Baron Partners Fund (the “Fund”) increased 5.52% (Institutional Shares) in the third quarter of 2021. This result nicely outpaced that of its primary benchmark, the Russell Midcap Growth Index (the “Index”), which declined 0.76%. The S&P 500 Index rose 0.58% while the Morningstar Large Growth Category (the “Peer Group”) Average declined 0.07%. The Fund was the second-best performing fund in the period according to Morningstar. There were 1,280 funds in the category.
The Fund’s year-to-date returns now marginally exceed its Index but still trail the S&P 500 Index. The Fund has gained 10.19%, while its benchmark Index and S&P 500 Index have risen 9.60% and 15.92%, respectively.
The Fund’s long-term absolute and relative performance have been exceptional. As demonstrated in Table I, the Fund has meaningfully exceeded its Index over the 1-, 3-, 5-, and 10- year periods. Additionally, for over 18 years since Baron Partners Fund converted into a mutual fund, it has an annualized return of 19.26%. Since its conversion, it was ranked number one among all U.S. equity funds (2,193 share classes) through September 30, 2021.*
The market has been volatile. Investors still grapple with the lingering economic implications of the COVID-19 pandemic. Concerns about supply chain disruptions, labor shortages, and wage rates have impacted many stock prices. Increased scrutiny by the Chinese government, company default risks, and rising interest rates have also given investors pause. In this environment, companies that have demonstrated an ability to execute on their business plans have been rewarded. However, investors have also shifted to a more defensive stance favoring cyclical businesses rather than the fast-growing companies that we generally favor and that are perceived to be in the crosshairs of these issues. We believe this is a good environment for our active investment approach.
Although Baron Partners Fund is a non-diversified portfolio, it is diversified by business type. In our quarterly analysis, we segment the Fund’s portfolio into four business categories (Disruptive Growth, Financials, Real/ Irreplaceable Assets, and Core Growth) and attempt to explain how eachhas performed in the current setting.
Disruptive Growth companies made the largest contribution, but also hadthe greatest dispersion of results. Three holdings gained more than 10% in the quarter, while four positions declined more than 10%. Companies that demonstrated business advancements appreciated, while those that faced external pressures declined. The largest contributors to performance in this group were Tesla, Inc., Space Exploration Technologies Corp. (“SpaceX”), and Moderna, Inc. These companies showed meaningful improvements in key metrics. Despite global supply chain disruptions, Tesla delivered 241,000 units in the period, a 73% increase over last year. And this growth is before new facilities open in Berlin and Texas and capacity upgrades are implemented in China and California. Consolidation of chemistry materials should enable battery production to outpace vehicle growth. This higher production should lead to the energy storage business becoming more impactful for the company over the coming years and provide even more upside for current shareholders. SpaceX reached orbital velocity with civilian passengers on its Inspiration4 mission. Its altitude of 585 km surpassed the Hubble Space Telescope and International Space Station. Its three-day journey significantly outpaced those of “comparable” companies like Blue Origin and Virgin Galactic, which only reached a suborbital distance of approximately 100 km for mere seconds. While that SpaceX launch inspired many and raised significant funds for St. Jude’s Hospital, SpaceX’s other commercial aspects also advanced. Its new Starlink satellites have satellite-to-satellite communication capabilities (rather than satellite-to-ground station communication capabilities). This link is faster, more secure, and provides greater coverage than previous versions. Finally, we believe Moderna (and BioNTech SE) vaccines are gaining increased acceptance. We believe the use cases for mRNA biotechnology will expand in the coming years.
However, some Disruptive Growth businesses, like Zillow Group, Inc., RingCentral, Inc., and Zymergen Inc., declined in value. We retain confidence in Zillow and RingCentral. Both companies continue to grow despite perceived competition and macro headwinds. Fundamentals of Zillow remain strong despite residential real estate concerns. The company has obtained limited market share for real estate transactions despite a superior experience. We believe it is positioned to grow. Its Premier Agent offering grew 82%; its Homes revenue grew 71%; and, its Mortgage business grew 68%. We believe these high growth rates can be sustained as they continually take market share and expand their offerings. RingCentral’s annualized recurring revenue growth is at its highest rate in more than five years. Its partnerships, which provide access to approximately half of eligible customers, should assist continued customer penetration. The company is also an attractive target for larger technology companies that desire RingCentral’s geographic reach and carrier relationships. However, we exited the position in Zymergen after we lost confidence in its ability to launch key products.
