Baron Opportunistic Small Cap Growth Strategy | Q1 2024

Baron Opportunistic Small Cap Growth Strategy (the Strategy) had a stellar first quarter. The Strategy was up 11.82% in the quarter, performing well ahead of the Russell 2000 Growth Index (the Benchmark), which was up 7.58%. The Benchmark’s performance was inflated by the anomalous performance of one stock, Super Micro Computer, Inc., which more than tripled in the quarter and accounted for over one-third of the Benchmark’s gains, so the relative performance of the Strategy was actually more impressive in comparison. The Strategy outpaced the broader S&P 500 Index as well, which was up 10.56% in the quarter. Large-cap stocks outperformed small caps and a handful of popular stocks drove general market returns.

As shown in Table I on the right, the Strategy has outperformed the Benchmark for all relevant periods. Many of our investors have loyally supported us for over 26 years. We thank you for your confidence in us and are happy we have been able to do well for you. We are working hard in an effort to continue to outperform. We are confident we can do so.

The market strength of the fourth quarter of 2023 continued into 2024, with the Dow Jones Industrial Average and S&P 500 Index closing the first quarter at record highs. Positive sentiment stemmed from the belief that the economy was resilient, inflation was moderating, and rate cuts were on the horizon, even expected in the near term. Stock valuations increased, with growth stocks outperforming value stocks. Information Technology (IT) and Communication Services led the overall market. IT, Energy, and Industrials were the top performers in the small-cap growth space, while more defensive sectors lagged behind.

Our Strategy’s strong performance this quarter was driven primarily by stock selection. Additionally, as has been the recent trend, many of our largest positions were among our best-performing stocks. Investments in Industrials and Financials were the source of most of our absolute gains and excess returns. The stocks rose because the fundamentals of the businesses were doing very well, and their outlooks were improving. Vertiv Holdings Co, the leading provider of cooling solutions to data centers, continued its torrid performance, gaining another 70% in the quarter after rising over 250% in 2023. TransDigm Group Incorporated, the maker of proprietary parts for planes, rose over 20%, as did liquid handling company Chart Industries, Inc., and composite decking manufacturer Trex Company, Inc. Strength in our Financials holdings came from specialty insurer Kinsale Capital Group, Inc., which gained over 50% in the quarter. Other sectors that did well were Health Care, paced by ICON Plc, a leading CRO, and Consumer Discretionary, with nice gains from casino operator Red Rock Resorts, Inc., childcare provider Bright Horizons Family Solutions, Inc., and online gaming company DraftKings Inc. Some of our stocks perceived to be interest-rate sensitive, including housing installation contractor Installed Building Products, Inc., and flooring retailer Floor & Decor Holdings, Inc., continued to rebound with rate declines. Our IT stocks underperformed this quarter. Several holdings, including vertical software companies Intapp, Inc. and Clearwater Analytics Holdings, Inc., and digital transformation service providers Endava plc and Grid Dynamics Holdings, Inc., all declined and negatively impacted our performance. Our Strategy’s bias towards larger market capitalization stocks for potential appreciation did provide some support this quarter. However, we are underweight in securities with high idiosyncratic volatility, which offset these gains.

Shares of Vertiv Holdings Co, a manufacturer of critical infrastructure equipment for data centers, rose during the quarter due to improved focus on operational execution, strong revenue growth prospects, and robust opportunities for margin expansion. We expect Vertiv to benefit from the rising demand for data center capacity, with approximately 70% of its revenue coming from the data center end market. As one of the leading providers of precision cooling for data centers, Vertiv also stands to benefit from the increasing adoption of generative AI (GenAI), as GenAI-related servers have higher energy density, which will necessitate more complicated cooling solutions. We reduced the position into strength, but we remain large shareholders. We believe that Vertiv’s leading market position in data center thermal and power management will lead to strong growth and substantial upside over the long term.

Specialty insurer Kinsale Capital Group, Inc. gained after financial results exceeded Street forecasts. After last quarter’s cameo on the detractor list, Kinsale fundamentals remain strong, with 34% growth in gross written premiums and 49% EPS growth highlighted by record underwriting margin. Market conditions remain favorable with rising premium rates and more businesses shifting from the standard market to the excess and surplus lines market where Kinsale operates. In addition, insurance stocks broadly rebounded from last quarter’s pullback as interest rates stabilized. We continue to own the stock because we believe Kinsale is well managed and has a long runway for growth in an attractive segment of the insurance market.

