Review and Outlook

as of 12/31/23

​Following a downdraft from the end of July through October, the markets went on a bull run in the last two months of 2023. 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 3.1% in November. 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 Small Cap Fund increased in the quarter. Industrials, Consumer Discretionary, and Information Technology (IT) holdings contributed the most. Top contributor Vertiv Holdings Co led positive returns within Industrials. Gains within Consumer Discretionary were led by third largest contributor Installed Building Products, Inc. Las Vegas locals casino owner Red Rock Resorts, Inc. and discount fitness chain Planet Fitness, Inc. were also noteworthy performers within the sector during the quarter. Appreciation within IT was led by second largest contributor Gartner, Inc. Communication Services investments detracted modestly, driven by weak performance of The Trade Desk. Shares of this leading internet advertising demand-side platform fell due to a rare miss on quarterly results. We believe the company is well positioned for 2024 and beyond, with strong tailwinds in Connected TV, a secular growth category capturing spend at an increasing pace from linear TV, retail media, platform upgrade adoption, audio, and more.

After limping into the fourth quarter, small-cap growth stocks rallied off their lows to stage a strong showing in the last two months of 2023. 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. Stocks will return to trading at appropriate multiples, which, for the most part, are higher than present. We believe higher earnings and multiples will result in strong returns for the portfolio.

Top Contributors/Detractors to Performance

as of 12/31/23

Contributors

  • Vertiv Holdings Co, a manufacturer of critical infrastructure equipment for data centers, contributed in the quarter. The company is benefiting from a robust demand environment as well as successful implementation of its strategy to improve margins. As one of the leading providers of precision cooling for data centers, Vertiv stands to benefit from the increasing adoption of AI, as AI-related servers have higher energy density, which will necessitate more complicated cooling solutions. During the quarter, Vertiv held its first analyst day, where it introduced long-term growth targets for revenue growth of 8% to 11% CAGR out to 2028 and 500 bps of margin expansion to 20% over that same time frame. We remain confident Vertiv will be able to execute on this plan given the company's operational focus under a new CEO combined with its competitive advantage and strong industry backdrop. We trimmed the position into strength, but we remain shareholders as we see substantial upside over the long term as the company executes on its strategy.
  • Shares of Gartner, Inc., a provider of syndicated research, soared after reporting excellent quarterly earnings results. Gartner’s core subscription research businesses continued to compound at attractive rates, and growth is poised to accelerate over the next several quarters. We believe Gartner will emerge as a critical decision support resource for every company evaluating the opportunities and risks of AI for its business. We expect this development to provide a tailwind to Gartner’s volume growth and pricing realization over time. Gartner’s sustained revenue growth and focus on cost control should drive continued 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.
  • ​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. Performance was helped by a pronounced decline in mortgage rates during the fourth quarter, which made new residential home purchases more affordable and improved the prospects for the residential end market. Continued strong operating and financial results also helped boost the share price. We remain investors. Installed Building Products is poised to benefit from ongoing growth across U.S. residential construction. In our view, its durable cost advantage enables it to expand faster than the market through share gains and accretive acquisitions and mitigates disintermediation risk.

Detractors

  • Shares of specialty insurer Kinsale Capital Group, Inc. gave back some gains from earlier this year after the company reported slower premium growth in the third quarter. Earnings beat Street expectations, with EPS doubling and ROE exceeding 34%. However, investors focused on the slowdown in gross written premiums to 33% growth from 58% growth in the prior quarter, which management attributed to normal seasonality for property insurance. Additionally, we believe some of the share price weakness resulted from a sector rotation away from defensive stocks to more speculative stocks following a decline in interest rates. 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.
  • Chart Industries, Inc. is a global leader in design, engineering, and manufacturing of process and storage technologies and equipment for gas and liquid handling. Shares fell after the company missed analyst earnings forecasts on project revenue recognition timing. Chart also held an investor day in which it provided mid-term financial targets instead of further detail on its 2024 outlook, falling short of some analyst expectations. We remain investors. Business fundamentals are strong, in our view, with management seeing solid demand across the portfolio and cost synergies from the Howden acquisition ahead of company targets. Chart also has a much larger than normal backlog supporting growth in 2024, providing good visibility. We believe the integration of Howden is proceeding well, with the combined company on track to become a globally diversified, high-quality, high-growth industrial business with proprietary technology and solutions serving the growing hydrogen, carbon capture, LNG, and other end markets. Valuation remains attractive against Chart's growth and margin profile, in our view.
  • The Beauty Health Company is a skin care and beauty company that sells the flagship HydraFacial machine and related consumables. Shares declined after reporting disappointing results that showed execution issues associated with the roll out of Syndeo, the latest generation of the HydraFacial machine. While the features and functionality of this new device far surpassed the prior version, the machine also had several defects that caused potential buyers to delay their purchase. Additionally, to remedy the defects, the company had to incur added costs to repair and replace existing Syndeos in the field. Lastly, the company announced that the CEO was leaving. Due to the continued uncertainty surrounding the defects with Syndeo and heightened management turnover, we exited the position.

