Baron Focused Growth Fund®: A Focused, Highly Differentiated Investment Approach
Space Exploration Technologies Corporation (SpaceX)
Baron Focused Growth Fund is a focused portfolio of the highest conviction small- and mid-cap ideas of Baron Capital’s Founder and CEO Ron Baron. The Fund is intended to maximize the advantages we have gained from four decades of refining and applying our proprietary, research-intensive, bottom-up process that seeks to invest in the most promising growth businesses for the long term.
This approach may seem old fashioned in a time seemingly dominated by algorithms and high-speed trading, but we make no excuses. In fact, now more than ever, we believe this investment approach is still the best way to create alpha. While other investors chase the latest unicorn or trade based on short-term macro trends – which we contend are virtually impossible to predict – we remain true to our repeatable, time-tested process.
For Baron Focused Growth Fund, portfolio managers Ron Baron and David Baron invest in businesses we believe could double in value within five to seven years. To accomplish this ambitious goal, we manage a focused portfolio of about 20 to 30 appropriately capitalized, competitively advantaged, well-run growth businesses at attractive prices, with the top 10 positions representing a significant percentage of net assets. We initiate positions in small- and mid-cap companies, and we hold these positions as long as our investment premise remains intact.
We look at the period since the February 2020 onset of the pandemic as a testament to our differentiated, long-term approach. We endured a global pandemic followed by a sharp spike in inflation and interest rates, continued global supply chain issues, volatile food and energy prices, and geopolitical turmoil, and the Fund is still trading well north of its pre-pandemic high. The patient, selective, long-term investor was rewarded for staying calm during the storm. As set forth in the table below, our approach has resulted in strong long-term performance.
The Fund’s long-term risk/return metrics are impressive. For the 5-year period, its upside capture is 130.94% while its downside capture is 94.58%. Its 13.64% alpha against its 1.11 beta for the same period is also impressive.
| Baron Focused Growth Fund Performance as of 3/31/2024 (annualized)* | ||||||||||
|---|---|---|---|---|---|---|---|---|---|---|
| 1-Year | 3-Year | 5-Year | 10-Year | Since Inception** | ||||||
| Baron Focused Growth Fund | 13.48% | 3.58% | 23.56% | 15.79% | 13.29% | |||||
| Russell 2500 Growth Index | 21.12% | -0.81% | 9.39% | 9.56% | 8.28% | |||||
| S&P 500 Index | 29.88% | 11.49 | 15.05% | 12.96% | 9.70% | |||||
The Fund has received a 5-star Overall Morningstar Rating™, and is ranked in the 92nd, 38th, 1st, and 1st percentile for its 1-, 3-, 5-, and 10-year performance, respectively.
* Institutional shares. For retail and R6 shares, visit baronfunds.com.
** 5/31/1996
Performance listed in the above table is net of annual operating expenses. Annual expense ratio for the Institutional Share Class as of fiscal year ended December 31, 2023, was 1.06%.
The performance data quoted represents past performance. Past performance is no guarantee of future results. The investment return and principal value of an investment will fluctuate; an investor’s shares, when redeemed, may be worth more or less than their original cost. The Adviser may waive or reimburse certain Fund expenses pursuant to a contract expiring on August 29, 2034, unless renewed for another 11-year term and the Fund’s transfer agency expenses may be reduced by expense offsets from an unaffiliated transfer agent, without which performance would have been lower. Current performance may be lower or higher than the performance data quoted. For performance information current to the most recent month end, visit baronfunds.com or call 1-800-99-BARON.
Morningstar calculates the Morningstar Mid-Cap Growth Category Average performance and rankings using its Fractional Weighting methodology. Morningstar rankings are based on total returns and do not include sales charges. Total returns do account for management, administrative, and 12b-1 fees and other costs automatically deducted from fund assets.
As of 3/31/2024 the Morningstar Mid-Cap Growth Category consisted of 549, 520, 489, and 393 share classes for the 1-, 3-, 5-, and 10-year periods. Morningstar ranked Baron Focused Growth Fund in the 92nd percentile for the 1-year period, the 38th percentile for the 3-year period, and the 1st percentile for the 5- and 10-year periods.
For the period ended 3/31/2024, Baron Focused Growth Fund received a 5-Star Overall Morningstar Rating™, 3-Star 3-Year Rating, 5-Star 5-Year Rating, and 5-Star 10-Year Rating. Morningstar Ratings are based on the Morningstar Risk-Adjusted Return measures of 520, 520, 489, and 393 funds in the category, respectively. This Morningstar Rating is for the Institutional share class only; other classes may have different performance characteristics.
