has rarely been seen in the past 25 years). Finally, small cap growth stocks typically show significant appreciation coming out of deep market downturns. We know that at some point the economic environment will become stronger and that there will be mean reversion in the relative valuations of large cap and small cap stocks. We continue to position the portfolio to be able to capitalize on this eventuality. We believe the portfolio is set up to shine in an environment where small cap stocks transition from a bear to a bull market.

Top Contributors/Detractors to Performance

as of 03/31/24

Contributors

  • Specialty insurer Kinsale Capital Group, Inc. contributed on financial results that exceeded Street forecasts. After a slowdown in the prior quarter, gross written premiums grew 34% and EPS grew 49% with a record-high underwriting margin. Market conditions remain favorable with rising premium rates and more business shifting from the standard market to the excess and surplus lines market where Kinsale operates. In addition, insurance stocks broadly rebounded from last quarter’s pullback as interest rates stabilized. We continue to own the stock because we believe Kinsale is well managed and has a long runway for growth in an attractive segment of the insurance market.
  • Shares of DraftKings, Inc., a leading online sportsbook in the U.S., rose during the quarter following an earnings release that showed strong market share gains and an improved outlook for future profitability. Market share capture has been driven by investment in innovative product offerings that are resulting in strong customer retention. The company also announced the acquisition of JackPocket, a digital lottery courier service. We believe the acquisition will help DraftKings achieve a first mover advantage in many states that offer the JackPocket service but have not yet legalized online sports betting and casino gaming. DraftKings is well positioned to generate margin expansion and positive free cash flow as it grows revenues alongside the rapidly expanding U.S. sports betting market, in our view.
  • Shares of CyberArk Software Ltd., an identity security platform focused primarily on privileged access management, rose after the company delivered strong quarterly results. CyberArk grew annual recurring revenue by 36% year-over-year and generated 20% free cash flow margins. New customer deal sizes and existing customer expansions at renewal were strong, boosted by high demand for CyberArk’s newer product categories like access management (credential management and multifactor authentication for all employees) and secrets management (credentials for machine identities). The increasing frequency and severity of cyberattacks, new SEC regulatory requirements for cyberattack disclosures, and greater emphasis from the federal government on privileged controls for its agencies and suppliers are driving healthy demand for CyberArk's products. Management issued consensus-beating full year guidance across all metrics. We remain optimistic about CyberArk’s long-term revenue and free cash flow growth prospects.

Detractors

  • Shares of IT services provider Endava plc fell after management cut guidance for the fiscal year ending June 30, 2024. Growth has slowed over the last year as business customers pulled back on discretionary IT spending due to macroeconomic uncertainty. Last fall, management was seeing early signs of a recovery, but new projects have been taking longer to materialize as customers delay spending decisions. Higher expenses due to increased staffing to meet anticipated demand weighed on margins as well. Management acknowledged that it misread the market and is taking steps to right-size the cost structure to improve margins. We remain invested because we expect these near-term headwinds to abate over time, leading to better growth as clients embrace digital transformation.
  • Inari Medical, Inc. offers catheter-based devices to remove clots from venous thromboembolism (VTE). VTE is the third most common vascular condition in the U.S. after heart attacks and strokes and if left untreated can be fatal. The stock detracted from performance on investor concerns about competition from Penumbra’s new product launch, coupled with Inari’s disclosure of a Department of Justice civil investigation concerning some of its payments to doctors. Such investigations are common in the medtech industry, and we anticipate any potential fine to be manageable based on precedent. Inari’s core VTE market remains largely untapped, with many patients still relying on ineffective drugs, leaving ample room for multiple devices to succeed.
  • Navitas Semiconductor Corporation is a leader in gallium nitride (GaN) power semiconductors and a smaller player in silicon carbide (SiC) power semiconductors. Shares fell during the quarter on lowered guidance as the stock was trading at a premium valuation. Despite the softer near-term outlook, the company highlighted several design wins across mobile, data center, renewable energy, and vehicle electrification that ramp later in 2024 into 2025 and should support above-industry growth. Navitas' monolithically integrated GaN power chips provide greater reliability and performance compared to discrete power devices. It recently purchased a co-packaged silicon controller to drive additional integration and performance. Its SiC products also offer better performance than peers and robustness across many applications. We expect Navitas to gain share in the rapidly growing GaN and SiC power semiconductor markets over time, driven by its superior technology, especially with its high-power GaN product in data center, solar, and electric vehicles just starting to ramp.

