Baron Durable Advantage Fund | Q4 2024

We had another good quarter to finish out a solid 2024.

Baron Durable Advantage Fund® (the Fund) gained 3.1% (Institutional Shares) in the fourth quarter, compared to the 2.4% gain for the S&P 500 Index (the Index). For calendar year 2024, the Fund gained 27.1%, which compared favorably to the 25.0% gain for the Index.

U.S. large-cap equities was again the place to be in 2024. After a 26.3% gain last year, the S&P 500 Index returned an impressive 25.0% for an encore. The U.S economy remains strong, with the latest GDP forecast from the Atlanta Fed estimating 3.1% GDP growth in the fourth quarter, while the rate of inflation remained below 3%. It seems that only yesterday Apple’s market cap reached the $1 trillion milestone. As of January 2025, after a two-year blockbuster run, there were ELEVEN companies with market values of $1 trillion or more. While Apple remained the world’s most valuable company at $3.8 trillion it was joined by NVIDIA, Microsoft, Alphabet, Amazon, Meta, Tesla, Berkshire Hathaway, Taiwan Semiconductor, Saudi Aramco, and Broadcom. An impressive run and a notable list, indeed. Seven of these companies, collectively known as the Magnificent Seven, were again the key driver of Index returns. In 2023, Alphabet, Amazon, Apple, Meta, Microsoft, NVIDIA, and Tesla represented 26% of the Index, on average, and accounted for 62% of its gains. In 2024, this group was responsible for 53% of the Benchmark’s return while representing approximately 31% of its weight. Our Magnificent Seven holdings outperformed the Index’s by 127bps, while the rest of our portfolio outperformed the remainder of the Index’s holdings by 402bps.

Magnificent Seven performance has captured a lot of attention from the news and financial media, who spend a lot of time highlighting the group’s returns but not so much emphasizing its fundamentals. As a group, Magnificent Seven total operating profits rose from $343 billion in 2022 to $575 billion in 2024⁴, and its free cash flow increased from $256 billion to $414 billion. During 2024, consensus estimates for 2025 earnings have increased by 21%. Now, add the fact that these companies are some of the best and most obvious beneficiaries of the AI opportunity, owning and operating key platforms enabling AI. In that context, is it really surprising that the Magnificent Seven performed as well as they did?

From a quarterly performance attribution perspective, there was not much insight to be gleaned from what was a pretty uneventful quarter. We did well in Financials where Apollo and LPL Financial generated excess returns, while our investments in Industrials and Health Care lagged. Not having investments in Materials, Utilities, and Energy also contributed to relative returns. Broadcom, Amazon, Apollo, LPL Financial, and Taiwan Semiconductor were our top five contributors to absolute returns, while Monolithic Power, Thermo Fisher, and Danaher detracted.

For the year, investments in Communication Services, Consumer Staples, Consumer Discretionary, and Financials contributed 376bps combined to relative returns, while not owning stocks in Energy, Materials, and Utilities added an additional 136bps. This was offset by poor performance in Real Estate, Information Technology (IT), and Health Care holdings, which detracted 126bps. From a stock specific perspective, we had 29 contributors and 8 detractors – a solid batting average in what was a mixed year for our investable universe. But where we really shined was our slugging percentage with NVIDIA, Meta, Amazon, Broadcom, Taiwan Semiconductor, Apollo, Alphabet, Microsoft, and Brookfield contributing over 100bps each to absolute gains, while 13 of our holdings saw their stock prices rise over 30%. The average position size of investments that outperformed the Index was 3.6%, while the average position size of those that underperformed was 2.1% – or 150bps lower.

The last three years proved to be quite a ride for equity investors. In many ways, it can be perceived and evaluated as a full market cycle: a sizable drawdown in 2022, followed by a meaningful recovery in 2023 and 2024. We are pleased with how the Fund performed over this combined period, generating a gain of 39.1%, close to 1,000bps better than the 29.3% return for the S&P 500 Index. As a reminder, we seek to generate 100bps to 200bps of alpha over the Index (per year, net of fees and expenses, and over full-market cycles) by investing in high-quality, competitively advantaged businesses for the long term, while minimizing the probability of a permanent loss of capital. We do it differently from many of our competitors who construct their portfolios similarly to the Index by combining cheap value stocks with more expensive growth stocks. Both value and growth labels are as much a function of the multiple that is currently assigned to the stock as they are of the business’s growth; they do not tell us anything about the most important characteristic of the business: its quality.

