Baron Global Advantage Fund | Q3 2024

Baron Global Advantage Fund® (the Fund) gained 5.6% (Institutional Shares) during the third quarter, compared to the 6.6% gain for the MSCI ACWI Index (the Index), and the 4.1% gain for the MSCI ACWI Growth Index, the Fund’s benchmarks.

Global equity indexes continued to grind higher in the third quarter with some making new all-time highs. The MSCI ACWI was up 6.6%, the MSCI ACWI Growth was up 4.1%, the Russell 1000 Growth was up 3.2%, and the S&P 500 was up 5.9%. Investment grade bonds were up 6.6%, while Bitcoin was up approximately 1.0%. In that context, the Fund had an in-line quarter underperforming modestly on the lower growth side of the curve and outperforming modestly against the higher growth comps. After 18 months of market returns being driven by large-cap stocks and in particular, the Magnificent Seven, we finally saw much improved market breadth. In the third quarter, the Magnificent Seven accounted for just 38bps, or 5.8% of the Index’s 6.6% gain – it was 105% in the last quarter.

Giant caps⁴ also underperformed, up 4.7%, while small-cap indexes such as the Russell 2000 and Russell 2000 Growth outperformed, up 8% to 10% compared to gains of 5.9% and 3.2% for the S&P 500 and Russell 1000 Growth, respectively. The long anticipated easing cycle has finally begun, with the Federal Reserve (the Fed) announcing a 50bps cut which we think had a lot to do with broadening investor appetite beyond the large technology and AI stocks. We have also observed a noticeable recovery in stock prices outside the U.S., particularly in China (up 23.4%) where significant government stimulus (interest rate cuts along with measures to support the mortgage market as well as the stock market) were well received by investors. After mostly avoiding China over the last few years, we dipped our toes back in, making two small investments in companies that we have owned in the past. As interest rates normalize and continue to decline, we expect economic activity to strengthen and investor appetite for growth stocks to improve. That could be a tailwind for recovery in multiples and potentially a near-term positive for the Fund. Of course, over the long term, stock prices will be more dependent on the growth (and the duration of growth) of business fundamentals – revenues, profits, and cash flows.

From the performance attribution perspective relative to the Index, stock selection contributed 39bps to relative returns, which was more than offset by the negative effect of sector allocation that detracted 148bps. Our investments in Consumer Discretionary (think MercadoLibre, Zomato, and Coupang) and Health Care (argenx and Viking Therapeutics) did well, while Information Technology (IT) (CrowdStrike, ASML, and Snowflake) and Industrials (SpaceX was flat compared to a rising benchmark) stocks detracted. We also benefited from having no exposure to Energy which was roughly offset by having no investments in Real Estate and Utilities. From a geographic perspective, the Fund’s investments in Argentina, Canada, India, Korea, the Netherlands, Taiwan, and Poland contributed to relative returns, which was offset by relative underperformance in the U.S., U.K., China, Spain, and Brazil. The Fund ended the quarter with just under 40% of its assets invested in the U.S., a significant underweight relative to the Index’s ending weight of 63.8%.

From a company specific perspective, we batted just over .500 with 19 gainers against 18 decliners but with an impressive slugging percentage as MercadoLibre, Shopify, Coupang, Zomato, and argenx contributed over 100bps each to absolute returns, while GDS and Adyen added over 60bps each. Notably, 14 out of our 39 investments posted double-digit gains during the third quarter, with 9 gaining over 20% each, and 5 appreciating over 30% each, in the process contributing 10.3% to absolute returns. On the other side of the ledger, 11 of our holdings experienced double-digit declines costing the Fund 465bps, with CrowdStrike, which unexpectedly became a household name for all the wrong reasons (a routine software update causing a widespread computer crash) knocking off 150bps all by itself.

To better understand the anatomy of performance, we deconstructed returns into two components – the change in multiples and the change in fundamentals. We analyzed the change in the weighted average multiple of the Fund and the change in weighted average consensus expectations for 2024 (for revenues, operating income, and operating margins). During the third quarter, the multiple⁵ contracted by 2.7% and is now down 0.9% year-to-date – driven by our IT holdings where the multiple contracted by 8.4%. Since the Fund was up 5.6%, fundamentals of our businesses increased by approximately 8% – an encouraging sign from our perspective. Revenue expectations for 2024 increased by 2.6% (after rising 1.7% in the June quarter), operating income expectations increased by 5.4% (down 2.4% in the June quarter), and operating margin expectations increased by 58bps (were down 58bps in the June quarter). Overall, business trends continue to be stable and, in many cases, improving.

