Baron Small Cap Fund | Q3 2024

Baron Small Cap Fund® (the Fund) was up 9.68% (Institutional Shares) in the third quarter of 2024. For the first nine months of 2024, the Fund is up 14.74%. The Fund is ahead of the Russell 2000 Growth Index (the Benchmark) for the quarter and the year to date, with the Benchmark rising 8.41% this quarter and 13.22% year to date. The Fund beat the broader Russell 3000 Index this quarter, as small-cap stocks outperformed large caps for the first time this year, but trails for the year. The Russell 3000 Index was up 6.23% this quarter and has gained 20.63% year to date.

As shown in Table I below, the Fund has outperformed the Benchmark for all relevant periods. As of October 2, 2024, the Fund is also in the first quartile of all small cap funds for each of the 1,3, 5, 10, and 15 year periods. Since inception, 27 years ago, the Fund has generated excess returns of 400 basis points a year. The compounded return of this outperformance adds up over time. If one had hypothetically invested in the Fund at its inception (as many of you have, and we are incredibly grateful), your investment would have risen 13.6 times, meaning a $10,000 investment would be worth $146,080. This is 2.7 times more than if you had invested in a Fund that tracked the Benchmark, which would be worth $53,874.

U.S. stocks were higher in the third quarter, for the fourth consecutive quarter and seventh out of the past eight, hitting record highs in mid-July and ending near peak levels. The market rally in the quarter, with solid performance from a wide swath of sectors and market caps, stood in contrast to the narrow market leadership of earlier periods. Small caps and rate sensitive sectors staged a strong rally at the beginning of the quarter, spurred by market anticipation of interest rate cuts that would propel economic growth. Stocks were volatile this period, as concerns of slowing economic growth/recession periodically entered the conversation and resulted in occasional big declines.

The Federal Reserve took a dovish stance based on greater confidence that inflation was moving back to its long-term target. Softer jobs reports had the Fed focused on trends in employment, the other side of its dual mandate. Chair Powell announced a policy adjustment, termed “recalibration.” In late September, the Fed began its easing cycle with a 50-basis point reduction in the Fed Funds rate. The cut was seen as aggressive and interpreted as the first of many cuts to come. The market reacted positively.

The Fund’s good performance was the result of solid stock selection, especially in Information Technology (IT) and Financials. In IT, our application software stocks performed well. Guidewire Software, Inc., Clearwater Analytics Holdings, Inc., Intapp, Inc., and Aspen Technology, Inc. each rose over 20% because of strong fundamentals and as sentiment towards vertical software providers turned positive after an extended period of fear that AI could hurt their prospects. In Financials, The Baldwin Insurance Group, Inc. and Kinsale Capital Group, Inc. rose with solid earnings reports and benefited as the sector gained on the prospects of lower interest rates. We had other holdings that posted strong results and significantly rose, such as day care provider Bright Horizons Family Solutions, Inc., medical device developer Inspire Medical Systems, Inc., and employment screener First Advantage Corporation. Our Industrials and Consumer Discretionary stocks, which are considered interest rate sensitive, did well this quarter, after falling last quarter when rate cuts were less certain. Landscape supplier SiteOne Landscape Supply, Inc., insulation installer Installed Business Products, Inc., and flooring retailer Floor and Décor Holdings, Inc., all gained nicely in the quarter.

The Fund’s Health Care stocks performed poorly and hurt our performance, as DexCom, Inc. declined after it cut its outlook significantly, and ICON Plc fell over concerns about biotech funding. Also, biotechnology stocks were strong this quarter. Since the Fund does not invest in this sub-industry, as we have explained, our relative performance was hurt. We benefited by not having any Energy exposure, as the sector was weak this quarter. Our exposure to higher market cap holdings as well as those with lower betas hurt somewhat, which often is the case when small caps begin to rally. Our focus on growth too was a negative, as small-cap value did better this quarter. 