Instead of splitting the investable universe into value stocks and growth stocks, we separate them into high-quality and lower-quality businesses. We further split the high-quality category into Big Ideas and companies that we call holders of value. Big Ideas are businesses going through the steep part of their growth s-curves that are in the earlier stages of their growth life cycles from the industry penetration perspective. These are companies that are either driving or are benefiting from disruptive change and that can become significantly larger in the future than they are today. This is the bread and butter of many investment strategies at Baron. This Fund, however, offers a home for the companies that are either in the later stages of being a Big Idea or that are transitioning into becoming holders of value (although, occasionally we may find a company priced and perceived as a holder of value that is on its way to becoming a Big Idea, as was the case with NVIDIA when we first invested in the company towards the end of 2022, and Broadcom, which was acquired early in 2024). Essentially, we focus on long-term compounders with lower risk: the highest quality large-cap companies with attractive business models (asset light, high recurring revenues, low financial leverage, etc.), durable growth characteristics (long duration of growth, though the growth rates may be lower), that solve critical problems for their customers and have durable competitive advantages. Typically, these companies face lower risk of getting disrupted by competitors or new technologies. We also look for management teams with long track records of operational excellence and prudent capital allocation. One of the most common signs of a company leaving the realm of a Big Idea and transitioning into the holder of value is the recognition that it can no longer reinvest all of its excess cash flow back into the business at high rates of return, and therefore it chooses to return capital back to shareholders via dividends or stock buybacks. If we are successful in identifying and investing in businesses with the above characteristics, it should make our claim and conviction in lower risk of a permanent loss of capital somewhat self-evident.

We believe that the best way to assess whether we are successful in doing what we set out to do is to measure our performance over full market cycles. We believe that rolling monthly performance is helpful in that regard. This analysis shows that on an annual basis, the Fund has outperformed the S&P 500 Index and its Morningstar peer group, 62% and 68% of the time, respectively.* But as the time horizon extends so has the Fund’s winning percentage. On a 3-year rolling monthly return basis, it has outperformed 78% and 86%, and on a 5-year basis, the Fund has outperformed 96%, and 100% of the time, respectively. Note of course that past performance does not guarantee future results.

The performance data quoted represents past performance. Current performance may be lower or higher than the performance data quoted. The indexes is unmanaged. Index performance is not Fund performance. Investors cannot invest directly in an index.

*As of 12/31/2024, the annualized returns of the Morningstar Large Growth Category average were 28.96%, 15.42%, and 14.28% for the 1-year, 5-year, and since inception (12/29/2017) periods, respectively. 

Sources: Baron Capital, S&P Global Inc., and Morningstar Direct.

Broadcom Inc. is a fabless semiconductor and enterprise software company with 60% of revenue from semiconductors and 40% from software. Shares increased 34.8% in the fourth quarter, and 72.4%⁵ in 2024, on rising investor confidence in its AI market opportunity and strong execution across segments. Broadcom reported solid fourth quarter results, driven by robust semiconductor solutions growth of 12% with AI revenues reaching $12.2 billion for the fiscal year, although software revenues slightly missed forecasts due to deal delays. Broadcom estimated its serviceable addressable market for AI at a range of $60 billion to $90 billion by fiscal 2027, primarily across Google, Meta, and ByteDance, with additional opportunity with other customers. Moreover, the company continues to progress ahead of schedule on integrating VMware, with rapid margin expansion (reducing VMware spend to $1.2 billion in the fourth quarter of 2024, down 50% from $2.4 billion prior to the acquisition) and faster-than-anticipated incremental EBITDA contribution, highlighting Broadcom’s operational discipline. Non-AI semiconductor businesses showed signs of recovery, while networking solutions including Tomahawk and Jericho continue to perform well. We remain confident in Broadcom’s ability to capitalize on the growth in AI infrastructure, deliver operational synergies, and maintain leadership in networking technologies.

