Baron Discovery Fund: Latest Insights and Commentary

U.S. equities increased in the fourth quarter, with much of the strength following the Republican sweep of the November elections, with its promise of market-friendly economic policies, including lower taxes and government deregulation, outweighing concerns around potentially higher tariffs. The "Trump rally" faded in December, as interest rates rose following more hawkish-than-expected commentary from the Federal Reserve. The defensive tone was also attributed to stretched valuations, the uncertain U.S. legislative backdrop given the risk of a government shutdown in late December, and market breadth deterioration as the Magnificent Seven dominated returns late in the year. The Magnificent Seven ended up accounting for all the S&P 500 Index’s fourth quarter gains and more than half of the Index’s overall performance in 2024. Small- and mid-cap stocks managed modest gains but trailed large caps by more than 200 basis points in the quarter.

Against this backdrop, Baron Discovery Fund increased in the fourth quarter. Holdings within Industrials, Information Technology (IT) and Communication Services contributed the most. Investments within Consumer Discretionary and Real Estate detracted. Top contributor Axon Enterprise, Inc. led advances within Industrials, while third largest contributor PAR Technology Corporation led positive returns within IT. Reddit, Inc. led appreciation within the Communication Services sector. Shares of the largest forum-based social network were up as financial results again exceeded expectations across the board, including year-over-year growth of 48% in daily active users and 67% in revenues. While we remain convicted in Reddit's premium growth, we acknowledge the stock has run up substantially and is relatively expensive. Declines within Consumer Discretionary were led by third largest detractor Floor & Décor Holdings, Inc. Real Estate lost ground due to share price weakness in Rexford Industrial Realty, Inc. We exited our position.

Looking ahead, with much of the data pointing to a soft landing in which inflation retreats without a major economic slowdown, investors seem increasingly confident it can be achieved. As always, we remain focused on identifying and researching well-managed unique businesses with durable competitive advantages and compelling growth prospects and investing in them at attractive prices.

CONTRIBUTORS

• Shares of Axon Enterprise, Inc., the leading provider of tasers and public safety solutions, rose after a robust quarterly earnings report in which the company closed with record bookings and highlighted the 2025 launch of an AI bundle oriented around its innovative Draft One product. With 11 consecutive quarters of more than 25% revenue growth, Axon continues to find new areas of expansion as it pulls ahead of the competition and is on track to become the dominant provider of public safety solutions in the U.S. and, increasingly, in Europe.
• 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 rose on robust financial results with free cash flow ahead of investor expectations. Business fundamentals were solid, with record revenue, backlog, and margins every quarter in 2024 and a book-to-bill ratio above one, indicating resilient demand. The stock had been in the penalty box for self-inflicted issues, with management setting too-high expectations and continuing to need to cut them back. The most recent quarter demonstrates that they have finally set more achievable expectations and are set up for solid execution into 2025. Chart is unique in its breadth of technology and solutions capabilities, with an EBITDA margin profile of mid-20% and increasing double-digit revenue growth in long-duration markets (LNG, hydrogen, carbon capture, water treatment, etc.). We believe the company will continue to grow and execute to earn the valuation it deserves.
• PAR Technology Corporation is a leading software, hardware, and service provider to the restaurant industry. Shares rose on continued strong growth alongside its first quarter of adjusted EBITDA profitability since embarking on its current strategy. The restaurant industry historically has under-invested in technology, and PAR is building an all-in-one platform for enterprise restaurants to run the most critical portions of their technology stacks. PAR remains well positioned given limited competition, accelerating restaurant adoption of technology, and best-in-class products. We believe PAR will deliver on its 20%-plus software revenue growth target for the next several years with possible significant upside if it closes some potential large customer deals. We believe EBITDA margins will rapidly scale from this first profitable quarter as the company maintains strong cost controls while continuing to grow. Its recent TASK and Stuzo acquisitions strengthen the long-term opportunity, allowing for expansion into convenience stores and international markets and opening up opportunities with additional Tier 1 restaurants.

 

DETRACTORS

• CareDx, Inc. is a diagnostic company that facilitates donor matches pre-transplant and rejection monitoring post-transplant. The market reacted poorly to its Investor Day in October, with its preannouncement of quarterly results underwhelming expectations. Short-term momentum shifts notwithstanding, our long-term investment thesis remains intact. We believe there is significant greenfield in the transplant diagnostics market alongside the backdrop of a cleaner reimbursement landscape.
• Montrose Environmental Group, Inc., a leading environmental services firm, detracted due to a multitude of issues and negative news flow. Previously, the stock came under pressure when the U.S. Supreme Court struck down the Chevron Doctrine in July, which raised investor concerns regarding the authority of federal agencies to enforce environmental regulations that drive portions of Montrose’s business. In September, shares sank after a short report that targeted the company. Finally, the perception that Montrose will fare worse under the incoming administration due to a reduced focus on regulation also hurt shares. Management has refuted all these points and met with investors to give confidence around their 2025 outlook. They noted the company grew under the prior Trump administration and paused acquisitions in the short term to demonstrate organic revenue growth and cash flow generation, which the short report claimed was lacking. We have added to our position on weakness.
• Floor & Decor Holdings, Inc. is a hard-surface flooring retailer. Shares fell on investor concerns that the housing recovery would take longer than expected due to an increase in the interest rate of longer-dated maturities. We remain shareholders. Floor & Decor has a long growth runway driven by double-digit unit expansion as it consolidates the hard-surface flooring industry. The company has long-term, sustainable competitive advantages in its ability to source and price products versus big box retailers and independents. Demand for its products appears to have stabilized, and we believe the company is well positioned to benefit once the housing market begins to recover.