Installed Building Products, Inc. is a leading distributor and installer of insulation and complementary building products for residential and commercial end markets in the U.S. Shares rose on improving industry conditions, particularly in the new single-family residential construction market, which drives approximately 60% of the company’s revenue. Installed Building Products’ excellent execution across various strategic initiatives continues to generate growth from other construction end markets, including multi-family construction, light and heavy commercial construction, and remodeling. We believe the company also stands to benefit from pricing and profitability improvements and our expectation of attractive tuck-in acquisitions, which has long been a mainstay of the company’s growth algorithm.

Other stocks that rose over 20% in the quarter but contributed less to the overall performance of the Strategy were DraftKings Inc., Repay Holdings Corporation, HealthEquity, Inc., WEX Inc., TransDigm Group Incorporated, The Trade Desk, Chart Industries, Inc., Trex Company, Inc., BRP Group, Inc., and Bright Horizons Family Solutions, Inc.

Shares of IT services provider Endava plc fell after management cut guidance for the fiscal year ending June 30, 2024. Growth has slowed over the last year as business customers pulled back on discretionary IT spending due to macroeconomic uncertainty. Last fall, management was seeing early signs of a recovery, but new projects have been taking longer to materialize as customers delay spending decisions. Higher expenses, due to increased staffing to meet anticipated demand, weighed on margins as well. Management acknowledged that it misread the market and is taking steps to right-size the cost structure to improve margins, but it remains confident in its pipeline of work. We remain invested because we expect these near-term headwinds to abate over time, leading to a return to historical growth rates as clients embrace digital transformation.

Shares of Neogen Corp., a leading provider of food and animal safety products, detracted from performance. While end-market challenges appear to be bottoming, this improvement is happening at a slower pace than the company had forecast, which caused it to lower fiscal year 2024 guidance. Despite challenges integrating its recent acquisition, 3M’s Food Safety business, we believe Neogen has significant long-term potential. We’ve been adding to our position and are confident the company will emerge as a leader once the integration is complete.

Shares of Fox Factory Holding Corp., a leading provider of suspension systems and engineered products for the mountain bike, power sport, and off-road truck categories, declined during the quarter following an earnings update that indicated uncertain volumes in its bike and aftermarket truck segments. The company’s challenges are mostly attributable to temporary issues, such as vehicle production delays associated with the 2023 United Auto Workers strike, which is now resolved. We believe Fox Factory is protecting its brand positioning and leading innovation within its categories. As near-term demand headwinds dissipate, Fox Factory should return to strong growth rates in the large automotive aftermarket.

Other stocks that declined over 15% in the quarter but had less impact on our results were Shoals Technologies Group, Inc., Intapp, Inc., Mercury Systems, Inc., Clarivate Plc, and Americold Realty Trust. 

As of March 31, 2024, the Strategy had $4.9 billion in net assets and owned 60 stocks. The top 10 stocks in the Strategy made up 43.1% of net assets, continuing the trend of higher concentration. This is the result of strong contributions from many of our larger holdings. We are comfortable with this outcome as we retain conviction about the prospects for these holdings. We are starting to see the reopening of the IPO market. We suspect this will lead to some new investments for us, as high-quality businesses are often the first ones to go public. We welcome this development, as new issues have historically been the source of successful investments for us. We also note that the capital markets are becoming unfrozen, which we expect will lead to more merger and acquisition activity. We suspect that some of our holdings will be acquired or taken private, like in the past.

The Strategy’s investments remain concentrated in the same sectors as usual. Industrials make up 32.9% of the Strategy’s net assets, IT is 17.9%, Consumer Discretionary is 17.1%, and Health Care is 11.4%. Compared to the Benchmark, we are notably overweight in Industrials, slightly overweight in Consumer (if one combines Consumer Discretionary with Consumer Staples), underweight in IT, and significantly underweight in Health Care. We are bottom-up investors, and the aforementioned variances are the result of the stock selections we make and their subsequent success. We invest in what we consider to be high-quality, competitively advantaged, well-managed businesses across various industries. We do not manage to mimic the Benchmark.

The high concentration in Industrials consists of multiple investments in leading niche businesses that we believe have strong long-term growth prospects because of superior market positioning and secular tailwinds. It does not reflect a near-term conviction in the pace of economic growth. The underweighting in Health Care is primarily caused by our aversion to investing in biotechnology stocks. Since most small-capitalization issues in this sector are early-stage companies, their success is binary, which does not align with our investment strategy.

