Baron Small Cap 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 Small Cap Fund declined in the fourth quarter. Industrials, Communication Services, and Information Technology (IT) holdings contributed to performance. Health Care, Consumer Discretionary, and Financials investments detracted the most. Top contributors Vertiv Holdings Co and Chart Industries, Inc. led positive performance within Industrials. Gains within Communication Services were attributable to Liberty Media Corporation - Liberty Formula One. Third largest contributor Intapp, Inc. led advances within IT. Top detractor ICON Plc led declines within Health Care. Third largest detractor Installed Building Products, Inc. led depreciation within Consumer Discretionary. Red Rock Resorts, Inc., a casino owner focused on the Las Vegas Locals market, also weighed on performance within the sector after shares fell on a slowdown in the market and cannibalization by its new Durango casino, which has had a larger-than-expected impact on its other casinos. Second largest detractor The Baldwin Insurance Group, Inc. led weakness within the Financials sector.

Looking ahead, with much of the data pointing to a soft landing in which inflation steadily 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

• Vertiv Holdings Co, a critical digital infrastructure solutions provider for data centers, contributed to performance. With a dominant market share in power and cooling applications for data centers, Vertiv is seen as a prime beneficiary of the AI-related data center build out. At its November analyst day, Vertiv raised organic sales guidance to 12% to 14% CAGR for the next five years and introduced guidance of 16% to 18% organic revenue growth for 2025. Vertiv also increased its target adjusted operating profit margin from 20% to 25%. With McKinsey forecasting global data center demand growth in a range of 19% to 27% CAGR out to 2030, we think Vertiv has the potential to exceed these forecasts. We see substantial value creation opportunities as the market grows and Vertiv remains the dominant provider. We have been trimming the position into strength to manage position size.
• 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.
• Intapp, Inc. offers a software platform for professional services verticals such as private equity, legal, and consulting firms. Shares rose on strong quarterly results, with year-over-year revenue growth of 17% beating expectations and operating margins more than doubled compared to the same period last year. Management also reported a record pipeline for new deal activity, particularly in large enterprises, boosted further by demand for its new AI products. The favorable backdrop for M&A and capital markets deal activity created by the election outcome should also benefit Intapp indirectly as stronger deal activity typically leads to higher fees, hiring, and technology investment in its investment banking and private equity end markets.

 

DETRACTORS

• ICON Plc is a leading contract research organization (CRO) that provides outsourced services to the biopharmaceutical industry. Shares fell on weak quarterly results and lowered 2024 guidance. Like other CROs, ICON is facing headwinds due to tighter management of R&D spend by pharmaceuticals, less biotechnology funding availability leading to slower decision making and capital allocation, a greater number of project delays and cancellations, and an industry shift in preferred business models from full to functional outsourcing. While we expect these headwinds will persist into at least the first half of 2025, we believe pharmaceutical R&D spend will continue to grow and global providers like ICON are well positioned to expand and gain share over time.
• Shares of insurance broker The Baldwin Insurance Group, Inc. gave back some gains due to weaker financial results and an expected earnings headwind from the loss of an insurance partner. The company reported 14% organic revenue growth and modest margin expansion that missed the Street’s more bullish expectations and led to a modest cut to full-year EBITDA guidance. In addition, it disclosed the need to replace an insurance partner in 2025, resulting in a 3% to 5% headwind to earnings. Rising interest rates also weighed on shares due to an elevated leverage profile consisting primarily of variable rate debt. We continue to own the stock because we expect Baldwin to gain market share while expanding margins and reducing leverage over the next several years.
• Installed Building Products, Inc. installs and delivers insulation and complementary building products for the U.S. residential and non-residential construction markets. Shares detracted on broader investor concerns that growth had stalled in the residential market, with buyers facing headwinds including crimped affordability (as mortgage rates continued to rise) and political and economic uncertainty. We view these headwinds are somewhat transitory and remain optimistic about the company's multi-year, multi-pronged growth strategy.

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 Small Cap Fund (the Fund) fell 0.99% (Institutional Shares) in the fourth quarter, trailing the Russell 2000 Growth Index (the Index) by 269 basis points as adverse stock selection overshadowed positive impacts from relative sector weights.

Unfavorable stock selection in Consumer Discretionary, Information Technology (IT), Financials, and Health Care accounted for most of the underperformance in the period. Weakness in Consumer Discretionary was broad-based, led by double-digit declines from casino owner Red Rock Resorts, Inc., premier insulation installer Installed Building Products, Inc. (IBP), corporate daycare provider Bright Horizons Family Solutions, Inc., and hard-surface flooring retailer Floor & Decor Holdings, Inc. Red Rock and Bright Horizons were hurt by adverse business developments, with disruptions at Red Rock’s newer Durango casino pressuring EBITDA growth and Bright Horizons reporting slowing enrollment backfill, decelerating full-service revenue growth, and a disappointing outlook for 2025. IBP and Floor & Decor suffered due to concerns that the housing recovery would take longer than expected because of rising interest rates. We remain investors and are excited about the prospects for all four companies.

