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. Investors entered the new year optimistic that a soft landing was in store for the economy, in which a recession would be avoided, inflation would continue to dissipate, and the Fed would start cutting interest rates in March. The economy has not only avoided recession but has been stronger than market forecasts. Meanwhile, inflation has again turned sticky, and Fed rate cuts have been delayed to at least June. Within the small cap growth universe, the Russell 2000 Growth Index’s performance was inflated by the anomalous performance of Super Micro Computer, which more than tripled in the quarter and accounted for over one-third of the index's gains. This event was an extreme statistical outlier which is highly unlikely to be repeated, in our view. 

Economic data was slightly mixed during the quarter. Strong growth in the U.S. labor supply, driven by increased labor force participation and a surge in immigration, supported job gains without higher inflation. The U.S. unemployment rate, though still low, rose slightly to 3.8%. The S&P Global US Services PMI, an index of the prevailing direction of economic trends in the U.S. service sector, pulled back modestly. Existing home sales jumped 9.5% in February 2024, the highest percentage increase in a year and above consensus expectations. At a 3.2% annualized rate, U.S. inflation, although it has yet to decline to the Fed’s stated 2% preferred level, is significantly less than the June 2022 peak of more than 9%. Looking ahead, a more normalized supply chain and moderating wage growth bode well for a continued slow decline in inflation.

Baron Small Cap Fund increased in the quarter. Holdings within Industrials, Financials, and Consumer Discretionary contributed the most to performance. Investments within Information Technology (IT) and Real Estate detracted. Advances within Industrials were led by top contributor Vertiv Holdings Co, while second largest contributor Kinsale Capital Group, Inc. led increases within Financials. Appreciation within the Consumer Discretionary sector was led by Installed Buildings Products Inc., the third largest contributor to performance. IT lost ground, led by top detractor Endava plc. Real Estate had a weak quarter, with both portfolio holdings within in the sector declining.

Small-cap growth stocks continued to rally off their October lows to stage a solid showing in the first quarter of 2024, although they lagged their large cap counterparts. We are cautiously optimistic that this is the start of a long-awaited relative recovery for small caps. Longer term, we believe our companies will revert to their historic growth rates and earnings will be higher. We believe higher earnings and multiples will result in strong returns for the portfolio.

Top Contributors/Detractors to Performance

as of 03/31/24

Contributors

  • Shares of Vertiv Holdings Co, a manufacturer of critical infrastructure equipment for data centers, rose during the quarter due to improved focus on operational execution, strong revenue growth prospects, and robust opportunities for margin expansion. We expect Vertiv to benefit from the rising demand for data center capacity, with approximately 70% of its revenue coming from the data center end-market. As one of the leading providers of precision cooling for data centers, Vertiv also stands to benefit from the increasing adoption of generative AI (GenAI), as GenAI-related servers have higher energy density, which will necessitate more complicated cooling solutions. We trimmed the position into strength, but we remain shareholders, as we think Vertiv's leading market position in data center thermal and power management will lead to strong growth in the future.
  • 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.
  • Installed Building Products, Inc. is a leading distributor and installer of insulation and complementary building products for residential and commercial end markets in the U.S. Shares rose on improving industry conditions, particularly in the new single-family residential construction market, which drives approximately 60% of the company’s revenue. Installed Building Products’ excellent execution across various strategic initiatives continues to generate growth from other construction end markets, including multifamily construction, light and heavy commercial construction, and remodeling. We believe the company also stands to benefit from pricing and profitability improvements and attractive tuck-in acquisition opportunities.

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.
  • Shares of Neogen Corp., a leading provider of food and animal safety products, detracted from performance. While end-market challenges appear to be bottoming, this improvement is happening at a slower pace than the company had forecast, which caused it to lower fiscal year 2024 guidance. While there will likely be some near-term volatility as a result of macroeconomic conditions and the integration with 3M's Food Safety business, we believe Neogen is a good company with solid industry tailwinds and is poised for success once the merger integration process is completed.
  • Shares of Fox Factory Holding Corp., a leading provider of suspension systems and engineered products for the mountain bike, power sport, and off-road truck categories, declined during the quarter following an earnings update that indicated uncertain volumes in its bike and aftermarket truck segments. The company's challenges are mostly attributable to temporary issues such as vehicle production delays associated with the 2023 United Auto Workers strike (now resolved). We believe Fox Factory is protecting its brand positioning and leading innovation within its categories. As near-term demand headwinds dissipate, Fox Factory should return to strong growth rates in the large automotive aftermarket.

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.