Review and Outlook

as of 12/31/23

​Following a downturn from the end of July through October, the markets went on a bull run in the last two months of 2023. Improving inflation data coupled with dovish comments from the Federal Reserve spurred an “everything rally.” In a significant shift from its earlier stance, the Fed suggested it was planning three interest rates cuts over 2024. The end of “higher for longer” rate fears especially boosted growth and small-cap stocks, as the market views these categories as beneficiaries of lower rates. Despite low unemployment and robust consumer spending – typically viewed as inflation drivers -- inflation continued to trend lower, with the annual inflation rate dropping to 3.4% in December. Investor fears of a recession were replaced by optimism that the Fed had successfully orchestrated a “soft landing,” generating further cause for cheer on top of the prospect that the Fed would soon start cutting interest rates.

Baron Discovery Fund increased in the quarter. Holdings within Information Technology (IT), Consumer Discretionary, and Industrials contributed the most to performance. Financials and Consumer Staples investments detracted. IT had a strong quarter, with all top three contributors within the sector. DraftKings Inc. led gains within Consumer Discretionary, after shares of this leading sports betting app rose as a result of sizable market share capture and strong customer engagement during the early months of the NFL season. We believe DraftKings's product and scale advantages will enable the company to maintain its leadership position in the rapidly growing online sports betting market. Military drone manufacturer Kratos Defense & Security Solutions, Inc. and Axon Enterprise, Inc., which makes the TASER non-lethal self-defense weapon, led positive returns within Industrials. Financials lost ground due to sole sector holding Kinsale Capital Group, Inc., whose shares gave back some gains after the company reported slower premium growth for the third quarter. Sole Consumer Staples holding the Beauty Health Company drove losses within the sector after reporting execution issues in the roll out of its latest generation HydraFacial machine. We exited our position.

We believe 2024 will be the “year of small cap," as relative valuations return to more normalized levels, with small caps garnering bigger multiples than large, versus the opposite situation that now exists. We also believe our style of stock picking -- active management driven by experientially based fundamental analysis -- will be amply rewarded. That said, we continue to apply our risk management process in all respects, including a wide diversity of investments, conservative position sizing, significant due diligence, and a strict adherence to our long-term valuation estimates.

Top Contributors/Detractors to Performance

as of 12/31/23

Contributors

  • SentinelOne, Inc. specializes in endpoint protection, cloud security, and security data analytics. Shares rose on outstanding quarterly financial results and strong guidance. SentinelOne is one of the fastest-growing public cybersecurity companies, with revenue expected to grow more than 46% this fiscal year. Growth has been driven by a combination of 1) market share capture from legacy endpoint vendors who struggle to compete against SentinelOne’s AI-enabled platform, 2) an ongoing shift of IT infrastructure to the cloud driving demand for cloud application protection (growing triple digits), and 3) cybersecurity vendor consolidation favoring platforms with comprehensive security portfolios over point solutions. The company is also leveraging its single data store and AI capabilities to cross-sell more products into its existing customer base and increase average sale prices. Between the larger deal sizes and improving operating efficiencies, we believe the company can continue to expand margins at a significant rate and begin generating positive free cash flow in the next fiscal year.
  • GitLab Inc. is an end-to-end software development and IT operations platform that enterprises use to create, secure, and deploy code. The stock rose after GitLab delivered strong quarterly results driven by improving win rates in enterprise deals, solid seat growth, and higher average selling prices. In recent years, GitLab has delivered more than 400 feature enhancements to its platform, enabling its customers to consolidate more software development steps into GitLab, lowering total IT costs and achieving faster software delivery times. As a result, GitLab has realized higher average revenue per user (ARPU) through a combination of price increases and upgrades to its Ultimate Tier. These ARPU increases, coupled with consistent user growth, bode well for future sales and margin expansion. Gitlab also has several exciting new growth levers, including a monetizable generative AI product (that helps developers write code, detect vulnerabilities automatically, and remediate bottlenecks in the coding process), a new enterprise planning SKU that brings non-developers into the platform, and a Dedicated Tier for clients in regulated industries.
  • Varonis Systems, Inc. is a cybersecurity vendor that helps organizations classify, locate, and protect sensitive data across on-premise and cloud environments. Shares of Varonis increased on strong quarterly results with annual recurring revenue (ARR) growth and free cash flow beating consensus. Last year, Varonis began transitioning to a SaaS model, which will benefit clients via lower maintenance costs, better automation, and faster remediations of data vulnerabilities. Throughout 2023, demand for the SaaS model has been much higher than investors anticipated, and SaaS already accounts for over 15% of ARR. SaaS customers are landing with more licenses, paying 30% higher prices per license, and signing deals faster. As this mix shift progresses, we anticipate improved sales efficiency and higher margins. Varonis remains a competitively advantaged business in the data security industry, which we believe can accelerate in 2024 as recent SEC disclosure requirements for security breaches drive industry awareness, and regulated companies look to invest in data security as a prerequisite for adopting generative AI.

