Review and Outlook

as of 09/30/19

The third quarter was challenging for both the markets and Baron Discovery Fund. Equities struggled for gains amid heightened volatility as trade tensions between the U.S. and China remained a concern. Weak global economic data combined with the inversion of the 10-year and 2-year U.S. yield curve also weighed on investor sentiment. A risk-off backdrop and declining interest rate environment benefited defensive sectors such as Utilities, Consumer Staples, and Real Estate. On the other hand, Health Care faced continued pressure due to uncertainty related to potential health care policy changes. Investors gravitated towards larger capitalization stocks for a third consecutive quarter, while the run of outperformance of growth stocks was challenged in September, particularly in small- and mid-cap, when investors rotated heavily into value stocks.

There is still plenty of good news to be found on the economic front. While global growth slowed down, we see few signs of an imminent recession on the horizon. Unemployment remains close to historic lows, wages are increasing – but not at a rate that would signal inflationary concerns – and U.S. consumers continue to spend and report confidence. Interest rates remain low, with the Fed cutting rates twice in the quarter. Credit markets are healthy, and we are seeing increasing amounts of liquidity in the capital markets.

Against this backdrop, Baron Discovery Fund declined in the quarter. Real Estate, Financials, and Communication Services holdings contributed the most. Health Care, Information Technology (IT), and Industrials investments were the top detractors. Real Estate advanced on the strength of share price increases in all three portfolio holdings. The sole Financials investment, property and casualty insurer Kinsale Capital Group, Inc., gained ground on improving conditions in the excess and surplus market after retrenchment from several large competitors. Increases in the share price of the portfolio’s three Communication Services holdings helped boost that sector’s performance. With top detractor ViewRay, Inc. and second largest detractor Silk Road Medical, Inc. within the sector, Health Care had a challenging quarter. Holdings in application software and IT consulting and other services led declines in IT as investors exited high-growth, high-multiple stocks in a risk-off rotation. Third largest detractor Bloom Energy Corporation led declines in Industrials.

The market volatility and mixed signals of the third quarter remind us why we are long-term investors. We believe short-term macro developments are largely unpredictable, and the corresponding impact on stock prices is even more mercurial. We believe valuations for our investments leave room for significant upside over the medium and long term (which we define as a three-to-five-year period). We continue to look for our targeted returns on each of our investments on an individual basis. Our goal, as always, is to find small, fast growing companies with what we believe to have great management teams, sustainable competitive advantages, and long runways for growth, before they are discovered by the rest of Wall Street.

Top Contributors/Detractors to Performance

as of 09/30/19

Contributors

  • TherapeuticsMD, Inc. develops hormone-based drugs for women's health. It has three FDA-approved drugs, two of which are already in limited launch. We believe that as payer reimbursement is solidified by early 2020, sales of all three drugs will accelerate dramatically. After a slide in the prior quarter, shares started to recover in Q3. The company surprised positively, beating earnings and slightly increasing full year guidance. We believe shares are significantly undervalued and that 2020 will be a watershed year in establishing the company's maturity and growth.
  • Floor & Decor Holdings Inc., a hard-surface flooring retailer, outperformed during the quarter following better than expected earnings. Investor sentiment around housing and tariffs continued to improve. The merchandising team has done a commendable job moving production out of China quickly to mitigate the tariff impact. We believe that Floor & Decor is a differentiated retail concept with a large long-term opportunity for store growth (106 stores today vs. 400 target). Over the next few years, we expect the company to grow square footage, sales, and EPS by more than 20%.
  • Trex Company, Inc. is the dominant manufacturer and industry pioneer of wood-alternative ("composite") residential decking in the U.S. The company had a strong quarter, driven by second quarter financial results and third quarter sales guidance, both of which were well above analyst expectations. Trex continues to enjoy robust demand for its products, driven by a secular shift towards composite from wood. Trex’s recently launched, more affordable "Enhance" product is expanding its addressable market and further accelerating demand.

Detractors

  • ViewRay Incorporated manufactures medical capital equipment that uses MRI imagery to guide cancer radiation treatment in real time. We believe ViewRay's technology, including software to automatically stop radiation when the tumor is out of field, is game changing and that the company can capture meaningful share in what could be a $2.5 billion market. This was a tough quarter as ViewRay lowered full year guidance by five units, causing a $30 million shortfall that could meaningfully affect funding needs a year out.
  • Shares of Silk Road Medical, Inc., a newly public medical device company offering a novel approach to the treatment of carotid artery disease, detracted from performance. The stock declined from record high levels due to high near-term valuation and a market sell-off in high-growth companies. We continue to believe Silk Road has a long runway for growth. The company has strong competitive advantages including strong clinical data, a unique FDA label, reimbursement, and patents, and we believe its approach will become the preferred treatment for carotid artery disease.
  • Bloom Energy Corporation designs, manufactures, and sells solid-oxide fuel cell systems. Bloom Energy has developed a proprietary, distributed, on-site electric power solution delivering highly reliable, uninterrupted power. The shares fell after the company guided to unit sales in 2020 that were much lower than analyst forecasts. Even though the technology continues to improve over time and costs are coming down, the near-term demand appeared much weaker than we expected. We sold our shares in the company.

Quarterly Attribution Analysis (Institutional Shares)

as of 09/30/19

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 09/30/19

Baron Discovery Fund (Institutional Shares) declined 4.84% in the third quarter and trailed the Russell 2000 Growth Index by 67 basis points due to stock selection.

Investments in Real Estate, Financials, and Communication Services and cash exposure in a down market added the most value. Within Real Estate, Americold Realty Trust, Rexford Industrial Realty, Inc., and Alexander & Baldwin, Inc. benefited alongside other REITs as investors gravitated toward securities with attractive dividend yields in a declining interest rate environment. Within Financials, outperformance of the Fund’s only holding in the sector, specialty insurer Kinsale Capital Group, Inc., added value. Kinsale’s shares outperformed as conditions in the Excess & Surplus lines market continued to improve following retrenchment from several large competitors. The company reported strong financial results for the latest quarter with 36% growth in gross written premiums and a 17% return on equity. Strength in Communication Services came from global motorsports business Liberty Media Corporation - Liberty Formula One and U.K.-based special interest publisher Future plc. Liberty Formula One’s stock price appreciated after the company reported solid second quarter financial results and management optimism regarding negotiations with Formula One teams concerning proposed structural changes to the sport. Future’s shares were up on strong e-commerce performance driven by Amazon Prime Day, increased investor awareness in the U.S., and foreign exchange tailwinds.

Underperformance of Health Care and Industrials investments and minimal exposure to the defensive Consumer Staples and Utilities sectors detracted the most from relative results. Negative stock selection in Health Care accounted for the entirety of the Fund’s underperformance, driven by radiation therapy systems developer ViewRay Incorporated, transcarotid artery revascularization pioneer Silk Road Medical, Inc., and organ transplant diagnostics leader CareDx, Inc. ViewRay and Silk Road were the top detractors from absolute performance in the quarter. CareDx’s shares were down on concerns about a competitor's entry into the market, the overall utility of cell-free DNA tests for kidney rejection monitoring, and a short seller's report claiming the overall market opportunity is smaller than originally indicated by management. We disagree with most of the issues raised and continue to like CareDx's prospects. Adverse stock selection in Health Care was partly offset by lower exposure to biotechnology stocks, which were down more than 14% in the index. Weakness in Industrials was mainly due to the underperformance of Bloom Energy Corporation, which designs, manufactures, and sells solid-oxide fuel cell systems. Bloom Energy was the third largest detractor on an absolute basis before being sold after guidance for full year 2019 came in well below Street expectations.

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.