Baron FinTech Fund | Q2 2024

In the quarter ended June 30, 2024, Baron FinTech Fund® (the Fund) fell 2.25% (Institutional Shares) compared with a 5.78% decline for the FactSet Global FinTech Index (the Benchmark). Since inception, the Fund has risen at a 9.41% annualized rate compared with 0.80% for the Benchmark.

U.S. equities rose in the second quarter with major market indices hitting new highs. Corporate earnings were better than expected and mixed economic data suggests that inflation continues to moderate. However, the equity rally was driven by a narrow segment of the market, mostly in the mega-cap technology sector. The so-called Magnificent Seven (Alphabet, Amazon, Apple, Meta, Microsoft, NVIDIA, and Tesla) appreciated 17.0% during the quarter, accounting for all the gains in the S&P 500 and NASDAQ Composite Indexes. The remaining securities in these benchmarks collectively declined during the period with the equal-weighted S&P 500 Index down about 3%, demonstrating the outsized impact of the Magnificent Seven. Outside of the U.S., emerging market equities outperformed due to a rebound in China and strength in India following election results. Small- and mid-cap stocks declined in the period, trailing large caps by almost 7%. Growth outperformed value across most size segments, with the differential being most prominent in large cap where the Magnificent Seven comprise more than half of the Russell 1000 Growth Index’s assets.

During the second quarter, the Fund outperformed the Benchmark but trailed the broader market given the Fund’s smaller market cap profile and lack of exposure to the Magnificent Seven. The general underperformance of Financials stocks, where the Fund has heavy exposure, was also a headwind to relative performance versus the broader market. Leaders outperformed Challengers (down 1.3% versus down 4.7%, respectively). Stock selection in five of our seven themes contributed to relative performance (Capital Markets, Information Services, Tech-Enabled Financials, E-Commerce, and Enterprise Software). Despite equity market performance being driven by large-cap stocks, the Fund’s smaller cap holdings outperformed our mid- and large-cap holdings during the quarter.

Favorable stock selection in the Capital Markets theme contributed the most to relative performance. Shares of global electronic broker Interactive Brokers Group, Inc. (IBKR) outperformed due to solid execution with 25% growth in client accounts and 20% growth in revenue. IBKR also benefited from persistently high interest rates as the company earns interest income on customer cash balances. Global investment bank Houlihan Lokey, Inc. performed well on expectations for M&A activity to improve from cyclically depressed levels due to stabilizing interest rates, firming corporate valuations, and significant dry powder across private equity funds that will eventually be deployed into new investments. Shares of electronic fixed income marketplace Tradeweb Markets Inc. rose due to strong volume trends driven by favorable market conditions and share gains in key products.

The Information Services theme also contributed to performance thanks to double-digit gains from data and analytics companies Fair Isaac Corporation (FICO) and Verisk Analytics, Inc. FICO was the largest contributor due to a beat-and-raise quarter and optimism about the large potential earnings benefit from a drop in interest rates leading to greater consumer lending activity. Verisk performed well due to better-than­ expected quarterly results and favorable trends in the company’s insurance end market. Stabilizing interest rates and favorable debt capital markets activity drove outperformance at rating agencies S&P Global Inc. and Moody’s Corporation. Non-financial corporate debt issuance was up by double digits, most notably in high yield bonds, leveraged loans, and structured finance where rating agencies earn higher fees.

Strength in Tech-Enabled Financials was broad based, led by gains from alternative asset manager Apollo Global Management, Inc. and specialty insurer Arch Capital Group Ltd. Apollo continues to benefit from disruptive trends in financial services, most notably the shift of retirement assets into higher-yielding private credit given the company’s dual role as an asset manager and an annuity provider. Arch outperformed after reporting strong quarterly results with a 21% operating ROE and 40% growth in book value per share due to strong underwriting profitability and the establishment of a deferred tax asset at the end of 2023. Favorable conditions persist in the property and casualty (P&C) insurance market with rapid premium growth and attractive margins after several years of significant price increases.

Partially offsetting the above were adverse impacts associated with the Fund’s meaningfully lower exposure to the better performing Enterprise Software theme and unique exposure to Digital IT Services, where Endava plc and Accenture plc were detractors. Shares of these companies underperformed due to weak revenue growth as business customers pulled back on discretionary IT spending and delayed decisions on new projects to better incorporate recent advancements in generative AI (GenAI). Our Digital IT Services holdings have been a persistent drag on performance due to less durable demand trends than we expected. We believe a revenue growth recovery is a question of when, not if, so we continue to own these stocks at what we believe to be attractive valuations, but they collectively represent a small 3.0% portion of Fund net assets.

