Review and Outlook

as of 12/31/23

Following a three-month down turn, the markets went on a bull run in the last two months of the year. 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 Focused Growth Fund increased in the quarter. Holdings within Consumer Discretionary, Industrials, and Information Technology (IT) contributed the most to performance. No sector detracted. Consumer Discretionary had a strong quarter, with Hyatt Hotels Corporation and Red Rock Resorts, Inc., respectively, the second and third largest contributor, leading gains within the sector. Top contributor Space Exploration Technologies Corp. drove advances within Industrials. All three IT holdings posted positive returns, led by P&C insurance software vendor Guidewire Software, Inc. After a multi-year transition period, we think the company’s cloud transition is substantially complete and that cloud will be the sole path forward, with revenue benefiting from new customer wins and migrations of the existing customer base to InsuranceSuite Cloud. We believe Guidewire will become 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%.

Looking ahead, we are encouraged by recent signs of recovery in the markets and the U.S. economy. However, as long-term investors who have lived through numerous market cycles, we have learned not to try to predict the unpredictable. 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. We think the combination of unchanged long-term growth outlooks and attractive valuations should result in strong returns over time.

Top Contributors/Detractors to Performance

as of 12/31/23

Contributors

  • Space Exploration Technologies Corp. (SpaceX), a high-profile private company founded by Elon Musk designs, manufactures, and launches rockets, and satellites. Shares contributed to performance in the wake of another record-breaking year. The company closed 2023 with a record 96 Falcon rocket launches, nearly twice a week on average, substantially more than the 61 launches in 2022 and surpassing all its private and government program peers. Starlink, SpaceX's satellite constellation, also achieved remarkable milestones, including operating over 5,500 satellites, the majority of active satellites in space, and now providing connectivity services to 2.3 million active customers, more than doubling its customer base during the year. Starship, SpaceX's groundbreaking new rocket, successfully performed its second test flight this quarter. Over time, SpaceX expects Starship to both reduce costs and expand SpaceX's operational capabilities, including supporting SpaceX's long-term goal to enable human beings to inhabit Mars. We value SpaceX using a proprietary valuation model and recent financing transactions, which trended positively even through a more complex funding environment.
  • Shares of global hotelier Hyatt Hotels Corporation increased in the quarter. The company reported strong demand across its portfolio, led by robust leisure travel and improvement in its business transient and group business that is now pacing above pre-COVID levels. Room rate increases are generating solid margins and cash flow. In our view, Hyatt's sound, underleveraged balance sheet keeps it well positioned should we enter a possible downturn in 2024. The hotel transaction market is improving, and the company has two properties for sale that should close in early 2024, resulting in an attractive business model in which more than 80% of revenue will be generated from fees with the remainder from owned assets. We also believe the transactions should help boost the stock's multiple over time.
  • Shares of Red Rock Resorts, Inc., a casino operator in the Las Vegas Locals market, increased on the opening of its new Durango casino in early December. The company reported strong initial visitation and spend levels without cannibalization at its other properties. Red Rock expects the casino to generate profits from its first day of operation and projects a 20% return on its $800 million investment by 2026. The company has 300 acres of gaming-entitled land in the Las Vegas Locals market to develop and expects to double its current EBITDA levels by the end of the decade while funding all new developments internally with cash flow. We believe its stock remains attractively valued at current levels.

Detractors

  • Shares of timeshare company Marriott Vacations Worldwide Corporation fell in the quarter, driven by soft sales of timeshare units due to higher interest rates and the slow ramp of a new product offering. A default rate that was higher than the company had anticipated forced it to take a charge to increase its reserves, pressuring earnings and cash flow. We remain investors. The company has a strong balance sheet with a well-covered 3% dividend. It continues to use cash flow to buy back its shares, and management has personally bought stock at much higher levels than current prices.
  • Iridium Communications Inc. is a mobile voice and data communications services vendor offering global coverage via satellite. In 2022, Iridium announced an agreement with Qualcomm to incorporate Iridium's technology into Qualcomm's Snapdragon chip, allowing devices to seamlessly connect to both cellular and satellite networks. In a surprise turn of events, Qualcomm backed out of the partnership in November 2023. The decision shook investors' confidence in Iridium's direct-to-device opportunity. We retain conviction. Iridium remains a unique satellite owner and operator, with L-band spectrum, years of operational experience, relatively new satellite hardware, and hundreds of partners across verticals and geographies. In addition, management announced a commitment of $3 billion in return to shareholders between 2023 and 2030, representing a material portion of the current enterprise value.
  • 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.

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 Focused Growth Fund (Institutional Shares) increased 9.74% in the fourth quarter, yet trailed the Russell 2500 Growth Index by 285 basis points as positive impacts from active sector weights were not enough to overcome disappointing stock selection.