Financials and Real/Irreplaceable Assets companies had more uniformity intheir results. Inflation and interest rate outlooks provided a positive macroeconomic environment for these segments. Financial technology businesses FactSet Research Systems, Inc. and MSCI, Inc. made the largest contributions among the Fund’s Financials holdings. These companies have well received new products along with a favorable sector backdrop. New products have been successfully sold to a well-established and loyal client base. FactSet has reaccelerated growth without sacrificing margins. They have improved their deep sector data and moved infrastructure to the cloud. Their customer base has grown as a result. MSCI’s asset-based products had appreciation and inflows. Additionally, it is replicating its public market information success within the private markets. This expansion should enable years of future growth. The soccer franchise Manchester United plc (which we categorize as an “Irreplaceable Asset”) appreciated because of the reopening of its stadium and the signing of incredibly talented Cristiano Ronaldo. Generational fans are eager to watch (in-person) and support the club.
Core Growth businesses were hurt by the rotation into more value andcyclical businesses. Despite the rotation, this business category still outperformed the broader Index. Gartner, Inc. and Adyen N.V. were standouts, while GDS Holdings Limited and Activision Blizzard, Inc. were pressured by political activities. Gartner has accelerated growth, improved margins, and repurchased shares. Adyen improved growth in all regions. Its newer North American business expanded 80%. It also received a federal banking license. This license will make Adyen less reliant on third-party providers and improve its service. It will now be able to settle transactions directly, which will lower operational costs. But not all Core Growth businesses fared as well. GDS and Activision both faced regulatory concerns in China and investors shifted to more stable businesses. While we do not attempt to predict the Chinese government’s future regulatory changes, GDS is already experiencing a high level of government oversight. Its Chinese data center services are essential for the country’s growing economy. Increased government oversight in the segment should help the GDS offering standout among its peers.
Tesla, Inc. (TSLA, Financial) designs, manufactures, and sells fully electric vehicles, solarproducts, energy storage solutions, and battery cells. The stock contributed as Tesla continued to present strong deliveries growth and a meaningful improvement in profitability despite a complex supply-chain environment. Demand remains robust, new localized manufacturing capacity is expected to support more efficient growth, and the autonomous program is accelerating. We expect Tesla’s growing vehicle offering, battery technology, and energy businesses to drive meaningful growth opportunities.
Shares of Gartner, Inc. (IT, Financial), a provider of syndicated research, contributed to performance after reporting financial results that exceeded Street estimates. Growth in the company’s research business has reaccelerated to double-digit levels. Research growth is led by the company’s GBS segment, which is benefiting from a multi-year investment cycle. We expect improved revenue growth and focus on cost control to drive margin expansion and enhanced cash generation. The company’s balance sheet is in excellent shape and can support aggressive share repurchases and bolt-on acquisitions.
Shares of FactSet Research Systems, Inc. (FDS, Financial), a leading provider of investment management tools, contributed to performance. FactSet reported strong earnings and provided encouraging guidance as technology and content investments the company has been making over the past few years started to pay off with stronger growth. We retain conviction in FactSet due to the large addressable market, consistent execution on both new product development and financial results, and robust free cash flow generation.
Shares of CoStar Group, Inc. (CSGP, Financial), a real estate information and marketing services company, contributed to performance this quarter. The company has moved to enter the residential real estate market, which meaningfully expands its total addressable market and should amplify growth as CoStar launches new technological innovations. While this move requires meaningful investments in the short term, we expect it to ultimately yield high returns that will boost CoStar’s revenue growth rate and margin profile over time.
Adyen N.V. (XAMS:ADYEN, Financial) provides technology that enables merchants to acceptelectronic payments. The stock increased after the company reported strong results for the first half of the year, with 46% revenue growth and 65% EBITDA growth. Processed volume growth rose to 67% due to resilient e-commerce demand, easier comparisons, and the onboarding of eBay. Margins also expanded despite rapid hiring and significant growth investments.
