DEAR BARON PARTNERS FUND SHAREHOLDER:
PERFORMANCE
The financial markets were extremely volatile in the third quarter of 2022. The S&P 500 Index was up 9.22% in July, down 4.08% in August, and down 9.21% in September. It was not uncommon for markets to move by over 2% in a single day. Substantial declines at the market’s open could be followed by gains throughout the day, and vice versa. The final result was that most indexes ended the quarter lower than where they began. The S&P 500 Index declined 4.88% in the period. The Russell Midcap Growth Index (the “Index”) fell 0.65%. And The Morningstar Large Growth Category Average (the “Peer Group”) declined 4.09%*.
However, Baron Partners Fund (the “Fund”) did considerably better than its comparable indexes and peer group category average. The Fund rose 10.00% (Institutional Shares) in the period.
The Fund’s absolute and relative performance over a longer term remains quite good. For the 1-, 3-, 5-, 10-year, and since inception periods ended September 30, 2022, the Fund’s performance has meaningfully exceeded the Index’s returns. The Fund’s 3-, 5-, and 10-year annualized returns were 40.61%, 27.81%, and 22.49%, respectively. These returns are substantially greater than the returns of 4.26%, 7.62%, and 10.85%, respectively, for the Index. Please see Table I for a full list of performance figures for the Fund and Indexes over various time periods.
And since the Fund’s inception, its performance has been industry leading. For the over 19 years since Baron Partners Fund converted into a mutual fund in 2003, it has an annualized return of 17.27% (Institutional Shares). Since its conversion, it is ranked number one among all U.S. equity funds (4,132 share classes) through September 30, 2022.**
This current volatile market remains a function of macroeconomic uncertainty. Inflation is a concern for businesses and individuals alike. The strong labor market is theorized to keep inflation elevated. The Federal Reserve continues to hike interest rates, its tool to curb rising prices. Investors question how quickly and how long these rate increases will persist. And the long-lasting war in Ukraine has strained the global economy (and has had horrific humanitarian consequences). But while markets have been volatile, performance of some individual securities has started to diverge. Companies that produced quality results were rewarded, while those that exhibited any weakness were punished. The magnitude of these movements, however, has been unusual.
As we have previously discussed, we segment the Fund’s portfolio into four categories (Disruptive Growth, Core Growth, Financials, and Real/ Irreplaceable Assets). The returns for each of these categories within theFund exceeded the Index’s. However, there were sizable differences of returns within each group. Each had companies whose stock price performed very well (increasing by more than 9%) over the prior three months. But there were also examples of stock prices that declined meaningfully. However, our selection and weighting of the “winners” surpassed those that were challenged in each segment.
The Disruptive Growth category produced the highest absolute returns because of investments in Tesla, Inc. (TSLA, Financial) and Iridium Communications Inc. (IRDM, Financial). Both companies appreciated over 18% in the quarter. Tesla, the electric vehicle manufacturer, has continued to increase its production of vehicles while also reducing manufacturing costs. We believe production and delivery growth should continue at industry-leading rates. We believe the electric vehicle market is reaching a “tipping point” for adoption and expect Tesla to dominate this segment. Additionally, the company is implementing initiatives to improve quality, consistency, and cost of its products. We do not believe that legacy manufacturers will be able to compete with Tesla’s enhanced offering.
Iridium is capitalizing on the approximately $3 billion it invested over several years to build and launch its current satellite network. It is now entering what it has termed a “cap-ex holiday” that should result in high free-cash-flow conversion. The company spent approximately $400 million on capital expenditures annually only a few years ago, but we expect this spend to decline to approximately $40 million in the coming years. It is an indication that the company’s substantial lead should persist as the capital investment and timeline to launch competitive products is too great. We expect Iridium to capitalize on the growing need for its high-speed L-Band network over this time.