While the macro environment remains complex, the economy continues to be resilient and from our perspective improving. The 2.5% inflation reading for August was the lowest since February 2021, the Fed has finally embarked on an easing path with interest rates starting to decline, and the soft landing scenario appears to be more and more likely. Of course, the election season is upon us and there are daily reminders from the media that this is “the most deeply divided electorate in the midst of the most consequential election of our time!” In that context we were recently asked if we had our “Trump basket” and “Harris basket” ready to go, and how we were planning to position the portfolio once the outcome of the election became known. The answer was – we do not. Anecdotally, a well-respected financial publication⁶ recently published an article detailing stock market performance during Republican and Democratic administrations from 1961 to 2023 (without specifying which index they used for “market”). The publication claimed that $10,000 hypothetically invested since 1961 under Republican presidencies would have returned $102,293 while $10,000 hypothetically invested under the Democratic regimes would have yielded $500,476. If that $10,000 stayed invested throughout that time period (under both administrations) it would have turned into $5,119,520. Though crude, it drove the point across rather well. It strikes us that the electorate was deeply divided four years ago, and the four years before that, and the four years before that. Every election we experienced seemed very consequential at the time. We practice a probabilistic approach to investing, and in that context, the rhetoric notwithstanding, we have a high degree of confidence that Trump’s victory would not spell the end of democracy, just like a win by Harris will not lead to the end of capitalism.

Shares of MercadoLibre, Inc., Latin America’s leading e-commerce company, rose 24.8% in the quarter, driven by results that beat expectations. The company reported 83% year-over-year growth in gross merchandise value (GMV), 131% growth in commerce revenues, and 86% growth in total payments volume. Despite its dominant position, the company generated above-market GMV growth across its major Latin American markets and is increasingly outperforming its peers in e-commerce, particularly in Brazil thanks to its broad selection and differentiated logistics capabilities, which enable faster delivery times than peers. MercadoLibre has also benefited from product innovation in fintech and solid underwriting in the growing credit business, which we believe will drive margin expansion and earnings growth as e-commerce in the region continues maturing over the next decade.

Shopify Inc. is a cloud-based software provider for multi-channel commerce. Shares rose 21.3% after reporting strong financial results with revenue growth of 25% year-on-year, accelerating from the prior quarter. Shopify’s operating margins also outperformed, at 14.6%, or nearly 3% better than expected, alleviating investor concerns over an upcoming investment cycle. While the company continues gaining share in its core business, we are increasingly seeing data points that point to a successful expansion to new opportunities including international, B2B, and offline. Despite volatility in the pace of reinvestments and margin expansion, we remain shareholders due to Shopify’s strong competitive positioning, innovative culture, and long runway for growth, as it still holds less than a 2% share of the global commerce market.

Shares of Coupang, Inc., Korea’s largest e-commerce marketplace, appreciated 17.2% after second quarter results saw a solid EBITDA beat, driven by higher margins in its core Product Commerce segment (EBITDA of $530 million, up 30% year-on-year, and margins of 8.2%, up 110bps year-on-year). We believe the trend in margin expansion will continue as Coupang scales margin-accretive offerings, improves operations and supply chain, and leverages technology and automation to drive efficiencies. Its food delivery business has experienced strong growth with overall developing offerings revenues up 188% year-on-year in constant currency, with improving unit economics in the recent quarters. We view Coupang as one of the most competitively advantaged e-commerce businesses globally, with significant runway for both revenue and earnings growth.

CrowdStrike Holdings, Inc. is a leading cybersecurity software company. Following a long period of outsized gains, shares fell 29.5% in the quarter after a software glitch caused a global Microsoft Windows outage in July. Despite the outage, the company delivered solid second quarter results that exceeded the high end of expectations across all key metrics. Management called out several delayed deals but noted that they remained in the pipeline and should close in coming quarters. Increased scrutiny and the implementation of new incentives, including discounts and free products and flexibility on billings, will likely negatively impact bookings and revenue growth over the near term. While the range of outcomes on the implications of the outage on customer retention and willingness to expand with CrowdStrike remains wider than usual, leading us to reduce our position, we believe that the fact that the incident was not due to a cybersecurity breach, the company’s competitively advantaged product, its transparent and rapid response, and the new procedures it had put in place, should help it retain its customers and grow share of wallet over time.

ASML Holding N.V. designs and manufactures photolithography equipment for semiconductor production. ASML is the leader across all types of lithography and the only company selling extreme ultra-violet (EUV) lithography tools, which are critical for leading-edge chip manufacturing. The stock fell 18.3% during the quarter on investor concerns around potential 2025 results driven by Intel’s capex cuts, sustainability of Chinese lithography demand, potential government restrictions on sales to China, and worries over slowing demand in the coming quarters. Despite near-term noise and uncertainty, ASML has a backlog covering the majority of expected revenues for 2025. More importantly, the long-term outlook remains favorable, regardless of where ASML is able to ship as demand for tools is ultimately driven by the overall demand for semiconductors regardless of the fab location. As a de facto monopoly on critical lithography tools supporting an industry with growing demand fueled by the proliferation of AI, we see durable competitive advantages that should translate into good upside for shares of ASML over the long term.

