Baron Global Advantage Strategy | Q3 2024

Baron Global Advantage Strategy (the Strategy) gained 5.39% during the third quarter, compared to the 6.61% gain for the MSCI ACWI Index (the Index), and the 4.07% gain for the MSCI ACWI Growth Index, the Strategy’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 Strategy 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 0.38%, or 5.8% of the Index’s 6.6% gain – it was 105% in the last quarter.

The long anticipated easing cycle has finally begun, with the Federal Reserve (the Fed) announcing a 0.50% 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 significant recovery in stock prices outside the U.S., particularly in China (up 23.4%), where substantial government stimulus (interest rate cuts and measures to support the mortgage and stock markets) was well-received by investors. After largely avoiding China over the past few years, we have cautiously re-entered the market, making two small investments in companies we have previously owned. As interest rates stabilize and continue to decline, we anticipate a strengthening economy and increased investor appetite for growth stocks. This could positively impact valuations in the near term and potentially benefit the Strategy. However, over the long term, stock prices will be primarily driven by the growth and sustainability of underlying business fundamentals, such as revenues, profits, and cash flows.

From the performance attribution perspective relative to the Index, stock selection contributed 0.39% to relative returns, which was more than offset by the negative effect of sector allocation that detracted 1.48%. 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 Strategy’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 Strategy 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 1.00% each to absolute returns, while GDS and Adyen added over 0.60% each. Notably, 14 out of our 39 investments posted double-digit gains during the third quarter, with nine gaining over 20% each, and five 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 Strategy 4.65%, with CrowdStrike, which unexpectedly became a household name for all the wrong reasons (a routine software update causing a widespread computer crash) knocking off 1.50% 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 Strategy 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 Strategy 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 0.58% (were down 0.58% in the June quarter). Overall, business trends continue to be stable and, in many cases, improving.

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 1.10% 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 Strategy’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 Strategy.

Our investments in the IT, Consumer Discretionary, Industrials, Financials, and Health Care sectors, as classified by GICS, represented 99.7% of the Strategy’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.

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 0.50% 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 Strategy 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,