Weakness in IT was driven by property and casualty insurance software vendor Guidewire Software, Inc. and syndicated research provider Gartner, Inc., whose shares pulled back after performing well over the prior 12 months. We remain investors. After a multi-year transition period, we believe Guidewire’s cloud transition is substantially over and cloud will be the sole path forward, with average recurring revenue (ARR) benefiting from new customer wins and migrations of the customer base to InsuranceSuite Cloud. We also expect the company to shift R&D resources to product development from infrastructure investment, which will help to drive cross-sales into its sticky installed base and potentially accelerate ARR over time. Additionally, we are also encouraged by Guidewire’s subscription gross margin expansion, which improved by more than 1,000 basis points in its most recently reported quarter. For Gartner, we believe core subscription growth trends are poised to accelerate over the next several quarters as comparisons ease and business conditions improve. In our view, Gartner will emerge as a critical decision support resource for every company evaluating the opportunities and risks of AI on its business, which should provide a tailwind to volume growth and pricing realization over time. Poor stock selection in IT was exacerbated by lack of exposure to a single stock in technology hardware storage & peripherals, whose share price appreciated nearly 400%.

Insurance broker The Baldwin Insurance Group, Inc. was largely responsible for the relative shortfall in Financials. Baldwin was a top detractor due to weaker financial results and an expected earnings headwind from the loss of an insurance partner. The company reported 14% organic revenue growth and modest margin expansion that missed the Street’s more bullish expectations and led to a modest cut to full-year EBITDA guidance. In addition, Baldwin disclosed the need to replace an insurance partner in 2025, resulting in a 3% to 5% headwind to earnings. Rising interest rates also weighed on shares due to an elevated leverage profile consisting primarily of variable-rate debt. We continue to own the stock because we expect Baldwin to gain market share while expanding margins and reducing leverage over the next several years.

Performance in Health Care was hindered by negative earnings revisions for ICON Plc, a leading contract research organization (CRO) that provides outsourced services to the biopharmaceutical industry. ICON was the Fund’s largest detractor after reporting weak quarterly results and lowering 2024 guidance during the period. Like other CROs, ICON is facing headwinds due to tighter management of R&D spend by pharmaceuticals, less biotechnology funding availability leading to slower decision making and capital allocation, a greater number of project delays and cancellations, and an industry shift in preferred business models from full to functional outsourcing. While we expect these headwinds will persist into at least the first half of 2025, we believe pharmaceutical R&D spend will continue to grow and global providers like ICON are well positioned to expand and gain share over time. Adverse stock selection in Health Care ended up being more than offset by the favorable impact of not owning weak performing biotechnology stocks, which were down 10% in the Index, contributing 150-plus basis points of relative gains.

Somewhat offsetting the above was solid stock selection in Industrials, where strong performance from data center cooling industry leader Vertiv Holdings Co. and engineered cryogenic equipment manufacturer Chart Industries, Inc. accounted for most of the relative gains. Vertiv was the Fund’s largest overall contributor after management raised organic sales guidance and increased its target adjusted operating profit margins for the next five years. With McKinsey forecasting global data center demand growth in a range of 19% to 27% CAGR out to 2030, we think Vertiv has the potential to exceed its forecasts. We see substantial value creation opportunities as the market grows and Vertiv remains the dominant provider. We have been trimming the position into strength to manage position size. Chart was another top contributor after reporting robust financial results with free cash flow ahead of investor expectations. The company 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.

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

Baron Small Cap Fund (the Fund) increased 13.61% (Institutional Shares) for the year, trailing the Russell 2000 Growth Index (the Index) by 154 basis points as disappointing stock selection overshadowed favorable impacts from active sector weights. Style biases also weighed on performance, notably underexposure to the better performing Residual Volatility and Beta factors.

Stock selection in Information Technology (IT) was largely responsible for the relative shortfall, detracting 400-plus basis points from relative results. A portion of the weakness came from outsourced software provider Endava plc, staffing firm ASGN Incorporated, and content management company Sprout Social, Inc. Endava’s shares were down sharply due to earnings pressure from soft demand trends. Organic revenue fell due to declines at a few large customers and delayed decision-making from new customers as they evaluated recent advancements in generative AI. Margins dropped due to lower utilization, growth investments, and integration costs related to a recent acquisition. We exited our position. ASGN’s stock lagged as uncertain macroeconomic conditions contributed to sluggish worker demand. Management noted that clients are behaving more cautiously than in previous economic cycles. We expect commercial demand to remain muted until businesses feel more confident about earnings power and the macroeconomic outlook. When clients restart spending, business should snap back quickly, especially in the shorter cycle assignment segment. We believe ASGN remains positioned well for long-term consulting growth.

Sprout’s stock fell sharply in early May after reporting a disappointing quarter with a revenue miss, weak net new annual recurring revenue, and a deceleration in current bookings from 53.7% in 4Q 2023 to 14.4% in Q1 2024. Management blamed weak sales execution, highlighting a smaller pipeline and elongation of deal closures as a result of underestimating the enterprise seasonality now present in the business. We exited our position in Sprout late in the year following several quarters of mixed execution and a change at the CEO position.

