Baron Focused Growth Fund Q4 2023 Shareholder Letter

DEAR BARON FOCUSED GROWTH FUND SHAREHOLDER

PERFORMANCE

Baron Focused Growth Fund (BFGIX, the Fund) had a strong fourth quarter. Although the Fund increased 9.74% (Institutional Shares) in the period, it underperformed the Russell 2500 Growth Index (the Benchmark), which increased 12.59%. Investor expectations of a U.S. Federal Reserve (the Fed) pivot from raising rates to lowering rates over the next year benefited leveraged, cyclical, and interest rate sensitive stocks significantly. We have modest investments in such businesses.

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

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For all of 2023, the Fund outperformed its Benchmark by 885 bps, increasing 27.78%. The Benchmark increased 18.93%. The Fund’s strength was led by our well-financed, Disruptive Growth companies that continue to take share of large market opportunities and achieve extraordinary returns on capital. Examples include Tesla, Inc. (TSLA), Space Exploration Technologies Corp., Spotify Technology S.A. (SPOT), and Shopify Inc. (SHOP)

Our highly differentiated Core Growth investments that have strong, recurring revenue with significant pricing power and high retention rates also led to outperformance in 2023. These include Guidewire Software, Inc. (GWRE) and Verisk Analytics, Inc. (VRSK) Finally, our Real/Irreplaceable Assets investments such as Hyatt Hotels Corporation (H), Red Rock Resorts, Inc. (RRR), and Choice Hotels International, Inc. (CHH) also helped performance in 2023 given strong, well-known brands that would benefit from a stable economic environment and a potential pivot towards lower interest rates, lower inflation and greater consumer disposable income.

Our portfolio companies performed well in 2023 despite continued macroeconomic concerns of a slowdown in consumer spending and capital investments. While inflation is affecting operating expenses, most of our portfolio companies have offset a portion of their increased costs with higher prices without impacting demand.

The Fund has continued to generate strong returns with less than market risk. Over the trailing 3, 5, and 10 years, the Fund has captured 106%, 129%, and 114%, respectively, of the upside when the market increased. When markets declined, the Fund lost less with 87%, 93%, and 91% downside capture, respectively. The Fund’s Sharpe ratio, a measure of risk adjusted return, was also higher than the Benchmark for each of these periods.

We believe these strong returns with downside protection are due to our research-based investment process. Our research enables us to identify and understand businesses’ competitive advantages, differentiation, long-term growth prospects, and exceptional people. As a result, the Fund has outperformed its Benchmark for the 1-, 3-, 5-, 10-, and 15-year periods, as well as since its inception on May 31, 1996. Since its inception as a private partnership more than 27 years ago, the Fund has increased 13.35% annualized. This compares to an 8.04% annualized return for the Benchmark and a 9.39% annualized return for the S&P 500 Index.

The underperformance in the fourth quarter was partly due to our Financials investments. Financials businesses represented 16.7% of the Fund’s net assets compared to 8.5% for the Benchmark. While these companies continued to perform well, investor expectations for the Fed to begin lowering rates this year negatively impacted their stock price performance. We believe these businesses can continue to grow in a declining rate environment. That is because their recurring revenue, fee-oriented businesses have strong pricing power and high client retention rates.

Several of our Real/Irreplaceable Assets and Disruptive Growth holdings also declined in the period, accounting for the remainder of our underperformance. Marriott Vacations Worldwide Corporation (VAC) and Rivian Automotive, Inc. (RIVN) penalized the Fund’s results in the quarter, and we sold out of these positions. Choice Hotels International, Inc., BioNTech SE (BNTX), and Tesla, Inc. (TSLA) also declined in the period.

Hotel franchisor Choice declined 7.5% and hurt performance by 19 bps. Choice’s proposed hostile takeover of Wyndham Hotels pressured shares because it would increase leverage that could take two to three years to pay down. Regardless, we think the acquisition would benefit Choice and Wyndham since increased scale would enable franchisees to pay lower fees to online travel agencies, increase revenue via a larger loyalty program, and generate higher royalty rates given better revenue management tools. Choice’s shares are now trading at historically attractive levels, and we believe the stock is likely to increase if this transaction is not consummated.

