Baron Global Advantage Strategy | Q2 2024

Baron Global Advantage Strategy® (the Strategy) gained 3.15% during the second quarter, compared to the 2.87% gain for the MSCI ACWI Index (the Index), and the 6.20% gain for the MSCI ACWI Growth Index, the Strategy’s benchmarks.

Global equity indexes continued to rise as we entered the second quarter of 2024. This pattern is familiar, as we have employed a similar statement in the past four shareholder letters. In short, the second quarter echoed the previous period. Gains were uneven and narrowly concentrated within the Magnificent Seven once again.

Index returns remained dominated by the largest market cap stocks, with giant caps increasing by 7.9% in the second quarter, while large caps, mid- caps, and small caps declined by 0.9%, 2.8%, and 8.7%, respectively. The focal point for returns continues to be large domestic platforms. NVIDIA, Alphabet, Microsoft, Tesla, Apple, Amazon, and Meta accounted for 105% of the Index’s return during the quarter. We trust readers can calculate the combined return of the Index’s remaining stocks.

Bernstein calculated that while technology stocks outperformed the market by 147% year-to-date (YTD), an equal-weighted technology index underperformed the market by 47%, exhibiting the worst breadth of technology outperformance since 2002.

This quarter again proved challenging for the Strategy, given its average 17.9% underweight position in the U.S. and 15.3% overweight position in micro-, small-, and mid-caps, coupled with no holdings in Apple, Microsoft, Amazon, Alphabet, or Meta. In this context, the Strategy’s 3.4% gain and 0.5% outperformance relative to the Index during the quarter felt like a modest achievement.

From a sector attribution perspective, stock selection was strong in Consumer Discretionary and Industrials, contributing 4.71% to relative returns. Unfortunately, it appears we “lost” our ability to “pick” technology stocks as stock selection in Information Technology (IT) detracted 4.52% (and a staggering 6.38% YTD). Fortunately, we have remained significantly overweight in IT, by far the best sector during the quarter and YTD, which contributed 2.14% for the quarter, and 3.44% YTD, respectively, to relative returns.

From a company-specific perspective, we had 17 gainers against 18 decliners with a significant dispersion of returns between contributors and detractors. Once again, the Strategy’s returns were led by NVIDIA, which continued its remarkable run, up another 36.8% during the quarter, and 150.7% YTD. NVIDIA, CrowdStrike, Coupang, SpaceX, MercadoLibre, and Wix contributed over 50 basis points each to absolute returns while the share prices of Tesla, InPost, Codere, Rivian, Fiverr, and Innovid each posted double-digit gains during the quarter. Of course, Tesla and Rivian were two of our largest detractors just last quarter owing to a complex macro environment and challenging near-term business fundamentals.

Tesla’s shareholders approved, or rather once again re-approved, Elon Musk’s compensation plan, which helped assuage concerns about Elon’s commitment to the EV leader. The company continues to show progress in its quest for full self-driving, which could unlock a much larger opportunity in the longer term. There are over 3 trillion miles driven annually in the U.S. alone. Since robo-Teslas won’t need a driver, imagine if Tesla started by charging $1 per mile, which is significantly lower than what the ridesharing companies charge today, the opportunity in the U.S alone could be in the hundreds of billions of dollars, at very high incremental margins. It seems that other market participants are starting to underwrite this possibility.

Rivian announced a deal with Volkswagen to license its software-defined electronic architecture, which shores up the company’s future capital needs through the R2 model introduction via a $5 billion investment, in several tranches over the next few years. At the same time, the company is significantly expanding its scale, driving better component prices from suppliers, sharing future ongoing R&D costs, and increasing the likelihood of reaching sustainable profitability levels sooner than previously expected. We think the Volkswagen deal serves as validation of the value of Rivian’s vertically integrated, software-defined architecture, and opens the opportunity for additional future IP licensing deals.

These strong results and positive outcomes were partially offset by poor stock performance by several of our software and internet holdings – Shopify, Cloudflare, and Snowflake, which detracted 2.93% combined from the Strategy’s absolute returns, due to multiple contraction as investors continue to be hyper-focused on short-term profitability. Both Shopify and Snowflake announced near-term investment cycles, while Cloudflare’s guidance for the year disappointed amid a more uncertain macro environment. Unlike the stocks of Tesla and Rivian which reversed most of last quarter’s declines, our digital IT consulting companies, Endava and Globant, continued to struggle, detracting 1.16% from the Strategy’s results, due to the ongoing headwinds to large digitization projects. Discretionary IT budgets are strained by accelerating investments into generative AI (GenAI) which seem to be crowding out everything else. Investors continue to penalize these stocks, which, in our opinion, now trade at trough (mid-teen EPS) multiples on what we believe to be cyclically depressed earnings.

