Dear Baron Partners Fund Shareholder:
Performance
The second quarter of 2022 was extremely difficult for financial markets. Baron Partners Fund (the “Fund”) declined 30.55% (Institutional Shares) in the period. The Russell Midcap Growth Index (the “Index”) and the Morningstar Large Growth Category Average (the “Peer Group”) declined 21.07% and 20.82%, respectively. The S&P 500 Index declined 16.10%.*
Declines accelerated from an already challenging start to the year. The Fund has fallen 34.60% year-to-date. This result is a little worse than the Index’s and Peer Group’s declines of 31.00% and 29.12%, respectively. The S&P 500 Index is lower by 19.96% over the first six months of 2022. The S&P 500 Index performance was helped by energy stocks. Baron Partners Fund has no energy or commodity investments.
Nevertheless, the Fund’s absolute and relative performance over a longer term remains quite good. Over the prior 1-, 3-, 5-, 10-year, and since inception periods, the Fund’s performance has meaningfully exceeded the Index’s returns. The Fund’s 3-, 5-, and 10-year annualized returns were 35.46%, 25.75%, and 22.11%, respectively. These results were meaningfully better than the Index’s returns of 4.25%, 8.88%, and 11.50%, respectively. Please see Table I for a full list of performance figures for the Fund and benchmarks over various time periods.
Since the Fund’s inception, its performance has been industry leading. For over 19 years, since Baron Partners Fund converted from a partnership into a mutual fund in 2003, it has an annualized return of 16.93%. Since conversion it is ranked number one among all U.S. equity funds (2,160 share classes) through June 30, 2022.*
Negative issues that began to present themselves towards the end of 2021 have, in many cases, become more pronounced. Inflation has continued to rise. The Fed has continued to tighten. Energy prices are elevated and act as a penalizing tax for consumers. Supply-chain disruptions remain a concern. And the war in Ukraine drags on without a diplomatic solution in sight. All these factors have pressured financial valuations. The S&P 500 Index had its worst start to a year since 1970. Particularly impacted have been growth businesses because of increased funding costs and greater discounts on future potential earnings. It’s a scenario that significantly impacts a concentrated and modestly levered growth equity portfolio like Baron Partners Fund.
However, these issues should not be viewed in isolation. They are all (except for Russia’s invasion of Ukraine) the result of the actions taken to navigate the economy through the COVID pandemic. The markets peaked on February 19, 2020. Panic soon gripped the economy and our society. Volatility has been rampant over the nearly two and half years since. On two separate occasions, most financial markets experienced declines of over a third. But throughout this challenging cycle, the Fund has performed well. Had you purchased the Fund at the market peak in 2020 (the worst possible time) and held through the end of the recent quarter end, your cumulative return would be 64.03%. Had you invested in a fund designed to track the Index, your cumulative return would be -1.41%.
We believe a focused portfolio of well-managed, competitively advantaged growth businesses can outperform over the long term and over the course of various market cycles. This has been achieved by the Fund since its inception. We do not try to mimic the Index, nor do we alter the strategy to coincide with short-term macro and unpredictable events. We remain focused on underlying business fundamentals. This approach may sometimes be out of favor. The Fund’s sector exposures compared to the Index has contributed to most of the underperformance this year-to-date. In fact, our returns in five out of the seven GICS sectors in which the Fund invests have exceeded the benchmark’s. However, the four sectors the Fund hasavoided (Energy, Consumer Staples, Utilities, and Materials) are the top performing sectors over the last six months. Energy and Consumer Staples were especially strong, increasing 31.3% and declining only 7.0%, respectively, during the first half of the year. While the near-term high inflationary environment undoubtedly helped stocks in these sectors, we continue to believe such commoditized businesses (along with the negative environmental impacts caused by most energy companies) make these sectors unattractive for growth investors over a long-term horizon.
We attempt to reduce risk in our concentrated portfolio by investing in businesses impacted by different factors. We segment the Fund’s portfolio into four categories: Disruptive Growth, Financials, Real/Irreplaceable Assets, and Core Growth. Below we describe how each has performed inthe current environment.
Our Financials and Real/Irreplaceable Assets have been able to weather global issues better than other businesses. The return for these groups has exceeded the Index’s. Higher interest rates and firming insurance prices assisted financials holdings. Leisure businesses benefit from inflation, which has allowed these businesses to increase prices to eager travel customers. Further, higher borrowing costs lowers the risk of new development harming established properties in our Real/Irreplaceable Asset category businesses.