Amazon.com, Inc. is the world’s largest retailer and cloud services provider. Shares increased 17.7% in the fourth quarter, ending 2024 up 44.5%, after the company reported solid third quarter results, with $17.4 billion in operating profits, nearly $3 billion above consensus expectations; solid growth in Amazon’s cloud business (Amazon Web Services or AWS), which grew 19% year-over-year; and continued positive commentary on AI, with Andy Jassy calling generative AI⁶ a “once-in-a-lifetime type of opportunity,” sharing promising data on growth: “our AI business is a multibillion-dollar business. It’s growing triple-digit percentages year-over-year, and it’s growing 3x faster at its stage of evolution than AWS did itself. We thought AWS grew pretty fast." While the company is investing large amounts in AI, it continues to improve profitability across its core North American retail, international retail, and even AWS, thanks to cost discipline and operational optimization. While we continue to monitor progress across all cloud hyperscalers, we believe AWS will ultimately be a winner in generative AI, given Amazon’s scale and technical infrastructure advantages. Longer term, Amazon has substantially more room to grow in e-commerce, where it still has less than 15% of its total addressable market. Amazon also remains the clear leader in the vast and growing cloud infrastructure market, with large opportunities in application software, including enabling generative AI workloads.

Shares of alternative asset manager Apollo Global Management, Inc. rose 32.6% in the fourth quarter, ending the year up 73.3%⁷. The company held a well-received Investor Day in October, in which management highlighted the work done to build Apollo into a successful credit manager and laid out bullish five-year targets of $1.5 trillion, $5 billion, and $5 billion for assets under management, fee-related earnings, and spread-related earnings, respectively, as well as a $15-plus EPS target. Apollo also participated in the broader rally of financial stocks spurred by the Republican November elections sweep, which has bolstered expectations for greater capital markets activity and reduced regulatory scrutiny. In addition, investors anticipate that a more business-friendly administration will not block growth initiatives from alternative managers, including plans to introduce private investments into a broader swathe of retirement assets. Finally, Apollo was added to the Index in the quarter. We remain shareholders given Apollo’s strong long-term growth prospects driven by the growth of alternative investments and the company’s strong competitive advantages thanks to scale, first-movers advantage, and proprietary origination capabilities.

Monolithic Power Systems, Inc. is a fabless high-performance analog and power semiconductor company serving diverse end markets across the semiconductor industry. Monolithic is a relatively small player that leverages its deep system-level and applications knowledge, strong design experience, and innovative process technologies to provide highly integrated, energy-efficient, cost-effective, and easy-to-use products. Shares fell 35.9% in the fourth quarter and finished the year down 5.6% on rumors Monolithic was being displaced as a power module supplier for NVIDIA’s AI systems. While management always discussed multi-sourcing for NVIDIA’s Blackwell, sell-side reports suggested Monolithic would be fully removed, which could also suggest issues with its products. After speaking with management, we believe the rumors are unlikely to materialize. As the demand environment improves, Monolithic should return to growing 10% to 15% above the industry average as it expands its addressable market and takes advantage of areas where competition fails to innovate, driving meaningful long-term upside in the stock.

Thermo Fisher Scientific Inc. is a life sciences company that offers instruments and consumables for research, tools for bioproduction, specialty diagnostics, and contract research and manufacturing services. Shares fell 15.8% in the fourth quarter and ended the year down 2.1%, on underwhelming quarterly results marked by cautious commentary around China, slow progress of biopharmaceutical projects, and equipment purchases. The election of Trump and his selection of Robert F. Kennedy, Jr. to head Health and Human Services also pressured shares as they introduced an element of uncertainty into health care regulation and life science funding. We retain conviction as Thermo Fisher is a dominant and a diversified supplier across multiple end markets, that together with its scale, make it more resilient to a variety of market conditions. Once the macro environment normalizes, we expect a durable organic growth profile in the high single-digit range along with double-digit EPS growth.

Danaher Corporation supplies instruments to the life sciences industry for lab research, genomics services, and bioproduction and diagnostics tools for clinical tests in large core labs, hospitals, pathology labs, and at the point of care. Shares declined 17.3% in the quarter and finished 2024 down 0.5% on cautious forward-looking quarterly commentary marked by weakness in China, biopharmaceutical projects, and equipment cycles. The election of Trump and his selection of Robert F. Kennedy, Jr. to head Health and Human Services also pressured shares as they introduced an element of uncertainty into health care regulation and life science funding. We retain conviction given Danaher’s market leadership and broad portfolio within bioprocessing, which addresses a biologics market with double-digit growth that should benefit growth thanks to a wave of biosimilars entering the market. Danaher has a portfolio of high-quality assets, with targets of high single-digit core revenue growth and double-digit EPS growth that we believe should sustain for the long term.

