Baron FinTech Fund | Q3 2024

In the quarter ended September 30, 2024, Baron FinTech Fund® (the Fund) rose 12.52% (Institutional Shares) compared with a 12.21% increase for the FactSet Global FinTech Index (the Benchmark). Since inception, the Fund has risen at an 11.63% annualized rate compared with 3.23% for the Benchmark.

U.S. equities rose for the fourth consecutive quarter as generally upbeat economic reports supported a soft landing narrative while easing inflation enabled the Federal Reserve’s long-awaited dovish pivot. There was a notable rotation toward smaller-cap stocks and away from the mega-cap Magnificent Seven, which drove most of the market performance during the first half of the year. This group of seven stocks posted a modest gain of 1.7% during the quarter, trailing the 7.9% gain for the remaining stocks in the S&P 500 Index. Small- and mid-cap stocks rose more than 9% in the period, beating large caps by the widest margin since the COVID-19 pandemic. Value outperformed growth during the quarter due to strength from cyclical and rate-sensitive sectors, while growth stocks remain ahead for the year. Outside of the U.S., emerging market equities outperformed due to aggressive stimulus measures in China.

During the third quarter, the Fund performed in line with the Benchmark but significantly outperformed the S&P 500 Index given its smaller market cap profile as market breadth improved. The Fund’s heavy exposure to outperforming Financials stocks and lack of exposure to the Magnificent Seven also boosted relative performance against the broad market. Challengers outperformed Leaders (up 18.0% versus up 11.5%, respectively), a meaningful reversal from the first half of the year reflecting a rally in smaller and more speculative stocks. Fund performance closely matched the Benchmark as positive impacts from active thematic exposures were offset by adverse stock selection in Tech-Enabled Financials.

Favorable stock selection in Information Services and E-Commerce, higher exposure to the better performing Capital Markets category, and lower exposure to the lagging Payments and Enterprise Software themes added the most value. Several holdings performed well in Information Services, led by data and analytics company Fair Isaac Corporation and consumer credit bureau TransUnion, whose shares were bolstered by higher pricing for mortgage credit scores and optimism about the potential for lower interest rates to stimulate consumer lending. Strength in E-Commerce was driven by MercadoLibre, Inc., which continues to grow rapidly despite its already dominant position in Latin America across both e-commerce and payments.

Somewhat offsetting the above was unfavorable stock selection in Tech- Enabled Financials, where broker-dealers LPL Financial Holdings Inc. and The Charles Schwab Corporation weighed on performance due to concerns about their ability to earn interest income on client cash.

Additionally, the Fund’s heavy exposure to Leaders weighed on relative performance against the Benchmark in a quarter when Challengers significantly outperformed.

Fair Isaac Corporation is a data and analytics company focused on predicting consumer behavior and is best known for its ubiquitous FICO scores. Like last quarter, shares increased after the company reported solid financial results and raised annual guidance. Management recently spoke at several conferences and was optimistic about both the scores and software businesses. Fair Isaac is a perceived beneficiary of lower interest rates, so the stock has likely gotten a boost from recent rate cuts. Mortgage originations are running 50% below the long-term historical average, so we estimate that a return to normal activity would increase Fair Isaac’s earnings by half. We continue to own the stock because of the company’s significant competitive advantages and expect that consistent earnings growth will drive attractive returns for the stock over the long term.

Shares of MercadoLibre, Inc., Latin America’s leading e-commerce and fintech company, rose after the company reported strong quarterly results that beat expectations across the board. Revenue more than doubled on a constant currency basis and grew 42% in U.S. dollars. MercadoLibre continues to gain share in the e-commerce market due to its broad merchandise selection and unique logistics capabilities that enable faster delivery times than peers. In the recent quarter, Commerce revenue grew 131% on a constant currency basis with 83% growth in gross merchandise value, benefiting from higher advertising penetration and a more favorable geographic mix. Fintech revenue grew 92% on a constant currency basis with 86% growth in total payment volume and 37% growth in monthly active users, reaching 52 million. MercadoLibre is benefiting from product innovation in fintech and profitable underwriting in the fast-growing credit business, which we expect will drive continued margin expansion and earnings growth.

Shares of insurance software vendor Guidewire Software, Inc. outperformed after the company reported strong quarterly results and provided annual guidance that exceeded consensus expectations. New sales activity drove 19% growth in annual recurring revenue (ARR) on a fully ramped basis and 37% growth in subscription revenue during the recent quarter. Subscription gross margins expanded by 11 percentage points, and free cash flow margins reached 18%, up from 2% last year. We believe the company’s multi-year cloud transition is substantially 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 should help drive cross-sales into the large installed base and potentially accelerate ARR over time. We believe Guidewire will remain the critical software vendor for the global property and casualty insurance industry, capturing 30% to 50% of its $15 billion to $30 billion total addressable market and generating margins above 40%.