Poor stock selection in Consumer Discretionary accounted for most of the relative losses in the period, as electric vehicle manufacturer Tesla, Inc., global ski resort operator Vail Resorts, Inc., and a handful of other holdings weighed on performance in the sector. Tesla’s shares fell slightly as the core automotive segment remained under pressure due to a complex macroeconomic environment, higher interest rates, factory shutdowns, and Tesla’s price reductions throughout the year, presenting pressure on the near-term growth and margin profile. Nevertheless, Tesla continued to generate sufficient gross profit to support a robust product development plan that can propel the automotive segment higher over time. Tesla also started to deliver its highly anticipated Cybertruck, its first pickup truck with a tremendous amount of consumer interest and a slew of new technologies within the car and its manufacturing lines. The refreshed Model 3 also seems to be generating strong demand while improving unit-level economics. Lastly, while early, investors now expect Tesla to benefit from its investment in artificial intelligence (AI) through development of autonomous driving technology Dojo (an AI training compute), autobidder (an automated energy trading platform), and humanoid (a human-like robot). Vail’s stock underperformed on concerns that limited snowfall would impact its results for the ski season, but we are optimistic that strong sales of season ski passes will offset this effect. The company's higher-end customer base should also provide some resiliency in earnings and cash flow. We believe the stock remains attractive at current levels and think its stock multiple should revert to historical levels over time on the strength of its growth and durability of earnings and cash flow.

Stock selection in Financials and Communication Services also played a role in the Fund’s underperformance during the quarter. Weakness in Financials was driven by declines from specialty insurer Arch Capital Group Ltd. and automated global electronic broker Interactive Brokers Group, Inc. 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. Interactive Brokers’ shares fell as the market's view of the number of future interest rate cuts increased. The company generates a significant amount of its revenue from interest income on idle client brokerage deposits, which it typically invests in short-term U.S. treasury bills. Rate cuts would reduce earnings as these investments would be re-invested at lower spreads. Longer term, the company continues to grow client accounts at more than 20% year-over-year, creating a strong foundation for years of revenue and earnings growth, and underwriting solid returns in the stock even if interest rates decline from current levels.

Performance in Communication Services was hindered by satellite communications company Iridium Communications Inc., whose shares fell 9.2% in the period. Earlier in the year, Iridium announced a strategic partnership with Qualcomm seeking to integrate Iridium’s satellite communication technology into Qualcomm’s Snapdragon chip series. While this collaboration was projected to yield substantial profits for Iridium over time, Qualcomm unexpectedly backed out of the partnership in November. The decision shook investors' confidence in Iridium's direct-to-device opportunity and generated further competitive uncertainty. We retain conviction. Iridium remains a unique satellite asset and operator, with L-band spectrum, years of operational experience, relatively new satellite hardware, and hundreds of partners across verticals and geographies. In addition, management announced a commitment of $3 billion in return to shareholders between 2023 and 2030, representing a material portion of the current enterprise value.

Somewhat offsetting these losses was solid stock selection in Information Technology (IT) and Industrials coupled with lack of exposure to the lagging Energy sector and higher exposure to the better performing Real Estate sector, which together added nearly 350 basis points of relative gains. Strength in IT was broad based, led by sharp gains from cloud-based commerce platform Shopify Inc. and property and casualty (P&C) insurance software vendor Guidewire Software, Inc. Shopify was a top contributor after the company’s excellent financial results featured gross merchandise value growth of 22% year-on-year, revenue growth of 25%, and non-GAAP operating margins in excess of 15% (and up 1,900 bps year-on-year). The company also hosted a well-attended investor day in which management shared a variety of data points showcasing the company's growing success in new segments, such as enterprise, business-to-business, and offline commerce. Guidewire’s shares rose as it appears the company’s cloud transition is substantially complete following a multi-year transition period. 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 to product development from infrastructure investment, 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 approximately 1,600 bps 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%.

Private rocket and spacecraft manufacturer Space Exploration Technologies Corp. (SpaceX) was responsible for gains in Industrials after the company’s shares were revalued 30% higher in the period. The company closed 2023 with a record 96 Falcon rocket launches, nearly twice a week on average, substantially more than the 61 launches in 2022 and surpassing all its private and government program peers. Starlink, SpaceX's satellite constellation, also achieved remarkable milestones, including operating over 5,500 satellites, the majority of active satellites in space, and now providing connectivity services to 2.3 million active customers, more than doubling its customer base during the year. Starship, SpaceX's groundbreaking new rocket, successfully performed its second test flight this quarter. Over time, SpaceX expects Starship to both reduce costs and expand the company's operational capabilities, including supporting SpaceX's long-term goal to enable human beings to inhabit Mars. We value SpaceX using a proprietary valuation model and recent financing transactions, which trended positively even through a more complex funding environment.

as of 12/31/23

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

Baron Focused Growth Fund (Institutional Shares) was up 27.78% for the year, outperforming the Russell 2500 Growth Index by 885 basis points due to stock selection, active sectors weights, and tailwinds from style biases, notably overexposure to the better performing Size, Beta, and Growth factors.

