Baron Focused Growth Fund: Latest Insights and Commentary

Inflation continued to drop, although it is still higher than the Federal Reserve’s 2% target. Despite ticking up, the unemployment rate remained near historic lows. Accordingly, the Fed held short-term interest rates steady while once again pushing back the date of its first rate cut since the pandemic. The Fed currently expects to make one rate cut by year end. The economy has exhibited some signs of slowing. As consumers continued to dip into excess savings accumulated during the pandemic and have limited expectations for more stimulus, they have been cutting back a bit on spend. Consumer confidence is also relatively subdued, possibly due to the lingering effects of high inflation and the pandemic, as this metric tends to be a lagging indicator of the economy.

Baron Focused Growth Fund declined modestly during the second quarter. Industrials, Communication Services, and Information Technology (IT) holdings contributed the most. Consumer Discretionary, Real Estate, and Health Care investments detracted. Top contributor Space Exploration Technologies Corporation (SpaceX) drove gains within Industrials, while third largest contributor Spotify Technology SA drove appreciation within Communication Services. Positive performance within IT was driven by Guidewire Software, Inc., which provides systems software services to the P&C insurance industry. Despite mixed performance, Consumer Discretionary lost ground, led by Krispy Kreme, Inc. and Vail Resorts, Inc., respectively the second and third largest detractors. Losses within Real Estate were attributable to top detractor CoStar Group, Inc. Illumina, Inc., the recognized leader in next-generation DNA sequencing platforms, led declines within Health Care.

As we enter the third quarter of 2024, we believe that, overall, conditions are positive for U.S. smid-cap growth stocks. Lower inflation and continued low unemployment rates should help offset declining excess savings and tighter credit conditions to result in moderating consumption, which, in turn, should carry the U.S. economy to a soft landing. That said, there are always risks. The upcoming U.S. election and ever-present geopolitical tensions could put pressure on the market, along with any number of other as-yet-unanticipated developments.

As long-term investors who have lived through numerous market cycles, we have learned not to try to predict short-term market movements. Instead, we focus on identifying and researching well-managed unique businesses with durable competitive advantages and compelling growth prospects and investing in them at attractive prices.

CONTRIBUTORS

• Space Exploration Technologies Corp. (SpaceX) is a high-profile private company founded by Elon Musk. Its primary focus is on developing and launching advanced rockets, satellites, and spacecrafts, with the ambitious long-term goal of enabling human colonization of Mars. SpaceX is generating significant value with the rapid expansion of its Starlink broadband service. The company is successfully deploying a vast constellation of Starlink satellites in Earth's orbit, reporting substantial growth in active users, and regularly deploying new and more efficient hardware technology. Furthermore, SpaceX has established itself as a leading launch provider by offering highly reliable and cost-effective launches, leveraging the company's reusable launch technology. SpaceX capabilities extend to strategic services such as crewed space flights. Moreover, SpaceX is making tremendous progress on its newest rocket, Starship, which is the largest, most powerful rocket ever flown. This next-generation vehicle represents a significant leap forward in reusability and space exploration capabilities. We value SpaceX using prices of recent financing transactions.
• Tesla, Inc. manufactures electric vehicles, related software and components, and solar and energy storage products. The stock contributed as Tesla continued to drive vehicle manufacturing costs lower, accelerate the launch of new models, and invest heavily in its lucrative AI initiatives. Shareholders reaffirmed the CEO's compensation plan, alleviating personnel and legal uncertainties. Despite material operational complexities resulting in significant shutdowns of key manufacturing facilities and lower sales volume, Tesla presented better-than-expected margins in the quarter. It expects to launch a lower cost model as soon as late 2024, which should result in accelerated revenue growth, reduced manufacturing costs, and increased factory utilization. The company continued to advance its autonomous driving capabilities, expanding its already significant data centers and developing its humanoid robot Optimus. These investments increased confidence in the attractive growth opportunities that remain ahead.
• Spotify Technology S.A. is a leading global digital music service, offering on-demand audio streaming through paid premium subscriptions and an ad-supported model. Shares of Spotify were up, largely attributable to impressive beats in gross margin and operating margin as well as the announcement of subscription price hikes. Given the strong value proposition of the product, Spotify is beginning to exercise its pricing power following last year's initial price increases that saw minimal churn. Users continue to grow at a healthy pace despite the pricing impact. Spotify also continues to innovate on the product side, with early trials of generative AI features and the addition of new verticals like audiobooks, which have seen solid early adoption. On the cost side, Spotify is on a path to structurally increase gross margins, aided by its high-margin artist promotions marketplace, increasing contribution by its podcast division, and growth of the margin-accretive advertising business. We still view Spotify as a long-term winner in music streaming with potential to reach more than one billion monthly active users.