Detractors

  • Shares of specialty insurer Kinsale Capital Group, Inc. gave back some gains from earlier this year after the company reported slower premium growth in the third quarter. Earnings beat Street expectations, with EPS doubling and ROE exceeding 34%. However, investors focused on the slowdown in gross written premiums to 33% growth from 58% growth in the prior quarter, which management attributed to normal seasonality for property insurance. Additionally, we believe some of the share price weakness resulted from a sector rotation away from defensive stocks to more speculative stocks following a decline in interest rates. 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.
  • Chart Industries, Inc. is a global leader in design, engineering, and manufacturing of process and storage technologies and equipment for gas and liquid handling. Shares fell after the company missed analyst earnings forecasts on project revenue recognition timing. Chart also held an investor day in which it provided mid-term financial targets instead of further detail on its 2024 outlook, falling short of some analyst expectations. We remain investors. Business fundamentals are strong, in our view, with management seeing solid demand across the portfolio and cost synergies from the Howden acquisition ahead of company targets. Chart also has a much larger than normal backlog supporting growth in 2024, providing good visibility. We believe the integration of Howden is proceeding well, with the combined company on track to become a globally diversified, high-quality, high-growth industrial business with proprietary technology and solutions serving the growing hydrogen, carbon capture, LNG, and other end markets. Valuation remains attractive against Chart's growth and margin profile, in our view.
  • Establishment Labs Holdings Inc. sells next-generation breast implants that have meaningfully lower safety risks compared to competitor products. The company's implants have captured significant share in many international markets, and the upcoming U.S. and China launches will more than double the addressable market. Shares fell in the quarter. The near-term issue is that breast augmentations are expensive discretionary cash-pay procedures, and macroeconomic headwinds are leading to weaker global demand. Compounding this, distributors in Asia-Pacific are working down inventory as they run leaner in uncertain economic times. This weakness also creates uncertainty whether Establishment Labs can achieve certain milestones needed to access additional tranches of debt, absent which the company will likely need to raise capital. Longer term, we think Establishment Labs will capture significant share in the U.S. and China, which will drive an acceleration in revenue growth and profitability.

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 Discovery Fund (Institutional Shares) increased 12.44% in the fourth quarter, performing roughly in line with the Russell 2000 Growth Index, which rose 12.75%. Active sector weights and style biases contributed to performance but were offset by weak stock selection and cash exposure in a sharp up market.

