Dear Baron Growth Fund Shareholder:
Performance
Baron Growth Fund (the "Fund") returned 10.95% (Institutional Shares) during the quarter ended September 30, 2020, and has gained 9.87% year-to-date. Performance in both periods compares favorably to the Fund's primary benchmark, the Russell 2000 Growth Index (the "Benchmark"), which gained 7.16% for the quarter and 3.88% year-to-date. Performance also compares favorably to the S&P 500 Index, which measures the performance of publicly traded large-cap U.S. companies. That index gained 8.93% for the quarter and 5.57% year-to-date.
The Fund's performance continues to be driven by favorable stock selection. This is the goal of our fundamentally driven investment strategy, and where we devote the preponderance of our time and attention. The companies in which we have invested serve large and growing addressable markets, boast sustainable competitive advantages, have scalable, recurring and cash generative financial models, and are led by exceptional management teams. Such attributes enable these businesses to be resilient in the face of extraordinary uncertainty and have made them compelling investments across market cycles.
Stocks continued to gain in the quarter, with the Fund returning 10.95%, its Benchmark gaining 7.16%, and the S&P 500 Index rising 8.93%. Markets, as measured by the S&P 500 Index, have rebounded over 50% off their March lows, and now sit in positive territory for the full year, albeit modestly off their highs. Aggressive actions by the Federal Reserve (the "Fed") ensured normal functioning of financial markets, while unprecedented fiscal and monetary policy have helped to temporarily cushion the short-term financial impact to many individuals and companies.
The Fed has reduced borrowing costs to near zero and has been explicit that rates will not rise for years. With discount rates sustainably low, and global economic growth slower than before, we think secular growth businesses like those that we own in the Fund will attract incremental investment capital. We are excited about the long-term return prospects for growth stocks in general, and for the Fund in particular.
We were more active in adding positions to the portfolio as we were able to identify compelling new investment opportunities and buy them at attractive prices relative to their long-term prospects. We made initial investments in five businesses this quarter after adding to four existing positions earlier in the year. Our new investments serve a variety of industries but share a set of attributes that are common to our entire portfolio. These include large addressable markets, high barriers to entry, positive secular trends, recurring or highly visible revenue, high margins, strong FCF conversion, and best-in-class management teams. We define "best-in-class" as well-managed, competitively advantaged, faster growing companies with higher margins and returns on invested capital and lower leverage that are leaders in their respective markets. Note that this statement represents our opinion and is not based on a third-party ranking.
Our largest new position is American Well Corporation (AMWL, Financial) ("AmWell"), a leader in the rapidly growing telehealth space. AmWell's platform serves as foundational technology for health systems, health plans, and self-insured employers, and enables providers of care to digitally reach a wide array of patients under their own brands. We elaborate on our AmWell thesis in the section titled "Recent Purchases."
Farmers Business Network, Inc. ("FBN®") is creating a two-sided digital marketplace to connect farmers and agricultural suppliers. FBN is seeking to disrupt $5 trillion global agricultural markets that are dominated by oligopolistic counterparties that control distribution channels and leverage opaque pricing models to squeeze customers. FBN is leveraging technology to modernize this ecosystem by offering services such as direct-to-farmer inputs and crop marketing and financing, all underpinned by farmer-oriented business analytics performed on a contributory data set.
Northvolt AB is a leader in green battery manufacturing that we believe is poised to benefit from the inevitable transition away from carbon-based energy and towards renewables. Northvolt has vertically integrated its cathode active material preparation and cell manufacturing, which optimizes its production process and gives the company cost and control advantages. This cost advantage is amplified by its location in Sweden, which has some of the lowest energy prices globally, and its data-driven design and production processes. Ultimately, we believe that Northvolt will be the most competitive supplier of batteries in Europe, enabling it to service markets including passenger and commercial electric vehicles, electrified industrial equipment, and energy storage systems.
Zymergen Inc. has developed a unique platform that combines biology, machine learning, and automation to reliably design microbes and manufacture them at scale. The company has assembled a vast library of proprietary genetic data, which it searches to identify molecules that offer material characteristics that are superior to traditional petrochemical-based materials. Zymergen's development and manufacturing platform is guided by artificial intelligence and machine learning, which helps the company ferment microbes at scale faster and more cheaply than traditional techniques. Early products include biological films for electronic applications including flexible circuits, display touch sensors, printed electronics, and 5G antennas, as well as an innovative insect repellant. We think that Zymergen's process, platform, and intellectual property has unlimited flexibility, and we expect the company to create microbes that offer enhanced materials characteristics for use in agriculture, health care, consumer care, and manufacturing end markets.
Finally, Yucaipa Acquisition Corporation (YAC, Financial) is a SPAC led by Ron Burkle, a visionary leader who began his career by consolidating grocery chains and has since made controlling private equity investments in a diverse array of industries.