The portfolio is constructed on a bottom-up basis with the quality of ideas and conviction level (rather than benchmark composition and weights) determining the size of each individual investment. Sector weights tend to be an outcome of the stock selection process and are not meant to indicate a positive or a negative “view.”

As of December 31, 2024, our top 10 positions represented 53.5% of the Fund’s net assets, the top 20 were 79.5%, and we exited 2024 with 34 investments (this compares to 52.6%, 82.2% and 30 investments as of the end of 2023, respectively). As of year end, Financials and IT were our largest sectors, representing 62.0% of the Fund. Communication Services, Health Care, Consumer Discretionary, Industrials, Real Estate, and Consumer Staples represented another 37.6% of the Fund. Cash was the remaining 0.3%.

During the fourth quarter, we initiated a position in the senior living focused REIT, Welltower. We also increased six existing positions, including continuing to build two of our most recent additions to the portfolio – the government-focused services contractor, Booz Allen, and the aerospace and defense supplier, TransDigm. We also sold our stub position in Lineage during the quarter as we reallocated to ideas in which we had greater conviction.

We initiated a new investment in Welltower Inc. in the most recent quarter. Welltower owns and operates senior housing and medical office buildings in the U.S. and internationally. Welltower owns over 2,100 properties with nearly 200,000 units and is focused on the most attractive, high end of the market, a segment in which they enjoy the benefits of geographic density, scale, and pricing power.

We believe that senior housing fundamentals will continue to be robust with Welltower well positioned to capture both the cyclical and secular growth inflection over the coming years. The industry backdrop hasn’t been this favorable in many years with accelerating demand while growth in supply is limited. Underlying demand is supported by a demographics boom with the 80+ year-old population growing at a 4% to 5% CAGR over the next five years versus annual growth below 2% coming out of the Great Financial Crisis. While growth is accelerating, supply is muted given construction starts are declining rapidly, current developer economics are no longer attractive, and there is a five-plus year timeline to entitle and build a new project.

We believe that by returning to normalized occupancy rates, there is a path for senior housing cash flow to grow by over 50%. In addition, there is further structural upside opportunity to both operating margins and occupancy through enhanced asset management, employing proprietary data analytics and introducing initiatives such as amenity-based pricing. We recently met with the entire Welltower executive team in our offices and came away even more encouraged by the multi-dimensional growth opportunities ahead. Welltower has recruited top senior executives from the multi-family space to execute and deploy these initiatives that will drive operating margins and occupancy beyond industry standards.

Lastly, the management team, led by Shankh Mitra (CEO), John Burkart (COO), Tim McHugh (CFO), and Nikhil Chaudhri (CIO) are astute allocators of capital focused on driving shareholder value. Shankh’s annual letters to shareholders might sound familiar to the Fund’s shareholders – from defining risk as “permanent capital loss; not volatility” to reducing risk by “seeking a large margin of safety… acquiring assets for less than what it costs to build” and with the company’s north star being the “long-term compounding of per share cash flow.” If you enjoy reading our letters, you will enjoy these even more – https://welltower.com/investors/.

The current capital constrained financing environment for senior housing with loans either coming due or interest rate caps coming off assets acquired during a period of low interest rates should provide an active and growing external growth pipeline where management will be able to invest at an attractive “cost basis” below replacement cost. Putting this all together, we see a path for earnings to more than double over the next five years, leading to attractive return prospects for shareholders.

