Baron Growth Fund: Latest Insights and Commentary

Inflation continued to drop, 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 Growth Fund decreased during the second quarter. Communication Services investments contributed on the strength of sole sector holding Iridium Communications Inc. Shares of this global satellite communications company rose on better-than-expected quarterly results driven by consumer device and equipment sales. Holdings within Financials, Consumer Discretionary, and Real Estate detracted the most. Top detractor Kinsale Capital Group, Inc. and third largest detractor MSCI Inc. led declines within Financials. Weakness within Consumer Discretionary was led by Vail Resorts, Inc. Shares of this global ski resort declined due to a slowdown in season pass sales and a disappointing ski season in Australia. Second largest detractor CoStar Group, Inc. drove depreciation within the Real Estate sector.

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

• Specialty insurer Arch Capital Group Ltd. contributed to performance after reporting positive financial results that exceeded Street expectations. Operating ROE was 21% in the first quarter, and book value per share rose 40% due to strong underwriting profitability and the establishment of a deferred tax asset at the end of 2023. Favorable conditions persist in the P&C insurance market with strong growth and attractive returns despite signs of increasing competition. We continue to own the stock due to Arch’s capable management team and our expectation of significant growth in earnings and book value.
• Shares of P&C insurance software vendor Guidewire Software, Inc. contributed to performance for the quarter. After a multi-year transition period, we believe the company’s cloud transition is substantially over. 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 from infrastructure investment to product development, 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 more than 1,000 basis points 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%.
• The stock of Altair Engineering Inc., a prominent player in the multi-billion-dollar Computer Aided Simulation market, contributed to performance. Better-than-expected quarterly results and an optimistic demand outlook from management drove the stock's upward movement. While macro commentary across software companies was mixed this quarter, Altair's leadership noted improving demand trends. The company is also poised to benefit from go-to-market changes, including increased partner traction, sales force verticalization, pricing adjustments, and enhanced cross-selling efforts across product segments. The potential acquisition of a key competitor, ANSYS, Inc., could position Altair as a standalone simulation software company in the public market, potentially boosting investor interest. We expect Altair will continue to benefit from the ongoing increase in product complexity, requiring customers to adopt more simulation while reducing compute costs, and product innovation should allow it to be adopted by a broader set of users within Altair's customers.

DETRACTORS

• 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.
• CoStar Group, Inc. is a provider of marketing and data analytics services to the real estate industry. Shares detracted from performance in the quarter along with the broader software sector. Most software companies experienced a slowdown in new sales activity in early 2024, leading to guidance reductions and multiple compression. We believe CoStar shares were also impacted by concerns that the company’s second quarter financial results will show a deceleration in net new sales of its residential product following outstanding first quarter performance. We remain encouraged by traction in CoStar’s residential offering although recognize that progress may not be linear. CoStar began to monetize its new Homes.com platform in February. We believe early momentum can be amplified by the recent NAR class action settlement, which has the potential to disrupt the residential brokerage industry and enhance the return on investment for brokers advertising on Homes.com.
• Shares of MSCI Inc., a leading provider of investment decision support tools, detracted from performance. The company reported mixed Q1 2024 earnings as its end market remained choppy, leading to elevated client cancelations and a more muted new sales environment. Despite this near-term macro uncertainty, we retain long-term conviction as MSCI owns strong, "all weather" franchises and remains well positioned to benefit from numerous secular tailwinds in the investment community.

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 Growth Fund (the Fund) fell 8.23% (Institutional Shares) in the second quarter, trailing the Russell 2000 Growth Index by 531 basis points due to stock selection and, to a lesser extent, differences in sector weights. 

Investments in Financials, Real Estate, and Consumer Discretionary were responsible for over three-quarters of the underperformance in the period. The relative shortfall in Financials was due to the Fund’s meaningfully higher exposure to this lagging sector coupled with losses from specialty insurer Kinsale Capital Group, Inc. and investment decision tools provider MSCI Inc. Kinsale’s shares gave back some 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. MSCI’s stock fell after the company reported mixed quarterly earnings as its end market remained choppy, leading to elevated client cancelations and a more muted new sales environment. Despite this near-term macroeconomic uncertainty, we retain long-term conviction as MSCI owns strong, "all weather" franchises and remains well positioned to benefit from numerous secular tailwinds in the investment community.

Within Real Estate, higher exposure to this underperforming sector combined with disappointing performance from real estate data and marketing platform CoStar Group, Inc. hampered relative results. CoStar’s stock declined alongside the broader software industry during the quarter. Many software companies experienced slowing new sales activity in early 2024, leading to guidance reductions and multiple compression. We believe CoStar shares were also impacted by concerns that the company’s second quarter financial results will show a deceleration in net new sales of its residential product following outstanding first quarter performance. We remain encouraged by traction in CoStar’s residential offering although recognize that progress may not be linear. CoStar began to monetize its new Homes.com platform in February. We believe early momentum can be amplified by the recent NAR class action settlement, which has the potential to disrupt the residential brokerage industry and enhance the return on investment for brokers advertising on Homes.com.

Adverse stock selection in Consumer Discretionary was driven by global ski resort operator Vail Resorts, Inc., whose shares were negatively impacted by a slowdown in season pass sales and a disappointing ski season in Australia. We retain conviction. Management believes skiers have held off on buying season passes given poor snow conditions for the past two seasons, and they still expect to generate almost $950 million in season pass revenue this year, representing close to a third of 2023 revenue. An 8% increase in prices combined with a favorable year-over-year comparison should result in a double-digit increase in EBITDA with strong free cash flow generation. The company is now trading at more than 6% free cash flow yield, all of which is being returned to shareholders through dividends and share buybacks. Weakness in the sector also came from sweet treat brand Krispy Kreme, Inc., hotel franchisor Choice Hotels International, Inc., and casino and gaming operators Boyd Gaming Corporation and Red Rock Resorts, Inc.

No sectors materially contributed to relative performance in the period.