Baron Focused Growth Fund | Q3 2024

Our Financials investments were also strong in the quarter. This is despite the expectation for lower future interest rates as our investments in this category, such as MSCI Inc., Interactive Brokers Group, Inc., and Arch Capital Group Ltd., benefitted from increases in business activity and consumer confidence. MSCI saw business activity accelerate while cancellation rates declined, and client engagement remained strong. Interactive Brokers benefited from a continued acceleration in new client growth and trading revenue, while Arch saw continued growth in insurance premiums written and higher pricing due to strong demand for its property & casualty (P&C) insurance.

Our Core Growth investments were also strong in the quarter, as these companies benefitted from recent investments in their businesses, which helped accelerate revenue and cash flow growth. These included Guidewire Software, Inc., On Holding AG, and Illumina, Inc. These companies continue to make strategic investments in their businesses that we believe should generate strong returns on invested capital and lead to further growth in the years to come.

The stock price gains mentioned above were slightly offset by underperformance in our more economic-sensitive stocks, including Birkenstock Holding plc, Krispy Kreme, Inc., Red Rock Resorts, Inc., and Vail Resorts, Inc. These companies were negatively impacted by an increase in investments across their businesses which penalized company margins as well as concerns that their pricing power would be eroded by the decline in inflation. However, we believe as interest rates decline, business activity for these companies should accelerate. We continue to believe these businesses have strong competitive advantages with underpenetrated growth opportunities ahead of them and robust balance sheets to fund their growth. We believe valuations are attractive at current levels and continue to see an acceleration in insider buying activity, a key pillar that gives us stronger confidence in our investment thesis for these companies and expected stock returns over time.

In the near term, we continue to believe that inflation will remain at or below the historic 3% to 4% annualized levels and interest rates will approximate the rate of inflation. This has been the case since World War II. We believe that is a favorable environment for businesses that are growing significantly faster than the rate of inflation and the 7% nominal annualized growth rate of our economy.

The Fund has continued to generate strong returns with less than market risk. Over the trailing 3, 5, and 10 years, the Fund has captured 101%, 131%, and 112%, respectively, of the upside when the market increased. When markets declined, the Fund lost less with 83%, 88%, and 87% downside capture, respectively. The Fund’s Sharpe ratio, a measure of risk-adjusted return, was also significantly higher than the Benchmark’s for each of these periods.

We believe these strong returns with downside protection are due to our research-based investment process. Our research enables us to identify and understand businesses’ competitive advantages, differentiation, long-term growth prospects, and exceptional people; and it allows us to invest in these businesses for the long term. As a result, the Fund has outperformed its Benchmark for the 3-, 5-, 10-, and 15-year periods, as well as since its inception on May 31, 1996. Since its inception as a private partnership over 28 years ago, the Fund has increased 13.48% annually. This compares to an 8.22% annualized return for the Benchmark and a 9.78% annualized return for the Russell 3000 Index that measures the performance of the largest 3,000 U.S. companies.

The Fund’s outperformance in the third quarter was due to our Disruptive Growth investments. These businesses represented 35.6% of the Fund’s net assets and gained 15.2%, adding 520 bps in the quarter.

Tesla increased 32.2% in the quarter, adding 274 bps to performance. Tesla designs, manufactures, and sells electric vehicles, related software and components, and solar and energy storage products. The stock increased as the core automotive segment accelerated sequentially. We continue to believe lower interest rates should help sell more cars and halt the company’s continuous lowering of prices on its cars. In addition, the company’s energy storage business continues to grow and almost doubled from last year’s third quarter levels. In time, we believe this business should add significantly to revenue and gross margins and help offset any margin degradation from its auto business. Tesla continues to generate sufficient gross profit to support a robust product development plan. The refreshed Models 3 and Y continue to generate strong demand with improving unit-level economics. Lastly, Tesla should benefit from its eight-year, $10 billion investment in data and compute that will allow AI to “train” cars to drive with autonomous technology. Dojo, an AI “training” compute; auto bidder, an automated energy trading platform; the Optimus, a human-like robot; and energy storage, we believe also provide opportunity. We believe Tesla is well positioned for further growth given its strong balance sheet and substantial cash.

