Baron Partners Fund: Latest Insights and Commentary

Inflation continued to decline, 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 Partners Fund increased during the second quarter. Investments within Industrials, Consumer Discretionary, Financials, and Communication Services contributed the most. Real Estate and Health Care positions detracted. Second largest contributor Space Exploration Technologies Corp. (SpaceX) led advances within Industrials, while top contributor Tesla, Inc. led positive returns within Consumer Discretionary and third largest contributor Arch Capital Group Ltd. led increases within Financials. Communication Services appreciated on share price gains in music streaming service Spotify Technology S.A. Top detractor CoStar Group, Inc. drove weakness within Real Estate, and third largest detractor IDEXX Laboratories, Inc. drove declines within Health Care.

As we enter the third quarter of 2024, we believe that, overall, conditions are positive for U.S. equities. 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

• 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.
• 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.
• Specialty insurer Arch Capital Group Ltd. contributed to performance 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.

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.
• 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.
• Shares of veterinary diagnostics leader IDEXX Laboratories, Inc. detracted from performance. Foot traffic to veterinary clinics in the U.S. remains uneven, which will modestly hamper aggregate revenue growth. Despite this, IDEXX’s excellent execution has enabled the company to continue to deliver robust financial results. We believe IDEXX’s competitive trends are outstanding, and we expect new proprietary innovations and field sales force expansion to be meaningful contributors to growth in 2024. We see increasing evidence that long-term secular trends around pet ownership and pet care spending have been structurally accelerated, which should help support IDEXX's long-term growth rate.

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 Partners Fund (the Fund) increased 1.02% (Institutional Shares) in the second quarter, outperforming the Russell Midcap Growth Index by 423 basis points as strong stock selection overshadowed headwinds from style biases and leverage.

The Fund uses leverage to enhance returns, although this does increase the volatility of returns. As of June 30, 2024, the Fund had 116.8% of its net assets invested in securities, and the use of leverage in a declining market detracted approximately 50 basis points from relative performance.

Favorable stock selection in Consumer Discretionary added 450-plus basis points of relative gains, accounting for most of the outperformance in the period. Electric vehicle manufacturer Tesla, Inc. led the way in the 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.

Investments in Industrials and Financials coupled with meaningfully lower exposure to the poor performing Health Care sector also added value. Stock-specific strength in Industrials came from private rocket and spacecraft manufacturer Space Exploration Technologies Corp. (SpaceX). 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.

Specialty insurer Arch Capital Group Ltd. was responsible for most of the relative gains in Financials 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 property and casualty 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. Brokerage firm The Charles Schwab Corporation also performed well in the sector.

Apart from leverage, poor stock selection in Real Estate combined with lower exposure to the outperforming Information Technology sector hampered relative results. Real estate data and marketing platform CoStar Group, Inc. weighed on performance in Real Estate after the company’s shares 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.