Favorable stock selection in Information Technology (IT) coupled with lack of exposure to the lagging Energy sector were material contributors in the period. Stock selection in IT added approximately 370 basis points of relative gains, with the principal driver being the Fund’s software holdings, which were up almost 32% as a group. Cybersecurity company SentinelOne, Inc. and software development platform GitLab Inc. led the way after posting gains of 62.1% and 39.2%, respectively, in the period. SentinelOne was the largest contributor after reporting outstanding quarterly financial results and strong guidance. The company is expected to grow revenue by more than 46% this fiscal year, driven by a combination of market share capture from legacy endpoint vendors, the ongoing shift of IT infrastructure to the cloud, and cybersecurity vendor consolidation favoring platforms with comprehensive security portfolios. GitLab was another top contributor after the company’s quarterly results impressed due to improving win rates in enterprise deals, solid seat growth, and higher average selling prices. In recent years, GitLab has delivered more than 400 feature enhancements to its platform, enabling its customers to consolidate more software development steps into GitLab, lowering total IT costs and achieving faster software delivery times. As a result, GitLab has realized higher average revenue per user through a combination of price increases and upgrades to its Ultimate Tier. Other software names worth highlighting were Varonis Systems, Inc., CyberArk Software Ltd., and Couchbase, Inc., which were among the top 10 contributors after reporting outstanding financial results during the period.

Apart from software, outsourced software development provider Endava plc had another strong quarter as the company’s shares continued to rebound after lagging for most of 2022 and the first half of 2023. Macroeconomic uncertainty has weighed on client demand and revenue growth, but management expects a meaningful rebound early in 2024 supported by a growing pipeline of large projects from newer clients. Margins should expand alongside faster revenue growth as the company leverages upfront costs to build capacity in anticipation of an expected recovery. The company has been acquisitive and is benefiting from vendor consolidation. We remain investors because we believe Endava will continue gaining share in a large global market for IT services.

Somewhat offsetting the above was adverse stock section in Health Care, Financials, Consumer Staples, and Industrials. Weakness in Health Care was largely driven by Establishment Labs Holdings Inc., which sells next-generation breast implants that have meaningfully lower safety risks compared to competitor products. The company's implants have captured significant share in many international markets, and the upcoming U.S. and China launches will more than double the addressable market. The company’s shares were down sharply in the quarter, with the near-term issue being that breast augmentations are expensive discretionary cash-pay procedures, and macroeconomic headwinds are leading to weaker global demand. Compounding this, distributors in Asia-Pacific are working down inventory as they run leaner in uncertain economic times. This weakness also creates uncertainty as to whether Establishment Labs can achieve certain milestones needed to access additional tranches of debt, absent which the company will likely need to raise capital. Longer term, we think Establishment Labs will capture significant share in the U.S. and China and will launch a unique minimally invasive implant product that will accelerate revenue growth and profitability. A handful of other holdings also weighed on performance in the sector, led by integrated drug containment and delivery solutions provider Stevanato Group S.p.A and venous thromboembolism treatment leader Inari Medical, Inc.

Performance in Financials and Consumer Staples was hindered by declines from specialty insurer Kinsale Capital Group, Inc. and facial treatments specialist The Beauty Health Company, respectively. Kinsale was the top detractor as the company relinquished some gains from earlier in the year after reporting slower premium growth in the third quarter. Earnings beat Street expectations, with EPS doubling and ROE exceeding 34%. However, investors focused on the slowdown in gross written premiums to 33% growth from 58% growth in the prior quarter, which management attributed to normal seasonality for property insurance. Additionally, we believe some of the share price weakness resulted from a market rotation away from defensive stocks to more speculative securities following a decline in interest rates. 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. Beauty Health’s shares declined after reporting disappointing results that showed execution issues associated with the roll out of Syndeo, the latest generation of the HydraFacial machine. While the features and functionality of this new device far surpassed the prior version, the machine also had several defects that caused potential buyers to delay their purchase. Additionally, to remedy the defects, the company had to incur added costs to repair and replace existing Syndeo machines in the field. Lastly, the company announced that the CEO was leaving. Due to the continued uncertainty surrounding the defects with Syndeo and recent management turnover, we exited the position.