DETRACTORS

• CoStar Group, Inc. is a provider of marketing and data analytics services to the real estate industry. Shares detracted from performance in the quarter along with the broader software sector. Most software companies experienced a slowdown in new sales activity in early 2024, leading to guidance reductions and multiple compression. We believe CoStar shares were also impacted by concerns that the company’s second quarter financial results will show a deceleration in net new sales of its residential product following outstanding first quarter performance. We remain encouraged by traction in CoStar’s residential offering although recognize that progress may not be linear. CoStar began to monetize its new Homes.com platform in February. We believe early momentum can be amplified by the recent NAR class action settlement, which has the potential to disrupt the residential brokerage industry and enhance the return on investment for brokers advertising on Homes.com.
• Doughnut chain Krispy Kreme, Inc. detracted during the quarter alongside the broader peer group, with small cap names being hit harder than their larger counterparts. Other company-specific concerns may also have pressured share prices, including the Federal Reserve's delay in the timing of rate cuts given Krispy Kreme's high leverage, weaker-than-anticipated credit card data, concerns around the strength of consumer sentiment, uncertainty around the company's ability to execute on its partnership with McDonald's, and holding company JAB's announced plans to diversifying outside of consumer. We remain investors. The expected sale of Insomnia cookies should alleviate leverage issues, the credit card data is not an accurate metric as it does not include its growing wholesale sales, and we do not believe JAB intends to sell down its position in the near future. We see a strong growth opportunity and potential for outsized shareholder returns as Krispy Kreme expands its network and prepares for the expanded McDonald's partnership.
• Shares of global ski resort operator Vail Resorts, Inc. declined in the second quarter due to a slowdown in season pass sales and a disappointing ski season in Australia. We retain conviction. Vail has said that it believes skiers are delaying buying season passes given poor snow conditions for the past two seasons, and it still expects to generate almost $950 million in season pass revenue this year, representing close to a third of 2023 revenue. An 8% increase in prices combined with a favorable year-over-year comparison should result in a double-digit increase in EBITDA with strong FCF generation. The company is now trading at more than 6% FCF yield, all of which is being returned to shareholders through dividends and share buybacks.

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.

Baron Focused Growth Fund posted a modest decline of 0.21% (Institutional Shares) in the second quarter, outperforming the Russell 2500 Growth Index by 401 basis points due to stock selection.

Industrials investments accounted for over 50% of the relative outperformance in the quarter, driven by double-digit gains from private rocket and spacecraft manufacturer Space Exploration Technologies Corp. (SpaceX) and data and analytics vendor Verisk Analytics, Inc. SpaceX is generating significant value with the rapid expansion of its Starlink broadband service. The company is successfully deploying a vast constellation of Starlink satellites in Earth's orbit, reporting substantial growth in active users, and regularly deploying new and more efficient hardware technology. Furthermore, SpaceX has established itself as a leading launch provider by offering highly reliable and cost-effective launches, leveraging the company's reusable launch technology. SpaceX capabilities extend to strategic services such as crewed space flights. Moreover, SpaceX is making tremendous progress on its newest rocket, Starship, which is the largest, most powerful rocket ever flown. This next-generation vehicle represents a significant leap forward in reusability and space exploration capabilities. We value SpaceX using prices of recent financing transactions. Verisk reported strong fiscal first quarter earnings, especially relative to muted expectations coming into the report, and the CEO expressed optimism regarding the state of the property and casualty (P&C) insurance end-market. We maintain conviction in the competitive positioning, long-term growth, margin expansion, and capital deployment prospects for the business.

Investments in Communication Services and Financials were the other meaningful relative contributors in the period. Within Communication Services, higher exposure to this better performing sector coupled with strong performance from digital music service platform Spotify Technology S.A. aided performance. Spotify’s shares were up on impressive beats in gross margin and operating margin as well as the announcement of subscription price hikes. Given the strong value proposition of the product, Spotify is beginning to exercise its pricing power following last year's initial price increases that saw minimal churn. Users continue to grow at a healthy pace despite the pricing impact. Spotify also continues to innovate on the product side, with early trials of generative AI features and the addition of new verticals like audiobooks, which have seen solid early adoption. On the cost side, Spotify is on a path to structurally increase gross margins, aided by its high-margin artist promotions marketplace, increasing contribution by its podcast division, and growth of the margin-accretive advertising business. We still view Spotify as a long-term winner in music streaming with potential to reach more than one billion monthly active users.