Vertiv Holdings Co is a leader in data center equipment, with significant share in both power and cooling applications. The stock rebounded off recent weakness, as investors gained confidence that a massive build out of AI datacenters globally was on the horizon. Vertiv’s strong relationship with chip manufacturers and involvement in the necessary technology roadmap for solutions as the energy density of server racks increases were catalysts. Vertiv’s orders were up 57% year-over-year in the second quarter, backlog was $7 billion, a record, and 2024 operating profit margin and EPS guidance was raised.

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, the company’s cloud migration is substantially over. We believe cloud will be the sole path forward, with annual recurring revenue benefiting from new customer wins and migration of the existing customer base to InsuranceSuite Cloud. We believe Guidewire will be the dominant, 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%.

Insurance broker The Baldwin Insurance Group, Inc. contributed to performance after reporting second quarter financial results that exceeded Street expectations. Revenue grew 19% on an organic basis and EBITDA grew 22% despite a temporary margin headwind from a timing shift of profit-sharing commissions. Management reaffirmed their expectation of ongoing margin expansion while growing revenue organically at a double- digit rate. Falling interest rates also likely helped the stock, due to the company’s elevated leverage profile consisting primarily of variable rate debt. We expect the company to continue gaining market share while expanding margins and reducing leverage over the next several years.

Other stocks that rose over 25% in the quarter but contributed less to the overall performance of the Fund were Intapp, Inc., Bright Horizons Family Solutions, Inc., Clearwater Analytics Holdings, Inc., Inspire Medical Systems, Inc., Floor & Décor Holdings, Inc., Grid Dynamics Holdings, Inc., Loar Holdings Inc., and Liberty Media Corporation – Liberty Live.
 

DexCom, Inc. sells a continuous glucose monitoring device for patients with diabetes. Shares fell after DexCom reported lower-than-expected second quarter financial results and reduced guidance for the year. A rare misstep for the company. Multiple issues surfaced during the earnings report. Management cited: 1) disruption from the expansion of its sales force; 2) channel dynamics including market share losses in the durable medical equipment channel, and a revenue per user headwind from Medicare Advantage plans offering pharmacy access to its members; 3) a negative impact from faster-than-anticipated rebate eligibility; and 4) a shortfall in international sales. We believe some of these issues are temporary and addressable, but we are circumspect.

Chart Industries, Inc. is a global leader in design, engineering, and manufacturing of process and storage technologies and equipment for gas and liquid handling. Shares declined after the company once again missed earnings expectations on revenue recognition timing and lowered full-year guidance. Business fundamentals are strong, with record revenue, backlog, margins, and a solid order pipeline. We believe the issues with the stock price are self-inflicted, with management setting expectations too high and then needing to cut them back. Chart is unique in its breadth of technology and solutions capabilities in long-duration secular growth markets (LNG, hydrogen, carbon capture, water treatment, etc.). As management “clear the decks” on guidance and focus returns to double-digit organic growth and improving free cash flow, we think the company will earn the valuation it deserves. The stock now trades at seven times our estimate of forward EBITDA, which is very cheap.

ICON Plc is the second largest global contract research organization, providing outsourced drug development services to pharmaceutical and biotechnology clients. Shares fell on continued concerns about levels of biotechnology and big pharma R&D funding, with investors focusing on book-to-bill figures, which came in slightly below expectations, and cancellations, which grew 7% sequentially. We retain conviction. Second quarter EPS beat consensus, more than offsetting a slight revenue miss. Longer-term, we are confident demand will improve as biotechnology funding picks up due to lower interest rates and big pharma R&D comes back due to the need for new products, especially for later stage projects that are ICON’s sweet spot.

Other stocks that declined over 20% in the quarter but had less impact on our results were Repay Holdings Corporation and indie Semiconductor, Inc.

As of September 30, 2024, the Fund had $4.5 billion in net assets and owned 57 stocks. The top 10 stocks in the Fund made up 43.3% of the net assets. Turnover was 12.4% as measured by a three-year average. This number of holdings is lower, level of concentration is higher, and trading activity is lower than usual. This is the outgrowth of strong performance of our top holdings, from us “cutting our weeds” as we are known to say…selling out of some small positions that we no longer favor, and investing less in new ideas. We think this is all just a moment in time and suspect that these measures will return to more historic levels. We expect that the capital markets will be more active in the future and will offer us the opportunity to invest in more IPOs and secondaries.