Negative stock selection in Industrials was partly due to poor performance from Chart Industries, Inc., a global leader in design, engineering, and manufacturing of process and storage technologies and equipment for gas and liquid handling. Chart’s stock fell after the company missed analyst earnings forecasts on project revenue recognition timing. The company also held an investor day in which management provided mid-term financial targets instead of further detail on its 2024 outlook, falling short of some analyst expectations. We remain bullish on the company’s prospects. Business fundamentals are strong, with management seeing solid demand across the portfolio and cost synergies from the Howden acquisition ahead of company targets. Chart also has a much larger than normal backlog supporting growth in 2024, providing good visibility. Modest declines from wholesale landscape supplies distributor SiteOne Landscape Supply, Inc., technology-focused aerospace and defense company Mercury Systems, Inc., and human capital management software vendor Ceridian HCM Holding Inc. also contributed to relative losses in the sector.

as of 12/31/23

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

Baron Discovery Fund (Institutional Shares) was up 22.58% for the year, outperforming the Russell 2000 Growth Index by 392 basis points due to stock selection, active sector weights, and tailwinds from style biases, notably higher exposure to the better performing Beta, Size, Mid Capitalization, and Growth factors.

Favorable stock selection in Information Technology (IT) accounted for the bulk of relative gains in the period, with the primary drivers being the Fund’s software and semiconductor holdings. Cybersecurity software vendor SentinelOne, Inc. and pure-play, next-generation power semiconductor company Navitas Semiconductor Corporation were the leaders in these areas. SentinelOne was a new addition during the year and the company’s shares surged late in the period because of outstanding financial results and strong guidance. Navitas performed exceptionally well in the first half of the year after management reiterated its outlook to double revenues in 2023, reported strong design win momentum, and introduced a new opportunity pipeline metric by end market indicating a healthy forward looking pipeline. Navitas sells monolithically integrated GaN power integrated circuit chips, which provide greater reliability and performance compared to competition that supplies discrete power devices. It recently purchased a silicon control company to drive even further integration and performance, and its SiC products offer high performance and robustness across many different applications. The company’s high-power GaN product launches remain on track for data center, solar, and electric vehicle (EV) applications, and its SiC product portfolio continues to grow in industrial, renewable energy, and EV charging infrastructure applications. We expect Navitas to gain share in the rapidly growing GaN and SiC power semiconductor markets over time, driven by its superior technology. Other strong performing software names were GitLab Inc., CyberArk Software Ltd., Couchbase, Inc., Varonis Systems, Inc., and Guidewire Software, Inc., while Allegro MicroSystems, Inc. and indie Semiconductor, Inc. contributed to relative strength in semiconductors.

Additional tailwinds to performance came from positive stock selection in Industrials, Consumer Discretionary, and Financials. Strength in Industrials was driven by defense contractor Kratos Defense & Security Solutions, Inc. and non-lethal self-defense weapons manufacturer Axon Enterprise, Inc., whose shares were up 96.4% and 54.8%, respectively, in the period. Kratos benefited from investor optimism around the growing need for effective, affordable unmanned drone solutions across the armed forces, which Kratos is arguably better positioned than any of its competitors to provide. Geopolitics is leading to accelerated momentum and interest in the company's solutions with 2024 poised to be a huge year. With both the Air Force, with its unmanned combat air vehicle program, and the Department of Defense, with the Replicator initiative, in the market for drones, Kratos is uniquely positioned, largely through its Valkyrie product, to provide best-in-class solutions at much lower costs than peers. Aside from the unmanned business, Kratos' government solutions segment continued to grow at a solid low double-digit level led by its OpenSpace satellite software with multiple areas of additional growth emerging from microwave electronics to turbine technologies. Axon experienced an acceleration across its business driven by successful new product introductions, penetration of new markets, and growth in higher-margin software products. With less than 15% of customer penetration of its software products, Axon is pushing software like Axon Records into Officer Safety Plan (OSP) bundles. Axon's most popular and expensive bundle is the OSP 10+ Premium for $299/month, which could see meaningful price increases over time. After years of investment, Axon has found true product market fit and has reoriented the sales force to sell into the federal market. The international business is seeing greater growth, with the path to mirror the U.S. business in Tier 1 markets (UK, Canada, Australia, New Zealand) and parts of Continental Europe getting clearer.

