Baron Discovery Strategy | Q3 2024
Performance
Baron Discovery Strategy (the Strategy) was up 13.53% in the quarter, outperforming the Russell 2000 Growth Index (the Benchmark) by 5.12%. For the year-to-date period, the Strategy returned 9.49%, 3.73% below the Benchmark return of 13.22%. We were pleased with the performance during the third quarter, and we feel that it is possible that the bear market in small-cap growth stocks that started way back in February 2021 is finally ending. We have been talking about the divergence between small-cap growth and large-cap valuations for several quarters now, but to give you a sense of how challenged small-cap growth has been, before this quarter, the Benchmark had only beaten the S&P 500 Index in two of the last 14 quarters. We have not seen small-cap growth quarterly underperformance of this magnitude since the late 1990s. A striking example of disparate performance within a single economy can be observed by comparing the S&P 500 Index and the Benchmark Index. Over the past three years, the S&P 500 has experienced a cumulative return of 55.81%, while the Benchmark has declined by 13.41%. Such a significant divergence is typically associated with investments in distinct economies with contrasting economic trajectories. Yet, both indices represent domestic assets.
| Baron Discovery Strategy (net)2 | Baron Discovery Strategy (gross)2 | Russell 2000 Growth Index2 | Russell 3000 Index2 | |||||
|---|---|---|---|---|---|---|---|---|
| Three Months3 | 13.53% | 13.81% | 8.41% | 6.23% | ||||
| Nine Month3 | 9.49% | 10.29% | 13.22% | 20.63% | ||||
| One Year | 23.18% | 24.39% | 27.66% | 35.19% | ||||
| Three Years | (5.37)% | (4.44)% | (0.35)% | 10.29% | ||||
| Five Years | 10.94% | 12.04% | 8.82% | 15.26% | ||||
| Ten Years | 12.20% | 13.23% | 8.95% | 12.83% | ||||
| Since Inception (October 31, 2013)4 | 12.46% | 13.42% | 8.36% | 12.94% | ||||
| Baron Discovery Strategy (net)2 | Baron Discovery Strategy (gross)2 | Russell 2000 Growth Index2 | Russel 3000 Index2 | |||||
|---|---|---|---|---|---|---|---|---|
| 2019 | 26.97% | 28.24% | 28.48% | 31.02% | ||||
| 2020 | 66.25% | 67.93% | 34.63% | 20.89% | ||||
| 2021 | 4.92% | 5.97% | 2.83% | 25.66% | ||||
| 2022 | (34.96)% | (34.32)% | (26.36)% | (19.21)% | ||||
| 2023 | 22.80% | 24.00% | 18.66% | 25.96% | ||||
For strategy reporting purposes, the Firm is defined as all accounts managed by Baron Capital Management, Inc. (“BCM”) and BAMCO, Inc. (“BAMCO”), registered investment advisers wholly owned by Baron Capital Group, Inc. As of 9/30/2024, total Firm assets under management were approximately $43.4 billion. The Strategy is a time-weighted, total return composite of all small-cap accounts managed on a fully discretionary basis using our standard investment process. Accounts in the Strategy are market-value weighted and are included on the first day of the month following one full month under management. Gross performance figures do not reflect the deduction of investment advisory fees and any other expenses incurred in the management of the investment advisory account. Actual client returns will be reduced by the advisory fees and any other expenses incurred in the management of the investment advisory account. A full description of investment advisory fees is supplied in the Firm’s Form ADV Part 2A. Valuations and returns are computed and stated in U.S. dollars. Performance figures reflect the reinvestment of dividends and other earnings. Baron Discovery Strategy is currently composed of one mutual fund managed by BAMCO and a separately managed account managed by BCM. The Strategy invests mainly in small cap growth companies. BAMCO and BCM claim compliance with the Global Investment Performance Standards (GIPS®). To receive a complete list and description of the Firm’s strategies or a GIPS Report please contact us at 1-800 99BARON. GIPS® is a registered trademark owned by CFA Institute. CFA Institute does not endorse, promote or warrant the accuracy or quality of the report.
Performance data quoted represents past performance. Current performance may be lower or higher than the performance data quoted. Past performance is no guarantee of future results.
