Baron Discovery Fund: Latest Insights and Commentary

Inflation continued to decline, although it is still higher than the Federal Reserve’s 2% target. Despite ticking up, the unemployment rate remained near historic lows. Accordingly, the Fed held short-term interest rates steady while once again pushing back the date of its first rate cut since the pandemic. The Fed currently expects to make one rate cut by year end. The economy has exhibited some signs of slowing. As consumers continued to dip into excess savings accumulated during the pandemic and have limited expectations for more stimulus, they have been cutting back a bit on spend. Consumer confidence is also relatively subdued, possibly due to the lingering effects of high inflation and the pandemic, as this metric tends to be a lagging indicator of the economy.

Baron Discovery Fund decreased during the second quarter. No sector contributed. Holdings within Health Care, Consumer Discretionary, and Industrials detracted the most. Second largest detractor Stevanato Group S.p.A. led declines within Health Care. Weakness within Consumer Discretionary was led by Floor & Décor Holdings, Inc. Shares of this hard-surface flooring retailer fell as the decline in housing turnover put pressure on shorter-term sales trends. Declines within Industrials were led by SiteOne Landscape Supply, Inc., the top detractor from performance in the quarter.

As we enter the third quarter of 2024, we believe that, overall, conditions are positive for U.S. small cap growth stocks. Lower inflation and continued low unemployment rates should help offset declining excess savings and tighter credit conditions to result in moderating consumption, which, in turn, should carry the U.S. economy to a soft landing. That said, there are always risks. The upcoming U.S. election and ever-present geopolitical tensions could put pressure on the market, along with any number of other as-yet-unanticipated developments.

As long-term investors who have lived through numerous market cycles, we have learned not to try to predict short-term market movements. Instead, we focus on identifying and researching well-managed unique businesses with durable competitive advantages and compelling growth prospects and investing in them at attractive prices.

CONTRIBUTORS

• Shares of Silk Road Medical, Inc. contributed to performance following the mid-June announcement that it has entered into a definitive agreement to be acquired by Boston Scientific Corp for $1.2 billion or $27.50 per share. Silk Road sells medical devices used in minimally invasive TCAR procedures that treat carotid artery disease to prevent strokes. TCAR is less invasive and has an easier recovery than carotid endarterectomy surgery and causes fewer periprocedural strokes than transfemoral carotid artery stenting. TCAR represents approximately 15% of carotid stenosis interventions, and we think adoption will grow over time.
• CareDx, Inc. is a diagnostic company that facilitates donor matches pre-transplant and rejection monitoring post-transplant. Shares increased on positive quarterly results and several quarters of testing volume growth despite the difficult reimbursement environment. We retain conviction. Business appears to be stabilizing despite a tough Medicare stance, and any improvement from Medicare would be pure upside, in our opinion.
• Nova Ltd. is a semiconductor equipment company focusing on the metrology portion of process control within the broader wafer fabrication equipment (WFE) industry. Its tools are used in optical, materials, and chemical metrology applications by chip manufacturers to ensure quality, reliability, and consistency of production. Nova’s stock rose on expectations that strong growth in chips for AI applications will drive accelerating adoption and growth across Nova’s product portfolio serving high bandwidth memory, advanced packaging, and leading-edge chip production, as Nova’s tools are uniquely capable of serving key metrology applications in these advanced processes. Nova is the only supplier of materials metrology tools that are increasingly required for cutting-edge chips, offers leading capabilities with its optical tools driving share gains, and benefits from adoption of its chemical metrology portfolio across front-end applications. We believe Nova is well positioned to outpace underlying WFE spend as its portfolio targets all the key technology inflection points in semiconductor manufacturing.

DETRACTORS

• SiteOne Landscape Supply, Inc. is the largest distributor of wholesale landscape supplies in North America. SiteOne sells irrigation, hardscapes, agronomics, and nursery products to landscapers through its network for residential and commercial maintenance, upgrade/repair, and new construction. Shares fell during the quarter after a negative intra-quarter update, with weaker-than-expected demand in upgrade/repair product categories and stronger-than-expected commodity deflation, which together will likely lead to lower full-year guidance when the company officially reports Q2 results. We believe SiteOne remains well positioned long term as its investments in operational efficiency, technology, and product category management enable it to continue taking share of the fragmented wholesale landscape supplies distribution industry while expanding its product catalog and geographic footprint through consistent M&A. Strong organic growth combined with M&A should drive EBITDA margins toward the 13% to 15% targeted range.
• Shares of Stevanato Group S.p.A detracted from performance. Stevanato sells packaging for injectable drugs. During the pandemic, the significant demand created by COVID vaccines resulted in a global shortage of vials. As a result, lead times were elongated, and customers stocked injectable drug packaging above normal inventory levels. As the supply chain situation normalized and demand for COVID vaccines declined, customers have been working through this excess inventory, leading to lower near-term vial sales and underutilized vial manufacturing capacity. We still think this is an attractive industry long term and remain investors.
• 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 first quarter. Earnings beat Street expectations with 44% EPS growth and 43% growth in book value per share. However, investors focused on the slowdown in gross written premiums to 25% growth from 34% last quarter, reflecting tough comparisons and moderating growth in property insurance. 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.

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 Discovery Fund (the Fund) declined 7.78% (Institutional Shares) in the second quarter, trailing the Russell 2000 Growth Index (the Index) by 486 basis points principally due to stock selection.