A Time-Tested, Repeatable Investment Approach
We believe the Fund’s strong performance is the result of our consistent, repeatable, and time-tested investment approach that is differentiated by the following characteristics:
- High-conviction portfolio with a limited number of names
- Long-term perspective with low turnover
- Multi-faceted management of risk
High-conviction portfolio with a limited number of names
We use a bottom-up investment approach to identify what we believe are competitively differentiated businesses that can grow independently of their sector economy and macroeconomy. To build and manage our portfolio, we use our extensive research capacity and industry expertise – currently comprised of 45 investment professionals – to source these opportunities. Because Baron Focused Growth Fund invests only in our highest-conviction ideas, it typically holds just 20 to 30 names; as of March 31, 2024, the Fund held 30 stocks. The top 10 holdings comprised 55.3% of the portfolio. We have always maintained high active share; our current active share is 98.7%.
Our high-conviction, long-term approach, combined with our deep bench of research analysts, means we can do the due diligence, including regularly engaging management companies and visiting key facilities, to develop and maintain the in-depth knowledge to gain the confidence we need to invest and stay invested. This is Baron Focused Growth Fund’s competitive advantage.
Long-term perspective with low turnover
Warren Buffett, who has a talent for words almost as impressive as his talent for investing, once said, “Our favorite holding period is forever.” We agree.
Consistent with Baron Capital’s longstanding investment philosophy, Baron Focused Growth Fund is managed with a long-term perspective. We believe this time-arbitrage approach gives us an edge by allowing us to take advantage of the shortsightedness of the market. Most managers are focused on the short term, basing trading decisions on factors that may have little or nothing to do with business fundamentals such as a quarterly earnings beat or miss or overall market volatility.
We leverage our extensive research capabilities to conduct a deep dive on the fundamentals of every company in which we are considering an investment. Our research allows us to develop an informed and thorough understanding of the longer-term secular advantages of these companies. Ultimately, we are more interested in the duration of a company’s growth opportunity rather than being overly focused on its timing. We like to invest early, before a company is on the market’s radar, because we believe it is impossible to pinpoint exactly when the market will take notice and start trading the stock up to properly reflect its growth opportunity. We believe this strategy is a key part of the engine that drives alpha for us.
The Fund is typified by its relatively low turnover, with a three-year average turnover of 22.75%. Our low turnover is an outgrowth of our investment process rather than a goal in and of itself. If we find and invest in the right companies, we believe that it makes little sense to replace these companies with new and relatively untested ones. We would rather remain invested throughout the duration of the growth trajectory of our highest conviction companies. We also believe this is a more tax efficient approach to managing a portfolio. We also find our reputation as long-term holders of stock opens doors to management teams who are eager to have and keep us as investors. Our primary goal is capital appreciation, and we strongly believe we should stay involved as our companies grow and flourish as long as our investment thesis holds true.
| Holding | Sector | % of Net Assets | |
|---|---|---|---|
| Space Exploration Technologies Corp. Industrials | Industrials | 9.1% | |
| Tesla, Inc. | Consumer Discretionary | 7.8% | |
| Arch Capital Group Ltd. | Financials | 6.0% | |
| Hyatt Hotels Corporation | Consumer Discretionary | 5.7% | |
| Spotify Technology S.A. | Communication Services | 5.0% | |
| CoStar Group, Inc. | Real Estate | 4.7% | |
| Guidewire Software, Inc. | Information Technology | 4.4% | |
| Vail Resorts, Inc. | Consumer Discretionary | 4.4% | |
| Red Rock Resorts, Inc. | Consumer Discretionary | 4.2% | |
| FactSet Research Systems Inc. | Financials | 4.1% | |
| Total | 55.3% | ||
*Portfolio holdings are subject to change. Current and future portfolio holdings are subject to risk.
Multi-faceted management of risk
We seek to offset the volatility that can result from a focused portfolio in two key ways:
- Extensive due diligence on our holdings while we are invested
- Diversifying our holdings across non-correlated categories
Extensive due diligence
We believe the best risk management starts with knowing the companies in which we invest. The extensive research we conduct for months and sometimes years prior to initiating a position in a company is just the beginning. Throughout the life of all our investments, we continue to conduct due diligence and interact with management to keep apprised of the company’s growth story as it develops. We visit with and speak to our companies’ management teams multiple times per year. Our sustained level of interaction helps sharpen our model inputs and assumptions. As portfolio managers of the Fund, Ron and David are involved in research on each name and are supported by Baron Capital analysts with industry-specific expertise.
From a quality standpoint, the Fund’s investments have stronger sales growth and higher EBITDA, operating, and free cash flow margins with stronger returns on invested capital than the index average. We believe these metrics are important to limit risk in this focused portfolio.
Our stock-specific approach to both opportunity and risk is borne out by our results, as virtually all our outperformance is driven by stock selection. In researching companies, we look for:
- Long-term, secular growth opportunities
- Durable competitive advantages
- Attractive business model
- Exceptional management
- Attractive valuation
Long-term, secular growth opportunities
We seek companies that we believe are well positioned to benefit from secular growth opportunities with large, addressable markets. We find these opportunities across a range of sectors and sub-industries.