LPL Financial Holdings Inc. is an independent broker-dealer with over $1.5 trillion of client assets. As an asset custodian, LPL earns a significant amount of interest income from client cash while paying only a modest amount of interest expense to clients. Shares fell due to concerns that regulators could force broker-dealers such as LPL to pay higher deposit rates to customers, thereby reducing the spread that firms earn from client cash. These fears were exacerbated by pricing changes at competitors such as Wells Fargo and Bank of America. We are actively monitoring these developments but have not seen evidence of any adverse regulatory changes. LPL management is confident that the company is fully compliant with existing regulations and won’t have to increase deposit rates. We continue to own the stock due to LPL’s strong organic growth and compelling valuation.

Intuit Inc. is the leading provider of accounting software for small businesses and tax preparation software for individuals and tax professionals. Shares declined due to a slower growth outlook for the Consumer segment (TurboTax) and greater dependence on upselling to drive growth in the Small Business segment (QuickBooks). Nevertheless, the company reported quarterly financial results that exceeded Street expectations and provided fiscal 2025 guidance that called for 12% to 13% revenue growth and 13% to 14% EPS growth. At Intuit’s Investor Day, management expressed confidence in the company’s market positioning and growth potential from selling higher-value services across its two major segments. We continue to own the stock due to Intuit’s strong competitive position and numerous growth opportunities.

The Charles Schwab Corporation detracted from performance following a weak quarterly update. The broker-dealer generates significant net interest income on idle client cash. Clients have been moving cash into higher- yielding money market funds, forcing Schwab to use higher-cost external funding to support its balance sheet. Although this expensive funding was intended to be temporary, the company made little progress in reducing its usage this quarter, which weighed on margins and disappointed the market despite the strong 17% growth in client assets. While the timing has been delayed, we think Schwab will eventually pay down this high-cost funding, which should increase margins and drive much faster earnings growth.

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 September 30, 2024, the Fund held 47 positions (36 excluding those smaller than 1%). The Fund’s 10 largest holdings represented 41.5% of net assets, and the 20 largest holdings represented 69.2% of net assets. International stocks represented 11.4% of net assets. The market capitalization range of the investments in the Fund was $798 million to $557 billion with a median of $31 billion and a weighted average of $107 billion. The Fund’s active share versus the Benchmark was 85.9%.

We segment the Fund’s holdings into seven investment themes. As of September 30, 2024, Tech-Enabled Financials represented 27.2% of net assets, Information Services represented 23.6%, Payments represented 16.3%, Enterprise Software represented 13.9%, Capital Markets represented 9.7%, E-Commerce represented 5.6%, and Digital IT Services represented 2.3%. Relative to the Benchmark, the Fund remains underweight in Enterprise Software, Payments, and Hardware, and has overweight positions in Tech-Enabled Financials, Capital Markets, Information Services, 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 September 30, 2024, Leaders represented 76.8% of net assets and Challengers represented 21.8%, with the remainder in cash.

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

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

We participated in the IPO of TWFG, Inc., an insurance broker for personal and commercial insurance based in Texas. TWFG (an acronym for The Woodlands Financial Group) is the seventh-largest personal lines insurance agency in the U.S. with 410 branches across 17 states. As an independent agency, the company provides homeowners and auto insurance on behalf of over 300 carriers without taking any underwriting risk. The company has been growing quickly by helping captive agents working for a single carrier (such as State Farm or Allstate) make the transition to an independent agency model with the ability to sell policies from multiple carriers. This model is better for customers by offering them a broader range of insurance options and better for agents who can sell more policies. TWFG provides agents all the tools they need to sell insurance, including carrier relationships, technology, training, back-office and marketing support. Most of the company’s agents are independent contractors that earn 80% of the sales commissions but are responsible for their own expenses, while TWFG keeps the remaining 20% of commissions. With relatively little overhead, TWFG enjoys a capital-light business model.

The U.S. property and casualty insurance market is large with $956 billion of premiums and growing steadily with 6% annualized growth over the last 10 years (faster growth more recently). Premiums are evenly split between personal lines and commercial lines. Insurance is often a compulsory purchase required to get a mortgage or drive a car, so demand is resilient through economic cycles. Premiums typically rise each year to reflect higher repair and replacement costs, so industry growth is inflation-protected. Brokerage commission rates have been relatively steady at a mid-teens percentage of premiums, so commission revenue typically grows in line with premiums. The industry has been undergoing a structural shift from the captive to the independent distribution model, leading to faster growth for independent agencies such as TWFG. In homeowners’ insurance, the share of premiums sold by independent agencies increased from 41% in 2011 to 49% in 2021, while the share sold by captive agencies fell from 51% to 35% over the same period. We expect this shift from captive to independent distribution will continue, which should further increase the addressable market for TWFG.

