Baron Small Cap Fund®: A Differentiated Approach to Small Cap Investing

As a firm that got its start investing in small-cap stocks over four decades ago, we are long believers in the potential for active managers to generate alpha and durable, long-term returns in this space. In addition to providing diversification, we think the breadth, diversity, and relative lack of coverage of this equity asset class is tailor made for the acumen and selectivity of a skilled active manager. The unique characteristics of the small-cap space create opportunities for managers like us who have the capacity to engage in comprehensive research to discover promising companies with great characteristics and opportunities for growth that we can invest in for the long term.

Baron Small Cap Fund

We launched Baron Small Cap Fund in 1997 with Cliff Greenberg as portfolio manager. Cliff is co-CIO of Baron Capital and has been instrumental in building our investment team – now numbering 45 investment professionals including 17 portfolio managers. He is a veteran investor with 40 years of experience and one of the Firm’s longest tenured portfolio managers. David Goldsmith has served as assistant portfolio manager of the Fund since 2016.

Cliff takes a distinctive approach that sets him apart from his peers in a number of key respects, including the types of names he favors, the number of stocks he holds and concentration of holdings, the length of time he holds them, and his management of risk.

As set forth in the table below, this approach has resulted in solid performance since the Fund’s launch 26 and a half years ago. The Fund has annualized alpha of 6.43% with beta of 0.98 and up/down capture of 109.51% and 89.83%, respectively, for the three-year period ended March 31, 2024. It has always maintained high active share; its current active share is 96.4%.

Table I. Baron Small Cap Fund Performance as of March 31, 2024 (annualized)*

The Fund has a Morningstar Medalist Rating of Silver, based on its proven and repeatable investment approach; focus on durable, long-term growth; solid long-term results; and Cliff’s status as a veteran investor backed by Baron Capital’s strong stock-picking culture.

A Differentiated Process

We combine fundamental, bottom-up research with a long-term perspective to invest in small-cap growth companies with what we believe have competitive advantages, excellent management, and secular growth opportunities, at an attractive valuation. We supplement this by investing in situations where we see investment opportunity in a company that is new to the market through a spinoff, IPO, restructuring, or acquisition by a SPAC (special purpose acquisition company); and also in “turnarounds,” companies with a strong business model that have stumbled and have a new management team and plan.

To build and manage our portfolio, we use our extensive research capacity and industry expertise to source promising investment opportunities. Because we invest only in stocks in which we have strong conviction, we hold a limited number of names. As of March 31, 2024, the Fund held 60 stocks, compared with a category average of 184 stocks. The top 10 holdings comprised 43.1% of assets. Our high-conviction, long-term approach, combined with our deep bench of research analysts, means we can do the necessary due diligence to gain in-depth knowledge of the companies we invest in, including engaging their management teams and visiting key facilities.

We favor certain kinds of companies. Our investments typically include:

• Companies that are leaders in their sectors and are often disrupting those industries while strengthening their competitive position
• Companies that we believe have great business models, with visible, recurring, and maintainable revenues and cash flows, and exceptionally high margins
• Companies run by, in our view, sharp, often founding executives, who have proven track records of success and are of high character
• Stocks with trading multiples that we think offer great upside as earnings grow over time and/or multiples expand to recognize the special qualities of these businesses

We look for companies with strong and compounding organic revenue growth. Often, strategic and accretive acquisitions add to value creation. We prefer companies with expanding margins, where profits are growing faster than revenue. Another attribute we look for is strong free cash flow that can be used to add value through debt reduction, acquisitions, capital expenditures, share buybacks, or dividends.

We are comfortable with a company that leverages its balance sheet to optimize returns if it is an established business with recurring and predictable free cash flow and debt levels are prudent. For instance, Bright Horizons Family Solutions, Inc., a provider of corporate-sponsored child care, has successfully used leverage for accretive acquisitions of established centers in its highly fragmented market and for geographic expansion.

We are valuation-conscious, buying only when we think firms are attractively priced relative to their earnings prospects over three to five years. To assess the growth opportunities of an investment, we build a proprietary, company-specific, long-term model focused on key revenue growth drivers, cost structure, profitability, and capital structure. We model five years of forward-looking earnings and financial metrics. Our valuations are done based on our projections applying conservative and reasonable multiples. We stress test for company-specific and market risk. We continuously update our models and thoughts based on new data points and developments.