Quarterly Attribution Analysis (Institutional Shares)

as of 03/31/24

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 03/31/24

Baron Discovery Fund (Institutional Shares) appreciated 4.57% in the first quarter, trailing the Russell 2000 Growth Index by 301 basis points principally due to stock selection.

Stock selection in Information Technology (IT) was a 700-plus basis point drag on performance, accounting for the entirety of the underperformance in the period. A portion of the relative weakness in IT was attributable to declines from outsourced software development provider Endava plc and several of the Fund’s software and semiconductor holdings. Endava’s stock collapsed after management cut guidance for the fiscal year ending June 30, 2024. Growth has slowed over the last year as business customers pulled back on discretionary IT spending due to macroeconomic uncertainty. Last fall, management was seeing early signs of a recovery, but new projects have been taking longer to materialize as customers delay spending decisions. Endava increased staffing to meet anticipated demand, so higher expenses have weighed on margins. Management acknowledged that it misread the market and is taking steps to right-size the cost structure to improve margins. We remain invested because we expect these near-term headwinds to abate over time, leading to better growth as clients embrace digital transformation. Cybersecurity vendor SentinelOne, Inc. and gallium nitride power semiconductors leader Navitas Semiconductor Corporation were the largest detractors in the software and semiconductor sub-industries. Both companies relinquished a portion of last year’s significant relative gains after reporting softer near-term outlooks during the quarter. We remain shareholders.

Adverse stock selection in IT was exacerbated by the Fund’s lack of exposure to benchmark heavyweights Super Micro Computer, Inc. (Supermicro) and MicroStrategy Incorporated, whose shares increased 255.3% and 169.9%, respectively, in the period. Together, these companies were a 360-plus basis point drag on performance, accounting for the Fund’s total underperformance in the period. As a manufacturer of commodity motherboards for servers, Supermicro has been caught up in the hype surrounding AI, pushing its market cap from around $6 billion a year ago to nearly $60 billion as of quarter end. MicroStrategy sells business intelligence software and is the largest public holder of Bitcoin. The company’s software business is not growing, but its shares spiked alongside the price of Bitcoin in recent months. Neither business suits our investment criteria given our view that the core businesses lack sustainable competitive advantages, have low profit margins, are inconsistent generators of cash flows, and are dependent on demand trends that we view as cyclical rather than secular.

Partially offsetting the above was strong stock selection in Consumer Discretionary, Financials, and Communication Services, which together added approximately 370 basis points of relative gains. Strength in Consumer Discretionary was broad based, led by sharp gains from online sportsbook DraftKings Inc. and steakhouse restaurant chain Texas Roadhouse, Inc. DraftKings’ stock rose during the quarter following an earnings release that showed strong market share gains and an improved outlook for future profitability. The company also announced the acquisition of JackPocket, a digital lottery courier service. Texas Roadhouse shares outperformed as the company continues to see robust sales trends despite a volatile macroeconomic environment. The company reported same-store sales growth of almost 10% during the quarter, driven by strong traffic as customers are gravitating to the company’s high-quality, freshly prepared food at compelling prices. Longer term, we continue to see strong growth potential at Texas Roadhouse due to new restaurant openings, positive traffic trends, and margin expansion.

Performance in Financials and Communication Services was bolstered by specialty insurer Kinsale Capital Group, Inc. and live entertainment company Liberty Media Corporation - Liberty Live, respectively. Kinsale’s shares rebounded after the company’s financial results exceeded Street forecasts. Following a slowdown in the prior quarter, gross written premiums grew 34% and EPS grew 49% with a record-high underwriting margin. Market conditions remain favorable with rising premium rates and more business shifting from the standard market to the excess and surplus lines market where Kinsale operates. In addition, insurance stocks broadly rebounded from last quarter’s pullback as interest rates stabilized. Shares of Liberty Live, a tracking stock representing Liberty Media Corporation’s holdings in Live Nation Entertainment, Inc., were driven higher by appreciation of the underlying Live Nation asset. Live Nation reported a healthy quarterly sales beat and issued upbeat guidance calling for strength in end-demand and earnings growth in 2024.

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.