Spotify increased 17.4% in the quarter and helped performance by 96 bps. The company continues to improve its platform by adding new products and making it more beneficial for the consumer. This has resulted in an increase in subscribers along with significant pricing power. The company has started to institute more regular price increases, which is accelerating its revenue and margin growth. Further, the company has been able to increase prices without increasing its churn rate. We believe the business should be able to improve gross margins from 26% to between 30% and 35% over time while continuing to add subscribers and generate strong top- and bottom-line growth. This should result in an increase in cash flow. Given strong cash flow conversion rates, we believe the company could initiate a return of capital program in the near future. We believe Spotify’s valuation remains attractive despite its recent stock price increase. Founder and CEO Daniel Eck continues to own a 15% stake in the business.

The Fund’s Financials investments also contributed to performance.

Interactive Brokers, a global automated electronic broker, increased 13.7% in the quarter and helped performance by 59 bps. The company continues to gain market share due to its strong automation and ability to operate in international markets with little competition. This is allowing the company to continue to grow its new accounts, which have accelerated recently as they have now added over a million customers in just 12 months. The company has industry-leading margins of over 70% generating robust cash flow. It has significant cash on its balance sheet and is looking to deploy it towards acquisitions and continued platform growth. We continue to believe the company’s focus on the most sophisticated investors who trade a range of assets across different global markets is a key differentiating factor. The vast array of markets it serves and strong growth from countries outside the U.S. where low-cost brokerage is not well penetrated are key competitive advantages for the company. This allows the company to offer its clients the lowest cost trading due to its high level of automation, while also offering highly competitive rates on margin loans and paying its customers attractive yields on their uninvested cash balances. More than 80% of Interactive Brokers’ clients are non-U.S. citizens, and more than 80% of their investments are in U.S. stocks. The company has little direct competition serving this clientele. Interactive Brokers continues to hire software and computer engineers with a focus on automating many of the processes that competitors rely on employees to perform. With its low-priced offerings and leading range of capabilities, we believe Interactive Brokers is well positioned to continue its rapid pace of account growth from just over 3 million clients today. The company’s focus on automation should enable it to continue to be a low-priced provider while earning best-in-class margins, which we believe should lead to double-digit revenue and earnings growth.

P&C insurance software vendor Guidewire a standout in Core Growth and a major reason why the group performed better than the Benchmark. The company was up 32.7% for the quarter, adding 163 bps to performance. After a multi-year transition period, the company’s cloud transition is substantially complete. We believe that cloud will be the sole path forward, with annual recurring revenue (ARR) benefiting from new customer wins and migrations of the existing customer base to Insurance Suite Cloud. We also expect the company to shift R&D resources to product development from infrastructure investment, which should help drive cross-sales into its sticky installed base and potentially accelerate ARR over time. We are encouraged by Guidewire’s subscription gross margin expansion, which improved by approximately 810 bps in its most recently reported quarter. We believe Guidewire will be the critical software vendor for the global P&C insurance industry, capturing 30% to 50% of its $15 billion to $30 billion total addressable market and generating margins above 40%.

The outperformance described above was partially offset by smaller than Benchmark gains in our Real/Irreplaceable Assets investments that are more susceptible to a slowdown in the macroeconomic environment and penalized by high interest rates. These businesses represented 20.0% of the Fund and increased 4.4%, compared to the Benchmark that increased 7.0%. These stocks underperformed due to an expected slowdown in the domestic economy from peak levels that could hurt revenue and cash flow growth. However, we believe these businesses can continue to grow even faster in a declining interest rate environment. This is due to the fact they all have strong recurring revenue, fee-oriented businesses with significant pricing power. Their high client retention rates are helped by consumers’ desire to spend more on experiences over goods in the current post-COVID-19 (COVID) environment.

Shares of global ski resort operator Vail declined 3.2% in the third quarter and hurt performance by 15 bps. This was due to concerns about a decline in units of season passes for the upcoming season, which could result in continued lower visitation of skiers to its resorts. In addition, further normalization of the ski industry after the post-COVID surge of travelers to its resorts was also a concern. However, we believe the company continues to have a captive high-end consumer who is willing to pay for its services even if it means paying a higher price. The company continues to have significant pricing power, which, when combined with a new two-year, $100 million cost-cutting plan from increased synergies within the business, should lead to strong growth over the coming years. The company continues to have a strong cash flow and balance sheet profile and despite continuing to invest in its resorts still generates strong cash to cover its dividend. It recently increased its share buyback program which if they bought all of it back would equate to another 5% of the business. The CFO recently bought stock personally at current levels, giving us further confidence in our view that the stock is attractively valued.

