Baron Generational Growth Fund: Latest Insights and Commentary

After selling off in March due to the U.S.-Iran conflict and disruptions in the Strait of Hormuz, U.S. equities rallied to new record highs during the second quarter, with most of the gains coming in April and May. Given narrow market breadth and concentrated position sizes in recent years, the gap in performance between the market cap-weighted S&P 500 Index and the equal-weighted version has reached extremes not seen since the dotcom bubble era (based on rolling three-year results). 

U.S. stocks saw a comeback after ending the prior quarter slightly down. The AI secular growth narrative was the principal driver of market returns, overshadowing uncertainty about a potential resolution to the U.S.-Iran conflict, shifting Federal Reserve rate expectations, and depressed consumer sentiment from high living costs, persistent inflation, and elevated borrowing rates. 

The S&P 500 posted one of its strongest quarterly profit prints in five years, thanks largely to the Magnificent Seven cohort, which reported blended earnings growth in excess of 60% (versus low double digits for other constituents in the Index). The other contributors were primarily Information Technology (IT) stocks—specifically companies that are perceived to be direct beneficiaries of AI capital spending and electrification and what the market has come to call “AI winners." 

Looking ahead, we remain focused on well-managed companies with durable competitive advantages and attractive growth prospects. While macroeconomic and policy uncertainty persist, we believe maintaining a disciplined, long-term perspective and emphasizing company fundamentals will be essential to navigating the evolving landscape.

CONTRIBUTORS

• Red Rock Resorts, Inc. is a casino owner and operator focused on the Las Vegas locals market. Shares increased in the second quarter as construction-related disruption dissipated and investors grew more optimistic about the benefits of the company's recent resort investments. This should result in increased earnings and cash flow, allowing the company to continue investing in its properties while returning capital to shareholders. The company's balance sheet remains strong, with increased liquidity to support further capital investment and shareholder returns. We believe the stock remains attractive relative to what we believe the business can become over time.
• Global hotel franchisor Choice Hotels International, Inc. contributed to performance as revenue per available room accelerated throughout the quarter and management highlighted an increase in new hotel contract signings. This momentum should support stronger margins and cash flow and enable the company to step up share repurchases. Choice’s balance sheet also remains solid, with financial leverage below targeted levels. Earnings and cash flow continue to improve, yet the stock still trades at historically low valuation multiples. We believe this disconnect leaves the shares attractive at current levels.
• Shares of life insurance and investment products provider Primerica, Inc. contributed to performance as rising equity markets improved the outlook for investment sales and asset-based fees. The company reported quarterly financial results that exceeded Street expectations, with 9% revenue growth and 19% earnings-per-share growth, reflecting investment products momentum, margin expansion, and share repurchases. We continue to own the stock because we expect earnings growth to persist, as Primerica provides much-needed financial advice to underserved middle-income households.

