Review and Outlook

as of 12/31/22

After a brutal nine months, stocks recovered somewhat in the fourth quarter. The small-cap Russell 2000 Growth Index advanced 4.13%. While the economy remained resilient, it was evident from many indicators, such as goods, energy, and rent prices, that inflation was cooling. There were signs of an economic slowdown on the horizon, stemming from aggressive central bank tightening. The market rallied in October and November, as interest rates declined, and the Federal Reserve chair laid the groundwork to slow the pace of its monetary tightening. However, the market gave back some gains in December as the Fed dampened hopes of interest rates cuts in 2023 and remained unified and steadfast in its goal of reducing inflation to 2% from December’s rate of 6.5%.

Against this backdrop, Baron Small Cap Fund increased in the quarter. Health Care, Information Technology (IT), and Industrials holdings contributed the most to performance. Investments within Consumer Staples detracted. Appreciation within Health Care was led by third largest contributor DexCom, Inc. Inspire Medical Systems, Inc. was another noteworthy contributor after shares of this medical device company rose on a beat and a raise. Gains within IT were led by top contributor Gartner, Inc. Industrials benefited from share price gains of second largest contributor Vertiv Holdings Co. Consumer Staples lost ground on weakness in the share price of facial treatment provider The Beauty Health Company.

The market is off to a good start in 2023, buoyed by a healthy economy highlighted by low unemployment and stable and solid consumer spending, declining inflation, and market expectations that the Fed is near the end of the rate hiking cycle.

The issue is that the Fed remains strident in its fight against inflation. It has posited short rates will rise to over 5% and remain there for an extended period. It remains focused on reducing “core” inflation, or the pace of wage growth, which will likely be difficult to reverse given tight labor markets. It is probably unnerved by the markets’ rise. We expect the Fed to continue to browbeat investors in the effort to slow down the economy, induce unemployment and reduce wage pressure, which it views as necessary. Higher rates will impact growth. Leading indicators point to a slowdown, and we hear that from the management teams of our holdings. However, we do not know if the slowdown or recession will be short-lived and shallow or longer and more severe. That’s the $64,000 question.

We own a portfolio of well-managed, high-quality companies. They are leaders in their niches, with strong competitive advantages. We believe they have great growth opportunities based on their positioning and well-established business plans. We underwrite significant long-term growth, which we do not believe is reflected in current trading prices where the market is presently focused. That will change.

Top Contributors/Detractors to Performance

as of 12/31/22

Contributors

  • Shares of Gartner, Inc., a provider of syndicated research, contributed to results. Business conditions remain strong, with Gartner’s research business compounding at double-digit levels. We expect sustained revenue growth and renewed focus on cost control to drive margin expansion and enhanced free cash flow generation. The company’s balance sheet is in excellent shape and can support aggressive repurchases and bolt-on acquisitions, in our view.
  • Vertiv Holdings, LLC, a leading provider of critical infrastructure solutions for data centers and communications networks, contributed in the quarter as the company demonstrated its ability to increase prices to recoup inflationary headwinds after a sharp earnings miss earlier in the year due to poor pricing. We remain shareholders due to Vertiv's strong product portfolio, exposure to secularly advantaged end markets, and potential to increase margins.
  • DexCom, Inc. is a leading provider of continuous glucose monitoring (CGM) devices for people with diabetes. The stock rose in response to solid third quarter earnings, proposed Medicare coverage of CGM use by non-intensive insulin type 2 patients, and the FDA approval of DexCom's seventh generation device, the G7. We continue to believe DexCom has a long runway for growth in a large market.

Detractors

  • Shares of Chart Industries, Inc., a leader in cryogenic technology and process/storage equipment, declined during the quarter. The company announced the acquisition of Howden, a leading compressor manufacturer, using a large amount of debt. Investor focus on the leverage weighed on shares. We believe the benefits of the acquisition (cost synergies and improved margins, increased aftermarket percentage, improved global footprint, bigger nexus of clean exposure) outweigh the execution risks. We believe the deal creates a best-in-class industrial compounder.
  • Grid Dynamics Holdings, Inc. provides outsourced software development to business customers. The company reported strong quarterly results with 40% revenue growth and 35% EPS growth and made a promising acquisition that expands its delivery capabilities in India. However, shares gave back some gains from the prior two quarters due to slower guidance for next quarter and concern about macroeconomic uncertainty weighing on client demand. We continue to own the stock because we believe the company has unique capabilities and a long runway for growth.
  • European Wax Center, Inc. is the fastest-growing franchisor and operator of out-of-home waxing services in the U.S. Shares fell on same-store sales growth that missed consensus, as the company's least frequent guests increased the time between visits due to the volatile macroeconomic environment. While short-term trends may be choppy, over time, we believe same-store sales will accelerate as economic conditions normalizes, and the company will continue to open units at a high-single-digit rate.

Quarterly Attribution Analysis (Institutional Shares)

as of 12/31/22

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 12/31/22

Baron Small Cap Fund (Institutional Shares) was up 4.24% in the fourth quarter, performing roughly in line with the Russell 2000 Growth Index as positive stock selection was mostly offset by cash exposure in a favorable market environment.