Shares of Red Rock Resorts, an owner and operator of casinos in the Las Vegas Locals market, underperformed the benchmark in the quarter, declining 0.3%. This was due to slower-than-expected growth in the Las Vegas Locals market and greater-than-expected cannibalization of its casinos from the opening of its new Durango casino late last year. The Durango casino continues to generate strong results that should enable Red Rock Resorts to meet its projected 20% return on invested capital, pay down debt, and return to its targeted leverage of 3 times by the end of next year. We believe the new casino combined with continued market growth should generate high single-digit growth in EBITDA and double-digit free cash flow growth over the coming years. Red Rock Resorts currently has over 300 acres of gaming-entitled land to develop. Its margins remain above pre-pandemic levels, despite increasing wage costs, thanks to strong incremental margins on revenue generated from its new resort.

Global hotelier Hyatt Hotels Corporation also underperformed the Benchmark in the quarter, increasing just 0.3%. This was due to a deceleration in revenue per available room growth from modestly slower leisure bookings. However, the company continues to increase its business transient and group bookings, which continue to pace 7% ahead of 2023 levels. These bookings are half of its business today. Robust mid-single-digit growth in units and modest margin expansion should lead to double-digit growth in EBITDA this year. In addition, Hyatt continues to sell assets in its bid to become more asset-light. It also has one of the strongest balance sheets in its industry today. All of the above should generate significant cash flow that Hyatt can use to accelerate share buybacks. Hyatt has repurchased more than 80 million shares since its IPO in 2009! It now has just over 100 million shares outstanding. Yet, despite 85% of Hyatt’s cash flow coming through fees, its stock still trades at a discount to peers.

Sources: FactSet PA, Baron Capital, and FTSE Russell.
* Individual weights may not sum to displayed total due to rounding.
** Represents the blended return of all share classes of the Fund.

Tesla, Inc. designs, manufactures, and sells fully electric vehicles, related software and components, and solar and energy storage products. The stock contributed on accelerated growth in the energy unit, growing expectations that Tesla will soon launch new vehicle models, and increasing investor confidence in its potentially lucrative AI initiatives. Despite macroeconomic challenges, delivery data in major markets like China showed improvement in the quarter, while declining interest rates could enhance demand and profitability in the coming quarters. Tesla has also launched operations at its advanced computing center in Texas, rolled out an improved version of its software-enhanced driving solution, and announced plans to provide an important update on its AI projects in early October. These investments and product releases are enhancing Tesla’s leadership position in real world AI and investor confidence that Tesla will benefit from these large and attractive growth opportunities.

Shares of P&C insurance software vendor Guidewire Software, Inc. advanced after subscription gross margins improved by more than 1,000 basis points in its most recently reported quarter. After a multi-year transition period, we believe the company’s cloud transition is substantially over. We believe cloud will be the sole path forward, with annual recurring revenue (ARR) benefiting from new customer wins and migration of the existing customer base to InsuranceSuite Cloud. We also expect Guidewire to shift R&D resources to product development from infrastructure investment, which should help drive cross-sales into its sticky installed base and potentially accelerate ARR over time. We believe Guidewire will be the critical software vendor for the global P&C insurance industry, capturing 30% to 50% of its $15 billion to $30 billion total addressable market and generating margins above 40%.

On Holding AG is a Swiss premium performance sports brand specializing in footwear. Shares contributed to performance on solid execution and market share gains across all channels, categories, and geographies. Heightened brand awareness following marketing campaigns around the Olympics and the unveiling of new differentiated products such as Light Spray helped boost quarterly results, with revenue expanding 28%. On also reported improving trends in the direct-to-consumer channel as it redressed logistical constraints at the Atlanta distribution center to better match supply with demand. We see a long growth runway supported by geographic expansion, a growing retail footprint, and opportunities in its nascent apparel business.

Moderna, Inc. is a leader in the emerging field of mRNA-based vaccines and therapeutics. Shares were pressured by increasing skepticism around whether a sizable market will exist for recurring boosters (whether bundled with flu or not) in a post-pandemic environment. During its R&D day, Moderna gave a weak 2025 outlook and said it is pulling back on R&D spend. We exited our position.