We are long-term investors. We set out to invest in small-cap companies, usually at an initial market cap of $1.5 billion to $2.0 billion, that we believe can grow and become significantly larger and that we can own for years. It is our experience that if the companies can succeed as hoped or as expected, their stocks will compound at high rates. Having managed the Strategy for the past 26-plus years, we can affirm this has been our practice. As shown in the chart below, at the end of the first quarter, we own 15 stocks, which make up about 31% of the Strategy’s net assets for ten years or more. We own another 17 stocks, representing 28% of the Strategy for between five and ten years. We hold 27 stocks, making up 40% of the Strategy for under five years. The weighted average return is over 20% for the stocks in the three different periods, which we believe is exceptional.

We are pleased to report strong performance from a significant portion of our holdings. As the table below details, ten of our holdings have experienced tenfold or greater growth since their initial purchase. These stocks have been part of our portfolio for an average of 14.5 years, with holding periods ranging from 7 to 20 years. Our investment strategy has delivered a compelling annualized weighted average return of 26.9%. This performance is particularly impressive, considering several outstanding individual holdings. TransDigm Group Incorporated, for example, has increased 123 times since our initial investment 18 years ago. Similarly, DexCom, Inc. has increased 40 times since our purchase 11 years ago. The Trade Desk has increased nearly 21 times since our initial investment seven years ago, and ICON Plc has increased nearly 12 times in the last 11 years. Beyond these exceptional performers, our Strategy includes another six stocks that have appreciated between five and ten times their initial purchase price. These holdings have generated a strong 44.1% annualized weighted average return. In total, these 16 stocks comprise 63.1% of the portfolio and have delivered a combined annual return of 36.1% during our holding periods. This has been the essence of our alpha generation.

There has been a noted change in market sentiment at the beginning of the second quarter. Interest rates have spiked, with the 10-Year Treasury Bond going from 3.9% to 4.6%. Rates have risen after a robust employment report in March, after hotter-than-expected inflation reports for March and the prior three months, and after oil prices jumped from increased tensions in the Middle East. The Federal Reserve Chair and Board of Governors are in a data-dependent mode, and their present stance seems to be that the economy is doing well and that inflation is not coming down quickly enough to reach its 2% target. So, it appears that interest rate cuts, which seemed likely, even imminent, early in the year, are now on hold. This shift in interest rate view has resulted in a whipsaw for stocks, which have now given back most of the gains for the year. 

We maintain consistent communication with the management teams of our portfolio companies and closely monitor industry trends. These conversations provide valuable insights into the pace and direction of economic growth. What we hear is incongruous with what is now common narrative. In our view, the economy is currently in a state of resilience rather than strength. We are more concerned about potential softening in consumer spending than overheating. The labor market has loosened; companies are now able to find qualified candidates, and some are scaling back after periods of rapid hiring during prior growth spurts. Inflation is in the rearview mirror. Most of our portfolio companies experienced significant cost increases during COVID-19 and then raised prices to maintain profit margins. That is over, and we see some signs of reversal. While our primary focus is not on macroeconomics, we anticipate a decline in interest rates. This is predicated on the expectation that policymakers will recognize the emerging signs of softer economic conditions and lower inflation.

The case for small-cap stocks remains compelling. Small-cap growth stocks have significantly underperformed large caps for years. Small-cap growth stocks are priced well below the premium they have historically traded at. Small-cap stocks usually perform better as the economy improves and interest rates are cut, which we believe are on the horizon. We believe our investments will continue to perform well, and we foresee faster growth in the future, as most of our portfolio companies are growing below what we expect to be their long-term pace. We considered our stocks to be cheap a year ago, and now the stocks are reasonably valued in the near term and still offer great upside on what we believe they will earn in the long term. The biggest risk to this scenario is that corporate earnings will disappoint, caused by a softer economy than we project. 

I would like to thank our fellow investors and others for your interest in the Strategy. We believe our approach of investing in high-quality, well-managed businesses diversified across industry sectors will continue to provide market-beating returns. We have cultivated a portfolio of successful businesses. Many of these businesses have thrived for years, and we view them as a strong indicator of future positive performance. We have a great research group at Baron Capital to help identify new potential investments and monitor our present holdings.