Baron FinTech Fund Q3 2023 Shareholder Letter

Dear Baron FinTech Fund Shareholder:

Performance

Table I. Performance† Annualized for periods ended December 31, 2023

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In the quarter ended December 31, 2023, Baron FinTech Fund (MUTF:BFIIX, the Fund) rose 13.85% (Institutional Shares) compared with a 15.54% gain for the FactSet Global FinTech Index (the Benchmark). In 2023, the Fund rose 27.31% compared with a 23.34% gain for the Benchmark. U.S. equities rose sharply in November and December, pushing the broad market indexes to double-digit gains for the quarter. Moderating inflation coupled with a softening labor market and a perceived peak in interest rates were the main drivers of the broad-based rally. After rising for much of the year, the 10-Year Treasury yield reached 5% in October and then promptly fell below 4% to end the year back where it started. The S&P 500 Index (SP500, SPX) returned more than 26% in 2023, finishing the year at an all-time high. Most of the S&P 500 Index’s gains came from mega-cap technology stocks with the Magnificent Seven up 76% for the year, while the remaining stocks in the Index rose by a more modest 14%. Most sectors closed higher during the quarter, led by Information Technology (‘IT’), while Energy was the only sector to close lower as oil prices fell. Growth outperformed value for the quarter and the year. Small-cap stocks outperformed large caps during the fourth quarter, while large caps outperformed for the year.

The Fund rose nearly 14% in the quarter, trailing the Benchmark, but outperforming the broader market. Challengers outperformed Leaders (up 20.8% vs. up 12.6%, respectively) in a risk-on environment. Four of our seven themes contributed to relative performance (Payments, Digital IT Services, E-Commerce, and Enterprise Software), while three themes detracted (Tech-Enabled Financials, Information Services, and Capital Markets).

Our Payments stocks contributed the most to relative performance during the quarter due to favorable stock selection coupled with lower exposure to this lagging category. Financial services and digital payments company Block, Inc. (SQ) led the way in this category with shares rebounding after poor performance in the prior quarter. The company reported healthy 21% gross profit growth and earnings that beat Street estimates. Management emphasized a greater focus on cost discipline and margin expansion, while continuing to innovate and grow faster than the market. Block committed to achieving a “Rule of 40” investment framework by 2026 with at least mid-teens gross profit growth and a mid-20% operating margin.

Our exposure to Digital IT Services also contributed to relative performance during the quarter. Shares of outsourced software provider Endava plc (DAVA) rose 35.7% during the quarter, continuing last quarter’s positive momentum after lagging for most of 2022 and the first half of 2023. Macroeconomic uncertainty has weighed on client demand and revenue growth, but management expects a rebound in 2024 supported by a large pipeline of projects from newer clients. Margins should expand alongside faster revenue growth as the company leverages upfront costs to build capacity in anticipation of a demand recovery. The company has been acquisitive and is benefiting from vendor consolidation. Latin America-based Globant S.A. (GLOB) also contributed to performance after rising over 20% during the quarter as the company gains market share.

The impact of falling yields was a common source of relative underperformance across Tech-Enabled Financials, Information Services, and Capital Markets. Lower yields drove a market rotation away from defensive stocks into more speculative ones, weighing on the performance of insurance carriers Arch Capital Group Ltd. (ACGL) and Kinsale Capital Group, Inc. (KNSL) and insurance data provider Verisk Analytics, Inc. (VRSK) Conversely, not owning highly shorted and credit-sensitive stocks hurt relative performance as these stocks benefited from the risk-on rally. Lower yields also impacted the fundamentals of some of our stocks, likely weighing on relative performance. Shares of broker-dealers LPL Financial Holdings Inc. (LPLA) and Interactive Brokers Group, Inc. (IBKR) fell slightly as investors anticipated the impact of lower yields on client cash balances. Nevertheless, both companies continue to grow client assets at a healthy clip and earn other fees that will likely benefit from lower interest rates, offsetting some of the potential headwinds on interest income. In addition, shares of alternative asset manager Apollo Global Management, Inc. (APO) didn’t fully participate in this quarter’s market rally due to the expectation that lower rates could weigh on annuity sales and fixed income spreads.

We take a balanced approach to portfolio construction when considering the impact of changing interest rates. By our estimate, approximately 20% of Fund holdings benefit from higher interest rates (e.g., higher interest income for insurance carriers and broker-dealers), while approximately 20% benefit from lower interest rates (e.g., higher debt issuance for ratings agencies and credit bureaus). We believe the remaining 60% of holdings have minimal direct exposure to interest rates, putting aside the valuation multiple expansion that may accompany falling rates and a lower cost of capital. We believe having a diversified portfolio with varying levels of interest rate sensitivity should lead to higher returns with lower volatility over a market cycle, even if short-term performance is impacted by interest rate movements.

For the year, the Fund beat the Benchmark, marking the fourth consecutive year of outperformance in the four years since inception. We are pleased with the over 800 basis points of average annual outperformance the Fund has achieved over this period. This was accomplished through outperformance in both up and down markets, with higher Upside Capture and lower Downside Capture compared to the Benchmark. We believe our focus on quality growth stocks and the Fund’s balanced holdings across Leaders and Challengers has served us well.