The Fund primarily invests in four sectors – Industrials, IT, Consumer Discretionary, and Health Care. These are the areas where we believe we have the most investment expertise and where we have had our greatest success over time. We are playing to our strength. We look for leading/ special companies in each of those sectors that often share the same characteristics of durable competitive advantage, compelling business models, successful track records, strong growth outlooks, and proven management teams that we respect.

We invest in these great companies after deep due diligence and size the positions based on conviction, valuation, and with consideration of risk mitigation. This results in a diversified portfolio that varies greatly from the Benchmark to which we are compared. As has been the case for a while, we are well overweight in Industrials, overweight in IT and Consumer Discretionary, and significantly underweight in Health Care. The overweight in Industrials was lower this quarter than in the past, since we have trimmed some of our holdings in that group. And our underweight in Health Care is more pronounced than in the past after the recent rebalancing of the Benchmark.

Our calling card is that our portfolio is laden with “big winners” and long- term holdings. These are distinguishing characteristics of the Fund.

As of September 30, about 74% of the net assets in the Fund are invested in stocks that have doubled or more since purchase. 48% of our assets are in 18 stocks that have risen five times or more from purchase, and 24% of our assets are in 10 stocks that have risen ten-fold or more since purchase. Pretty extraordinary and a testament to our research process and investment philosophy. The “ten baggers” have appreciated at an annualized rate of 40% on a weighted average basis over the years, proving that great stock performance can last for years. And they have risen 49% on a weighted average basis year to date, showing they are still strong performers.

Also, 34% of the assets are invested in stocks we have held 10 years or more, and another 26% in stocks held from 5 to 10 years….so 60% of our capital is in stocks held at least 5 years. The stocks we have held over 10 years have returned 19% a year since purchase, which is about the same return for holdings of 5 to 10 years and under 5 years. So, it has paid to hold onto “winners” for the long term...to “let our flowers” grow.

We have been practicing this approach of long-term investing since inception. We hold onto our winners as they grow, as this has been additive to our performance and consistent with our style. We proactively trim the position sizes as the size of our holdings increases in market capitalization and recycle that capital into new small-cap investments. For our largest holdings, we own a very modest portion of our peak position.

This approach has resulted in a different market cap spread than most other small-cap funds. Presently 25% of the Fund is invested in small-cap stocks; another 44% is in small/mid cap; 24% is in mid-caps and 5% is in mid/large caps. As you can see, the levels of these holdings have been very consistent over the years, which is by design.

Ibotta, Inc. stock traded down in the quarter, due to short-term headwinds (primarily in display advertising, which is not an area of focus for the company). We retain conviction that Ibotta will remain the leader in consumer rewards and incentives, with multiple drivers to reach greater than 20% revenue growth per year and strong incremental profitability. Beyond continued initiatives in ramping their partnership with Walmart, Ibotta announced a partnership with Instacart, which validates our belief that Ibotta can be the aggregated platform for consumer incentives. We believe there is a strong pipeline of retailers and brands to join the Ibotta ecosystem. As a result, we added to our Ibotta position when the stock was trading at around 7 times next year’s EV/EBITDA, which we think is inexpensive for a market leader with a strong financial profile.

We initiated a position in GCM Grosvenor Inc. in the quarter. Grosvenor is an alternative asset manager with $79 billion in assets under management (AUM), which is invested in both Private Markets ($56 billion) and hedge funds ($23 billion). Grosvenor has a 53-year history of supporting clients with their investments in alternatives, a secular growth area within financial services. Due to the long duration nature of these investments, capital is generally committed for 5 to 10 years. This creates a highly resilient earnings model, helped further by client reinvestments, which are typically 30% higher than the prior commitment.