Fair Isaac Corporation (FICO) is a data and analytics company focused on predicting consumer behavior and is best known for its ubiquitous FICO scores. Shares increased after the company reported solid quarterly results and raised annual guidance. During the quarter, we attended the company’s annual user conference where CEO Will Lansing expressed confidence about the business’s performance under varying macroeconomic conditions and was optimistic about the growth potential for the software business. The market brushed off areas of near-term uncertainty, such as the impact of consumer lending activity on Scores volumes and a potential regulatory investigation into Scores pricing, and instead focused on the likely benefits of Federal Reserve rate cuts.

Mortgage originations are running 50% below the long-term historical average, so we estimate that a return to normal activity would increase FICO’s earnings by half. We continue to own the stock because of FICO’s significant competitive advantages and expect that consistent earnings growth will drive attractive returns for the stock over the long term.

Shares of P&C insurance software vendor Guidewire Software, Inc. outperformed after the company reported strong quarterly results that exceeded consensus expectations and raised full-year guidance. Annual recurring revenue (ARR) growth accelerated to 15%, subscription revenue grew 35%, and subscription gross margins expanded by over 10 percentage points during the recent quarter. We believe the company’s multi-year cloud transition is nearly complete. ARR should benefit from new customer wins and migrations of existing on-premise software customers to InsuranceSuite Cloud. We also expect the company to shift R&D resources from infrastructure investment to product development, which will help drive cross-sales into the large installed base and potentially accelerate ARR over time. We believe that Guidewire will be the critical software vendor for the global P&C insurance industry, capturing 30% to 50% of its $15 billion to $30billion total addressable market and generating margins above 40%.

Shares of Verisk Analytics, Inc., a leading data and analytics vendor for the insurance industry, contributed to performance. The company reported strong quarterly earnings, especially relative to muted expectations, with accelerating revenue growth and significant margin expansion. Management expressed optimism regarding the state of the P&C insurance end-market with strong premium growth and improving profitability leading to better growth prospects for Verisk. We maintain conviction in the competitive positioning, long-term growth, margin expansion, and capital deployment potential for the business.

Wise Plc is a UK-based provider of money transfer services for individuals and businesses across the world. Despite reporting solid operational trends and a large earnings beat in its half-year results, Wise shares declined as commission price cuts led to weaker-than-expected fiscal year 2025 earnings guidance. Medium-term guidance of 15% to 20% underlying income growth was also below consensus expectations. We believe the guidance is conservative and aligned with the company’s strategy to reduce fees and reinvest in the business. Wise captures less than 5% of the $2.6 trillion that individuals transfer across borders each year and less than 1% of the $11.6 trillion that businesses move internationally. We remain bullish on Wise as we believe its platform, licenses, and global connections are competitive advantages that enable the company to deliver a better value proposition to customers and gain share in a large global market.

Shares of payment processor Global Payments Inc. fell due to concerns about margins in its merchant acquiring segment as well as weak performance of payments stocks overall during the quarter. Nevertheless, the company reported solid quarterly results with revenue growth of 7% and earnings per share (EPS) growth of 8% or mid-teens excluding a business divestiture. Management reaffirmed annual guidance, calling for 6% to 7% revenue growth and 11% to 12% EPS growth on an adjusted basis. We view the shares as significantly undervalued at less than nine times earnings given our expectations for continued double-digit EPS growth.

Block, Inc. provides point-of-sale technology to small businesses and operates the Cash App ecosystem of financial services for individuals. Shares gave back gains from earlier this year despite reporting strong quarterly results and raising full-year guidance. In the first quarter, gross profit grew 22% and EBITDA grew 91%, both exceeding Street expectations. Given the strong start to the year, second-quarter guidance of 16% to 17% gross profit growth may have disappointed some investors. Management remains committed to a “Rule of 40” investment framework in 2026 with at least mid-teens gross profit growth and a mid-20% operating margin. We continue to own the stock due to Block’s long runway for growth, durable competitive advantages, and innovative product offering.

We seek to invest in competitively advantaged, growing fintech companies for the long term. We conduct independent, fundamental research and take a long-term perspective. We invest in companies across all market capitalizations and geographies. The quality of the ideas and level of conviction determine the position size of each investment. We do not try to mimic an index, and we expect the Fund will look very different from the Benchmark.

As of June 30, 2024, we held 45 positions (or 35excluding positions smaller than 1%). The Fund’s 10 largest holdings represented 42.5% of net assets, and the 20 largest holdings represented 70.4% of net assets. International stocks represented 12.0% of net assets. The market capitalization range of the investments in the Fund was $699 million to $539 billion with a median of $30.3 billion and a weighted average of $99.9 billion. The Fund’s active share versus the Benchmark was 86.8%.