Table II. Top contributors to performance for the quarter ended December 31, 2023

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Shares of Fair Isaac Corporation (FICO), a data and analytics company that predicts consumer behavior, contributed to performance. The company reported good earnings results and provided annual financial guidance that appears conservative, especially given significant pricing actions in the Scores business. CEO Will Lansing expressed confidence that the business can perform well in varying economic environments and was optimistic about continued momentum in the software business. We expect price increases and margin expansion to drive double-digit earnings growth and share price returns.

Intuit Inc. (INTU) is the leading provider of accounting software for small businesses and tax preparation software for individuals and tax professionals. Shares increased after the company reported quarterly financial results that exceeded Street expectations, with 15% revenue growth and 49% EPS growth. Intuit is benefiting from the sale of higher value services and is well positioned to capitalize on increasing adoption of artificial intelligence (‘AI’) given its vast data sets. The company recently launched Intuit Assist, a generative AI-powered digital assistant that improves productivity and unlocks valuable insights for customers. We continue to own the stock due to Intuit’s strong competitive position and numerous growth opportunities.

Shares of rating agency and data provider S&P Global Inc. (SPGI) increased due to higher debt issuance amid more favorable market conditions. Billed issuance rose 47% in October and 26% in November against subdued levels last year, with issuance boosted by declining interest rates and tighter bond spreads. Positive equity market performance in the fourth quarter benefited asset based fees. In addition, the company reported strong quarterly financial results with double-digit growth in revenue and earnings and raised full-year earnings guidance. We continue to own the stock due to the company’s long runway for growth and significant competitive advantages.

Table III. Top detractors from performance for the quarter ended December 31, 2023

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Shares of specialty insurer Kinsale Capital Group, Inc. gave back some gains from earlier this year after the company reported slower premium growth in the third quarter. Earnings beat Street expectations, with EPS doubling and ROE exceeding 34%. However, investors focused on a slowdown in gross written premiums, which management attributed to normal seasonality for property insurance. Additionally, we believe some of the share price weakness resulted from a market rotation away from defensive stocks to more speculative stocks following a decline in yields. 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.

TransUnion (TRU) is a consumer credit bureau that helps businesses make lending and marketing decisions. Shares fell after the company reported quarterly financial results that were below consensus expectations and reduced full-year guidance. Lending and marketing activity softened during the quarter, particularly among smaller, subprime lenders. Management believes the new financial guidance is highly achievable and is increasingly focused on cost efficiency to improve margins. We continue to own the stock because we expect earnings growth to improve as cyclical headwinds abate and the company integrates recent acquisitions.

BILL Holdings, Inc. (BILL), a leading provider of cloud-based software that simplifies, digitizes, and automates back-office financial processes, detracted from performance. The company reported solid quarterly financial results, but the stock fell after management provided a weaker-than-expected outlook. Slower economic growth among small- and medium-sized businesses (‘SMB’) is weighing on customer payment volumes. In addition, there is some pressure on the revenue take-rate due to some suppliers limiting acceptance of virtual cards and a stronger U.S. dollar impacting currency conversion fees for international payments. Despite near-term headwinds, we retain conviction as the digitization of B2B payments is a powerful secular trend with a long runway for growth, and we believe BILL will be a winner in the SMB market.

Portfolio Structure

We seek to invest in competitively advantaged, growing fintech companies for the long term. We conduct independent, fundamental research and take a long-term perspective. We invest in companies across all market capitalizations and geographies. The quality of the ideas and level of conviction determine the position size of each investment. We do not try to mimic an index, and we expect the Fund will look very different from the Benchmark.

As of December 31, 2023, we held 44 positions. The Fund’s 10 largest holdings represented 41.0% of net assets, and the 20 largest holdings represented 67.7%. International stocks represented 14.3% of net assets. The market capitalization range of the investments in the Fund was $703 million to $537 billion with a median of $29.6 billion and a weighted average of $100.9 billion. The Fund’s active share versus the Benchmark was 85.4%.

We segment the Fund’s holdings into seven investment themes. As of December 31, 2023, Information Services represented 23.8% of net assets, Tech-Enabled Financials represented 21.7%, Payments represented 18.2%, Enterprise Software represented 13.6%, Capital Markets represented 8.5%, Digital IT Services represented 7.8%, and E-Commerce represented 5.3%, with the remainder in cash. Relative to the Benchmark, the Fund was meaningfully underweight Enterprise Software and Payments, and has overweight positions in Tech-Enabled Financials, Capital Markets, Digital IT Services, Information Services, and E-Commerce.

We also segment the Fund’s holdings between Leaders and Challengers. Leaders are generally larger, more established companies with stable growth rates, higher margins, and moderate valuation multiples. Challengers are generally smaller, earlier-stage companies with higher growth rates, lower margins, and higher valuation multiples. As of December 31, 2023, Leaders represented 76.6% of net assets and Challengers represented 22.2%, with the remainder in cash.