BioNTech declined 12.2% in the fourth quarter and hurt performance by 20 bps. The company, a leader in the mRNA drug industry, was hurt in the quarter by lower uptake of its mRNA COVID vaccine as fewer people took the new vaccine. This has resulted in lower revenue and cash flow this year, but the company’s strong pipeline of new oncology and infectious disease drugs over the next couple of years remains promising. The company is profitable and is generating strong cash flow. At current valuations, 70% of the company’s equity value is cash. Accordingly, we believe investors are getting its pipeline for free at current price levels.

Our large position in Tesla was down modestly in the period, detracting 28 bps from performance. Tesla designs, manufactures, and sells electric vehicles, related software and components, and solar and energy storage products. The stock detracted as the core automotive segment remained under pressure due to a complex macroeconomic environment, higher interest rates, factory shutdowns, and Tesla’s price reductions throughout the year, presenting pressure on the near-term growth and margin profile. Nonetheless, Tesla continued to generate sufficient gross profit to support a robust product development plan that can propel the automotive segment higher over time. Tesla also started to deliver its highly anticipated Cybertruck, its first pickup truck with a tremendous amount of consumer interest and a slew of new technologies within the car and its manufacturing lines. The refreshed Model 3 also seems to be generating strong demand while improving unit-level economics. Lastly, while early, investors now expect Tesla to benefit from its investment in artificial intelligence (AI) through development of autonomous driving technology Dojo (an AI training computer), autobidder (an automated energy trading platform), and humanoid (a human-like robot).

The one group that outperformed the Benchmark in the fourth quarter was Core Growth, owing mostly to strong gains from IDEXX Laboratories, Inc. (IDXX) and Guidewire Software, Inc.

Veterinary diagnostics leader IDEXX appreciated 26.9% in the period, contributing 34 bps to performance. While foot traffic to veterinary clinics in the U.S. has been subdued for the past year, IDEXX’s excellent execution has enabled the company to continue delivering robust financial results. Traffic to clinics now appears to be rebounding, and we expect this to lead to accelerated revenue growth. We believe IDEXX’s competitive trends are outstanding, and we expect new proprietary innovations to contribute to growth in 2024 and beyond. We see increasing evidence that long-term secular trends around pet ownership and pet care spending have been structurally accelerated, which should help support IDEXX’s long-term growth rate.

Property and casualty (P&C) insurance software vendor Guidewire was up 21.2% for the quarter, adding 85 bps to performance. After a multi-year transition period, we believe the company’s cloud transition is substantially complete. We believe that cloud will be the sole path forward, with annual recurring revenue (‘ARR’) benefiting from new customer wins and migrations of the existing 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. We are also encouraged by Guidewire’s subscription gross margin expansion, which improved by approximately 1,600 bps in its most recently reported quarter. We believe that 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%.

Table II. Total returns by category for the quarter ended December 31, 2023

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

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Space Exploration Technologies Corp. (SpaceX), a high-profile private company founded by Elon Musk, designs, manufactures, and launches rockets and satellites. Shares contributed to performance in the wake of another record-breaking year. The company closed 2023 with a record 96 Falcon rocket launches, nearly twice a week on average, substantially more than the 61 launches in 2022 and surpassing all its private and government program peers. Starlink, SpaceX’s satellite constellation, also achieved remarkable milestones, including operating over 5,500 satellites, the majority of active satellites in space, and now providing connectivity services to 2.3 million active customers, more than doubling its customer base during the year. Starship, SpaceX’s groundbreaking new rocket, successfully performed its second test flight this quarter. Over time, SpaceX expects Starship to both reduce costs and expand the company’s operational capabilities, including supporting SpaceX’s long-term goal to enable human beings to inhabit Mars. We value SpaceX using a proprietary valuation model and recent financing transactions, which trended positively even through a more complex funding environment.

Shares of global hotelier Hyatt Hotels Corporation increased in the quarter. The company reported strong demand across its portfolio, led by robust leisure travel and improvement in its business transient and group business that is now pacing above pre-COVID levels. Room rate increases are generating solid margins and cash flow. In our view, Hyatt’s sound, underleveraged balance sheet keeps it well positioned should we enter a possible downturn in 2024. The hotel transaction market is improving, and the company has two properties for sale that should close in early 2024. At that time more than 80% of revenue will be generated from fees with the remainder from owned assets. We also believe these transactions should help boost the stock’s multiple over time.