† The Strategy’s historical performance was impacted by gains from IPOs and there is no guarantee that these results can be repeated or that the Strategy’s level of participation in IPOs will be the same in the future.
(1)With the exception of performance data, most of the data is based on a representative account. Such data may vary for each client in the Strategy due to asset size, market conditions, client guidelines, and diversity of portfolio holdings. The representative account is the account in the Strategy that we believe most closely reflects the current portfolio management style for the Strategy. Representative account data is supplemental information.
(2)The Russell 2000® Growth Index measures the performance of small-sized U.S. companies that are classified as growth. The Russell 3000® Index measures the performance of the largest 3,000 US companies representing approximately 98% of the investable US equity market, as of the most recent reconstitution. All rights in the FTSE Russell Index (the “Index”) vest in the relevant LSE Group company which owns the Index. Russell® is a trademark of the relevant LSE Group company and is used by any other LSE Group company under license. Neither LSE Group nor its licensors accept any liability for any errors or omissions in the indexes or data and no party may rely on any indexes or data contained in this communication. The Strategy includes reinvestment of dividends, net of withholding taxes, while the Russell 2000® Growth and Russell 3000® Indexes include reinvestment of dividends before taxes. Reinvestment of dividends positively impacts the performance results. The indexes are unmanaged. Index performance is not Strategy performance. Investors cannot invest directly in an index.
(3)Not annualized
(4)The Strategy has a different inception date than its representative account, which is 9/30/2013.
Over the past several quarters, our quarterly letters have highlighted the unsustainable divergence between small-cap growth and large-cap stocks. We predicted that a decline in inflation and subsequent rate cuts by the Federal Reserve (the Fed) would catalyze a rotation into small-cap growth stocks. Inflation has been trending lower for multiple quarters, prompting the Fed to reduce rates by 0.50% in September. Small-cap stocks responded positively to this news, and the higher-quality growth companies within the Strategy outperformed the Benchmark during this period.
While some might dismiss this performance as an anomaly, similar to the short-lived small-cap rally in early 2023, we believe this quarter’s scenario is distinct. Several factors support our conviction in the small-cap growth versus large-cap “reversion to the mean” trade:
First, the Fed’s stance has shifted from neutral to dovish. As we’ve discussed previously, our portfolio companies reported that inflation and supply chain issues, prevalent during the COVID-19 pandemic, had largely dissipated by the end of 2022. Government inflation data has consistently declined over several quarters, enabling the Fed to initiate interest rate normalization. Lower rates benefit our smaller growth companies in two primary ways:
- Increased Present Value of Future Cash Flows: Lower interest rates enhance the present value of future cash flows, particularly for small-cap growth stocks with higher growth rates. This leads to expanded valuation multiples and upward pressure on stock prices.
- Economic Growth Tailwind: Lower interest rates stimulate economic growth, creating a favorable environment for our portfolio companies to accelerate revenue growth.
Second, small-cap growth stocks remain attractively valued compared to their large-cap counterparts. In fact, small-cap growth is currently trading at its largest discount to large-cap in the past 25 years.
Third, negative earnings revisions have been prevalent in recent years. We anticipate a reversal of this trend as year-over-year earnings comparisons become more favorable. Periods of positive earnings revisions are bullish for both valuation multiples and stock prices.
Fourth, Chinese economic growth has been a drag on global economic growth. However, the stimulus measures announced by the Chinese government in late September, potentially reaching $1.4 trillion, could revitalize the Chinese economy and positively impact global economic activity.
In conclusion, numerous factors support a rotation into small-cap growth stocks, especially our secular growers. The combination of lower interest rates, stronger economic growth, attractive valuations, and easier earnings comparisons creates a promising environment for stronger small company fundamentals and valuation multiples.
Outlook
The last three and a half years have been a challenging period for small company stocks. We believe the divergent performance of small-cap growth versus large-cap stocks cannot continue forever and thus, there will be a “reversion to the mean” where small-cap growth stocks can outperform large-cap stocks. The current economic backdrop of lower interest rates and some early signs of better economic growth ahead is more conducive for small-cap company fundamentals and valuations. As we look out over the medium to long term, we believe that investing in small-cap growth stocks over the next three and a half years will be significantly more profitable than it was over the last three and a half years.
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