Within our Disruptive Growth group, some companies depreciated in value. New position Figs Inc. (FIGS, Financial) declined about 15%. The relatively new direct-to-consumer producer of health care apparel has declined along with the broader group of young, high-growth, publicly traded companies. Investors have continued to shun newer business models that they perceive to be riskier. The company has declined over 80% from its highs achieved in late 2021. The recent volatility created an opportunity for us to initiate and build a position in a company that we believe can continue to grow revenue above 20% annually while also expanding margins. Its superior product is competing against brands that lack investment capabilities to improve their offerings. We believe Figs could command a meaningful share of the $79 billion global health care apparel market and eventually develop products for other professions.
The Core Growth segment also contained businesses that appreciated meaningfully while others declined. CoStar Group, Inc. (CSGP, Financial) and Gartner, Inc. (IT, Financial) both performed well in the quarter. Both companies had been enhancing their products, expanding their services, and growing their sales teams. These investments are now paying off with top-line growth that has exceeded consensus expectations. But companies that continue to invest in their services, like fintech company Adyen N.V. (XAMS:ADYEN, Financial), saw their stock prices decline as investors continue to avoid uncertainty. The electronic payments company announced that it would grow its headcount to tackle additional services for clients. We believe the company could be as successful in these tangential categories, which would provide meaningful growth in the years ahead. We think these current investments and elevated costs should benefit long-term investors.
It was not only Disruptive Growth and Core Growth that had large differences of returns among its components. While companies in the Financials and Real/Irreplaceable Assets categories had historically performed more in-line in the short term, we saw differences of returns here, too. Companies like The Charles Schwab Corp. (SCHW, Financial) and Hyatt Hotels Corp. (H, Financial) performed well in the quarter, as they were able to demonstrateorganic growth. But Brookfield Asset Management Inc. (BAM, Financial) and Douglas Emmett, Inc. (DEI, Financial) are both in segments that are facing headwinds in the currentenvironment. Investors are concerned about the volatile market’s impact on Brookfield’s ability to both realize distributable earnings as well as raise new funds. Investors feared that Douglas Emmett’s portfolio of office properties could face high vacancies and lower prices if a near-term recession, coupled with a work-from-home environment, persists. We believe these issues will be temporary and its quality assets will be more fully utilized in a normal environment.
We believe this market, while difficult, is beginning to reward high quality companies that are demonstrating good operational performance. The Fund’s ownership of many of these businesses allowed it to perform well in the current quarter. But investors are still shunning companies that are investing for growth and penalizing near-term performance. We believe this provides opportunities for timely investments and future strong returns for many stocks in the portfolio.
Tesla, Inc. manufactures electric vehicles (EVs), related software offerings,solar and energy storage products, and battery cells. Shares rose on increased production volumes from Tesla’s global factories, new full self-driving functionality, manufacturing techniques that improve quality and reduce costs, and industry-leading margins despite complex COVID-related shutdowns. A new federal tax incentive program should also provide material benefits for Tesla’s differentiation, margins, and demand. We remain investors in this uniquely innovative company leading the EV revolution.
Shares of real estate data and marketing platform CoStar Group, Inc. contributed to performance on strong financial results and its inclusionin the S&P 500 Index. We believe the company is well positioned to benefit from the continuing migration of real estate market spend to online channels. CoStar is investing aggressively to build out its residential marketing platform, which will launch later in 2022 and offers significant upside potential, in our view. CoStar has over $4.7 billion of cash on its balance sheet, which we expect it to begin to deploy for opportunistic M&A.
Shares of online brokerage firm The Charles Schwab Corp. were buoyed by investor expectations that rising interest rates will lead to increased profits on the company’s more than $600 billion in interest-earning assets. We are also encouraged by Schwab’s organic growth. Despite turbulent markets, the company attracted over $400 billion of net new client assets over the past 12 months. We also believe Schwab’s operating expense per client assets should drop to record low levels once equity markets improve.
Shares of Iridium Communications Inc., a leading satellite-based mobile voice and data communications services vendor, rose on increased expectations for smartphone compatibility after it announced a related development agreement and other market participants announced similar capabilities. In addition, Iridium reported record quarterly results showing an acceleration of revenue growth with strong profitability. Lastly, growth initiatives continue to mature including Aireon, an award from the Space Development Agency, and increasing speeds for its Certus offering.