Shares of Red Rock Resorts, Inc., a casino operator in the Las Vegas Locals market, increased on the opening of its new Durango casino in early December. The company reported strong initial visitation and spend levels without cannibalization at its other properties. Red Rock expects the casino to generate profits from its first day of operation and projects a 20% annualized return on capital its $800 million investment by 2026. The company has 300 acres of gaming-entitled land in the Las Vegas Locals market to develop and expects to double its current EBITDA levels by the end of the decade while funding all new developments internally with cash flow. We believe its stock remains very attractively valued at current levels.

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

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Shares of timeshare company Marriott Vacations Worldwide Corporation fell in the quarter, driven by soft sales of timeshare units due to higher interest rates and the slow ramp of a new product offering. A default rate that was higher than the company had anticipated forced it to take a charge to increase its reserves, pressuring earnings and cash flow. We opted to exit our position due to the increased stress on its consumer base and a resulting increase in financial leverage, which we found inappropriate for a focused fund.

Iridium Communications Inc. is a mobile voice and data communications services vendor offering global coverage via satellite. In 2022, Iridium announced an agreement with Qualcomm to incorporate Iridium’s technology into Qualcomm’s Snapdragon chip, allowing devices to seamlessly connect to both cellular and satellite networks. In a surprise turn of events, Qualcomm backed out of the partnership in November 2023. The decision shook investors’ confidence in Iridium’s direct-to-device opportunity. We retain conviction. Iridium remains a unique satellite owner and operator, with L-band spectrum, years of operational experience, relatively new satellite hardware, and hundreds of partners across verticals and geographies. In addition, management announced a commitment of $3 billion in return to shareholders between 2023 and 2030, representing a material portion of the current enterprise value.

Shares of specialty insurer Arch Capital Group Ltd. gave up some gains in the fourth quarter after solid performance for most of the year. We believe the share price weakness was primarily due to a sector rotation away from defensive stocks to more speculative stocks following a decline in interest rates. Company fundamentals remained strong, with net premiums written growing 23%, operating ROE expanding to 25%, and book value per share rising 30% in the third quarter. Management expects favorable market conditions will persist. We continue to own Arch due to its experienced and talented management team and our expectation of solid growth in earnings and book value.

Investment Strategy & Portfolio Structure

We remain steadfast in our commitment to long-term investing in competitively advantaged growth businesses. We believe these investments are an effective way to protect and increase the purchasing power of your savings. Wars, pandemics, financial panics, higher-than-normal inflation, and interest rate increases can cause significant market declines, but when these negative influences abate, and interest rates stabilize and decline, stock prices can increase substantially. We believe this will happen again, although the timing remains uncertain.

As of December 31, 2023, we owned 31 investments. The Fund’s average portfolio turnover for the past three years was 24.5%. This means the Fund has an average holding period for its investments of approximately four years. The average mid-cap growth mutual fund typically turns over its entire portfolio every 17 months. From a quality standpoint, the Fund’s investments have stronger sales growth, higher EBITDA, operating, and free cash-flow margins, and stronger returns on invested capital than the Benchmark. We believe these metrics help limit risk in this focused portfolio.

While focused, the Fund is diversified by sector. The Fund’s weightings are significantly different than those of the Benchmark. For example, we are heavily weighted to Consumer Discretionary businesses with 40.9% of net assets in this sector versus 13.4% for the Benchmark. We have no exposure to Energy, Materials, or Utilities. We believe companies in these sectors can be cyclical, linked to commodity prices, and/or have very little if any competitive advantage. This compares to the Benchmark that had 8.8% exposure to these sectors. We also have lower exposure to Health Care stocks at 5.1% for the Fund versus 21.0% for the Benchmark. The performance of many stocks in the Health Care sector can change quickly due to exogenous events or binary outcomes (e.g., biotechnology and pharmaceuticals). As a result, we do not invest a large amount in these stocks in this focused portfolio. In Health Care, we invest in competitively advantaged companies such as our positions in IDEXX Laboratories, Inc., the leading provider of diagnostics to the veterinary industry, BioNTech SE, the leader in mRNA drugs, and Illumina, Inc., the leader in DNA sequencing instruments and consumables. The Fund is further diversified by investments in businesses at different stages of growth and development.

Table V. Disruptive Growth Companies as of December 31, 2023

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Disruptive Growth firms accounted for 36.0% of the Fund’s net assets. On current metrics, these businesses may appear expensive; however, we think they will continue to grow significantly and, if we are correct, they have the potential to generate exceptional returns over time. Examples of these companies include electric vehicle leader Tesla, Inc., commercial satellite and launch company Space Exploration Technologies Corp., and audio streaming service provider Spotify Technology S.A. These companies all have large, underpenetrated addressable markets.