To better understand stock 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 Strategy and the weighted average change in consensus expectations for 2024, for revenues, operating income, and operating margins. The weighted average multiple for the Strategy contracted by 1% during the quarter (or by 2.7% if we exclude NVIDIA). As relates to near-term fundamentals, during the second quarter, revenue expectations for 2024 increased by 1.7% (or by 0.9% excluding NVIDIA), operating income expectations decreased by 2.4% (declined by 3.9% excluding NVIDIA) and operating margin expectations declined by 0.58% (down by 0.70% excluding NVIDIA). These trends are broadly in line with what we have seen in the first quarter and are driven by a slow recovery in business fundamentals (compared to low expectations) which is being reinvested back by some of our companies, hurting short- term margins but expanding long-term opportunities. While short-term focused investors penalize these stocks as can be seen by multiple contraction for the companies that have entered investment cycles (such as Shopify or Snowflake), we believe their investments make sense, and, as long-term investors, we are willing to accept some short-term pain for the benefit of long-term gain

NVIDIA Corporation sells semiconductors, systems, and software for accelerated computing, gaming, and generative AI. NVIDIA’s stock continued its strong performance, rising 36.3% in the second quarter and finishing the first half of 2024 up 149%. The company reported unprecedented growth at scale, with quarterly revenues of $26 billion increasing 262% year-over-year. Datacenter segment revenues soared to $22.6 billion, up 427% year-over-year, and operating margins reached an impressive 69.3%. NVIDIA’s growth is particularly notable given the impending launch of the Blackwell product cycle in the third quarter. Despite the anticipated performance-to-cost improvements of the next- generation architecture, customer demand for GPUs remains urgent. The Blackwell architecture, specifically the new GB200 NVL72/36 racks, is expected to become “the new unit of compute” when shipping commences in 2025. In our view, this development will: 1) increase the company’s content per server (for example, an NVL72 rack will house 18 compute trays with four Blackwell GPUs and two Grace CPUs each, and nine networking trays with NVIDIA content); and 2) further solidify its competitive advantages as demand for datacenter-scale computing grows. This growth is driven by scaling laws, the emergence of new model types (such as Mixture of Experts), and model optimization mechanisms (like tensor, pipeline, and expert parallelism), which collectively increase the demand for connectivity and full-system capabilities. NVIDIA’s latest generation of NVLink, capable of connecting up to 576 GPUs (up from 8), is pivotal in this context.

While the stock’s strong performance has pulled forward some of the longer-term upside (which we manage through position sizing), we remain early in the accelerated computing platform shift and in the adoption of AI across industries and therefore remain shareholders.

CrowdStrike Holdings, Inc. is a cloud-architected SaaS cybersecurity vendor offering endpoint security, threat intelligence, and cyberattack response services. Shares continued their strong performance from the first quarter and were again a top contributor, rising 19.6% in the second quarter on better execution than peers in the broader security space. The company reported strong quarterly results with 33% year-over-year revenue growth, driven by customers standardizing their cyber-security spend on CrowdStrike with free cash flow margins reaching 35%. With accelerating share gains in its core endpoint detection and response market, emerging products including Cloud, Identity, and SIEM reaching material scale, and newer products in Data Protection and AI ramping quickly, net new annual recurring revenue and total revenue look to sustain a long duration of growth. With its leading competitive positioning in cybersecurity, the growing threat landscape (which is also driven by the advancements in AI, making hackers more dangerous), its unique lightweight, single-agent, architecture, and its platform approach, we retain conviction in CrowdStrike, which is emerging as the security platform to beat in terms of scale, profitability, and free cash flow conversion.

Shares of Coupang, Inc., Korea’s largest e-commerce marketplace, appreciated 17.8% in the second quarter on strong quarterly results with revenue growth of 33% year-over-year (in constant currency, excluding the impact of an accounting change for fulfillment services and the acquisition of Farfetch), showing continued acceleration from 20% growth in the first quarter of 2023, and 29% growth in the fourth quarter of 2023, driven by market share gains within Korean e-commerce and retail overall. EBITDA margins in its core Product Commerce segment also continued to surprise to the upside, reaching 7.2%, up 210bps year-over-year. We view Coupang as one of the most competitively advantaged e-commerce businesses globally, with significant runway for both revenue and earnings growth as the company continues to gain market share in the U.S. $500 billion-plus Korean retail market, while expanding its offerings into additional categories, expanding its ecosystem via a third-party marketplace, expanding internationally and continuing to invest in infrastructure density to further capture inefficiencies, enhancing the customer experience and improving profit margins.