When reviewing performance attribution on our portfolio, please be aware that we construct the portfolio from the bottom up, one stock at a time. Each stock is included in the portfolio if it meets our rigorous investment criteria. To help manage risk, we are aware of our sector and security weights, but we do not include a holding to achieve a target sector allocation or to approximate an index. Our exposure to any given sector is purely a result of our stock selection process.

Baron Discovery Fund’s (the Fund) resurgence continued in the fourth quarter, with the Fund gaining 6.20% (Institutional Shares) and outperforming the Russell 2000 Growth Index by 450 basis points. The outperformance was driven by a combination of stock selection, differences in sector weights, and tailwinds from various style biases.

Strong stock selection in Health Care, Industrials, and Communication Services contributed 400-plus basis points of relative gains, accounting for most of the Fund’s overall outperformance in the period. The Fund also benefited from its higher exposure to strong performing application software stocks within Information Technology, which was a 60-plus basis point tailwind to performance. Stock-specific strength in Health Care came from the Fund’s health care equipment holdings, namely Masimo Corporation and Inari Medical, Inc., whose respective share prices were up 24% in the period. Masimo manufactures and sells a variety of non-invasive patient monitoring technologies, including devices measuring pulse oximetry (or blood oxygenation levels). The company’s shares outperformed in response to a successful activist campaign from Politan, which recently won a proxy battle in September to bring independent directors to the Board. Masimo is also on track to divest a consumer audio business that strayed from its core competency within health care.

Inari offers catheter-based devices to remove clots from venous thromboembolism (VTE). VTE is the third most common vascular condition in the U.S. after heart attacks and strokes, and if left untreated can be fatal. Inari’s stock outperformed after the company reported solid quarterly results, driven by 20% growth in the company’s core VTE business. Growth in the VTE business has been stable over the last few quarters despite all the noise from competitors like Penumbra. The market is still mostly greenfield, where patients are only getting ineffective drugs, and we believe there is room for multiple devices to win. Favorable stock selection in Health Care was enhanced by the Fund’s lack of exposure to lagging biotechnology stocks, which added 160-plus basis points of relative gains.

A handful of holdings performed well in Industrials, led by public safety technology company Axon Enterprise, Inc. and engineered cryogenic equipment manufacturer Chart Industries, Inc., which were the Fund’s largest overall contributors in the period. Axon issued a robust quarterly earnings report in which the company closed with record bookings and highlighted the 2025 launch of an AI bundle oriented around its innovative Draft One product. Similarly, Chart reported excellent financial results with free cash flow ahead of investor expectations. Business fundamentals were solid, with record revenue, backlog, and margins every quarter in 2024 and a book-to-bill ratio above one, indicating resilient demand. Defense companies Kratos Defense & Security Solutions, Inc. and Mercury Systems, Inc. also contributed to relative gains after rising alongside other aerospace & defense stocks on the belief that U.S. defense spending is expected to increase under President-elect Donald Trump.

Performance in Communication Services was bolstered by leading forum-based social network Reddit, Inc. and Liberty Media Corporation - Liberty Live, a tracking stock consisting of Liberty Media Corporation's interest in Live Nation Entertainment, Inc. Reddit’s financial results exceeded expectations across the board for a second consecutive quarter. The company reported year-over-year growth of 48% in daily active users and 67% in revenues for the third quarter. Adjusted EBITDA of 27% came in ahead as well. Users are increasing at a healthy pace as the product keeps improving, and international expansion efforts are still early. Advertising has substantial room for expansion, with more products, higher performance, and better coverage. Revenue from data licensing for AI model training remains margin accretive, and we expect more of these licenses in 2025. The business model is quite profitable, as the roadmap ahead does not require much additional investment. Longer term, we see opportunities in search monetization and user economy. While we remain convicted in Reddit's premium growth, we acknowledge the stock has run up substantially and is relatively expensive.

Liberty Live contributed following better-than-expected margin growth in the concert segment and an increase in long-term adjusted operating income targets based on strong demand performance indicators. In November, an announcement by the parent company that it planned to simplify its complex corporate structure bolstered market conviction that the Liberty Live tracking stock will eventually be acquired by Live Nation, which would decrease Liberty Live’s discount to full market value. Donald Trump's election victory also increased expectations that the company will reach a favorable settlement in the Justice Department's monopoly case against it.