We funded these new investments by exiting four positions and making modest reductions to other existing positions. We exited six positions earlier in the year. We are constantly working with our team of analysts to research and analyze companies' long-term growth prospects, and we devote as much time researching positions that we are considering purchasing as we do to those that we have owned for decades. When we determine that the growth prospects of an investment are impaired, we move rapidly to sell the stock and reinvest into more compelling opportunities. We reached this conclusion in several positions and acted accordingly. We also look to assess risk and return profiles on a relative basis and are constantly striving to allocate our capital to its highest and best use. Several of our sales were motivated by this thinking, where we identified new or existing investments that we preferred to others that we already owned.
While we were more active in purchasing new positions, our initial position sizes remain small. For example, AmWell, our largest new position, represents just 30 basis points of the portfolio. This is a deliberate decision, as we prefer to make small initial investments as we build confidence in our investment thesis and management's ability to execute. We will seek to add opportunistically to these positions where appropriate but prefer to allow them to accrete in size through performance. Our current top 10 positions, which presently represent 55.1% of the portfolio, have all achieved their size primarily through performance rather than through additional investments.
As we highlighted last quarter, we considered our Consumer Discretionary investments to be particularly attractive, as they had failed to keep pace with the market's rebound from April through June. Stock performance in the sector improved meaningfully in the quarter, as our investments gained 38.6% and are now up 7.6% year-to-date. Performance was led by Penn National Gaming, Inc., which rallied 138% on the back of strong reopening trends, robust cost controls, building excitement for online gaming and sports betting, enthusiasm for the company's Barstool Sports acquisition, and a meaningfully improved balance sheet. We remain optimistic about the long-term appreciation potential offered by these stocks. We believe there is significant pent-up demand for travel and entertainment and expect most leisure activities will recover to pre-pandemic levels. We believe that all of our Consumer Discretionary investments boast sustainable competitive advantages, such as Vail Resorts, Inc.'s unique network of best-in-class ski resorts, Penn's possession of regional gaming licenses, and Marriott Vacations Worldwide Corp.'s proprietary customer database and exclusive relationship with Marriott Hotels. We believe that all are run by best-in-class management teams, are appropriately capitalized to endure slow and uncertain recoveries, and can generate earnings equal to or greater than their pre-COVID-19 peaks.
While the Fund didn't make much money from the peak of the Internet Bubble on December 31, 1999 through the trough of the Financial Panic on December 31, 2008, it did generate a positive annualized return of 2.46%. Conversely, a hypothetical investment in the Fund's Benchmark would have declined in value by 4.71% on an annualized basis over the same time, while a hypothetical investment in the large-cap S&P 500 Index would have declined 3.60% annualized. (Please see Table III – Millennium Internet Bubble to Financial Panic).
The effects of compounding over the long term illustrate the difference between making money and losing it. A hypothetical investment of $10,000 in the Fund on December 31, 1999 was worth $69,844 on September 30, 2020. That is more than double a hypothetical investment in the Benchmark (Please see Table III – Millennium Internet Bubble to Present). We have observed similar performance during the COVID-19 pandemic and associated recession. The Fund has gained 9.87% through September 30, which exceeds the Benchmark by 5.99% and the S&P 500 Index by 4.30%. We are pleased that our long-term investments in what we believe are competitively advantaged growth companies with exceptional management teams have generated attractive returns in good markets and have helped to protect capital during more challenging ones.
Shares of regional casino company Penn National Gaming, Inc. (PENN, Financial) increased on strong betting activity after the early September launch of the Barstool Sportsbook app. Penn owns a 36% stake in Barstool, with an option to increase its ownership to 50%. The company also reported better-than-expected financial results, driven by robust margin growth across its assets. The resulting increase in cash flow, combined with a recent equity offering, should help Penn pay down debt on its balance sheet and make additional investments.
Shares of real estate information and marketing services provider CoStar Group, Inc. (CSGP, Financial) contributed to performance as net new sales reaccelerated more quickly than investor forecasts. Demand for CoStar's digital marketplace businesses has grown as traditionally offline activities have increasingly shifted online during the pandemic. This growth was partially offset by slower trends in CoStar's CRE data licensing businesses. The company has over $3.6 billion of cash on its balance sheet, which we expect to be used for market-expanding acquisitions.
Shares of veterinary diagnostics leader IDEXX Laboratories, Inc. (IDXX, Financial) contributed to performance in the quarter. Veterinary visits continued to exhibit a "V" shaped recovery from the initial pandemic-related slowdown, with visits growing at double-digit rates. IDEXX's competitive trends are outstanding, and we expect new proprietary innovations and field sales force expansion to be meaningful contributors to growth. Margins are moving significantly higher, and we believe that margins can exceed 30% over time.