Birkenstock Holding plc is a global footwear brand that has been making its distinctive style of sandals since 1774. Shares fell on a slight miss in quarterly revenue due to a demand mix shift away from the direct-to-consumer channel, which grew only 14%, and into the wholesale channel, which expanded 23%. The change was the result of a shift in consumer preference toward in-person shopping, prompting them to purchase shoes from Birkenstock’s wholesale partners due to the company’s limited retail presence of just 64 stores. We remain investors. Broad-based quarterly revenue growth of 19% pointed to continued strong demand across different product lines and geographies with high levels of full price sell through, as well as market share gains. We see a long growth runway for Birkenstock, supported by retail, geographic, and category expansion.

Global ski resort company Vail Resorts, Inc. detracted from performance, as a result of a drop in the number of season passes sold and the normalization of the ski industry following the post-pandemic surge of visitors. We remain investors. With a captive high-end consumer base who is willing to pay a premium for its services, Vail enjoys significant pricing power. It plans to cut $100 million in costs over the next two years by leveraging synergies within the business, which should result in improved margins. The company uses its strong balance sheet and robust cash flow to invest in its resorts and cover its dividend, and it recently increased its share buyback program. We think shares are attractive at current valuations.

We remain steadfast in our commitment to long-term investing in competitively advantaged growth businesses. We believe these investments are an effective way to protect and increase the purchasing power of your savings. Wars, pandemics, financial panics, higher-than-normal inflation, and interest rate increases can cause significant market declines, but when these negative influences abate, interest rates stabilize and decline, stock prices in the past have increased substantially. We believe this will happen again, although the timing remains uncertain.

As of September 30, 2024, the Fund owned 29 investments. The Fund’s average portfolio turnover for the past three years was 21.7%. This means the Fund has an average holding period for its investments of almost five years. This compares to the average mid-cap growth mutual fund that typically turns over its entire portfolio every 17 months. From a quality standpoint, the Fund’s investments have stronger sales growth; higher EBITDA, operating, and free-cash-flow margins; and stronger returns on invested capital than the Benchmark. We believe these metrics help limit risk in this focused portfolio and are why the portfolio has generated strong risk-adjusted returns over time.

While focused, the Fund is diversified by sector. The Fund’s weightings are significantly different than those of the Benchmark. For example, the Fund is heavily weighted to Consumer Discretionary businesses with 40.2% of net assets in this sector versus 14.4% for the Benchmark. The Fund has no exposure to Energy, Materials, or Utilities. We believe companies in these sectors can be cyclical, linked to commodity prices, and/or have little if any competitive advantage. This compares to the Benchmark that had 8.1% combined exposure 
to these sectors. The Fund also has lower exposure to Health Care stocks at 3.1% for the Fund versus 22.1% for the Benchmark. The performance of many stocks in the Health Care sector can change quickly due to exogenous events or binary outcomes (e.g., biotechnology and pharmaceuticals). As a result, we do not invest a large amount in these stocks in this focused portfolio. In Health Care, we invest in competitively advantaged companies that are leaders in their industries such as IDEXX Laboratories, Inc., the leading provider of diagnostics to the veterinary industry and Illumina, Inc., the leader in DNA sequencing instruments and consumables. The Fund is further diversified by investments in businesses at different stages of growth and development. 

Disruptive Growth firms accounted for 35.6% of the Fund’s net assets. On current metrics, these businesses may appear expensive; however, we think they will continue to grow significantly and, if we are correct, they have the potential to generate exceptional returns over time. Examples of these companies include electric vehicle leader Tesla, Inc., commercial satellite and launch company Space Exploration Technologies Corp., and audio streaming service provider Spotify Technology S.A. These companies all have large underpenetrated addressable markets, are well-financed with significant equity stakes by these founder-led companies, giving us further conviction in our investment.

Core Growth investments, steady growers that continually invest in their businesses for growth and return excess free cash flow to shareholders, represented 23.9% of net assets. An example is CoStar Group, Inc., a marketing and data analytics provider to the real estate industry. The company continues to add new services in commercial and residential real estate, which have grown its addressable market and enhanced services for its clients. This has improved client retention and cash flow. CoStar continues to invest its cash flow in its business to accelerate growth, which we believe should generate strong returns over time.

