Baron Focused Growth Fund: Latest Insights and Commentary

The upsurge was also marked by a change in leadership. Unlike recent quarters dominated by the Magnificent 7 megacap technology companies, gains were widespread. Buoyed by expectations of lower rates and steady growth, certain corners of the market, including small caps, real estate, and value stocks, led the rally. These segments also benefited from the rotation out of the Magnificent 7 into previously disfavored options.

The most recent economic data points to continued solid growth, with annualized GDP growth on track to increase by 1.3% to 2.5% in the third quarter. Inflation dipped to 2.5% in August, the lowest reading since February 2021. Unemployment ticked up but without the layoffs that tend to accompany a recession. Consumer spending remained solid, trending slightly up in August.

Baron Focused Growth Fund increased in the quarter. Consumer Discretionary, Financials, and Information Technology (IT) holdings were the top contributors. Consumer Discretionary had a strong quarter, with top contributor Tesla, Inc. and third largest contributor On Holding AG within the sector. Financials advanced on gains in all five sector holdings. Second largest contributor Guidewire Software, Inc. led positive performance within IT. Industrials detracted slightly due to weakness in data and analytics vendor Verisk Analytics, Inc. Despite strong subscription-based revenue, quarterly transactional revenue was softer due to difficult comps, and the stock pulled back.

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. Corporate earnings improved in the second quarter and third quarter consensus estimates show a broadening out from the mega caps, which bodes well for the economy. An increase in credit availability and lending activity as a result of lower rates should help boost investment activity by businesses and consumers alike.

Many investors are now focused on the upcoming U.S. presidential election. As the cliché goes, markets hate uncertainty. However, while the market does tend to have a short-term reaction to election outcomes, history shows the winning candidate or party has little long-term impact on returns. This is the view we take, and we are not concerned. 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 relative to their intrinsic values.

CONTRIBUTORS

• Tesla, Inc. designs, manufactures, and sells fully electric vehicles, related software and components, and solar and energy storage products. The stock contributed on accelerated growth in the energy unit, growing expectations that Tesla will soon launch new vehicle models, and increasing investor confidence in its potentially lucrative AI initiatives. Despite macroeconomic challenges, delivery data in major markets like China showed improvement in the quarter, while declining interest rates could enhance demand and profitability in the coming quarters. Tesla has also launched operations at its advanced computing center in Texas, rolled out an improved version of its software-enhanced driving solution, and announced plans to provide an important update on its AI projects in early October. These investments and product releases are enhancing Tesla's leadership position in real world AI and investor confidence that Tesla will benefit from these large and attractive growth opportunities.
• Shares of P&C insurance software vendor Guidewire Software, Inc. advanced after subscription gross margins improved by more than 1,000 basis points in its most recently reported quarter. After a multi-year transition period, we believe the company’s cloud transition is substantially over. We believe cloud will be the sole path forward, with annual recurring revenue (ARR) benefiting from new customer wins and migration of the existing customer base to InsuranceSuite Cloud. We also expect Guidewire to shift R&D resources to product development from infrastructure investment, which should help drive cross-sales into its sticky installed base and potentially accelerate ARR over time. We believe Guidewire will be the critical software vendor for the global P&C insurance industry, capturing 30% to 50% of its $15 billion to $30 billion total addressable market and generating margins above 40%.
• On Holding AG is a Swiss premium performance sports brand specializing in footwear. Shares contributed to performance on solid execution and market share gains across all channels, categories, and geographies. Heightened brand awareness following marketing campaigns around the Olympics and the unveiling of new differentiated products such as Light Spray helped boost quarterly results, with revenue expanding 28%. On also reported improving trends in the direct-to-consumer channel as it redressed logistical constraints at the Atlanta distribution center to better match supply with demand. We see a long growth runway supported by geographic expansion, a growing retail footprint, and opportunities in its nascent apparel business.

DETRACTORS

• Moderna, Inc. is a leader in the emerging field of mRNA-based vaccines and therapeutics. Shares were pressured by increasing skepticism around whether a sizable market will exist for recurring boosters (whether bundled with flu or not) in a post-pandemic environment. During its R&D day, Moderna gave a weak 2025 outlook and said it is pulling back on R&D spend. We exited our position.
• Birkenstock Holding plc is a global footwear brand that has been making its distinctive style of sandals since 1774. Shares fell on a slight miss in quarterly revenue due to a demand mix shift away from the direct-to-consumer channel, which grew only 14%, and into the wholesale channel, which expanded 23%. The change was the result of a shift in consumer preference toward in-person shopping, prompting them to purchase shoes from Birkenstock's wholesale partners due to the company's limited retail presence of just 64 stores. We remain investors. Broad-based quarterly revenue growth of 19% pointed to continued strong demand across different product lines and geographies with high levels of full price sell through, as well as market share gains. We see a long growth runway for Birkenstock, supported by retail, geographic, and category expansion.
• Global ski resort company Vail Resorts, Inc. detracted from performance, as a result of a drop in the number of season passes sold and the normalization of the ski industry following the post-pandemic surge of visitors. We remain investors. With a captive high-end consumer base who is willing to pay a premium for its services, Vail enjoys significant pricing power. It plans to cut $100 million in costs over the next two years by leveraging synergies within the business, which should result in improved margins. The company uses its strong balance sheet and robust cash flow to invest in its resorts and cover its dividend, and it recently increased its share buyback program. We think shares are attractive at current valuations.