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 two securities detracted nearly 260 basis points from relative results, accounting for about two-thirds of the relative shortfall in the sector. Excluding the impacts of Supermicro and MicroStrategy, the Fund would have hypothetically outperformed by more than 100 basis points for the year. Neither business suited 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.

Adverse stock selection in Consumer Discretionary and Health Care accounted for most of the remaining underperformance in the period. Weakness in Consumer Discretionary was driven by declines from casino owner Red Rock Resorts, Inc. and high-performance suspension products manufacturer Fox Factory Holding Corp. Red Rock’s shares were pressured by slower-than-expected market growth rates and disappointing EBITDA growth owing to disruptions at the company’s newer Durango casino. We remain shareholders. The Las Vegas population is growing at a low single-digit rate, which, when combined with inflationary pricing and recent renovations, should lead to improved EBITDA growth. Management has been buying stock at current levels, suggesting the stock is attractively valued. Fox Factory’s stock fell during the period held following earnings misses resulting from sales weakness across several automotive vehicle products. In particular, top-line pressure was driven by consumer demand weakness and supply chain limitations for the chassis of its upfitted truck product. Given the high fixed costs in this manufacturing-intensive business, the dip in revenues caused margins to contract from 20% in 2023 to about 13% in 2024. We exited our position due principally to our reduced conviction in normalized demand for upfitted trucks, a product we had originally perceived as a long-term growth driver for the company.

Poor stock selection in Health Care, owing mostly to declines from contract research organization (CRO) ICON Plc and food and animal safety products provider Neogen Corp., was somewhat offset by the Fund’s meaningfully lower exposure to this lagging sector. ICON was the largest detractor in response to weaker-than-expected second half results including slower-than-expected top-line growth and lowered 2024 guidance. We remain shareholders. Neogen was another top detractor during the year. While end-market challenges seem to be bottoming, improvement is happening at a slower pace than management had originally forecasted. Shares also may have been pressured by investor fatigue after two years of M&A integration (leading to some relatively price insensitive sellers) and tax loss selling into year end. We expect some near-term volatility but believe Neogen is a good company with solid industry tailwinds and is poised for success post-merger integration.

Mostly offsetting the losses above was strong stock selection in Industrials, Communication Services, and Financials along with favorable impacts from having limited to no exposure to the lagging Energy, Materials, and Utilities sectors. The 375-plus basis points of stock-specific gains in Industrials were almost entirely attributable to data center cooling company Vertiv Holdings Co, whose shares rose 140.9% for the year. Apart from recent strength, Vertiv’s shares performed well early in the year due to the company’s improved focus on operational execution, strong revenue growth prospects, and robust opportunities for margin expansion. The NVIDIA partner network and other strong industry relationships that Vertiv maintains has enabled the company to participate in the creation of the technology roadmap for the future of the data center. In addition, Vertiv is investing in capacity to serve this growing end market more effectively. 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. We trimmed the position into strength, but we remain shareholders, as we think Vertiv's leading market position in data center thermal and power management will lead to strong growth in the future.

Strength in Communication Services was due to sharp gains from internet advertising demand-side platform (DSP) The Trade Desk and tracking stock Liberty Media Corporation – Liberty Formula One. Trade Desk’s shares were up as the company continued to demonstrate premium revenue growth and healthy profitability. The medium-term setup continues to look favorable for Trade Desk, as the company continues to benefit from the secular tailwinds in Connected TV taking share from linear TV, retail media, platform upgrade adoption, audio, and more. We believe this will be aided by large partners increasingly using the company’s platform to reach more advertisers, with Netflix, Disney+, and Spotify among those looking to scale their programmatic ads businesses with Trade Desk in the next few years.

Shares of Liberty Formula One increased due to strong top-line growth across all business lines. Growth was driven by the signing of new agreements with media, race promotion, and sponsorship partners. Formula One is benefitting from demand to host a race, or secure sponsorship inventory, that outpaces supply, and thus the going-rate to partner with the sport is increasing. Sponsorship was a notable area of strength as the growing popularity of the sport led to incremental agreements with global corporations including American Express and LVMH. The company also announced the acquisition of MotoGP, which produces Grand Prix motorcycle races, an emerging sport with numerous growth opportunities in the U.S. and Asia. The acquisition presents an opportunity similar to Liberty’s original investment in Formula One, and we believe management has the experience and resources to maximize the sport’s popularity. Both Formula One and MotoGP are well positioned to continue monetizing robust demand for live events and sports media rights.

Favorable stock selection in Financials came from insurance broker The Baldwin Insurance Group, Inc. and specialty insurer Kinsale Capital Group, Inc. Baldwin’s shares performed well after reporting strong growth and margin expansion during the year. In the first nine months of 2024, organic revenue grew 16% and EBITDA grew 22%, with management guiding to 200 basis points of EBITDA margin expansion for the full year. Management expects a continuation of double-digit organic revenue growth and margin expansion in 2025. We continue to own the stock because we expect the company to continue gaining market share while expanding margins and reducing leverage over the next several years. Kinsale was a top contributor 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.