Durable competitive advantages
A durable competitive advantage is another key attribute of our holdings. We look for businesses that are establishing their competitive advantage, as a fully realized competitive advantage is more likely to be reflected in the stock price.
Attractive business model
We prefer companies with pricing power tied to the utility of their product or service rather than a monopolistic hold on the market. For example, companies with subscription-based business models are often able to leverage the continual improvement and expansion of their services to increase prices on a regular basis. Long-term contracts with high retention rates – another characteristic of many of our subscription-based businesses – provide stability, durability, and transparency, as does recurring or reoccurring revenue.
We like companies with high or expanding margins that are reinvesting their profits in future growth. Many of our holdings are asset light, low capital-intensive businesses because once they have built their core assets – proprietary data, platform, etc. – as they scale, margins can expand significantly. We also like strong and visible free cash flow because we consider it a more accurate measure of a company’s financial situation than earnings per share. Finally, we look for a capital structure appropriate to the industry in which the company operates. We are comfortable with leverage if it is an established business with recurring and predictable free cash flow and sensible debt levels. We believe such balance-sheet optimization is a way to maximize shareholder returns.
Exceptional management
Baron Capital’s long-held motto, “we invest in people,” reflects our belief that experienced, visionary management is at the heart of a company’s success. To find these talented people, Ron and David tap their decades of experience as investment professionals, over the course of which they have met with and interviewed thousands of executives about their companies. Among other attributes, we look for executives’ personal financial stake in the company’s success.
Attractive valuation
We project the long-term intrinsic value of every stock we own through quantitative and qualitative analysis. Our projection is based on key revenue growth drivers, free cash flow, profitability, cost structure, and capital structure as well as more qualitative factors, such as the total addressable market, durability of the competitive advantage, and strength of the management team. We will initiate a position only if we believe the stock can double in size in a fiveto-seven-year period. We will stay invested as long as the stock’s valuation is supported by our projection of intrinsic value.
Diversifying our holdings across categories
The second way we seek to mitigate risk is by diversifying the portfolio across four categories, each of which tends to behave differently in different economic environments. These four categories are:
- Disruptive Growth
- Core Growth
- Real/Irreplaceable Assets
- Financials
Tesla, Inc., the electric vehicle manufacturer, and the Fund’s second largest holding, is the most well-known name among our Disruptive Growth holdings, which are typically very fast-growing companies. It has enjoyed phenomenal growth in recent years, but we think it is just getting started. Despite some recent short-term headwinds, we expect Tesla to continue to grow its automotive business through international production capacity and product expansion over the long term. We believe that Tesla’s vertical integration, technology innovation, brand, profitability, and growing supplier support offer unique and durable growth opportunities that are hard to replicate. In addition, Tesla’s energy and software expertise is broadening the industrial opportunity to large and profitable revenue avenues that were locked in the legacy vehicle architecture such as autonomous, insurance, and other AI use cases.
The Fund’s largest holding is another disruptive growth company, Space Exploration Technologies Corp. (SpaceX), that designs, manufactures, and launches rockets, satellites, and spacecrafts. Products include a reusable orbital launch offering and a broadband service leveraging its satellite constellation, Starlink. We believe SpaceX will continue to drive down the cost of space launches and capture market share with its unique, reliable, and improving reusable launch capabilities. As costs decline, we also expect demand for access to space to increase. By leveraging its launch cost leadership, vertical integration, and innovative design approach, we think SpaceX will have an advantage in building and operating its rapidly expanding satellite-based broadband services, creating an even more attractive growth profile for the company.
To help dampen volatility, we seek to balance investments in Disruptive Growth businesses with other, more stable holdings. Core Growth businesses, steady growers that regularly return excess free cash flow to shareholders, include names like CoStar Group, Inc. The company continues to add services in the commercial and residential areas of real estate to expand its addressable market and improve retention and cash flow. Real/Irreplaceable Assets businesses have tangible properties that are less subject to competition. Companies like global hotel owner Hyatt Hotels Corporation and ski resort owner/operator Vail Resorts, Inc. possess meaningful brand equity and barriers to entry that translate to pricing power. Financials businesses generate strong recurring earnings through subscriptions and premiums that produce highly predictable earnings and cash flow. Examples include specialty insurer Arch Capital Group Ltd. and market data vendor FactSet Research Systems, Inc.
Conclusion
Throughout its long history, the Fund has remained steadfast in its commitment to long-term investments in competitively advantaged businesses with large growth opportunities that are taking share and are managed by people we believe to be exceptional executives. We believe this approach is a smart strategy especially in a focused fund.