Snowflake Inc. is a leading cloud data platform predominantly used for data analytics. Shares fell 15.2% in the third quarter due to a cybersecurity incident, a shifting competitive landscape, a change in leadership, and general macro complexities which are pressuring customer IT budgets. With generative AI (Gen AI) front and center, both investors and customers are closely evaluating Snowflake’s positioning in the future data ecosystem. Databricks and other competitors whose core users are data scientists who are also key buyers of Gen AI technologies, are benefiting. In addition, while Snowflake’s product innovation push should fuel future growth, it may also lead to short-term headwinds to profitability. Management reported healthy demand for its core data analytics, evidenced by solid growth rates among current customers alongside new go-to-market initiatives that could support growth. We are optimistic the new CEO, Sridhar Ramaswamy, can lead the company towards an AI-centric strategy, and therefore remain shareholders.

The portfolio is constructed on a bottom-up basis with the quality of ideas and conviction level having the most significant roles in determining the size of each individual investment. Sector and country weights are an outcome of the stock selection process and are not meant to indicate a positive or a negative “view.”

As of September 30, 2024, the top 10 positions represented 61.4% of the Fund’s net assets, and the top 20 represented 85.9%. We ended the quarter with 37 investments compared to 36 at the end of the second quarter. Note that our top 27 investments represented over 95% of the Fund.

Our investments in the IT, Consumer Discretionary, Industrials, Financials, and Health Care sectors, as classified by GICS, represented 99.7% of the Fund’s net assets. Our investments in non-U.S. companies represented 60.4% of net assets, and our investments in emerging markets and other non-developed countries (Argentina) totaled 32.3% of net assets.

During the third quarter, we initiated three new investments: the Chinese e-commerce platform, PDD; the Chinese data center company, GDS; and the leading global semiconductor manufacturer, Taiwan Semiconductor. We also increased two existing holdings: the leading next-generation sequencing platform, Illumina, and the small-cap auto-focused semiconductor designer, indie Semiconductor. We also sold Rivian and liquidated our small position in Tempus AI.

We also reduced 21 existing positions to fund redemptions and new purchases.

During the third quarter we re-initiated a small investment in PDD Holdings Inc. We believe the company is truly unique in the global e-commerce landscape, with an innovative business model, and very strong growth prospects. Founded in 2015 as Pinduoduo, the company has grown into China’s second-largest e-commerce player, capturing over 20% market share. PDD’s Consumer-to-Manufacturer (C2M) model, which connects manufacturers directly to consumers eliminated intermediaries, allowing for ultra-low prices that attract price-sensitive consumers and small merchants. Its discovery-based, algorithm-driven shopping experience has created a highly engaging platform, driving user and merchant growth in a virtuous cycle. We expect PDD to continue gaining share in China given its dominance in the value-for-money segment, growing branded product offerings at affordable prices, and high operational efficiency. PDD’s network effects and cost advantage, supported by its lean structure and efficient C2M model, are set to grow as it scales, both domestically and internationally. Its cross-border e-commerce platform, Temu, launched in September 2022, has rapidly become one of the world’s fastest-growing apps. Leveraging China’s excess capacity and PDD’s supply-chain efficiency, Temu wields strong pricing power over Chinese suppliers and attracts overseas consumers with competitively priced products. While still in early stage, Temu has achieved 2% of the global ex-China e-commerce market and a variable breakeven in the U.S. market, underscoring PDD’s focus on sustainable growth. Despite its rapid growth and profitability, PDD trades at a double-digit free cash flow yield (despite losses from the early-stage international expansion through Temu), significantly below sector peers. While concerns over geopolitical tensions exist, we believe PDD’s growing competitive edge, strong cash flow, and disciplined management position it to create substantial long-term value for shareholders.

We also re-acquired a small position in GDS Holdings Limited, a leading Chinese data center operator. We were encouraged by several fundamental updates and recently met with CEO/founder William Huang and CFO Daniel Newman in our offices. We remain optimistic about the company’s growth prospects: i) its Asia ex-China data center business (GDS International or GDSI) and ii) its mainland China data center business (GDS Holdings or GDSH). We see a path for the business to be worth $46 to $56 per share in two to three years versus approximately $20 at recent market price. We value the mainland China data center business at $30 to $40 per share and GDS’s equity stake in its Southeast Asia data center business at $16 per share.

