Baron Focused Growth Fund 1st Quarter Shareholder Letter

Overview of holdings and markets

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Jun 07, 2017
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Dear Baron Focused Growth Fund Shareholder:

Performance

Baron Focused Growth Fund (the “Fund”) had a strong start to the year. During the first quarter, the Fund increased in value per share by 8.55% (Institutional Shares), exceeding the Russell 2500 Growth Index, the benchmark against which we compare the performance of the Fund, by 230 basis points. That index rose 6.25% during the quarter. The S&P 500 Index, which measures the performance of large-cap companies, increased 6.07% during the same period.

The Fund’s focused investments continue to make good progress against their large addressable markets. This quarter, unlike last quarter, they were rewarded with higher multiples and strong stock performance as investors rotated into the Fund’s higher quality, secular growth businesses and away from more cyclical stocks and sectors.

Since its inception on May 31, 1996, the Fund’s 10.64% annualized performance has exceeded that of its benchmark by an average of 3.12% per year. This means that a $10,000 investment in Baron Focused Growth Fund at its inception over 20 years ago would now be worth over $82,000! If an investor had instead invested $10,000 in a passive index that mirrored Russell 2500 Growth Index, it would be worth approximately $45,000. Please see Tables I and II.

Baron Focused Growth Fund’s beta has averaged 0.77 since inception. This means the Fund has been 77% as volatile as the benchmark. As a result of Baron Focused Growth Fund’s strong absolute and relative returns and lower risk, the Fund has achieved 4.93% annual “alpha,” a measure of risk-adjusted performance, since inception.

Baron Focused Growth Fund, like all Baron Funds, utilizes a bottom up, fundamental research approach to invest in fast growing, competitively advantaged, well-managed businesses. We invest for the long term, and do not seek to change our portfolios from one quarter to the next as a result of macro events, which we consider impossible to predict.

Despite the market’s recent gains, we believe many of the businesses owned by the Fund remain undervalued relative to their long-term potential. Many of these companies’ stocks prices changed little during the past three years despite substantial growth of their businesses. We think this is because their earnings in the near term have been depressed by those companies’ consistent re-investment in their businesses, with organic growth initiatives and opportunistic acquisitions.

Vail Resorts, Inc. continued to add to its portfolio of premier ski resorts with its purchase of Stowe Mountain in Vermont. Stowe offers Vail Resorts an excellent cross-sell of its annual Epic Ski Pass in the large East Coast market. Hyatt Hotels Corp.’s acquisition of Miraval Spas brings them an added level of service that for their business guests will distinguish their properties from rivals, increase both occupancy and revenue per guest, and improve its expansion prospects with developers.

CoStar Group, Inc., the leading provider of commercial real estate information, is generating robust double-digit revenue growth, while significantly investing in its business as it expands its sales, research, and product development capabilities. Manchester United plc has a globally recognized brand and vast worldwide following, with almost 700 million fans. The company is penalizing its present earnings by investing heavily in a new manager and players. We expect Manchester United’s investments to boost its revenues more than 50% to $1.2 billion and double its EBITDA during the next five or six years. The company increased its revenue 31% and its EBITDA 42.5% during the last three years while its stock prices fell 12%. Guidewire Software, Inc. (GWRE, Financial), the leading provider of technology solutions to the P&C insurance industry, is benefiting from a replacement cycle of 30-year-old legacy systems. Through innovation and targeted acquisitions, Guidewire has more than tripled its addressable market since becoming a public company. We believe the company has the potential to increase its EBITDA 10-fold over our investment horizon.

Shares of electric vehicle company Tesla, Inc. (TSLA, Financial) rose during the first quarter following its launch of GigaFactory, one of the world’s largest manufacturing facilities, which will potentially drive significant cost reduction. Tesla is on target for a July 2017 launch of its mass market Model 3, potentially the largest product cycle in history. Additionally, the company’s SolarCity merger is on track, showing less cash drain than initially feared by investors. We believe a pro-U.S. jobs administration is a tailwind for Tesla as it is one of North America’s fastest growing employers. The company also raised $1.4 billion from capital markets during the period. As importantly, we think, was an announcement by Tencent, the largest publicly owned company in China, that it had acquired 5% of Tesla for $1.8 billion. (Gilad Shany/Ishay Levin)

Shares of ski resort company Vail Resorts, Inc. (MTN, Financial) increased in the first quarter on an earnings report that beat Street expectations due to increased visitation and spend levels in a strong ski season. Vail’s recent acquisitions of Whistler Blackcomb, Park City, and Perisher continue to help drive season pass sales and visitation, which will help insulate earnings from poor snowfall seasons and improve its cash flow. (David Baron)

Manchester United plc (MANU, Financial) is an English Premier League professional sports team that generates revenue from broadcasting, sponsorship, and licensing. Shares were up in the first quarter over enthusiasm around the hiring of Jose Mourinho as the new manager and the addition of marquee players to its roster. The company recently launched MUTV, a global video subscription offering, which we expect to grow over coming quarters and years. The company maintains a strong pipeline of sponsorship deals, and we expect shares to benefit as it provides greater detail on its merchandising and licensing strategy and new growth initiatives in 2017. (Ashim Mehra)

Table V.