During the quarter, our largest additions were to two of our recent purchases – TransDigm Group Incorporated and Booz Allen Hamilton Holding Corporation. While commercial aftermarket growth has slowed relative to the elevated levels seen in 2022-2023, OEMs still struggle to ramp up production, and travel demand remains strong, providing durable tailwinds for TransDigm. With 90% of its portfolio classified as proprietary, the company has significant pricing power, enabling mid-single-digit growth even with inflation coming down. Additionally, the company just had one of its most active years of M&A in a while and sees more opportunities ahead with the new administration’s more pro-M&A-stance. Booz Allen is seeing extraordinary demand from different federal agencies with its technology focused solutions. It has become the largest provider of AI and sophisticated cyber services and is at the forefront of the government’s broad-based technology modernization efforts. The incoming administration’s DOGE initiative is being perceived as a risk, and it has hurt both companies’ share prices post the election results. While we continue to assess the range of possible outcomes, we believe the risk is both overstated and manageable. Approximately 6% of TransDigm’s sales are direct to the DoD with less than 1% not under formal contracts. The company’s parts are mission-critical, low cost, and purchased in low volumes. Even in scenarios in which replacement parts were to be considered, since TransDigm’s parts are largely sole-sourced, it would take a while to develop, test, and certify a whole new set of solutions. More importantly, it is unlikely to yield meaningful savings and would be extremely time-consuming and risky. Booz Allen has a key set of strategic capabilities as an enabler of efficiency and technological progress with especially strong capabilities in cyber and AI.

“Time is the friend of the wonderful business, the enemy of the mediocre.” 
– Warren Buffett’s letter to shareholders, 1989

We continue to operate in an environment where an overwhelming majority of investors are hyper-focused on the minute-by-minute news cycle. What is the incremental change? The reality is that this incremental change is very rarely of any consequence or materiality, yet stock prices react to the change and pick up momentum in both directions. We work hard on trying to cut through the noise and focus on seeing the forest for the trees.

The range of outcomes continues to be fairly wide, creating a challenging environment for investors. We stick to focusing on well-managed, high-quality businesses with sustainable competitive advantages for the long term. We continue to speak with company management teams as often as we can, test our investment theses, look for disconfirming evidence, and measure how well our businesses are performing fundamentally.

Over the long term, stock prices will reflect the intrinsic value of businesses. Of course, in any given year, stocks can trade ahead or behind because businesses’ intrinsic values are not readily available to investors. Instead, they must be estimated by making assumptions and projections about growth rates, profitability, direction and level of interest rates, opportunity costs, and so on. These projections are often volatile and can swing violently in both directions depending on a multitude of factors including investors’ psychology, time horizon, and risk appetite.

To get a glimpse into the direction of intrinsic values and investor perception, we deconstructed the Fund’s returns into two components – the change in multiples and change in the fundamentals. During the quarter, the Fund’s weighted average multiple⁸ declined by 0.7%, and finished 2024 up 6.4%. Since the Fund was up 3.1% in the quarter and 27.1% during 2024, the fundamentals of our holdings grew by approximately 4% in the quarter and by approximately 21% during 2024 – implying that 77% of our performance in 2024 was driven by growth in fundamentals while 23% was driven by the change in multiples. The fundamentals of our businesses continue to improve after the slowdown in 2022 with consensus revenue expectations for 2025 rising by 1.1% during the quarter and 7.6% during 2024⁹, operating income estimates increasing by 1.7% and 10.6% respectively, and operating margin expectations increasing by 28bps in the quarter and 59bps in 2024. Business trends are improving across most sectors and geographies. A longer-term perspective on the weighted average multiple of the Fund shows that the weighted average multiple today is in line (0.1% lower) with the weighted average multiple of our holdings over the last five years.

Every day, we live and invest in an uncertain world. Well-known conditions and widely anticipated events, such as Fed rate changes, ongoing trade disputes, government shutdowns, and the unpredictable behavior of important politicians the world over, are shrugged off by the financial markets one day and seem to drive them up or down the next. We often find it difficult to know why market participants do what they do over the short term. The constant challenges we face are real and serious, with clearly uncertain outcomes. History would suggest that most will prove passing or manageable. The business of capital allocation (or investing) is the business of taking risk, managing the uncertainty, and taking advantage of the long-term opportunities that those risks and uncertainties create. We are confident that our process is the right one, and we believe that it will enable us to make good investment decisions over time.

Our goal is to invest in large-cap companies with, in our view, strong and durable competitive advantages, proven track records of successful capital allocation, high returns on invested capital, and high free-cash-flow generation, a significant portion of which is regularly returned to shareholders in the form of dividends or share repurchases. It is our belief that investing in great businesses at attractive valuations will enable us to earn excess risk-adjusted returns for our shareholders over the long term. We are optimistic about the prospects of the companies in which we are invested and continue to search for new ideas and investment opportunities.

Sincerely,