Favorable stock selection in Consumer Discretionary together with significantly higher exposure to this strong performing sector added the most value. Within Consumer Discretionary, electric vehicle (EV) manufacturer Tesla, Inc. was almost entirely responsible for the Fund’s outperformance in the period, contributing 800-plus basis points of relative gains. Tesla’s shares rebounded after coming under significant pressure towards the end of 2022 due to investor concerns about macroeconomic uncertainty, softer demand, stronger competition, and headwinds to profitability. Throughout 2023, Tesla experienced a degradation in margins as it reduced prices, but, while margins declined, they remained healthy, allowed robust investments in growth, and significantly outperformed the negative EV margins of the vast majority of its competitors. 2023 also represented a record year for the Energy division's revenues and margins. Tesla continued to demonstrate its innovation engine, including launching its highly anticipated Cybertruck, initiating the production of its Dojo compute, releasing important updates to its Autopilot solution, and expanding its battery activities.

Another material contributor was global hotelier Hyatt Hotels Corporation, whose shares increased nearly 45% in the period. The company reported strong demand across its portfolio, led by robust leisure travel and improvement in its business transient and group segment that is now pacing above pre-COVID levels. Room rate increases are generating solid margins and cash flow. Hyatt's sound, underleveraged balance sheet keeps it well positioned should we enter a possible downturn in 2024. The hotel transaction market is improving, and the company has two properties for sale that should close in early 2024, resulting in an attractive business model in which more than 80% of revenue will be generated from fees with the remainder from owned assets. Apart from stock selection, the Fund benefited from its significantly higher exposure to this strong performing sector, which was up almost 28% in the index.

Positive stock selection in Information Technology (IT) and Financials coupled with significantly lower exposure to the lagging Health Care sector and lack of exposure to the underperforming Energy sector added another 750-plus basis points of relative gains. Strong stock selection in IT, owing mostly to gains from property and casualty (P&C) insurance software vendor Guidewire Software, Inc. and cloud-based commerce platform Shopify Inc., was partly offset by the Fund’s meaningfully lower exposure to this better performing sector. Guidewire has mostly completed its cloud transition, which we believe will significantly benefit annual recurring revenue due to new customer wins and migrations of the existing customer base to InsuranceSuite Cloud. Shopify’s shares more than doubled as the company sold off the capital-intensive and money-losing Shopify Fulfillment Network to Flexport while significantly refocusing the business on its core offerings, accelerating innovation, and increasing profitability. Physics-based simulation software vendor ANSYS, Inc. was the other driver of performance in IT after the company’s shares jumped late in the year on rumors that it would be acquired by Synopsys, a software company focused on electronic design automation.

Strength in Financials was widespread, with the principal drivers being investment decision support tools provider MSCI Inc. and specialty insurer Arch Capital Group Ltd. MSCI reported largely solid earnings results throughout the year and was aided by generally supportive equity market performance. Despite some near-term macro uncertainty, we retain long-term conviction as MSCI owns strong, "all weather" franchises and remains well positioned to benefit from numerous secular tailwinds in the investment community. Similarly, Arch reported strong financial results that exceeded Street expectations all year amid favorable industry conditions. Through the first nine months of the year, net premiums written grew 27%, earnings more than doubled, ROE exceeded 20%, and book value per share grew 30%. Pricing trends in the P&C insurance market remain favorable, and elevated interest rates are driving higher investment income. We continue to own the stock due to Arch’s strong management team and our expectation of significant growth in earnings and book value.

Partially offsetting the above was disappointing stock selection in Real Estate combined with lack of exposure to the better performing Consumer Staples sector. Weakness in Real Estate was mostly due to poor performance from life sciences REIT Alexandria Real Estate Equities, Inc. and real estate data and marketing platform CoStar Group, Inc. Alexandria’s underperformance was driven by slower leasing conditions that resulted from prolonged tenant decision making and softer operating conditions for biotechnology tenants. In addition, certain markets are seeing elevated levels of new supply deliveries, which is further pressuring rent growth. We expect Alexandria's portfolio to outperform the broader life sciences market because of its differentiated cluster model and captive tenant base. We remain excited about the company’s long-term prospects and view the current valuation as attractive. CoStar’s share price performance was held back by challenging commercial real estate headlines. We believe trends in the company’s core subscription offerings remain strong. We are also increasingly encouraged by growing traction in CoStar’s nascent residential offering, which is making remarkable progress, with traffic to its Homes.com residential platform reaching 100 million monthly unique visitors in September. Given the growing momentum, CoStar is increasing its residential investment, and we expect to see an additional increase in 2024. While this is a significant upfront investment, we believe residential represents a transformative opportunity for CoStar. We believe the company’s proprietary data, broker-oriented approach, and best-in-class management uniquely position it to succeed in this endeavor.

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.