DETRACTORS

• FIGS, Inc. designs and sells scrubwear for health care professionals through a digitally native, direct-to-consumer strategy. The stock detracted from performance as shares slipped due largely to investor positioning. Even so, the company reported a very strong first quarter. Revenue came in at $159.9 million, up 28%, well ahead of the company's guidance for low-20% growth and above consensus expectations. The results were broad-based. U.S. revenue grew 24% to $131.6 million, with strength across core offerings, new product launches, and promotional periods, while international revenue accelerated 50% to $28.3 million, with double-digit growth in every region. Active customers surpassed 3 million for the first time, up 12% year over year, with both new and repeat customers contributing. We continue to have conviction in the strength of FIGS' business model and the company's ability to gain market share in the attractive global health care apparel industry.
• Syndicated research provider Gartner, Inc. detracted from performance due to multiple compression driven by rising AI fears.  The market has increasingly come to view AI as an existential risk for a growing number of industries, including software, business services, information services, and video games. While there is little evidence of any fundamental impact on these sectors, investors have largely adopted a “shoot first and ask questions later” approach, leading to significant stock price declines. We continue to own Gartner given its large addressable market, significant competitive advantage, and robust free cash flow generation, which we expect management to deploy toward share repurchases at depressed valuation levels.
• Shares of property and casualty (P&C) insurance software vendor Guidewire Software, Inc. declined after a handful of deals slipped from the fiscal third quarter into the fiscal fourth quarter. We believe this is purely a timing issue, with these deals having since closed in the current period. Guidewire’s InsuranceSuite platform serves as the core system of record for insurance carriers, functioning as the single source of truth for the policies an insurer writes, the claims it processes, the premiums it collects, and the payments it makes. We think the core-system opportunity alone represents nearly $20 billion of annual recurring revenue, or roughly 20 times Guidewire’s current size. In our view, AI will meaningfully expand this opportunity by enabling automation and intelligence on top of the core system of record. Guidewire is already bringing new AI-enabled capabilities to market and signing customers, and we expect adoption to accelerate over the coming year. Finally, we expect Guidewire to benefit from the same internal productivity enhancements AI is driving across enterprises, which should help it grow faster with lower costs and ultimately improve profitability.

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 Generational Growth Fund (the Fund) declined 2.51% (Institutional Shares) in the second quarter, trailing the Russell 2000 Growth Index (the Index), which appreciated 25.71%. The Fund underperformed by 28% for the quarter, with about 80% of the shortfall coming from style-related headwinds, notably underexposure to Beta in a period of market strength. The Beta factor posted its best three-month performance on record in the period, with the factor’s performance rivaling prior sharp market rallies that followed bear markets, such as “Black Monday”, the dotcom collapse, the Great Recession, and the COVID pandemic. Underexposure to Momentum was another material detractor, as the factor continued its sustained run of strong performance in the period, powered by investor excitement about AI. Many of the top contributors in the Index were what the market calls “AI winners” with elevated exposure to the Beta and Momentum factors. In other words, it was the AI winners that drove outsized factors performance, especially when it comes to Beta and Momentum, contributing to the Fund’s meaningful underperformance in the period. The remaining deficit was attributable to stock specific and industry factors, with the AI trade playing a prominent role given lack of exposure to certain AI winners, whether they be individual securities (Bloom Energy Corporation, Credo Technology Group Holding Ltd., and Sterling Infrastructure, Inc.) or industries (Semiconductors, Semiconductor Equipment, and Computer Electronics). 

From a sector perspective, investments in Financials, Information Technology (IT), Consumer Discretionary, and Real Estate weighed the most on relative performance. Weakness in Financials came from a combination of stock selection and substantially higher exposure to this lagging sector. Specialty insurers Arch Capital Group Ltd. and Kinsale Capital Group, Inc. accounted for over half of the losses in the sector, as investors rotated away from resilient insurance stocks in a risk-on market environment. Concerns about moderating growth amid a cyclical slowdown in the property and casualty (P&C) insurance industry also weighed on shares. Rates for property insurance are falling due to strong profitability and elevated capital levels following last year’s benign hurricane season. This cyclicality is normal, and we remain shareholders. We continue to own Arch stock because of the company’s strong management team and our expectation of continued growth in earnings and book value over time. Regarding Kinsale, we believe the company is well managed and has a long runway for growth in an attractive segment of the insurance market. Financial exchanges & data companies MSCI Inc., Morningstar, Inc., and FactSet Research Systems Inc. also contributed to relative losses in the sector due to ongoing concerns that generative AI could disrupt their businesses. We maintain long-term conviction because all three companies have strong, "all weather" franchises underpinned by proprietary data assets and we believe they remain well positioned to benefit from numerous secular tailwinds in the investment community.