Table VI. Investments with Real/Irreplaceable Assets as of December 31, 2023

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Companies that own what we believe are Real/Irreplaceable Assets represented 24.2% of net assets. Vail Resorts, Inc., owner of the premier ski resort portfolio in the world, Hyatt Hotels Corporation, upscale lodging brand, and Red Rock Resorts, Inc., the largest player in the Las Vegas Locals casino gaming market, are examples of companies we believe possess meaningful brand equity and barriers to entry that equate to pricing power.

Table VII. Core Growth Investments as of December 31, 2023

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Core Growth investments, steady growers that continually invest in their businesses for growth and return excess free-cash-flow to shareholders, represented 22.5% of net assets. An example would be CoStar Group, Inc., a marketing and data analytics provider to the real estate industry. The company continues to add new services in commercial and residential real estate, which have grown its addressable market and enhanced services for its clients. This has improved client retention and cash flow. CoStar continues to invest its cash flow in its business to accelerate growth, which we believe should generate strong returns over time.

Table VIII. Financials Investments as of December 31, 2023

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Financials investments accounted for 16.7% of the Fund’s net assets. These businesses generate strong recurring earnings through subscriptions and premiums that generate highly predictable earnings and cash flow. These businesses use cash flows to continue to invest in new products and services, while returning capital to shareholders through share buybacks and dividends. These companies include Arch Capital Group Ltd., FactSet Research Systems Inc., and MSCI Inc.

Portfolio Holdings

As of December 31, 2023, the Fund’s top 10 holdings represented 55.6% of net assets. Most of these investments have been successful and were purchased when they were much smaller businesses. We believe they continue to offer significant appreciation potential, although we cannot guarantee that will be the case.

The top five positions in the portfolio, Tesla, Inc., Space Exploration Technologies Corp., Arch Capital Group Ltd., Hyatt Hotels Corporation, and FactSet Research Systems Inc.,all have, in our view, significant competitive advantages due to irreplaceable assets, strong brand awareness, technologically superior industry expertise, or exclusive data that is integral to their operations. We think these businesses cannot be easily duplicated, which enhances their potential for superior earnings growth and returns over time.

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

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Recent Activity

In the fourth quarter, we initiated a new position in Illumina, Inc. (ILMN), the leader in next-generation DNA sequencing, after the stock fell 45% earlier in the year. Controversy regarding the company’s acquisition and disposition of Grail with its cancer diagnostic test is the reason Illumina’s share price performed poorly. With Illumina’s products, customers perform life science research, run diagnostic tests, treat cancer, and perform noninvasive prenatal testing, among other applications. Customers include leading genomic research centers, academic institutions, government laboratories, and hospitals. Illumina has a $120 billion addressable market opportunity through oncology testing, genetic disease testing, prenatal testing, and scientific research and analysis. Its sales are currently about $4.5 billion. The company generates high margins and cash flow and is currently accelerating its investments in the business. We believe Illumina can grow its revenue at a double-digit rate, and its EBITDA even faster.

Outlook

We believe the shares of many of our portfolio investments already reflect overly pessimistic earnings estimates for 2024. Investors obviously remember operating declines during the 2008/2009 Global Financial Crisis and are pricing in similar declines today. If we do not go into a deep recession this year, or if the slowdown and expected decline in earnings are not as bad as feared, we believe investors will see significant near-term upside in the portfolio. We believe our stocks are cyclically depressed, not secularly challenged, and see further upside over the next 12 to 18 months. So far, most of our portfolio holdings have not experienced a slowdown in sales or earnings growth, and their outlooks remain strong. In addition, we believe that even if a downturn were to occur, our portfolio companies would still be operating above pre-pandemic levels. These businesses’ balance sheets have been strengthened compared to pre-COVID levels, and we believe they remain well positioned to weather a downturn should one occur.

Thank you for investing with us in Baron Focused Growth Fund. We continue to work hard to justify your confidence and trust in our stewardship of your family’s hard-earned savings. We also continue to try to provide you with information we would like to have if our roles were reversed. This is so you can make an informed judgment about whether Baron Focused Growth Fund remains an appropriate investment for your family.

Respectfully,

Ronald Baron, CEO and Portfolio Manager

David Baron, Portfolio Manager

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Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.