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 Small Cap Fund (Institutional Shares) increased 12.64% in the fourth quarter, keeping pace with the Russell 2000 Growth Index, which rose 12.75%.

Favorable stock selection in Consumer Discretionary and Information Technology (IT) together with lack of exposure to the lagging Energy sector were the largest contributors to performance. Strength in Consumer Discretionary came from premier installation contractor Installed Building Products, Inc., casino operator Red Rock Resorts, Inc., and gym franchisor and operator Planet Fitness, Inc. Installed Building Products stock was lifted by the pronounced decline in mortgage rates during the quarter, which makes new residential home purchases more affordable and improves the prospects for the residential end market. Strong operating and financial results also factored into the company’s excellent performance during the quarter. Red Rock’s shares rose on the opening of its new Durango casino in early December, with the company reporting strong initial visitation and spending 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. Planet Fitness shares appreciated after the company reported strong quarterly results and increased expectations for revenue and profitability growth for the year. Management also outlined several changes intended to improve franchisee returns, which in turn could accelerate unit development.

Syndicated research provider Gartner, Inc. was responsible for most of the relative gains in the IT sector after reporting excellent quarterly earnings results. The company’s core subscription research businesses continued to compound at attractive rates, and growth is poised to accelerate over the next several quarters. We believe Gartner will emerge as a critical decision support resource for every company evaluating the opportunities and risks of artificial intelligence for its business. We expect this development to provide a tailwind to Gartner’s volume growth and pricing realization over time. Other drivers of performance in the sector were outsourced software development provider Endava plc, property and casualty insurance software vendor Guidewire Software, Inc., and global technology company Altair Engineering Inc., whose share prices were each up in excess of 20% for the period.

Largely offsetting the above was disappointing stock selection Financials, Health Care, and Communication Services together with cash exposure in a rapidly advancing market. Weakness in Financials was mostly due to poor performance from Kinsale Capital Group, Inc., a specialty insurance group focusing on the excess and surplus lines market. Kinsale gave back some gains from earlier in the year after reporting slower premium growth in the third quarter. Earnings beat Street expectations with EPS doubling and ROE exceeding 34%. However, investors focused on the slowdown in gross written premiums to 33% growth from 58% growth in the prior quarter, which management attributed to normal seasonality for property insurance. 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.

Within Health Care, lack of exposure to strong performing biotechnology stocks accounted for most of the relative losses in the sector, as this sizeable segment was up more than 26% in the index, detracting 125-plus basis points from relative results. Health Savings Account custodian HealthEquity, Inc. and sleep apnea device manufacturer Inspire Medical Systems, Inc. also contributed to relative weakness in the sector, offsetting double-digit gains from continuous glucose monitoring pioneer DexCom, Inc. and global contract research organization ICON Plc. HealthEquity’s stock was pressured by falling interest rates. The company earns custodial revenue from assets held by depository and insurance company partners and revenue generated is tied to interest rates. We remain positive on HealthEquity because the company has a laddered portfolio and even if rates start to decline, they can continue to place new deposits at higher yields than they were previously receiving (contracts typically range from 3 to 5 years so the deposits from a few years ago at very low rates are up for renewal at higher rates). In addition, the company has implemented an Enhanced Yield program, which generates a premium over traditional yields, and as more deposits are placed in this program it should provide additional tailwinds to revenue and earnings. Therefore, we think the company has good earnings visibility over the next several years even in a declining rate environment. Inspire Medical’s shares underperformed due to a combination of disappointing financial results and ongoing concerns about the impact of GLP-1 weight loss medicines on the company’s business as a result of the association between obesity and sleep apnea. Inspire Medical’s financial results fell short of expectations after the company implemented a pilot program where they disengaged with some high volume centers to let those centers handle prior authorization submissions. Unfortunately, some of these centers did not submit the prior authorization requests, resulting in procedures not being authorized and scheduled. We think this issue is easily fixable. As for GLP-1 drugs, we think the net impact remains unclear as some severely obese patients who would otherwise be ineligible for the company’s therapy could become candidates for treatment after losing weight.