Table IV. Top 10 holdings as of December 31, 2023

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Table V. Fund investments in GICS sub-industries as of December 31, 2023

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Recent Activity

Trading activity was relatively limited during the quarter with no new positions added and only one small position exited. Below we discuss some of our top net purchases and sales.

Table VI. Top net purchases for the quarter ended December 31, 2023

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We added to Arch Capital Group Ltd. after initiating a position in the prior quarter. The insurance carrier reported excellent quarterly results with 30% growth in its book value per share and a 25% ROE, which reached a multidecade high for a September quarter that is typically impacted by hurricane season. Nevertheless, the share price fell during the quarter, likely due to a market rotation away from defensive stocks to more speculative stocks following a decline in yields. Arch is now a full-sized position and is attractively valued below 10 times earnings as of the end of the quarter.

We also added to insurance software provider, Guidewire Software, Inc. (GWRE), a long – time holding that is nearing a successful completion of its cloud transition. The company recently held an Investor Day where management guided to accelerating revenue growth and expanding margins based on customer wins that are ramping up over the next few years. Following years of infrastructure investment to build out its cloud-based offering, the company will now pivot R&D resources to developing new applications, which offer significant revenue potential. Guidewire’s competitive position appears as strong as ever, with a high 90% customer retention rate and an 80% win rate by value for new business. We expect free cash flow per share to exceed $6 in a few years, which should drive continued share price appreciation.

Table VII. Top net sales for the quarter ended December 31, 2023

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We trimmed LPL Financial Holdings Inc. and Kinsale Capital Group, Inc. to fund the purchase of higher-conviction ideas. We trimmed TransUnion and used the proceeds to add to Equifax Inc. where we have greater confidence in the competitive positioning of the employment and income verification business and expect an earnings recovery as mortgage activity normalizes. We sold our small position in Paymentus Holdings, Inc. (PAY) as the valuation looked full following a period of significant outperformance.

Outlook

Since the Fund’s inception four years ago, global events have had massive impacts on equity markets. We’ve lived through a global pandemic, enormous fiscal and monetary stimulus, a reopening economy, supply-chain disruptions, a war involving a global superpower, soaring inflation, and unprecedented interest rate hikes. Against this backdrop, the Fund produced strong returns in 2020 (+47%), solid returns in 2021 (+15%), lousy results in 2022 (-33%), and good returns in 2023 (+27%).

The fintech sector has underperformed the broader market over this four-year period with the Benchmark up 2% per year compared to the S&P 500 Index up 12% per year. Most of the weakness was concentrated in the 12-month period from September 2021 through September 2022. This period corresponded with core CPI rising above 4% and peaking at over 6%, leading to tighter monetary policy. However, since the end of 2022, core CPI has been slowing and recently fell below 4% on a 12-month basis, increasing expectations for more dovish Fed rate policy later this year. If inflation remains low and the historical pattern holds, then we’d expect the fintech sector to generate more consistent outperformance against the broader market going forward.

We believe the fintech sector is experiencing a normalization following the boom cycle in the years following the COVID-19 pandemic. Venture capital funding for fintech companies fell 44% by volume and 32% by number of deals in 2023 according to PitchBook. While these declines appear substantial, we believe investment activity is normalizing from abnormally heightened levels in 2021 and 2022 when funding was driven by low interest rates and insatiable demand for growth. The investment environment has since reversed with interest rates at elevated levels and investors increasingly focused on profitability. We believe the end of the hype cycle is healthy for the long-term growth of the fintech industry and more aligned with our strategy of investing in competitively advantaged businesses with sustainable earnings growth.

We are optimistic about our portfolio holdings at the start of 2024. We expect many of the cyclical headwinds that our companies faced last year to reverse and become tailwinds this year. This includes stronger debt issuance for our rating agencies, rebounding mortgage and consumer lending for our credit bureaus, more robust deal activity for our advisory firm, and a return to digital transformation projects for our IT services companies. This is counterbalanced by potentially moderating rates of growth for payment businesses that benefited from elevated inflation and a post-pandemic travel surge.

We expect forward-thinking fintech companies to invest more in AI, especially generative AI, which improves the accessibility of AI for consumers. We see AI as more of an enabler than a disrupter for the fintech industry, at least over the next few years, with incumbents benefiting first from AI since they have the scale to invest, the data to train models, and the broad distribution to capitalize on AI innovations. Financial services are highly regulated, so AI adoption might take longer or be more limited in scope for fintech than for other industries that don’t require regulatory approval for new advancements. Like other major technologies, AI likely follows Amara’s Law, which states that the market overestimates the potential of a technology in the near term but underestimates it in the long term. This pattern was demonstrated during the PC, internet, mobile, and cloud adoption eras. We view 2024 as an investment year for AI that will be followed by measurable productivity improvements beginning in 2025. We maintain an active dialogue with the management teams of our portfolio companies to evaluate the opportunities and threats of technology innovation, including AI.

Thank you for investing in the Fund. We remain significant shareholders alongside you.

Sincerely,

Josh Saltman

Portfolio Manager

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