We segment the Fund’s holdings into seven investment themes. As of June 30, 2024, Tech-Enabled Financials represented 25.9% of net assets, Information Services represented 23.8%, Payments represented 17.1%, Enterprise Software represented 14.1%, Capital Markets represented 9.5%, E-Commerce represented 5.1%, and Digital IT Services represented 3.0%. Relative to the Benchmark, the Fund remains underweight in Enterprise Software and Payments, and has overweight positions in Tech-Enabled Financials, Information Services, Capital Markets, Digital IT Services, and E-Commerce.

We also segment the Fund’s holdings between Leaders and Challengers. Leaders are generally larger, more established companies with stable growth rates, higher margins, and moderate valuation multiples. Challengers are generally smaller, earlier-stage companies with higher growth rates, lower margins, and higher valuation multiples. As of June 30, 2024, Leaders represented 77.6% of net assets and Challengers represented 20.9%, with the remainder in cash.

* Individual weights may not sum to the displayed total due to rounding.

During the quarter, we initiated one new position. Below we discuss some of our top net purchases and sales.

We initiated a position in KKR & Co. Inc., one of the largest alternative asset managers in the world with $578 billion of assets under management (AUM). We believe alternative asset management is one of the best secular growth areas of financial services, and KKR should be a prime beneficiary. Global alternatives AUM totaled $16.3 trillion at the end of 2023 and grew at an 11% CAGR since 2010, according to Preqin. Annual industry growth is expected to exceed 8% over the next five years with private equity (PE), venture capital, and private credit expected to grow at double-digit annual rates.

Founded in 1976 as one of the earliest leveraged buyout firms, KKR was led for decades by co-founders Henry Kravis and George Roberts. Since going public in 2010 as a pure-play PE firm, KKR has successfully diversified into other private asset classes, including private credit, real estate, and infrastructure investing. AUM has risen nearly 10-fold since 2010 (an 18% CAGR), and PE’s share of firm AUM has shrunk to less than one-third. These non-PE asset classes are less penetrated than PE and provide a substantial runway for KKR to continue growing its funds, fees, and earnings. KKR also has significant growth opportunities in Asia. The firm entered the Asian market in 2005 and has a scaled presence with 570 employees in a region where alternative asset management is far less penetrated compared to Western countries. In 2021, KKR successfully transitioned leadership from Kravis and Roberts to co-CEOs Scott Nuttall and Joe Bae, longtime KKR employees responsible for many of the growth initiatives that are driving KKR’s success today.

In addition to its globally diversified asset management business, KKR has significant exposure to the growth of private credit through its ownership of Global Atlantic, an insurance company with $177 billion of AUM. Like Athene (an insurer owned by Apollo Global Management, Inc., another holding of the Fund), Global Atlantic is a beneficiary of the shift of illiquid credit assets into the private markets where they are better matched from a funding duration perspective and can deliver higher yields than publicly traded fixed income securities with the same credit ratings. KKR also has a strategic holdings segment that includes co-investments in a portfolio of high-quality businesses managed by KKR’s PE funds. These balance sheet investments should generate a durable stream of earnings and dividends for KKR that will be reinvested back into the business or returned to shareholders.

As KKR enters a new fundraising cycle, management expects to raise over $300 billion of capital over the next three years. When we attended the company’s investor day in April, management guided to 20% annualized growth in fee-related earnings and 30% annualized growth in earnings per share, reaching $7 to $8 by 2026. We believe our initial purchase of the stock around $100 per share represents an attractive valuation of 12.5 times earnings (using the top end of the 2026 guidance range) for a durable growth business. Furthermore, KKR management expects earnings to more than quadruple to over $15 per share within ten years, representing a 16% CAGR. We think KKR’s diversified platform of leading businesses gives the company multiple ways to grow earnings as they execute into the expanding market for alternative assets, which should bode well for the stock over the long run.

We trimmed Accenture plc and Globant S.A. due to continued weak demand for IT services. Business customers are spending on cost-optimization projects, while discretionary spending on revenue-generating projects remains under pressure. We had expected GenAI excitement to be a more meaningful contributor to demand by now, but GenAI-related projects represent a small portion of revenue, AI infrastructure spending is crowding out software spending, and uncertainty about the impact of GenAI is likely causing delays in client decision-making. We believe most of these issues are temporary and expect growth to eventually improve, but we redeployed the proceeds from these sales into higher conviction ideas. We also made small trims of Fair Isaac Corporation and The Progressive Corporation on strength to manage position sizes and fund purchases elsewhere in the portfolio.