Shopify Inc. is a cloud-based software provider for multi-channel commerce. Shares declined 14.4% in the second quarter despite reporting solid quarterly results with revenue growth of 23% year-over-year, which implies continued market share gains, after the company announced it is entering an investment cycle. Since the increased investment period comes after over a year of consistent margin expansion, it left short-term-focused investors disappointed. We, however, believe that this is the right course of action for several reasons. First, the company expects solid returns on the increased marketing spend with 18-month payback periods. Second, the investment should help solidify Shopify’s competitive position and drive further market share gains. Finally, the increased spend should contribute to the probability of success in newer areas of opportunity with large addressable markets, including offline commerce, international, and enterprise. Shopify shared several metrics showing early success, with gross merchandise value up 130%, 38%, and 32% year-over-year in B2B, EMEA, and offline, respectively. 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.

Cloudflare, Inc. provides content delivery network services, cloud cybersecurity, denial-of-service mitigation, Domain Name Service, and ICANN- accredited domain registration services. Shares fell 14.5% during the quarter on remarks from the CEO about worsening macro conditions, citing the negative impact of geopolitical uncertainties on customer buying behavior. On the positive side, the company posted strong quarterly results with revenue growth of 30% year-over-year, showing evidence that the changes to the company’s go-to-market strategy were resonating with solid growth across its large customer cohorts (revenues from customers spending over $100,000 represented 67% of the total, up from 62% in the first quarter of 2023), double-digit improvement in sales productivity, and new pipeline attainment ahead of plan. Cloudflare reiterated revenue guidance for the year on resilience in cybersecurity spend. While we fine-tuned our model on the back of the company’s increased macro headwind commentary, pushing out revenue reacceleration estimates from the second quarter of 2024 to the first quarter of 2025, this is still ahead of guidance. We retain conviction in the long-term thesis: a strong founder-led business with a unique global network and significant pricing advantages powering a disruptive multi-product growth story with improving margins. We therefore remain shareholders.

Shares of IT services provider Endava plc fell 23.1% during the second quarter on continued soft demand trends. Revenue declined in the most recent reported quarter as customers pulled back on discretionary IT spending and delayed decisions on new projects to better incorporate recent advancements in GenAI. However, management believes demand is stabilizing as they are seeing a growing pipeline of new projects. While timing the cycle remains a challenge, we remain invested because we expect these near-term headwinds to abate over time, leading to better growth as clients embrace digital transformation, and as the current valuation offers a positively skewed risk/reward equation for long-term investors, in our view.

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 June 30, 2024, the top 10 positions represented 60.1% of the Strategy’s net assets, and the top 20 represented 88.2%. We ended the second quarter with 36 investments compared to 34 at the end of 2023. Note that our top 25 investments represented over 96% of net assets.

Our investments in the IT, Consumer Discretionary, Industrials, Financials, and Health Care sectors, as classified by GICS, represented 99.9% of the Strategy’s net assets. Our investments in non-U.S. companies represented 53.4%, and our investments in emerging markets and other non-developed countries (Argentina) totaled 27.6%.

During the quarter, we sold our small position in the fabless semiconductor company Astera Labs, Inc., as the company’s stock shot up immediately post-IPO, which didn’t enable us to build it into a core position with a favorable enough risk/reward.

Additionally, we reduced 15 of our other existing positions in order to Strategy investor outflows and reallocate to the names we added. These included a reduction in our NVIDIA Corporation position. We would note that our conviction level in the company has not changed, although the stock’s incredible recent performance pulled forward some of its future returns, which, by definition, tilts the risk/reward equation, prompting us to slightly reduce our position. Nevertheless, NVIDIA remains our largest position in the Strategy as we remain in the early innings of AI adoption across industries from health care to automotive and as the race for Artificial General Intelligence continues. The demand growth curve for accelerated computing remains exponential as newer frontier models continue to get larger and are trained on more data. In addition, as we continue to go down the demand elasticity curve through innovation by NVIDIA and as AI algorithms become more compute-efficient and go up the level of intelligence generated per unit of compute curve, the demand for accelerated computing will continue to grow, benefiting NVIDIA, in our view.

As in years past, we have little to offer in the way of a market outlook. Has inflation been tamed? Will the economy continue to slow down? Will we get the three interest rate cuts or none? Trump or Harris or someone else? While these questions are not new, the answers remain elusive, and once they are answered, other similar questions will arise. We practice a probabilistic approach to investing, and for the time being, we expect to continue to operate in an environment where the range of outcomes will remain unusually wide.

Importantly, we do not structure or position the portfolio to benefit from any particular market environment. Instead, we focus on investing in what we believe are high quality businesses – companies with sustainable competitive advantages, exceptional management teams with a proven track record of operational excellence and successful capital allocation, and importantly, businesses that we believe have a long runway for growth and an opportunity to become materially larger than they are today.

The rapid advancement of GenAI technology presents both clear risks and compelling opportunities. While the implications of AI on the global economy and on particular industries and businesses are not yet clear, we believe our portfolio includes many companies that are well-positioned to benefit from this technological paradigm shift.

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 risks, managing 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,