Shares of global hotelier Hyatt Hotels Corp. increased in the quarter on strong revenue-per-available-room results as business travel continued to recover from pandemic lows. While leisure rates dropped a little in the seasonally slower back-to-school period, this decline was expected and was more than offset by increases in business transient and group bookings. Robust rates across the industry are leading to higher margins, including for Hyatt. Hyatt is using the increased cash flow to buy-in its shares, indicating that it sees value in the stock.
Space Exploration Technologies Corp. (SpaceX) is a high-profile privatecompany founded by Elon Musk that designs, manufactures, and launches rockets, satellites, and spacecrafts. Its ultimate goal is to make humanity multi-planetary. Products include reusable orbital launch offering and a broadband service leveraging its satellite constellation, Starlink. We value SpaceX using prices of recent financing transactions and a proprietary valuation model.
Figs Inc. is the largest direct-to-consumer platform in health care apparel.While the company reported quarterly results that beat consensus and reaffirmed its outlook for the rest of the year, shares fell due to market-related weakness in late September. Despite macroeconomic uncertainty, we believe Figs will be more resilient than other apparel categories as its products are largely non-discretionary and replenishment-driven. We also believe Figs can continue to expand its customer base due to its superior product offering.
Shares of P&C insurance software vendor Guidewire Software, Inc. detracted from performance due to broader multiple compression inhigh-growth stocks. We remain shareholders. Guidewire has crossed the midpoint of its cloud transition, which should correspond with improving financial results. Guidewire has tripled its potential market through new products and cloud delivery. Over time, we think Guidewire will be the key software vendor for the global P&C insurance industry, with 30% to 50% of its $15 billion to $30 billion total addressable market and margins above 40%.
Douglas Emmett, Inc. is a REIT that owns a portfolio of office andapartment buildings concentrated in West Los Angeles and Honolulu. Weak operational and financial results combined with investor concerns over a potential recession drove down the share price during the quarter. We remain optimistic about Douglas Emmett’s long-term prospects given its irreplaceable real estate portfolio.
Arch Capital Group Ltd. (ACGL, Financial) is a specialty insurance company based inBermuda. The share price was flat during the quarter as earnings that beat consensus were offset by a small decline in book value as higher interest rates weighed on the market value of the fixed income portfolio. Pricing trends remain favorable in the P&C insurance market, and margins for the mortgage insurance business have improved substantially since the onset of the pandemic. We remain shareholders due to Arch’s strong management team and our expectation of robust growth in earnings and book value.
Investment Strategy and Portfolio Structure
Baron Partners Fund seeks to invest in businesses that we believe can double in value within five or six years. The Fund invests for the long term in a focused portfolio of appropriately capitalized, well-managed growth businesses at attractive prices across market capitalizations. We attempt to create a portfolio of approximately 30 securities diversified by GICS sectors, but with the top 10 positions representing a significant portion of net assets. These businesses are identified by our analysts and portfolio managers using our proprietary research. We think these well-managed businesses have sustainable competitive advantages and strong, long-term growth opportunities. We may use leverage to enhance returns, which increases the Fund’s volatility.
As of September 30, 2022, Baron Partners Fund held 30 investments. The median market capitalization of these growth companies was $15.9 billion. The top 10 positions represented 98.0% of net assets. Leverage was 14.9%.
Portfolio leverage is significantly below historical levels. We have traditionally managed the portfolio with 20% to 25% leverage (the average leverage over the prior 10 years was 21.9%). At the start of 2020, leverage was 27.0%. However, due to a combination of a rapidly rising market, higher market volatility, and increased concentration in our top holdings, we managed risk by reducing leverage. Quarterly leverage bottomed at 3.3% at the end of March 2021 and has remained below average. Market volatility enabled us to make a few new investments in companies we have long followed at what we believe are attractive prices. Therefore, leverage has slowly risen. While we expect legacy positions to be the main contributors to performance in the near term, we expect these new investments to be more meaningful contributors in the future.