Health Care investments added significant value during the quarter, with most of the strength coming from diabetes management pioneer DexCom, Inc. and sleep apnea device manufacturer Inspire Medical Systems, Inc. DexCom was a top contributor in response to solid third quarter earnings, proposed Medicare coverage of its continuous glucose monitoring device for use by non-intensive insulin type 2 patients, and FDA approval of the company's seventh generation device, the G7. Inspire’s shares were bolstered by above-consensus third quarter financial results with revenue increasing more than 70% year-over-year. Management also raised guidance again for full-year revenue. Minimal exposure to lagging health care services, biotechnology, health care supplies, and pharmaceutical stocks together with outperformance of weighing instruments provider Mettler-Toledo International, Inc. also boosted relative results. Mettler’s shares were up after quarterly results and full-year guidance surprised to the upside due to solid performance in China as well as the Laboratory and Industrial segments. Favorable stock selection in Financials, Information Technology, and Consumer Discretionary also contributed to relative gains thanks in large part to noteworthy returns from global investment bank Houlihan Lokey, Inc., syndicated research provider Gartner, Inc., and fitness center operator Planet Fitness, Inc.

Adverse stock selection in Industrials and Consumer Staples along with lack of exposure to the top performing Energy sector mostly offset the above-mentioned gains. Weak stock selection in Industrials, owing largely to declines from staffing firm ASGN Incorporated and cryogenic technology and equipment leader Chart Industries, Inc., was partially offset by higher exposure to this better performing sector. ASGN’s shares fell on investor concerns about possible economic slowdown. We believe investors do not fully recognize how well ASGN is positioned given its exposure to sectors with favorable long-term secular growth trends. Chart’s share price reacted negatively to the Howden acquisition announcement as the amount of debt needed to fund the transaction spooked investors. We believe the benefits of the acquisition (cost synergies and improved margins, increased aftermarket percentage, and enhanced manufacturing footprint to serve the world’s clean energy needs) outweigh the execution risks. Performance in Consumer Staples was hindered by skin care treatment leader The Beauty Health Company, whose shares fell after announcing disappointing guidance for the remainder of the year due to uncertainty regarding the pace of recovery in China coupled with mounting foreign currency headwinds. We remain excited about the future of Beauty Health, as the company continues its global rollout of HydraFacial machines and grows utilization and brand awareness while increasing the profit margins.

as of 12/31/22

Yearly Attribution Analysis (for year ended 12/31/2022)

Baron Small Cap Fund (Institutional Shares) declined 31.05% for the year, trailing the Russell 2000 Growth Index by 469 basis points due to stock selection and differences in sector/sub-industry weights.

Cash exposure in a down market along with favorable stock selection in Financials, Information Technology (IT), Real Estate, and Communication Services added the most value. Strength in Financials came from specialty insurer Kinsale Capital Group, Inc., whose shares outperformed after reporting above-consensus financial results as market conditions and pricing trends remained favorable. Positive stock selection in IT was largely due to the outperformance of syndicated research provider Gartner, Inc. and process automation software leader Aspen Technology, Inc. Gartner was the largest contributor after the company’s quarterly financial results consistently exceeded Street estimates during the year. Growth in the research business compounded at double-digit levels, led by the company’s GBS segment, which is benefiting from a multi-year investment cycle. Aspen’s shares were up over 20% as organic trends continued to improve, with annual contract value growing 7.5% in the latest period. The company also closed a transformative deal with industrial equipment manufacturer Emerson. Performance in Real Estate and Communication Services was bolstered by temperature-controlled warehouse operator Americold Realty Trust and media company Liberty Media Corporation – Liberty Formula One, respectively. Americold’s shares outperformed the broader market due to increased optimism from management that labor, occupancy, and cash flow could soon begin to improve, while Liberty Formula One’s stock was aided by excellent financial results and excitement surrounding the company’s advantageous new broadcasting deal with ESPN.

The above-mentioned gains were undone by weak stock selection in Industrials and Consumer Discretionary coupled with lack of exposure to the top performing Energy sector. Adverse stock selection in Industrials was responsible for much of the relative shortfall, as wholesale landscape supplies distributor SiteOne Landscape Supply, Inc. and composite decking manufacturer Trex Company, Inc. were hurt by concerns about a housing-related slowdown negatively impacting their businesses into 2023. Insights and analytics leader Clarivate Plc and data center equipment and services provider Vertiv Holdings, LLC also weighed on performance in the sector. Housing market volatility also contributed to weakness in the Consumer Discretionary sector, where hard surface retailer Floor & Decor Holdings, Inc. and residential insulation installer Installed Building Products, Inc. were down sharply. Performance in the sector was also hampered by automotive products manufacturer Holley Inc. and corporate daycare provider Bright Horizons Family Solutions, Inc. Holley’s stock declined on disappointing results and lowered guidance due to microchip shortages and other supply-chain challenges that prevented it from building and shipping many of its most popular products. Results were also impacted by a sell-down of reseller inventories due to macroeconomic uncertainty. Bright Horizons shares were down as labor shortages are exacerbating the time needed to backfill center enrollment lost during the pandemic.

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.