Multi-Faceted Risk Management

As seen in the chart above, over the five-year period ended March 31, 2024, the Fund has had better beta, downside capture and risk-adjusted performance, as measured by its Sharpe ratio, than its benchmark index. The solid risk/return characteristics of Baron Small Cap Fund are no accident. Rather, they are a direct result of our multipronged approach to risk that involves:

• Extensive due diligence
• Barbell approach to portfolio weighting
• Focus on non-correlated end markets

Extensive due diligence

We believe the best risk management starts with knowing the companies in which we invest. Throughout the life of all of our investments, we continue to conduct due diligence and interact with management in order to stay on top of the company’s growth story as it develops. We speak to our holdings’ management teams multiple times per year. Our sustained level of interaction with management helps sharpen our model inputs and assumptions. Cliff is involved in research on each name with the support of David and our team of research analysts.

Barbell approach to portfolio weighting

We manage a diversified portfolio with its heaviest weightings in stocks with which we have had long-term success, yet we still believe have considerable upside. This approach dampens volatility of the Fund, since many of these companies are growth companies with business models that are “baked,” are building off established market positions, and have predictable and reliable revenues. We supplement these long-term winners with new ideas that are smaller and younger companies, but that can provide more significant upside and develop into long-term holdings.

As an example, aircraft parts manufacturer TransDigm Group, Inc. generates recurring cash flow and high margins on after-market replacement parts for airplanes that remain in service for decades. We have held the stock for almost 18 years and the stock has made a 29.6% annualized total return since our initial investment. Another example is SBA Communications Corp., which leases towers to wireless carriers. The company benefits from long-term leases and limited competition due to zoning and licensing obstacles that prevent new entrants into its markets. We have held SBA for nearly 20 years, and the stock has made a 23.7% annualized total return since our initial investment.

Table II. Baron Small Cap Fund Top 10 Holdings as of March 31, 2023

Focus on non-correlated end markets

We also manage risk by investing in businesses across a range of noncorrelated end markets. For instance, although we own a number of application software businesses, they serve different end markets, so we believe they are less correlated than they would appear at first glance. The Trade Desk is involved in media and advertising; Aspen Technology, Inc. services process engineering markets; and Guidewire Software, Inc. the property and casualty insurance industry. The fate of each of these application software companies will be impacted in large part by how it is transforming its particular end market.

Proven Long-Term Approach

Our approach for the Fund is simple in premise but difficult in execution. We seek to find special, one-of-a-kind companies that have competitive advantages and strong business models, are well managed, and can grow on a compounding basis, in our view. We hope to find these companies when they are smaller and own them as they mature and grow. We stay invested as long as the businesses perform (as the stock should follow) but sell out and replace them in the portfolio if the businesses falter.

As Cliff likes to say, “We water our flowers and cut our weeds.” Consistent with our strategy of watering our flowers, we leverage our experience to resist the urge to sell when a stock takes a hit for nonfundamental reasons such as short-term market volatility or a missed quarter or when it spikes up on good news. We will not hold a stock indefinitely, but strive to maintain a rigorous sell discipline, informed by regular conviction checks to determine whether the investment premise remains intact.

An outgrowth of this approach is that the Fund has about 31% of its assets in stocks that it has held longer than 10 years. The weighted average annualized return on these holdings is 20.2%, which confirms the wisdom of staying invested in these special companies.

Of course, not every stock we invest in performs as well as the examples we have cited. In addition, please note that there is no guarantee that these results will be repeated in the future.

We realize that our approach is unusual for a small-cap fund and we are committed to maintaining our small-cap mandate. In a given year, we will normally sell about a quarter of our holdings and use the proceeds to purchase new small-cap companies or add to existing smaller-cap holdings. By doing so, we remain small cap. Our three-year average turnover is 13.63%. We sell stocks of companies that get acquired, or meet our long-term price targets, or that we like less than new ideas we uncover, and trim our larger-cap holdings to regulate position sizes and be mindful of the small-cap charter of the Fund.

This process keeps the portfolio fresh, and the overall market cap controlled. Our primary goal is to maximize the returns of the Fund, and we strongly believe we should hold on to our winners and stay involved as our investments flourish, as proven by past results. We believe we would be doing our investors a disservice if we were forced to sell out of our big winners too soon and try to replace them with a new position that might not perform as well.

Conclusion

We own a portfolio of what we believe to be well-managed, high-quality companies. They are leaders in their niches, with strong competitive advantages. We think they have great growth opportunities based on their positioning in their sectors and well-established business plans. The growth is evidenced by strong historical results. We continue to adhere to our approach of staying investing in these special, high-quality businesses wherever we happen to be in the market cycle, as we believe they will outperform over the long term.