Top detractors from performance for the quarter ended March 31, 2017

Quarter
End
Market Market
Cap Cap or
When Market Cap
Year Acquired When Sold Total Percent
Acquired (billions) (billions) Return Impact
Under Armour, Inc. 2017 $12.4 $11.5 –34.37% –1.00%
AO World plc 2016 0.8 0.7 –24.34 –0.61
Benefitfocus, Inc. 2014 0.7 0.9 –5.89 –0.22
Hyatt Hotels Corp. 2009 4.2 7.0 –2.32 –0.21

Shares of athletic apparel company Under Armour, Inc. (UA, Financial) declined in the first quarter on reported earnings and guidance that missed Street expectations. Increased promotional activity, improved competitor positioning and a key distributor’s bankruptcy lowered wholesale revenue. The company is attempting to diversify its wholesale distribution domestically while growing into other geographies and categories, which will likely cut into profitability over the next year, in our view. We believe many of these issues are temporary and the long-term demand for its products, and, as a result, its earnings potential remains relatively intact. (Michael Baron)

AO World plc (LSE:AO., Financial) is the leading online seller of major domestic appliances in the U.K. Shares were down in the first quarter as the company continues to be negatively impacted by rising appliance manufactured in Europe as the British Pound weakens relative to the Euro. We expect higher costs for AO products to stabilize later in 2017. AO continues to execute its domestic U.K. plan and take share from competitors. We expect its German business to expand while the company works to improve terms with vendors in advance of further volume expansion. (Ashim Mehra)

Shares of benefits software vendor Benefitfocus, Inc. (BNFT, Financial) fell in the first quarter after the company reported 2017 guidance that was lower than analysts expected. We see several short-term headwinds, including longer implementation periods for national accounts, slower employer signings because of a sales force restructuring, and a revenue share of BenefitStore commissions. While we believe these headwinds will weigh on reported growth through mid-2017, we don’t believe they impact its large long-term growth opportunity. (Neal Rosenberg)

Investment Strategy & Portfolio Structure

The objective of Baron Focused Growth Fund is to double its value per share within five years. Our strategy to accomplish this goal is to invest for the long term in a focused portfolio of what we believe are appropriately capitalized, well-managed, small- and mid-cap growth businesses at attractive prices. We attempt to create a portfolio of less than 30 securities diversified by GICS sectors that will be approximately 80% as volatile (beta) as the market. These businesses are identified by our proprietary research.

As of March 31, 2017, Baron Focused Growth Fund held 16 investments. The weighted average market capitalization of these small- and mid-sized growth companies was $11.7 billion as compared with $4.8 billion for the benchmark Russell 2500 Growth Index. The Fund’s average portfolio turnover for the past three years was 19.4%. This means the Fund has an average holding period for its investments of over five years. This contrasts with the average mid-cap growth mutual fund which typically turns over its portfolio every 18 months. From a quality characteristics standpoint, the Fund’s investments have higher sales and earnings growth than the average holdings in the benchmark, are more conservatively financed (evidenced by lower debt to market capitalization ratio), and offer more consistent earnings (lower beta and lower standard deviation of EPS growth). We believe these metrics are important to help limit risk for this focused portfolio.

While focused, the Fund is diversified by sector. The Fund’s weightings are significantly different than that of the Russell 2500 Growth Index. The Fund is further diversified by investments in businesses at different stages of growth and development. For example, we classify the holdings of Baron Focused Growth Fund as one of three types: rapid, early stage growth businesses; companies with irreplaceable assets that offer pricing power and a hedge against inflation; and foundational, long-term holdings that continue to steadily grow sales and earnings while using excess free cash to return value to shareholders.

Rapidly growing firms account for approximately 38% of the Fund’s assets. On current metrics, these businesses look expensive; however, we think they will continue to grow and have the potential to generate exceptional returns. Examples of these companies include electric vehicle leader Tesla, commercial satellite company Iridium Communications Inc., commercial real estate data supplier Costar Group and corporate benefits software provider Benefitfocus.

Companies with what we believe are irreplaceable assets make up approximately 29% of the assets. Vail Resorts, owner of the premier ski resort portfolio in the world, upscale lodging brand Hyatt Hotels and storied soccer franchise Manchester United’s are all examples of companies we believe possess meaningful brand equity and barriers to entry in their businesses that equate to pricing power over time.

Steady growers that continually return excess free cash to shareholders represent approximately 22% of the portfolio. For example, Choice Hotels International, Inc. employs a capital-light franchise model for its mid-tier hotel brands that allows the company to return cash to shareholders through buybacks and dividends, while still achieving strong revenue and earnings growth. As the leading specialty P&C insurance underwriter in its industry, Arch Capital Group Ltd., generates a steady stream of cash flow. Recently, the company acquired AIG’s mortgage insurance subsidiary at what we believe was an unusually attractive price. That business complements Arch’s underwriting philosophy. We expect this acquisition will lead to even faster growth in Arch earnings and book value per share.

Thank you for investing in Baron Focused Growth Fund.

We are continuing to work hard to justify your confidence and trust in our stewardship of your family’s hard-earned savings. We are also continuing to try to provide you with information I would like to have if our roles were reversed. This is so you can make an informed judgment about whether Baron Focused Growth Fund remains an appropriate investment for your family.

Respectfully,

Ronald Baron

CEO and Portfolio Manager

April 20, 2017

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.