Schrodinger, Inc. (SDGR, Financial) shares gave back gains after a post-IPO rally that saw shares increase almost six-fold from the IPO price. Schrodinger is a hybrid computer science, physics, and biotechnology company. Schrodinger's software suite allows drugs developers to explore the endless range of possible drug/target interactions allowed via the rules governing single atom interactions, which reduces the cost and time to develop new therapeutics.
Shares of Cohen & Steers, Inc. (CNS, Financial), a global investment manager specializing in real assets and alternative income, detracted from results in the quarter. Shares declined as investors took a more cautious view on the outlook for real estate assets, which is the company's area of focus. We continue to believe that the asset class remains attractive over the longer term, and Cohen & Steers is uniquely positioned to benefit from increasing investor demand for listed real estate investments.
Douglas Emmett, Inc. (DEI, Financial) is a REIT with a portfolio of office and apartment properties located in Western Los Angeles and Hawaii. The stock fell on investor concerns that a portion of tenants would be unable to pay rent in a timely manner, both due to financial distress and new municipal laws. We retain conviction owing to Douglas Emmett's irreplaceable portfolio, attractive sub-markets, and low debt levels.
RECENT PURCHASES
We participated in the September IPO of AmWell, an innovative digital health care platform vendor. AmWell was founded, and continues to be managed by, two Israeli brothers who are both doctors and successful serial entrepreneurs. AmWell's flagship offering is a white-label telehealth solution that allows hospitals, health systems, and health plan customers to offer virtual care to patients under their own brands. AmWell compliments its technology platform by offering direct-to-consumer telehealth appointments on a fee-for-service basis, including primary and urgent care, behavioral health, and other specialties.
We believe that telemedicine conveys benefits to the entire health care ecosystem. Virtual care improves convenience for patients, enhances the safety of visits, helps providers balance supply and demand, allows for more integrated care across specialties and locations, and is better suited to managing chronic disease. Ultimately, we believe that telehealth will broaden access and reduce the cost of care, which we view as critical national priorities. These benefits are translating into a vast and growing market for telehealth services. We estimate that AmWell serves an addressable market that exceeds $34 billion annually, which we expect to grow as the company expands specialty services, adds additional functionality, and enters international markets.
We view the company's positioning as a technology platform vendor to be highly differentiated from competitors offering telehealth services. AmWell's technology enables video and audio interactions; and it integrates clinical and back office workflows across patients, health plans, providers, and hospitals. The platform is fully embedded in third-party platforms such as electronic medical records and patient and provider portals. All telehealth visits are delivered under the provider's brand rather than AmWell's, which positions the company as a strategic partner to the industry rather than a direct competitor.
We expect the company to compound revenue at 25% annually as telemedicine becomes more widely utilized. We believe that COVID-19 has been a meaningful accelerant to the industry, as a spike in demand and loosening of regulatory and reimbursement restrictions have highlighted the benefits of telehealth, removed stigmas, and solidified a payment model. We expect AmWell to grow through new customer acquisition and deeper penetration into existing customers. AmWell has already achieved wide adoption, supporting the telehealth platforms at 55 health plans and 150 of the U.S.' largest health systems, which encompass over 2,000 hospitals. However, it is presently contracted to cover just half of its clients' 150 million insured lives, providing a long runway for same-store growth. We also expect the release of additional modules, expanding partnerships with innovators like Apple, Cerner, and Philips, expansion into international markets, and selective M&A to add to growth.
The company has built a durable financial model that is designed to scale over the long term. AmWell primarily charges customers a subscription fee, which is presently supplemented by utilization fees for AmWell-delivered surge capacity. We estimate that 85% of revenue is recurring, and customer retention rates are in the mid-90% range. The company is investing aggressively to build out its platform and network of integrations in order to drive growth. This is depressing current margins and cash flows relative to their long-term potential. We view most of these investments as fixed and believe that as telehealth inevitably becomes ubiquitous, the company will own a vast and valuable network with high switching costs, giving AmWell pricing power and dramatic margin expansion potential. We believe profitability can be enhanced by a recently consummated partnership with Google, which purchased $100 million worth of AmWell stock and will serve as the company's cloud infrastructure provider.
PORTFOLIO STRUCTURE AND INVESTMENT STRATEGY
The Fund seeks to invest in businesses that we believe have attractive fundamental characteristics and are underpinned by durable competitive advantages. We search for businesses that serve large addressable markets and are benefiting from favorable secular trends. We favor business models that have high levels of recurring revenue, generate attractive incremental margins, are cash generative, and are not dependent on third-party financing. We exclusively invest with management teams that we consider exceptional and are investing in their businesses to generate long-term profitable growth.
