Review and Outlook

as of 03/31/20

U.S. equity markets suffered their worst quarter since the 2008 financial crisis, abruptly ending the longest bull market in U.S. history. U.S. equities achieved new all-time highs in mid-February before falling sharply as the spread of the COVID-19 virus worsened outside of China, raising concerns about global health risks and impacts on global supply chains and economies. The situation was made worse by an escalating oil price war between Russia and Saudi Arabia, which sent oil prices tumbling more than 20% in early March. Despite the Federal Reserve’s drastic actions and Washington’s massive stimulus plan to counter the coronavirus-induced economic slowdown, stock prices remained under pressure as the number of reported cases continued to rise globally. Small-cap stocks, which investors view as more vulnerable to economic disruption and less liquid, were particularly hard hit.

Against this backdrop, Baron Discovery Fund declined in the quarter. No sector contributed. Health Care, Information Technology (IT), and Consumer Discretionary investments detracted the most. Top detractor Sientra, Inc. led declines within Health Care. Despite some gains within IT, detractors outweighed contributors, led by third largest detractor PAR Technology Corporation. The portfolio’s Consumer Discretionary investments experienced steep losses as many retail, restaurant, and casino locations were shuttered as a result of COVID-19. The sector included second largest detractor Floor & Décor Holdings, Inc.

As long-term investors, our investment horizon goes beyond the impact of COVID-19. We believe we will get through this pandemic -- it is just a question of timing. Knowing this allows us to capitalize on the benefits of contractionary periods. Most importantly, we will be able to buy high- quality, fast growing businesses at valuations you will not see at other points in the business cycle. In addition, as weaker companies tend to go bankrupt during contractions, survivors are left in better competitive positions, allowing for faster growth and higher profit margins post-contraction. Businesses also become more efficient in challenging economic times, making targeted cost cuts that typically do not need to be layered back on during the recovery. Finally, we expect valuations to increase when investors have more visibility into the coming recovery.

We fully expect our small, fast growing businesses to weather the current economic environment and emerge in a stronger competitive position on the other side. We also believe that the current uncertainty and dislocation will create opportunities to purchase additional fast-growing businesses at reasonable valuations. Economic recoveries have typically been good environments to be invested in fast growing small companies and we would expect the next recovery to be no different.

Top Contributors/Detractors to Performance

as of 03/31/20

Contributors

  • Shares of Teladoc Health Inc., the U.S.'s leading provider of telehealth services, soared during the first quarter due to the COVID-19 outbreak. Telehealth is perfectly suited as an initial patient touchpoint in a time of social distancing and growing concerns of overwhelming the health care system. Call volumes have spiked, reimbursement for telehealth has been widely expanded, and restrictions on MD cross-state licensure have been lifted to expand the pool of available doctors. We believe the crisis has accelerated the adoption and cemented the use of telehealth. 
  • Inogen, Inc. is a medtech company that develops, manufactures, and markets innovative portable oxygen concentrators (POCs) for use by chronic respiratory patients who are reliant on long-term oxygen therapy. Signs of early COVID-19 outbreak in the U.S drove up shares after our well-timed purchases as oxygen is a vital element of patient treatment. While Inogen does not make hospital-oriented ventilators, its POCs and other ventilation products can be used for oxygen-oriented treatments. We believe the company has great long-term growth prospects as the market for POCs is underpenetrated by 20%. 
  • Qualys, Inc. provides cloud-based software solutions for security risk and compliance management and has a rapidly expanding line of new security-related products. Shares appreciated as investors expect cybersecurity spend to better withstand potential changes in IT spend. We believe Qualys’ multi-year investments in its own modernization activity will allow it to potentially serve existing and new customers better, leveraging its cloud architecture with new agents and endpoint products to combat the rapid changes taking place in the software stack due to the COVID-19 pandemic. 

Detractors

  • Shares of Sientra, Inc., an aesthetics medical device company, declined sharply in the first quarter on fears related to lower sales due to the COVID-19 outbreak, as elective surgeries have effectively been cancelled across most of the U.S. We think the discounted share price ignores significant positives including a cost savings plan, better manufacturing utilization, and growth of its MiraDry (underarm sweat) product. Despite COVID-19-related setbacks, we believe the company has sufficient cash resources until it regains its stride in early 2021. 
  • Shares of Floor & Decor Holdings Inc., a hard-surface flooring retailer, fell as the company closed all stores in March due to the COVID-19 pandemic. Although online orders are still being accepted, we expect store closures and weaker end-demand to negatively impact 2020 results. We believe Floor & Decor is a differentiated retail concept with a big long-term opportunity for store growth (120 stores today vs. 400 target), and expect the company to emerge from this crisis stronger and in a better position to open stores and gain market share in the long term. 
  • Shares of PAR Technology Corporation, a provider of point-of-sale solutions to restaurant chains, fell sharply during the quarter. Investors discounted a near-term slowdown in growth as restaurants are unlikely to invest in technology in the current environment. Given PAR’s strong balance sheet and superior product, we believe PAR will emerge from the current uncertain period with strong growth as restaurants realize the importance of technology. Additionally, we expect the company to see accretive acquisition opportunities to rapidly grow annual recurring software revenues.

Quarterly Attribution Analysis (Institutional Shares)

as of 03/31/20

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 03/31/20

Baron Discovery Fund (Institutional Shares) fell 19.95% in the first quarter, yet outperformed the Russell 2000 Growth Index by 581 basis points due to stock selection and, to a lesser extent, relative sector weights and modest cash exposure in a down market. Style biases also added value, driven by underexposure to the poor performing earnings yield and leverage factors.

Investments in Industrials, Real Estate, Information Technology (IT), and Financials and lower or lack of exposure to the lagging Consumer Discretionary, Materials, and Energy sectors added the most value. Stock selection in Industrials contributed nearly 300 basis points to relative performance, driven by defense company Mercury Systems, Inc. and hydraulic and electronic control solutions manufacturer Helios Technologies, Inc. Mercury’s stock price rose in the quarter because the company is considered a necessary enterprise, allowing it to operate without interruption during the COVID-19 crisis. Helios’ shares benefited from a backlog of orders entering the year, which provided stability in a shifting environment. Performance in the sector was also bolstered by wood-alternative decking and railing manufacturer Trex Company, Inc., wholesale landscape supplies distributor SiteOne Landscape Supply, Inc., and composite wind blade manufacturer TPI Composites, Inc. Strength in Real Estate came from temperature-controlled warehouse operator Americold Realty Trust and industrial real estate firm Rexford Industrial Realty, Inc., whose shares outperformed as investors appreciated the stability of their business models amid an uncertain macroeconomic environment. Within IT, outperformance of Qualys, Inc., RIB Software SE, and other software holdings and higher exposure to this better performing industry added the most value. Shares of cloud-based security solutions provider Qualys outperformed because security spending is expected to less impacted by any potential changes in overall IT spending. Shares of construction modeling software company RIB were up sharply for the period held after the company received an acquisition offer from Schneider Electric. The Fund’s largest position in Financials, specialty insurer Kinsale Capital Group, Inc., performed well after being less impacted by COVID-19 and slower economic growth than many other businesses.

Health Care and Communication Services investments and lack of exposure to the defensive Utilities sector detracted the most from relative results. Weakness in Health Care was driven by aesthetics medical device company Sientra, Inc., whose shares fell sharply on fears about lower sales due to COVID-19. Lower exposure to outperforming biotechnology stocks also weighed on performance in the sector. The primary sources of underperformance in Communication Services were tracking stock Liberty Media Corp. – Liberty Formula One Group and U.K.-based special interest publisher Future plc.

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.