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 Focused Growth Fund rose 11.77% (Institutional Shares) in the third quarter, outperforming the Russell 2500 Growth Index (the Index) by 478 basis points due to a combination of stock selection and differences in sector weights.

Investments in Information Technology (IT) and Consumer Discretionary accounted for about 90% of the relative outperformance in the period, owing to a mixture of stock selection and material active positions in these sectors. Stock selection in IT added 200-plus basis points of relative gains thanks to strong performance from insurance software vendor Guidewire Software, Inc. and e-commerce specialist Shopify Inc. Guidewire was a top contributor after subscription gross margins improved by more than 1,000 basis points in its most recently reported quarter. Shopify’s shares rose sharply after reporting outstanding financial results with revenue growth of 25% year-on-year, accelerating from the prior quarter. In addition, operating margins of 14.6%, or nearly 3% better than expected, alleviated investor concerns over an upcoming investment cycle. The company continues to capture share in its core business, and we are increasingly seeing data that supports an expansion into new opportunities, including international, business-to-business, and offline.

Electric vehicle manufacturer Tesla, Inc. and premium performance sports brand On Holding AG were generally responsible for relative strength in the Consumer Discretionary sector. Tesla was the top contributor due to accelerated growth in the energy unit, growing expectations that the company will soon launch new vehicle models, and increasing investor confidence in its potentially lucrative AI initiatives. On’s shares were lifted by solid execution and market share gains across all channels, categories, and geographies. Heightened brand awareness following marketing campaigns around the Olympics and the unveiling of new differentiated products such as Light Spray helped boost quarterly results, with revenue expanding 28%. On also reported improving trends in the direct-to-consumer channel as it redressed logistical constraints at the Atlanta distribution center to better match supply with demand. Heath care apparel brand FIGS, Inc. was another material contributor after the company’s results showed improved momentum with several key performance indicators inflecting positive. Revenue expanded 4.4%, with active customers growing 6.1% and order frequency turning positive, and the international and non-scrub categories rose over 30% and 14%, respectively. Management also called out several innovations that are driving demand.

Solid stock selection in Communication Services, higher exposure to the top performing Real Estate and Financials sectors, and lack of exposure to the lagging Consumer Staples and Energy sectors were other sources of strength in the period. Performance in Communication Services was bolstered by Spotify Technology S.A., a leading global digital music service, offering on-demand audio streaming through paid premium subscriptions and an ad-supported model. Spotify’s shares were up in response to another impressive gross margin beat and a solid increase in operating margin. Given the strong value proposition of the product, Spotify has started to exercise its pricing power with a subscription price hike in June, following last year's initial increases that saw minimal churn. Users grew at a healthy pace despite the higher pricing. Spotify also continued to innovate on the product side, with early trials of generative AI features and improving new verticals like audiobooks. On the cost side, Spotify is on a path to structurally increase gross margins, aided by its high-margin artist promotions marketplace, increased contribution from podcasts, and growth in the margin-accretive advertising business.

Somewhat offsetting the above was disappointing stock selection in Industrials and Real Estate, where private rocket and spacecraft manufacturer Space Exploration Technologies Corp. (SpaceX) and real estate data and marketing platform CoStar Group, Inc. hampered performance. SpaceX’s primary focus is developing and launching advanced rockets, satellites, and spacecrafts, with the ambitious long-term goal of enabling human colonization of Mars. The company is also generating significant value through the rapid expansion of its Starlink broadband service. Driven by its vast constellation of proprietary Starlink satellites, Starlink has seen substantial growth in its active user base. SpaceX is also making significant progress on its newest rocket, Starship, the largest, most powerful rocket ever flown. This next-generation vehicle represents a significant leap forward in reusability and space exploration capabilities. We value SpaceX using prices of recent financing transactions, and the company’s share price trailed the Index after remaining unchanged for the period.

CoStar’s shares were negatively impacted by deceleration in net new sales of Homes.com, its residential product offering. We remain encouraged by the website traffic growth and growing brand awareness for the platform, and we are optimistic that sales momentum will improve as the company builds out a dedicated residential sales force and enhances its customer targeting. We believe performance in CoStar’s non-residential business remains strong, and we expect to see better organic growth as the commercial real estate market improves and salespeople return to focus exclusively on a single product.