Within IT, lack of exposure to semiconductors, which were up 100% in the Index, and double-digit losses from syndicated research provider Gartner, Inc. and P&C insurance software vendor Guidewire Software, Inc. hampered performance. Shares of Gartner and Guidewire underperformed as investors continued to rotate out of stocks perceived as at risk of being disrupted by AI. We believe this characterization is misplaced and that AI will ultimately be a significant tailwind for both companies. While the market has expressed concern about the impact of AI on Gartner’s insights business, we see no evidence that it is negatively impacting the company’s value proposition. We believe Gartner has a vast and growing set of proprietary data, generated by hundreds of thousands of interactions with buyers, sellers, and consumers of technology. Gartner’s proprietary insights extend to corporate technology roadmaps, enabling the company to assess future trends, and its contract review program delivers tangible returns on investment for customers. We expect growth trends to improve as U.S. public sector headwinds abate and the company’s sales force productivity strengthens. We also think Gartner is being extremely aggressive in repurchasing stock to take advantage of what we view as a discounted valuation.

Guidewire’s InsuranceSuite platform serves as the core system of record for insurance carriers, functioning as the single source of truth for the policies an insurer writes, the claims it processes, the premiums it collects, and the payments it makes. Insurance policies are complex, highly regulated, and stored exclusively in digital form within Guidewire, which makes the system of record particularly critical and therefore highly valuable. We believe the core system opportunity alone represents nearly $20 billion of annual recurring revenue, or roughly 20 times Guidewire’s current size. In our view, AI meaningfully expands this opportunity by enabling automation and intelligence on top of the core system of record. Guidewire is already bringing new AI enabled capabilities to market and signing customers, and we expect adoption to accelerate over the coming year. Finally, we expect Guidewire to benefit from the same internal productivity enhancements AI is driving across enterprises, helping the company support faster growth with lower costs and ultimately improving profitability.

Most of the losses in Consumer Discretionary came from the Fund’s sizable positions in health care apparel company FIGS, Inc. and global hotel franchisor Choice Hotels International, Inc. Following strong performance to begin the year, FIGS stock declined in the second quarter, driven primarily by investor positioning. FIGS reported a very strong first quarter, with revenue of $159.9 million, up 28%, well ahead of management’s “low-20% growth” guidance and consensus expectations. Results were broad-based. The U.S. grew 24% to $131.6 million, with strength across core demand, new product launches, and promotional activity, while the international segment accelerated to 50% growth, reaching $28.3 million with double-digit growth in every region. Active customers surpassed 3 million for the first time, up 12% year-over-year, with both new and repeat cohorts contributing. We retain conviction in FIGS’ long-term growth potential as it gains share in the attractive global healthcare apparel market. 

Choice Hotels stock detracted from performance in the second quarter amid investor concerns that the company was losing share to competitors and delivering lower-than-expected revenue per available room (RevPAR). The RevPAR shortfall reflected a difficult comparison, as last year’s performance benefited from hurricane-related lodging demand in several regions during the rebuilding and recovery period. RevPAR otherwise would have increased by low single digits, and we believe it will accelerate through the balance of the year due to below-normal supply growth in many of the company’s markets. This, together with accelerating domestic and international unit growth and royalty rate expansion enabled by new tools provided to franchisees, should contribute to a reacceleration in earnings growth. Strong cash flow should follow, which, when combined with an already strong balance sheet, is likely to result in multiple expansion and generate strong stock returns for investors.

Real estate information and marketing services platform CoStar Group, Inc. hampered performance in the Real Estate sector before being sold. Like Gartner and Guidewire, CoStar’s shares remained under pressure due to multiple compression driven by rising AI fears. After owning CoStar for more than 21 years and realizing meaningful gains over the life of our investment, we decided to step to the sideline for various reasons, including reduced expectations for success with the company’s residential strategy (Homes.com), concerns about market share erosion in multifamily marketing, a sub-optimal capital allocation strategy focused heavily on the residential opportunity rather than the its commercial business lines or returning capital to shareholders, and diminished management credibility. 

Marginally offsetting the above were favorable impacts from not owning weak performing securities in the Energy and Materials sectors, which added 180-plus basis points of relative gains.