Companies that own what we believe are Real/Irreplaceable Assets represented 20.0% of net assets. Vail Resorts, Inc., owner of the premier ski resort portfolio in the world, Hyatt Hotels Corporation, upscale lodging brand, and Red Rock Resorts, Inc., the largest player in the Las Vegas Locals casino gaming market, are examples of companies we believe possess meaningful brand equity and barriers to entry that equate to significant pricing power over time.

Financials investments accounted for 18.3% of the Fund’s net assets. These businesses generate strong recurring earnings through subscriptions and premiums that generate highly predictable earnings and cash flow. These businesses use cash flows to continue to invest in new products and services, while returning capital to shareholders through share buybacks and dividends. These companies include Arch Capital Group Ltd., FactSet Research Systems Inc., and MSCI Inc.

As of September 30, 2024, the Fund’s top 10 holdings represented 58.2% of net assets. Many of these investments have been successful and were purchased when they were much smaller businesses. We believe they continue to offer significant appreciation potential, although we cannot guarantee that will be the case.

The top five positions in the portfolio, Tesla, Inc., Space Exploration Technologies Corp., Arch Capital Group Ltd., Spotify Technology S.A., and Guidewire Software, Inc. all have, in our view, significant competitive advantages due to irreplaceable assets, strong brand awareness, technologically superior industry expertise, or exclusive data that is integral to their operations. We think these businesses cannot be easily duplicated and have large market opportunities to penetrate further, which enhances their potential for superior earnings growth and returns over time. 

In the third quarter, we initiated a new position in Airbnb, Inc., the leader in the management and operation of vacation rentals and hotels on their proprietary platform. The company has an incredible brand, and benefits in both upcycles with strong demand, and downcycles through an increase in supply as owners look to rent their places for additional income. Despite concerns about slower travel growth from peak levels, the company continues to grow at a double-digit rate in revenue despite worries about a consumer slowdown and is now leaning in with increased marketing to grow internationally where it remains underpenetrated. The company is still generating 35% EBITDA margins and 40% free cash flow margins with a strong balance sheet that remains in a net cash position. It is still founder-led with the three founders still owning over 30% of the business. However, the company now trades at the same valuation as hoteliers despite growing faster with a less capital-intensive business and stronger cash conversion of its revenue. We believe valuation remains attractive at current levels.

In the quarter, we also increased our positions in Vail Resorts, Inc. and Shopify Inc., two companies we believe were trading at attractive valuations and should see accelerated growth in the years ahead. We increased our position in Vail as the stock declined in the quarter due to declines in season pass sales units. However, we believe assuming normal winter weather, the company should grow its earnings at a double-digit rate next year. Its season pass sales should still grow this year and help the company lock in close to a third of its revenue before the season even starts. We continue to believe the company has significant pricing power given no new ski supply, which enables the company to generate strong free cash flow. The company is trading over a 6% free cash flow yield, a level we deem attractive.

We also added to our Shopify investment when it declined significantly due to an increase in product and marketing investments the company is currently making to increase its already strong competitive advantages. While this will hurt current profitability, we believe it is the right decision and should result in strong returns on invested capital, especially as competitors shy away from investments in their own businesses.

We believe the shares of many of our portfolio investments already reflect overly pessimistic earnings estimates for this year. Investors obviously remember operating declines during the 2008/2009 Global Financial Crisis and are pricing in similar declines today. If we do not go into a deep recession this year, or if the slowdown and expected decline in earnings are not as bad as feared, we see significant near-term upside in the portfolio. We continue to believe our stocks are cyclically depressed, not secularly challenged, and see further upside over the next 12 to 18 months. So far, most of our portfolio holdings have not experienced a slowdown in sales or earnings growth, and their outlooks remain strong. In addition, we believe that even if a downturn were to occur, our portfolio companies would still be operating above pre-pandemic levels. These businesses’ balance sheets have been strengthened post-COVID, and we believe they remain well positioned to weather a downturn should one occur. We find the current risk/reward inherent in our portfolio holdings attractive at current levels.

Thank you for investing in Baron Focused Growth Fund. We continue to work hard to justify your confidence and trust in our stewardship of your family’s hard-earned savings. We also continue to try to provide you with information we would like to have if our roles were reversed. This is so you can make an informed judgment about whether Baron Focused Growth Fund remains an appropriate investment for your family.

Respectfully,