Grosvenor helps its clients to access, choose, and manage these investments. This requires specialized expertise due to the fragmentation of the alternatives industry, the illiquid nature of these assets, and LPs lacking the necessary scale to build this talent and effectively diligence managers and investments for themselves. Grosvenor has particular strengths in infrastructure and sustainable investing, with each growing AUM at a 20%-plus CAGR over the past 3.5 years.

We think Grosvenor is a high-quality business with durable earnings, secular growth tailwinds, and further margin expansion opportunities, led by a management team with significant skin in the game (CEO owns over 35% of the company). We believe Grosvenor can double fee-related earnings and EPS over the next 5 years and, with the stock trading at a discount to peers, this should lead to good upside from current levels.

During the quarter we trimmed some of our strong performers and exited four positions. We decreased our holdings in Installed Building Products, Inc. and Floor & Décor Holdings, Inc. to manage the position sizes after recent stock rallies. Both stocks ran in the quarter as interest rates declined.

We exited our position in Sprout Social, Inc. during the quarter following several quarters of mixed execution and a change at the CEO position.

We sold Endava plc as IT services demand has slowed due to macroeconomic uncertainty, overspending during the pandemic, and as customers evaluate recent advancements in generative AI. Endava’s results have been worse than its peers’ due to less diversified end-market exposure and pullbacks from a few large customers. Given low visibility into a rebound in sales and margins, we decided to exit the investment.

We exited our small position in European Wax Center, Inc. following continued deterioration in unit economics and belief that management’s efforts to increase customer counts might not be effective. Subsequent to our sale, European Wax Center reduced their expectations for unit growth and also announced the exit of both the CEO and Chief Marketing Officer.

Finally, we sold Loar Holdings Inc. following the stocks over 150% appreciation from its IPO price of $28 in April. Trading at 45 times 2024 EBITDA and 35 times 2025 EBITDA, we believe that a material portion of future gains have been pulled forward even with the assumption of a significant amount of M&A and organic growth estimated in coming years.

As we begin the fourth quarter, as usual, there are some issues weighing on the market.

First, the U.S. elections are only a month away, and the race is too close to call. The candidates favor different economic policies. It seems unlikely that one party would sweep the presidency and both House and Senate, but it is possible. It is reasonable that investors would take a cautious approach until this all is settled.

Second, the war in the Middle East has intensified. There is fear of an expanded regional war, which would likely result in a spike in oil prices, among other things. Fingers crossed that this does not happen, but, if it does, it would disturb the present benign inflation outlook and could alter the path of interest rate cuts, which is at the core of the current positive market sentiment.

And third, and most importantly, the economic outlook is uncertain. The U.S. economy is solid but slowing. We hear it in our conversations with company executives. More of our holdings reduced their outlooks this quarter than usual, related to the softening macro environment.

The Federal Reserve has acknowledged this slowdown. With inflation under control, they have turned their focus to the level of employment. The market now expects many more interest rate cuts and is hopeful that the economy will remain intact as rates decline. The recent positive payroll report, with unemployment rate falling to 4.1%, has momentarily eased concerns about the near-term path of growth. But on the other hand, if the economy holds up too well, then the pace of rate cuts might disappoint, and inflation may even reappear. It’s a bit of a double-edged sword.

Lower interest rates would be positive for future growth, especially for certain areas that are depressed, such as housing, finance, and consumer spending. Lower rates are also good for stock valuations. Often small-cap stocks have benefited the most, relatively speaking, when rate cuts begin. However, sometimes interest rate cuts are the precursor to a recession, which would be bad for earnings and stocks.

We believe we own a portfolio of special businesses that have succeeded and will continue to do so. For the most part, the companies are presently growing slower than normal, as we are still working our way through this unusual post-COVID environment. We expect growth to be faster in the future, we are just not sure if that is around the corner or not. We believe our stocks are reasonably valued on their present fundamentals and cheap when looked at over the long term or assuming an acceleration in growth.

Thank you very much for your interest in the Fund. We remain excited about the prospects for continued strong returns.