• i) GDSI: We see cash flow for GDSI growing from below $50 million today to over $500 million over the next three years, which we value at $16/share at GDS’ ownership stake after accounting for the growth capital it has secured from renowned U.S. and global investors. Blackstone’s recent $16 billion acquisition of Southeast Asia based data center operator Airtrunk at 25 times is still at a substantial premium to where GDS is raising growth capital today, which provides an important valuation marker for a potential IPO of this business over the next 12 to 15 months.
• ii) GDSH: We believe that growth will accelerate in the China data center segment with cash flow growing from around $700 million today to $1 billion over the next three years. We value the China business at $30 to $40 per share and remain encouraged that there will be several catalysts to further surface value (e.g., transaction to place certain stabilized assets into a listed REIT vehicle).

We established a small position in Taiwan Semiconductor Manufacturing Company Limited (TSMC). Morris Chang founded TSMC in 1987, as the world’s first dedicated semiconductor foundry. Until then, semiconductor chips were always designed and manufactured by the same company. TSMC introduced a groundbreaking new business model, in which it acted purely as a contract manufacturer, which proved to be highly successful. TSMC maintained a focus on improving its manufacturing process technology and enabled the emergence of innovative fabless design companies, including NVIDIA, Apple, and Qualcomm, who became TSMC’s key customers. Today, TSMC has a more than 60% share of the total semiconductor foundry market and over 90% share in leading-edge manufacturing. TSMC enjoys high barriers to entry given the ever-increasing cost and technological complexity of semiconductor manufacturing while benefiting from economies of scope as once leading-edge manufacturing becomes lagging edge on fully depreciated equipment. TSMC also benefits from scale– higher profits lead to higher R&D and capex investments, allowing for further technological differentiation, resulting in more profits. We believe TSMC will sustain strong double-digit earnings growth for years to come, driven by continued market share gains, strong pricing power, and structural growth in AI demand. According to C.C. Wei, TSMC’s CEO, “almost all the AI innovators are working with TSMC to address the insatiable AI-related demand.”⁷ Management forecasts that revenue from server AI chips, such as GPUs and other AI accelerators, will grow at a 50% CAGR from 2022 to 2028 and account for more than 20% of TSMC’s revenue by 2028. We except further long-term upside from the eventual proliferation of edge AI devices, including AI smartphones and AI PCs, which will require significantly more computing power and drive even stronger demand for TSMC’s leading-edge technology.

Lastly, we added to our investment in Illumina, Inc. The company supplies instruments and consumables for next generation sequencing (NGS), a technique that enables massive amounts of genetic analysis in both research and clinical diagnosis. It is the dominant player today with 80% of the market. We believe Illumina is on a path to return to double-digit growth in the intermediate to long term while benefiting from a long runway for growth with genomes sequenced for less than 1% of humans and 0.1% of species. We believe that Illumina would be able to grow its TAM by continuing to reduce the cost of sequencing as it has in the past (its recent Novaseq X) has reduced the cost from $600 to $200. We also believe that Illumina is more than a sequencing company. It’s an entire workflow and ecosystem, from sample prep to sequencing and bioinformatic analytics. While it used to be that the sequencing portion was a big chunk of the whole workflow’s costs, nowadays it’s in line with the other parts of the workflow. If researchers are used to Illumina protocols and their solution is spec’ed in on the workflows (particularly on the clinical side), it doesn’t make sense to save a bit more money on that few hundred dollars, if Illumina makes them more efficient on the other parts of the workflow like sample prep and bioinformatics.
 

After six months of “higher for longer” dominating the investing narrative, the Fed officially embarked on an easing cycle after reducing the interest rates by 50bps following its September meeting. While we continue to have no view on the timing or the pace of further interest rates cuts, we will point out that lower rates reduce the cost of capital, increase the wealth effect, and generally improve investor confidence. That in turn often leads to longer time horizons which potentially impact the multiples investors are willing to pay for growth stocks.

The majority of the businesses we tend to favor can be considered as long- duration assets because as beneficiaries of disruptive change with large and fast growing markets they almost always penalize near-term profitability in order to reinvest aggressively for future growth. In other words, they overinvest and underearn. Mathematically speaking, using lower cost of capital and lower interest rates to discount future free cash flows to present value yields higher results. The proverbial two birds in the bush are worth more – when the rates are lower and even more when rates are expected to decline further. As a Fund focused on Big Ideas, we tend to be consistently underweight the large and giant-cap companies (as well as the U.S. – relative safe havens) and overweight small and mid-caps (as well as the emerging markets) and so a rise in investor confidence and a broader participation in the market recovery could become a much welcome tailwind for the way we invest.

Every day we live and invest in an uncertain world. Well-known conditions and widely anticipated events, such as Federal Reserve 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 optimistic about the long-term prospects of the companies in which we are invested and continue to search for new ideas and investment opportunities while remaining patient and investing only when we believe the target companies are trading at attractive prices relative to their intrinsic values.

Sincerely,