The long-term absolute and relative performance of the Fund has been very good. The Fund has returned 15.31% annualized since inception as a private partnership on January 31, 1992, beating its benchmark Index by 6.04% per year.
The Fund’s performance has also exceeded its Index over the prior 1-, 3-, 5-, 10-, 15-, and 20-year periods. In addition to viewing the Fund’s returns over various trailing periods, we believe it is helpful to understand how the Fund has performed over an economic cycle.
The Fund has appreciated considerably in good times (Table V)…
There have been two distinct periods over the life of the Fund with significant economic growth. The nearly 8-year period from the Fund’s inception through the Internet Bubble (1/31/1992 to 12/31/1999) and the more recent 11-year period Post-Great Recession to the start of the COVID Pandemic (12/31/2008 to 12/31/2019). During both periods, the Index had strong returns; however, the Fund’s returns were even better. Baron Partners Fund’s annualized return during the most recent robust economic 11-year period was 17.44% compared to the Index’s 16.84%.
The Fund has retained value in challenging times (Table VI)…
We believe what sets the Fund apart from other growth funds is its historic ability to outperform in more challenging economic periods. The 9-year period from the Internet Bubble collapse through the Great Recession (12/31/1999 to 12/31/2008) saw lower returns for the Fund. It had annualized returns of 1.54%. However, the Index declined substantially. $10,000 hypothetically invested in the Fund at the start of this period would have been worth $11,479 after those nine years. A $10,000 hypothetical investment in funds designed to track the Index would be worth only $6,488, more than a 35% cumulative decline. The Fund preserved (and slightly grew) capital during this difficult economic time because its investments in a diverse set of high-quality growth businesses were able to weather the environment and enhance their competitive positioning.
Today’s environment is also challenging. The COVID-19 pandemic and its lingering macroeconomic issues have caused great volatility. In just under three years, there have been two sizable market corrections each with an approximate 33% decline in major indexes. But so far, the Fund has performed admirably in both, protecting and growing clients’ capital. Since the start of the COVID pandemic through this quarter (12/31/2019 to 9/30/2022), the Fund has an annualized return of 36.67%. The Index has an annualized return of 1.71%. We do not know how long this challenging period will persist, but we are pleased with how the Fund has performed so far.
During periods of strong economic expansion, investors often disregard these more challenging periods. Losing capital during those periods, we believe, makes it nearly impossible to have exceptionally strong returns over the long term. Baron Partners Fund has shown a prior ability to grow capital during those challenging periods. We believe the high-quality growth portfolio should be able to perform well again in future difficult economic periods, although there is no guarantee that will be the case.
Over the longer term, this combination has been rewarding for clients. A $10,000 hypothetical investment at the inception of the Fund on January 31, 1992, would have been worth $788,955 on September 30, 2022. That same $10,000 hypothetical investment in a fund designed to track the Index would now be worth $151,762, only about 19% of what it would have been worth if invested in the Fund.
Thank you for joining us as fellow shareholders in Baron Partners Fund.
We continue to work hard to justify your confidence and trust in our stewardship of your hard-earned savings. We remain dedicated to providing you with the information we would like to have if our roles were reversed. We hope this letter enables you to make an informed decision about whether this Fund remains an appropriate investment.
Respectfully,
Ronald Baron, CEO and Lead Portfolio Manager
Michael Baro, Co-Portfolio Manager
The discussions of the companies herein are not intended as advice to any person regarding the advisability of investing in any particular security. The views expressed in this report reflect those of the respective portfolio managers only through the end of the period stated in this report. The portfolio manager’s views are not intended as recommendations or investment advice to any person reading this report and are subject to change at any time based on market and other conditions and Baron has no obligation to update them.
This report does not constitute an offer to sell or a solicitation of any offer to buy securities of Baron Partners Fund by anyone in any jurisdiction where it would be unlawful under the laws of that jurisdiction to make such offer or solicitation.