TWFG was founded in 2001 by the company’s CEO, Gordy Bunch. Bunch, a former insurance agent himself, has grown the business every year since inception while taking in little outside capital and retaining majority ownership. Over the last five years, the company’s premiums and revenue have grown at a 19% annualized rate, more than twice as fast as the overall industry. With less than 1% share of a growing market, TWFG has a very long runway for growth. We expect TWFG will continue growing nearly 20% per year by adding agencies, both organically and through acquisitions. We believe that the 80/20 commission split is an attractive proposition for agents that delivers substantial value while allowing them to retain most of the economics. Additionally, TWFG has begun acquiring smaller agencies at favorable terms, leading to higher revenue and margins. We expect the company will use the IPO proceeds to accelerate the pace of these accretive acquisitions.

We believe that TWFG’s long track record of growth, large addressable market, capital-light business model, opportunities for accretive M&A, and a founder-CEO with significant skin in the game make for a compelling investment. We expect TWFG to double EBITDA within three years, which should lead to good upside in the stock.

We also initiated a position in Primerica, Inc., a provider of life insurance and investment products to middle income customers in the U.S. and Canada. We believe Primerica is a steady earnings grower with significant competitive advantages trading at a cheap valuation due to its underappreciated business model.

As the responsibility for retirement savings increasingly shifts to individuals, Primerica serves a growing need for financial planning in the underserved middle income customer segment. While most life insurers and financial planners target the wealthiest households, Primerica instead serves the less competitive middle-income segment, defined as the 54% of U.S. households with $30,000 to $130,000 of annual income. Primerica’s 145,000 sales reps sell term life insurance underwritten by the company as well as mutual funds, annuities, and managed accounts on behalf of third-party asset managers. The company reinsures between 80% and 90% of the mortality risk for all term life insurance policies, thereby reducing the capital intensity and making the business model more akin to an asset-light broker than a traditional life insurer. The company’s 26.5% ROE last year was more than double the 12.5% average ROE for other publicly traded life insurers.

The company’s primary competitive advantage is its multi-level distribution model that uniquely positions it to reach small customers in a cost-efficient manner. Primerica’s sales reps are all independent contractors who are responsible for their own expenses (much like TWFG’s insurance agents discussed earlier). Reps earn commissions on both their own sales and sales made by other reps that they’ve recruited, thereby encouraging growth in the sales force. This mostly variable cost structure enables the company to efficiently serve a large number of small customers. Primerica’s unique sales model is difficult to replicate since it was built through decades of recruiting and brand-building.

Primerica grew EPS at a 12% annualized rate over the last five years (adjusted for a recent accounting change) despite headwinds from uncertain equity markets and an unprofitable senior health business that was recently divested. We expect earnings to grow at a faster pace over the next few years from continued sales force growth, higher investment sales and asset- based fees, and ongoing share repurchases. The late Charlie Munger advised investors to “pay close attention to the cannibals – the businesses that are eating themselves by buying back their stock.” Primerica fits this bill given that the share count has shrunk by over half since the company’s IPO in 2010. We expect Primerica to continue buying back 4% to 5% of its shares each year, providing a meaningful tailwind to EPS growth. We believe our purchase of the stock at 12 times next year’s earnings is a bargain for a high-quality, double-digit EPS compounder.

We trimmed Fair Isaac Corporation and Apollo Global Management, Inc. to manage position sizes and fund additional purchases of KKR & Co. Inc., which is now a full position after we first bought the stock in the second quarter. We trimmed Endava plc due to continued weak demand for IT services and lackluster management execution.

We’re pleased by the strong rally for fintech stocks during the third quarter, narrowing the performance gap with the broader market for the full year. While the rest of the market has been fixated on the infrastructure buildout to support generative AI, many fintech stocks have demonstrated strong earnings growth and share price appreciation due to idiosyncratic growth trends.

Sixteen of the Fund’s holdings have risen more than 30% this year, representing 42% of the Fund’s net assets. These strong performers operate across a variety of sectors, including consumer credit, enterprise software, insurance, asset management, payments, and brokerage. All of them are gaining share in large, growing markets due to their significant competitive advantages and outstanding management teams. We continue to invest in high quality companies operating at the intersection of financial services and technology where we see significant growth potential and superior returns.

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

Sincerely,