Adverse stock selection in Communication Services came from internet advertising demand-side platform The Trade Desk and media company Liberty Media Corporation – Liberty Formula One. Trade Desk’s shares declined after quarterly guidance fell short of investor expectations. We believe the company remains well positioned for 2024 and beyond, with strong tailwinds in Connected TV, a secular growth category capturing spend at an increasing pace from linear TV and other forms of media. Longer term, we remain positive on the company given its technology, scale, and estimated 10% share in the $100 billion programmatic advertising market, a small and growing subset of the $700 billion global advertising market. Liberty Formula One’s stock underperformed as lower year-one profitability of the Las Vegas Grand Prix (LVGP) led to a reduction in annual guidance. Management noted that while the LVGP is proving to be a bigger spectacle than previously anticipated (with the potential for greater direct and indirect revenue opportunities over the long term), the race is expected to cost more in year one than initially anticipated due to greater startup costs and the initial focus on enhancing the fan experience. We continue to believe the event will eventually generate an attractive return on invested capital and be a key contributor to sustaining growth in U.S. fan interest. 

as of 12/31/23

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

Baron Small Cap Fund was up 27.19% for the year, outperforming the Russell 2000 Growth Index by 853 basis points due to stock selection and, to a lesser extent, active sector weights. Style biases also added value, driven by higher exposure to the better performing Size, Mid Capitalization, and Growth factors.

Favorable stock selection in Industrials was responsible for about two-thirds of the outperformance in the period, with the primary driver being Vertiv Holdings Co, a manufacturer of critical infrastructure equipment for data centers. The company is benefiting from a robust demand environment as well as successful implementation of its strategy to improve margins. As one of the leading providers of precision cooling for data centers, Vertiv stands to benefit from the increasing adoption of artificial intelligence (AI), as AI-related servers have higher energy density, which will necessitate more complicated cooling solutions. During the quarter, Vertiv held its first analyst day, where the company introduced long-term growth targets for revenue growth of 8% to 11% CAGR out to 2028 and 500 basis points of margin expansion to 20% over that same time frame. Higher exposure to this better performing sector coupled with sizeable gains from engineered aerospace components supplier TransDigm Group, Inc., composite decking manufacturer Trex Company, Inc., and wholesale landscape supplies distributor SiteOne Landscape Supply, Inc. also added value.

Additional tailwinds to performance came from the Fund’s Consumer Discretionary and Health Care holdings together with lack of exposure to the underperforming Energy sector. Strength in Consumer Discretionary was broad based, led by sharp gains from premier installation contractor Installed Building Products, Inc. and specialty flooring retailer Floor & Decor Holdings, Inc. Both companies benefited from improved sentiment for housing-related stocks, as the potential for lower interest rates in 2024 should enhance the prospects for the residential end market. Within Health Care, lower exposure to this lagging sector combined with substantial gains from contract research organization (CRO) ICON Plc and veterinary drugmaker Dechra Pharmaceuticals PLC added the most value. ICON has benefited from increased scale and growth share since its 2021 merger with PRA Health Sciences and is seeing strong demand despite lingering concerns over biotechnology funding levels. Customer preference is shifting toward functional outsourcing services, which should disproportionally benefit ICON as the market leader in this category. Backlog growth has grown more than 10% year-over-year to $22 billion in the third quarter, when EBITDA margins of 21% hit the mid-2025 target. Dechra’s shares jumped in mid-April on news of an attractive offer by Swedish investment firm EQT to take the company private. We have since trimmed our position.

Partially offsetting the above was adverse stock selection in Consumer Staples and Information Technology, where the primary detractors were facial treatments specialist The Beauty Health Company and connected supply chain software platform E2open Parent Holdings, Inc. Beauty Health’s shares declined after reporting disappointing results that showed execution issues associated with the roll out of Syndeo, the latest generation of the HydraFacial machine. While the features and functionality of this new device far surpassed the prior version, the machine also had several defects that caused potential buyers to delay their purchase. Additionally, to remedy the defects, the company had to incur added costs to repair and replace existing Syndeo machines in the field. Lastly, the company also experienced significant management volatility with both the CEO and CFO leaving. Due to the continued uncertainty surrounding the defects with Syndeo and heightened management turnover, we exited the position. E2open had multiple disappointing earnings reports during the year and recently lowered guidance for fiscal year 2024. Given the company’s inconsistent execution and a lack of conviction on the timing of a material growth re-acceleration, we exited our position.

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.