Performance in Consumer Discretionary was bolstered by mobile sportsbook and gaming operator DraftKings Inc. and hard-surface flooring retailer Floor & Decor Holdings, Inc. DraftKings’ strong performance was the result of increasing market share capture and strong customer engagement, especially during the early months of the NFL season. We believe DraftKings's product and scale advantages will enable the company to maintain its leadership position in the rapidly growing online sports betting market. Additionally, after years of losses from startup costs and investment in customer acquisition, the company should begin to generate positive free cash flow in 2024. Despite a weakening housing environment, Floor & Decor’s shares increased throughout the year as the company's everyday low prices and broad assortment enabled it to take share. The stock was particularly strong in the later part of the year as mortgage rates started to decline and investors became excited about an eventual recovery in the housing market. We believe Floor & Decor's large assortment at compelling prices offer a significant competitive advantage and remain positive about its growth prospects as the category killer in the hard surface flooring market. We see a path to more than double the current store count of just over 200 stores to 500 over the long term.

Specialty insurer Kinsale Capital Group, Inc. led the way in Financials after reporting consensus-beating quarterly results on multiple occasions during the year. Market conditions remained favorable, with rising premium rates and more business shifting from the standard lines market to the excess and surplus lines market where Kinsale operates. The company is also capitalizing on disruption in the property market, where rates are rising rapidly after years of industry losses and a reduction in reinsurance capacity.

These gains were partly offset by disappointing stock selection in Health Care, where a few of the Fund’s health care equipment holdings proved costly, namely Silk Road Medical, Inc. and ViewRay, Inc. Silk Road sells medical devices used in minimally invasive TCAR procedures that treat carotid artery disease to prevent strokes. Compared with alternatives, TCAR is less invasive and has an easier recovery than the gold standard carotid endarterectomy surgery (CEA), and it causes fewer periprocedural strokes than the other minimally invasive transfemoral carotid stenting procedure (TF-CAS). Use of Silk Road's devices accelerated after receiving Medicare approval in 2022 for use in "standard surgical risk" carotid stenosis patients, which increased the number of eligible patients and further legitimized the procedure in the eyes of conservative surgeons. However, the company’s shares declined in 2023 as Medicare updated reimbursement for the alternative TF-CAS procedure to be equivalent to TCAR, and investors are debating the potential competitive impact in 2024. Big picture, we believe that TCAR is safer, easier-to-perform, and a more scalable procedure than TF-CAS, and less invasive and easier to recover from than CEA. TCAR represents roughly 15% of carotid stenosis interventions, and we think adoption will grow over time. ViewRay sold equipment that enables MRI-guided radiation treatment of cancer, allowing for real-time imaging of the tumor location and accurate radiation delivery, even if the tumor moves during treatment. We were bullish on the long-term adoption of the technology and had seen positive signs that adoption had started to accelerate over the past few years, as ViewRay published impressive early clinical trial results in pancreatic and prostate cancer, and awareness about the technology grew. However, shares declined sharply starting in April 2023 due to a credit crunch driven by the culmination of 1) several macro-related system install timeline delays, 2) a working capital squeeze due to delayed payments from international distributor customers, and 3) the ongoing need for significant outlays to purchase raw material inventory in a challenging supply chain environment. Unfortunately, ViewRay had limited access to additional capital, and the credit crunch led ViewRay to file for bankruptcy in July 2023 and ultimately cease operations. We sold our shares in mid-April when the stock was down 76%.

Consumer Staples was another source of weakness thanks to a difficult year for The Beauty Health Company, a skin care and beauty company that sells the flagship HydraFacial machine and related consumables. The company’s shares were pressured by execution issues associated with the roll out of Syndeo and management turnover. We exited our position in mid-November when the stock was down more than 80%.

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.