Favorable stock selection in Financials came from specialty insurer Arch Capital Group Ltd. and global electronic broker Interactive Brokers Group, Inc. (IBKR). Arch’s stock rose after reporting positive financial results that exceeded Street expectations. Operating ROE was 21% in the first quarter, and book value per share rose 40% due to strong underwriting profitability and the establishment of a deferred tax asset at the end of 2023. Favorable conditions persist in the P&C insurance market with strong growth and attractive returns despite signs of increasing competition. We continue to own the stock due to Arch’s capable management team and our expectation of significant growth in earnings and book value. IBKR’s shares outperformed as the business continues to execute solidly on its growth opportunity. The company has been growing the number of customer accounts by over 25% year over year. While these new accounts tend to trade less frequently than the back book, the company is still a beneficiary of the growth, with revenues growing in excess of 20% in the first half of the year. Additionally, while IBKR remits a high-level of interest to its customers, it does retain some interest income. As IBKR largely invests excess balances into short-term government bonds, the company has been a beneficiary of persistently high interest rates, which has further supported revenue and earnings growth.

Lastly, stock selection in Information Technology (IT) and Consumer Discretionary contributed another 145-plus basis points of relative gains. Strength in IT was driven by P&C insurance software vendor Guidewire Software, Inc., whose shares increased double digits for the quarter. After a multi-year transition period, we believe the company’s cloud transition is substantially over. We believe that cloud will be the sole path forward, with annual recurring revenue (ARR) benefiting from new customer wins and migrations of the existing customer base to InsuranceSuite Cloud. We also expect the company to shift R&D resources from infrastructure investment to product development, which will help to drive cross sales into its sticky installed base and potentially accelerate ARR over time. We are also encouraged by Guidewire’s subscription gross margin expansion, which improved by more than 1,000 basis points in its most recently reported quarter. We believe that Guidewire will be the critical software vendor for the global P&C insurance industry, capturing 30% to 50% of its $15 billion to $30 billion total addressable market and generating margins above 40%.

Electric vehicle manufacturer Tesla, Inc. led the way in the Consumer Discretionary sector as the company continued to drive vehicle manufacturing costs lower, accelerate the launch of new models, and invest heavily in its lucrative AI initiatives. Shareholders reaffirmed the CEO's compensation plan, alleviating personnel and legal uncertainties. Despite material operational complexities resulting in significant shutdowns of key manufacturing facilities and lower sales volume, Tesla presented better-than-expected margins in the quarter. It expects to launch a lower cost model as soon as late 2024, which should result in accelerated revenue growth, reduced manufacturing costs, and increased factory utilization. The company continued to advance its autonomous driving capabilities, expanding its already significant data centers and developing its humanoid robot Optimus.

Somewhat offsetting the above was adverse stock selection in Real Estate and Health Care., where real estate data and marketing platform CoStar Group, Inc. and DNA sequencing leader Illumina, Inc. were the principal detractors. CoStar’s stock declined alongside the broader software industry during the quarter. Many software companies experienced slowing new sales activity in early 2024, leading to guidance reductions and multiple compression. We believe CoStar shares were also impacted by concerns that the company’s second quarter financial results will show a deceleration in net new sales of its residential product following outstanding first quarter performance. We remain encouraged by traction in CoStar’s residential offering although recognize that progress may not be linear. CoStar began to monetize its new Homes.com platform in February. We believe early momentum can be amplified by the recent NAR class action settlement, which has the potential to disrupt the residential brokerage industry and enhance the return on investment for brokers advertising on Homes.com.

Illumina’s shares underperformed as the company has been dropping its price per genome in the face of competitive pressure. Despite robust underlying sequencing activity, this move has constrained topline growth and margins. We believe that, as Illumina laps these price cuts, average selling prices can stabilize at a more manageable level of attrition, since workflows within next generation sequencing are quite sticky among customers. We think any incremental pricing pressure would be more than offset by the increased sequencing activity unlocked, especially in clinical diagnostics and oncology. In addition, the company has finally divested Grail, which was a cash-burning business that had been an overhang on fundamentals.