Despite an acceleration in revenue and increased guidance, shares of RingCentral, Inc. (RNG, Financial), a leading Unified Communications as a Service provider,lagged during the quarter on investor fears around contraction in its total addressable market and increasing competition from Microsoft and Zoom. We believe the market is big enough to support multiple long-term winners and that RingCentral can continue to innovate at a fast rate with its platform, sustaining pricing and winning strong share.
Zymergen Inc. (ZY, Financial) is a company dedicated to biofacturing, or harnessingbacteria to manufacture materials. Zymergen was a detractor following an unexpected update announcing both a major delay in the launch of lead product Hyaline and the removal of CEO Josh Hoffman, who was replaced by company chairman and former Illumina CEO Jay Flatley. We exited our position given material impacts to the business.
GDS Holdings Limited (GDS, Financial) is a leading Chinese data center operator within Tier1 cities. Shares fell in concert with a general sell-off in Chinese technology-related companies in response to tightening regulations and unknown future government actions against businesses that may not be perceived as aligned with the government’s goals. We retain conviction in GDS given durable secular tailwinds in cloud adoption (early innings in China), increased visibility of growth, ample capital, and its status as a provider of choice to China’s leading technology companies.
Spotify Technology S.A. (SPOT, Financial)is a leading digital music service available in 178international markets, offering on-demand audio streaming through paid premium subscriptions as well as a free ad-supported model. Shares were down as engagement declined while economies reopened and pandemic restrictions were lifted. We continue to view Spotify as a long-term winner in music streaming with potential to go from 158 million paying subscribers today to over 250 million in four years, driven by its scalable core music product as well as its growing library of spoken word content.
Investment Strategy and Portfolio Structure
Baron Partners Fund seeks to invest in businesses that we believe could 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 use modest leverage to enhance returns, which increases its volatility.
As of September 30, 2021, Baron Partners Fund held 36 investments. The median market capitalization of these growth companies was $15.9 billion. The top 10 positions represented 88.8% of net assets. Leverage was 11.9%.
Portfolio leverage has increased slightly but is still significantly below historical levels. We have traditionally managed the portfolio with 20% to 30% leverage (the average leverage over the prior five years was 21.3%). 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 the amount of leverage used. Quarterly leverage bottomed at 3.3% at the end of March 2021. 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, but is still meaningfully below historical levels.
While we expect legacy positions to be the main contributors of performance in the near term, we expect these new investments to be contributors in the future.
The long-term absolute and relative performance of the Fund has been very good. The Fund has returned 16.45% annualized since inception as a private partnership on January 31, 1992, beating its benchmark Index by 5.55% 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. (Please see Table V.)
The Fund has appreciated considerably in good times…
The Fund performed very well during the current economic expansion that followed the Financial Panic. For nearly 13 years, there has been sizable growth in the economy and stock market appreciation. While the market had strong returns, the Fund’s returns were significantly better. Baron Partners Fund’s annualized return during this period was 24.34%. Had you hypothetically invested $10,000 in the Fund on January 31, 2008, it would have been worth $160,864 on September 30, 2021. Had you only tried to mimic the Index’s returns by investing in a Fund designed to track the Index, that $10,000 hypothetical investment would be worth $82,301.
The Fund has retained value in difficult times…
We believe it is equally important to examine the Fund’s performance during more challenging economic times. The nine-year period from the Internet Bubble collapse through the Financial Panic (12/31/1999– 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. The Fund preserved (and slightly grew) capital during this difficult economic time because its investments in high-quality growth businesses were able to weather the environment and enhance their competitive positioning.
The strong relative returns during difficult times are what we believe sets the Fund apart and makes its returns over an entire cycle exceptional. A $10,000 hypothetical investment at the start of the cycle on December 31, 1999 would have been worth $184,651 on September 30, 2021. That same $10,000 hypothetical investment would be worth 71% less had it been invested in a fund designed to track the Russell Midcap Growth Index. That investment would be worth only $53,394.
During periods of strong economic expansion, investors often disregard 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 modestly grow capital during those tough times. We believe the high-quality growth portfolio should be able to perform well again in future difficult economic stretches, although there is no guarantee that will be the case.
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 committed 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.
Ronald Baron, CEO and Lead Portfolio Manager
Michael Baron, 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.