Fintech sector returns in the first half of 2024 haven’t matched the strong returns in the broader equity market over the same period or the 23% return that the fintech Benchmark produced last year. The year-to-date return for the Fund is nearly 4% and the fintech sector is down more than 2% (as measured by the Benchmark), both of which are well below the 15% return for the S&P 500 Index. As mentioned earlier, U.S. equity market indices have been driven by a small number of very large technology companies, most of which are direct beneficiaries of the massive infrastructure spending on GenAI (e.g., NVIDIA chips) or are spending massively on GenAI with the potential for a future payoff (e.g., Alphabet, Amazon, Meta, Microsoft). Meanwhile, returns for most stocks have been relatively muted, with the equal-weighted S&P 500 Index up 5% year-to-date, only somewhat better than the Fund’s performance.

GenAI has captured the market’s imagination, but it’s still very early in the user adoption of this new technology, and the financial payoff from investments into GenAI models and infrastructure is still unknown. We are focused on investing in strong businesses that will be improved by AI, even if this improvement takes time to materialize. For example, FactSet Research Systems Inc. recently launched new products that use GenAI to extract insights from earnings call transcripts and to draft portfolio commentary at the click of button, reducing the time and effort needed to write quarterly letters like this. Intuit Inc. has been rolling out Intuit Assist, a GenAI­ powered digital assistant, across its product lines to help Credit Karma users select new credit cards, QuickBooks customers forecast cash flow, Mailchimp customers create targeted email marketing campaigns, and TurboTax customers understand changes in their tax returns from the prior year. Klarna, the privately held consumer lending and payments company, is cutting costs by using GenAI assistants to handle two-thirds of customer service chats and reduce its dependency on external marketing agencies. We consider these GenAI advancements to be evolutionary rather than revolutionary, but we continue to closely monitor the impact of new technologies on the fintech industry.

Despite share price performance in the fintech sector lagging broad market indices, fintech sector fundamentals remain strong with mid-teens earnings growth across the Fund. We continue to invest behind secular themes where the intersection of financial services and technology should drive innovation and growth for years to come.

One of these themes is the growth of private markets, which are the fastest growing segment of asset management with alternative assets expected to reach nearly $40 trillion by 2030. BlackRock Inc. is acquiring Global Infrastructure Partners, a leading independent infrastructure fund manager with over $100 billion in AUM, to capitalize on the growing need to modernize digital infrastructure, upgrade supply chains and logistics infrastructure, and invest in renewable energy. BlackRock also announced the acquisition of Preqin, a leading private markets data vendor, to provide standardized information, benchmarks, and analytics in an $8 billion data market expected to grow 12% annually through the end of the decade. This $3.2 billion acquisition of Preqin should underscore the significant value of Morningstar, Inc.’s private market data provider, Pitchbook, which generates more than twice as much revenue as Preqin and is growing at a double-digit rate.

Another theme we’re investing in is the growth of private credit in life insurance investment portfolios. In contrast to commercial banks which fund long-duration loans with short-duration deposits that can be unexpectedly withdrawn or repriced at any time, life insurance companies create more stable funding by selling multi-year fixed annuities to investors. These annuities have fixed terms and are usually protected from early surrender, which allows the proceeds to be invested in highly rated private credit with higher yields but less liquidity than publicly traded fixed income securities with the same credit risk. This illiquidity premium is highly valuable in an industry with narrow spreads, providing a competitive edge to well-managed annuity providers that invest in private credit. In addition, higher interest rates combined with a growing population of retirees are spurring greater demand for guaranteed income products. Fixed annuity sales grew 37% in 2023 and have more than doubled since 2021, providing a greater supply of capital that can be invested in highly rated private credit. Apollo Global Management, Inc. and KKR & Co. Inc. are capitalizing on this trend through their ownership of life insurers Athene and Global Atlantic, which are also driving growth in those firms’ private credit asset management businesses.

While the Magnificent Seven and GenAI enthusiasm have been the primary drivers of equity market performance in the first half of the year, we sense that momentum may shift over the rest of the year. In the first three weeks of July, small caps outperformed large caps with returns for the equal-weighted S&P 500 Index exceeding the market cap-weighted version. While this recent trend could reverse, a broadening of market performance beyond mega-cap technology stocks could shift attention back to the fast-growing, competitively advantaged, and well-managed fintech companies in which we invest.

Thank you for investing in the Fund. We remain significant shareholders alongside you.

Sincerely,