Disappointing stock selection in Health Care, Consumer Discretionary, Industrials, and Financials was responsible for much of the underperformance in the period. Performance in Health Care was hindered by substantial declines from sleep apnea treatment leader Inspire Medical Systems, Inc. and a few of the Fund’s life sciences tools & services holdings. Inspire offers a treatment for moderate to severe obstructive sleep apnea (OSA) called hypoglossal nerve stimulation. OSA is a common sleep disorder caused by relaxation of the airway muscles and obstruction of the airway, which interrupts normal breathing during sleep. Since receiving FDA approval in 2014, Inspire’s device has gained rapid adoption, growing from $8 million in sales in 2015 to an estimated $783 to $793 million in 2024. Inspire’s stock came under pressure for the period held after data from Eli Lilly and Company’s SURMOUNT-OSA trial showed that its drug tirzepatide reduced OSA in adults with obesity by up to 62.8%, and up to 51.5% of participants met the criteria for disease resolution. In our view, Lilly’s tirzepatide and other GLP-1 medicines will have an impact on the OSA treatment paradigm. However, we think that even if some patients are no longer candidates for Inspire’s method of treatment after taking a GLP-1, many new patients will still enter Inspire’s funnel. This is because patients who have a very high BMI are not considered candidates for Inspire’s therapy, and if those patients lose enough weight with a GLP-1, they can become candidates for Inspire. As a result, we continue to believe Inspire’s total addressable market remains very large and underpenetrated.

The Fund’s life sciences tools & services underperformed after falling more than 18%, with Stevanato Group S.p.A and Repligen Corporation leading the decline. Stevanato sells packaging for injectable drugs. During the pandemic, the significant demand created by COVID vaccines resulted in a global shortage of vials. As a result, lead times were elongated, and customers stocked injectable drug packaging above normal inventory levels. As the supply chain situation normalized and demand for COVID vaccines declined, customers have been working through this excess inventory, leading to lower near-term vial sales and underutilized vial manufacturing capacity. We still think this is an attractive industry long term and remain investors. Repligen is a life science tools supplier to the bioprocessing industry. The company offers a broad portfolio of tools involved in the production of biologic drugs, including upstream cell culture, downstream chromatography and filtration, and process analytics. The company’s shares declined due to near-term headwinds related to funding constraints for smaller biotechnology companies and China weakness. We still like the long-term story. Repligen has a strong track record of smart acquisitions and innovation, including the introduction of differentiated filters and development of in-line process analytics (real-time monitoring of the drug production process). With a wave of biosimilars coming to market, Repligen has a unique opportunity to become embedded into new drug manufacturing processes with its differentiated systems.

Weakness in Consumer Discretionary was broad based, led by double-digit declines from hard-surface flooring retailer Floor & Decor Holdings, Inc. and online sportsbook DraftKings Inc. Floor & Decor’s shares were pressured by recent trends in the housing market. While the company continues to open new stores and consolidate the hard-surface flooring market through its large format stores with everyday low prices, the decline in housing turnover has put pressure on shorter-term sales trends. We maintain our long-term conviction. We view Floor & Decor as a differentiated, high-growth retailer offering a broader assortment of low-cost products than competitors. Floor & Decor holds an 8% market share in the highly fragmented $21 billion U.S. hard-surface flooring market, where we believe the company will continue to gain share. We think the replacement of carpet with hard-surface flooring, which we see as a secular shift in the flooring industry, will aid growth. We believe Floor & Decor can continue to grow stores in the 15% to 20% range. DraftKings stock declined after Illinois raised the tax rate on online sports betting from 15% to 35%, causing investor fear that other states would soon follow suit. Though we can’t know for sure, we believe future tax increases will be contained to a limited number of states. More importantly, we expect DraftKings to offset the impacts of increased taxation. The company is well positioned to generate margin expansion and positive free cash flow as it grows revenues alongside the rapidly expanding U.S. sports betting market, in our view.

Poor stock selection in Industrials and Financials was driven by sharp declines from wholesale landscape supplies distributor SiteOne Landscape Supply, Inc. and specialty insurer Kinsale Capital Group, Inc., respectively. SiteOne was the top detractor in response to a negative intra-quarter update. Management noted weaker-than-expected demand in upgrade/repair product categories and stronger-than-expected commodity deflation, which together will likely lead to lower full-year guidance when the company officially reports Q2 results. We believe SiteOne remains well positioned long term as its investments in operational efficiency, technology, and product category management enable it to continue taking share of the fragmented wholesale landscape supplies distribution industry while expanding its product catalog and geographic footprint through consistent M&A. Strong organic growth combined with M&A should drive EBITDA margins toward the 13% to 15% targeted range.

Kinsale relinquished a portion of the prior quarter’s gains after reporting slower premium growth in the first quarter. Earnings beat Street expectations with 44% EPS growth and a 43% growth in book value per share. However, investors focused on the slowdown in gross written premiums to 25% growth from 34% last quarter, reflecting tough comparisons and moderating growth in property insurance. 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.

Partially offsetting the above was solid stock selection in Information Technology, where semiconductor equipment company Nova Ltd. and several of the Fund’s application software holdings performed well. Nova was a top contributor on expectations that strong growth in chips for AI applications will drive accelerating adoption and growth across the company’s product portfolio serving high bandwidth memory, advanced packaging, and leading-edge chip production. The Fund’s application software holdings held up well in the period thanks to double-digit gains from property and casualty insurance software vendor Guidewire Software, Inc. and cloud-based digital banking platform Alkami Technology Inc. Guidewire’s shares were lifted by the near completion of the company’s multi-year transition to the cloud, while Alkami benefited from strong quarterly earnings results, improved guidance for fiscal year 2024, and optimism about its pipeline. Favorable stock selection in the sector was exacerbated by a lack of exposure Index heavyweight Super Micro Computer, Inc., whose shares pulled back in the period, contributing approximately 60 basis points of relative gains.