Somewhat offsetting the above was disappointing stock selection in Consumer Discretionary, where hard-surface flooring retailer Floor & Decor Holdings, Inc. was a material detractor. Floor & Decor’s shares fell on investor concerns that the housing recovery would take longer than expected due to an increase in the interest rate of longer-dated maturities. We remain shareholders. Floor & Decor has a long growth runway driven by double-digit unit expansion as it consolidates the hard-surface flooring industry. The company has long-term, sustainable competitive advantages in its ability to source and price products versus big box retailers and independents. Demand for its products appears to have stabilized, and we believe the company is well positioned to benefit once the housing market begins to recover. Declines from digital sports entertainment and gaming company DraftKings Inc. and casino operator Red Rock Resorts, Inc. also weighed on performance in the sector.

Yearly Attribution Analysis (for year ended 12/31/2024)

Baron Discovery Fund (the Fund) appreciated 16.28% (Institutional Shares) for the year, modestly outperforming the Russell 2000 Growth Index (the Index) by 113 basis points principally due to active sector/sub-industry weights.

Significantly higher exposure to the top performing Information Technology (IT) sector and lack of exposure to lagging biotechnology stocks within Health Care added nearly 350 basis points of relative gains, accounting for most of the outperformance in the period. The Fund also benefited from its lack of exposure to the underperforming Materials, Energy, and Utilities sectors, which contributed 150-plus basis points of relative gains.

Stock selection failed to contribute to the Fund’s excess returns as weakness in IT overshadowed solid stock selection in Health Care, Communication Services, and Financials. A portion of the relative weakness in IT was attributable to sharp declines from indie Semiconductor, Inc. and a handful of other holdings. Automotive semiconductor company indie was the top detractor on repeated cuts in revenue expectations due to demand weakness and an industry-wide inventory correction. Despite share price weakness, indie’s revenue growth outperformed peers. The company continued to win new sockets in future platforms and is well positioned for growth over the medium and long term, driven by its $7.1 billion strategic backlog and expected large program ramps in 2025, specifically its marquee radar program -- the biggest in the company’s history -- which remains on track. We believe indie will return to outsized growth in 2025 and outpace peers on its path to $1 billion in revenue by the end of this decade, supported by contracted visibility.

Adverse stock selection in IT was exacerbated by the Fund’s lack of exposure to Index heavyweights Super Micro Computer, Inc. (Supermicro) and MicroStrategy Incorporated, whose shares increased 188.2% and 118.1%, respectively, prior to their removal from the Index halfway through the year as part of the annual Russell reconstitution. Together, these companies were a 260-plus basis point drag on performance, accounting for nearly 60% of the relative shortfall in the sector. As a manufacturer of commodity motherboards for servers, Supermicro benefited from exuberance for AI-related investments early in the year. The company’s shares soared 255% in the first quarter alone, propelling the stock to a market capitalization of nearly $60 billion. MicroStrategy sells business intelligence software and is the largest public holder of Bitcoin. The company’s software business is not growing, but its shares spiked alongside the price of Bitcoin early in the year. Neither business suits our investment criteria given our view that the core businesses lack sustainable competitive advantages, have low profit margins, are inconsistent generators of cash flows, and are dependent on demand trends that we view as cyclical rather than secular.

Some of the stock-specific weakness in IT was offset by strength in Health Care, Communication Services, and Financials, where Silk Road Medical, Inc., Liberty Media Corporation - Liberty Live, and Kinsale Capital Group, Inc. were among the top contributors. Silk Road manufactures devices used in transcarotid artery revascularization (TCAR), a minimally invasive procedure that treats carotid artery disease to prevent strokes. TCAR is less invasive and has an easier recovery than the gold standard carotid endarterectomy surgery and causes fewer periprocedural strokes than the other available TCAR procedure. Silk Road’s stock price surged in July after the company announced it has entered into a definitive agreement to be acquired by Boston Scientific for a significant premium. We sold our position not long after the announcement.

Liberty Live is a tracking stock consisting of Liberty Media Corporation's interest in Live Nation Entertainment, Inc. The company was a material contributor due to continued top-line growth, strong margin improvement in its concert segment, and positive management commentary around the 2025 stadium concert slate. In November, an announcement by the parent company that it planned to simplify its complex corporate structure bolstered market conviction that the Liberty Live tracking stock will eventually be acquired by Live Nation, which would decrease Liberty Live’s discount to full market value. President-elect Donald Trump's November victory also increased expectations that the company will reach a favorable settlement in the Justice Department's monopoly case against it.

Specialty insurer Kinsale performed well after reporting solid premium growth and better-than-expected earnings throughout the year. In the first nine months of 2024, gross premiums grew 22%, EPS grew 33%, and return on equity remained elevated at 28% due to strong underwriting margins and higher investment income. Premium growth slowed as the year progressed due to greater competition and moderating price increases, but Kinsale gained market share while earning superior margins. 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.