The Fund holds investments for the long term. As of September 30, 2020, 32 of the Fund's investments, representing 91.7% of the portfolio's net assets, had been held for more than 5 years, and 20 investments, representing 8.3% of the portfolio's net assets, had been held for less than 5 years. This is dramatically longer than most other small-cap growth funds, which, according to Morningstar, turn over about 71% of their portfolios annually.
We view this long-term perspective as a source of our competitive advantage. Most investors focus on short-term results. By concentrating on long-term results, we are researching a less efficient area of the market. We believe this enables us, along with our growing team of analysts, to uncover high-quality businesses that can compound revenue and earnings at faster rates for far longer than others prospectively recognize. Our long-term orientation also allows us to act opportunistically. When companies miss quarterly earnings estimates, or announce investment programs, stocks go down indiscriminately. We can evaluate these situations dispassionately and assess the fundamentals of the opportunity or the expected return of an investment program. Ideally this allows us to buy a best-in-class business at a more attractive valuation.
We believe the merits of our long-term approach are evident in our historical performance. As of September 30, 2020, the portfolio's 10 largest positions have been owned for a weighted average of 15.3 years. As a group, they have returned 19.5% annually based on weighted average assets since their initial purchase. This has exceeded the Benchmark by 10.2% annualized.
The cohort of investments that have been held for more than five years includes 32 positions representing 91.7% of assets. This cohort has earned an annualized rate of return of 19.3% based on weighted average assets since they were first purchased, which exceeds the performance of the Fund's Benchmark by 9.2% per year annualized. Ten of these investments have achieved annualized returns that exceed their Benchmark by more than 10% per year, including two that have achieved annualized returns that exceed their Benchmark by more than 20% per year.
We exclusively purchase small-cap companies that we think can double in size in a five- or six-year period. Investments held for less than five years include 20 stocks that account for 8.3% of the Fund's net assets. As a group, they have returned 43.3% annually based on weighted average assets since their initial purchase and exceeded the Benchmark by 33.6% annualized. Seven of these investments have achieved annualized returns that exceed their Benchmark by more than 10% per year, including five that have achieved annualized returns that exceed their Benchmark by more than 20% per year.
PORTFOLIO HOLDINGS
As of September 30, 2020, Baron Growth Fund held 52 investments. The top 10 holdings represented 55.1% of the Fund's net assets. All were small-cap businesses at their time of purchase and have increased their equity value by a weighted average of 12.8 times since our initial investment. All have become top 10 positions through stock appreciation, and we believe all continue to offer significant further appreciation potential. We believe the Fund's diversified portfolio offers investors potentially better-than-market returns with less risk than the market. Note that diversification cannot guarantee a profit or protect against loss.
Baron Growth Fund only purchases small-cap companies. Since the Fund holds its investments for the long term, the Fund has a significant percentage of assets invested in securities that have appreciated beyond their market capitalizations at the time of the Fund's investment. Baron Growth Fund's median market cap is $4.5 billion and its weighted average market cap is $15.0 billion. This compares to Morningstar's U.S. market cap breakpoints for small- and mid-cap funds of $4.4 billion and $25.9 billion, respectively, as of September 30, 2020.
Thank you for joining us as fellow shareholders in Baron Growth Fund. We are appreciative of the confidence you have shown in us. We will continue to work hard to justify your confidence.
Respectfully,
Ronald Baron, CEO and Lead Portfolio Manager
Neal Rosenberg, Co-Portfolio Manager
- The indexes are unmanaged. The index performance is not Fund performance; one cannot invest directly into an index. The Russell 2000® Growth Index measures the performance of small-sized U.S. companies that are classified as growth and the S&P 500 Index of 500 widely held large cap U.S. companies. The indexes and the Fund are with dividends, which positively impact the performance results. Russell Investment Group is the source and owner of the trademarks,service marks and copyrights related to the Russell Indexes. Russell is a trademark of Russell Investment Group.
- The performance data in the table does not reflect the deduction of taxes that a shareholder would pay on Fund distributions or redemption of Fund shares.
- Performance for the Institutional Shares prior to May 29, 2009 is based on the performance of the Retail Shares, which have a distribution fee. The Institutional Shares do not have a distribution fee. If the annual returns for the Institutional Shares prior to May 29, 2009 did not reflect this fee, the returns would be higher.
- Not annualized.
Investors should consider the investment objectives, risks, and charges and expenses of the investment carefully before investing. The prospectus and summary prospectus contain this and other information about the Funds. You may obtain them from its distributor, Baron Capital, Inc., by calling 1-800-99BARON or visiting www.BaronFunds.com. Please read them carefully before investing.
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 Growth Fund by anyone in any jurisdiction where it would be unlawful under the laws of that jurisdiction to make such offer or solicitation.