However, several of our investments in Disruptive Growth and Core Growth businesses, we believe, have been unfairly characterized (and penalized) as beneficiaries of a COVID economy. Others have theorized that these businesses will not be able to sustain growth in a post-pandemic economy. We disagree. Shopify Inc. enables a brand’s e-commerce but has declined 77% this year. While the pandemic accelerated customer growth (gross merchandise value grew 96% and 47% in 2020 and 2021, respectively), client retention has been sustained in 2022. These clients are now migrating into additional services resulting in a higher take-rate and stickier long-term relationships. Spotify Technology S.A. declined 60% in the first half of the year. The audio streaming service gathered subscribers over the prior two years at a very strong rate. Monthly average users rose 27% and 21% in 2020 and 2021, respectively. While this user growth has moderated to a more normalized figure, the company is also having more success in retaining users. It has reinvested back into its platform to improve the listener’s experience and increase use cases. As a result, Spotify users spend 60% more time on its service than with competitors. IDEXX Laboratories, Inc., the leading provider of diagnostics to the veterinary industry, declined47% since the start of the year. The pet care industry has seen a decline in veterinary visits following tough comparables stemming from an increase in pet adoption during the pandemic. Additionally, tight labor markets and COVID flareups resulted in clinics being less than fully utilized. However, most important for the long-term success of the business are the company’s instrument installments. Instrument placements grew 31% in the recent quarter leading to a 14% increase in the installed base. These purchases come with six-year contracts and the potential for increasing test usage. With test utilization occurring at only about a quarter of visits, we expect this figure to increase with the higher installed base. Finally, Tesla, Inc., the electric car manufacturer and the Fund’s largest holding, has declined 36% since the end of 2021. Some fear that the unit growth and margin expansion are not sustainable. The theory is that a shortfall in industry production and higher demand during the pandemic will reverse. Tesla’s deliveries grew 36% and 87% in 2020 and 2021, respectively. Automotive gross margins (excluding credit) were 21.0% in 2020 and 27.0% in 2021. But Tesla has continued to advance in 2022. In its most recently reported quarter, the company grew production 27% despite a prolonged COVID-related shutdown at its most advanced facility in China. Upon reopening that factory, June 2022 was the highest vehicle production month in the Tesla’s history. More remodels at its Shanghai and Berlin factories could increase Tesla’s production capacity by nearly 50%. And production efficiencies, scale, and battery advances (excluding near-term material cost pressures) should result in lower manufacturing costs over the coming years. We remain pleased with the company’s progress.
While valuations have declined because of a host of macro factors, we believe that the controllable fundamentals for the companies held in the Fund are strong. Leading indicators imply future expansion to top line revenue and earnings. Even if multiples stay compressed, we are optimistic that the Fund will perform especially well from these levels.
Space Exploration Technologies Corp. (SpaceX) is a high-profile privatecompany founded by Elon Musk that designs, manufactures, and launches rockets, satellites, and spacecrafts. Its long-term goal is to enable human beings to inhabit Mars. We believe SpaceX is creating substantial value through the expansion of its Starlink broadband service. It also reliably provides reusable launch capabilities, including crewed space flights, and is making progress on its largest rocket, Starship. We value SpaceX using prices of recent financing transactions and a proprietary valuation model.
Gaming and Leisure Properties, Inc. (GLPI, Financial), a gaming REIT that owns the realestate of many casino operators, contributed to performance on the strength of its well-covered dividend yield and prospects for growth even in a recessionary economy. Its tenants remain solvent and flush with cash, which suggests that rent payments should remain steady regardless of the economic environment. A strong balance sheet allows for additional acquisitions, which should be accretive to the dividend and enhance shareholder returns.
Tesla, Inc. (TSLA, Financial) makes fully electric vehicles, related software offerings, solar andenergy storage products, and battery cells. With the three-week shutdown of its factory in China, ongoing supply-chain disruption, and slowed manufacturing volume in its recently launched production facilities, shares fell during the quarter. We believe current production limitations will be resolved, allowing the company to execute its ambitious long-term goals across electrification and software initiatives.
Shares of veterinary diagnostics leader IDEXX Laboratories, Inc. (IDXX, Financial) fell in the quarter. The broader veterinary industry was a pandemic beneficiary as pet adoptions surged and owners working from home were more attentive to pet illness. While 2022 results are being adversely impacted by difficult comparisons, we believe the pandemic has accelerated long-term secular trends around pet ownership and pet care. IDEXX’s competitive trends are outstanding, and we expect new proprietary innovations and field sales force expansion to be meaningful contributors to growth.
Shares of global hotelier Hyatt Hotels Corp. (H, Financial) declined in the quarter on investor concerns that a possible recession will result in growth rates that would slow or even turn negative. We maintain conviction. The company has seen no slowdown in occupancy levels or rates and continues to demonstrate the ability to increase prices, especially on the leisure side. While leisure may be experiencing peak demand levels, management believes any slowdown in growth should be offset by the continued recovery on the group and business side as pacing returns to pre-pandemic levels.
Spotify Technology S.A. (SPOT, Financial) is a leading digital music service available in 178markets, offering on-demand audio streaming through paid premium subscriptions as well as an ad-supported model. Disappointing gross margin disclosure resulting from its investments in podcasts pressured shares. Subsequently, on its analyst day, Spotify provided better disclosure that highlighted the improving profitability of the company’s music business. We continue to view Spotify as a long-term winner in music streaming with potential to reach more than one billion monthly active users.
Shares of online brokerage firm The Charles Schwab Corp. (SCHW, Financial) detracted in the quarter over concerns that clients will shift assets to less profitable money market funds and declining equity markets will pressure the asset management business. We retain conviction. Despite turbulent markets, Schwab attracted over $120 billion of net new client assets in the recent quarter. Rising interest rates should lead to increased profits on the company’s nearly $600 billion of interest earning assets as well.
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 durable competitive advantages and strong, long-term growth opportunities. We use moderate leverage to enhance returns, which increases the Fund’s volatility.
As of June 30, 2022, Baron Partners Fund held 31 investments. The median market capitalization of these growth companies was $14.6 billion. The top 10 positions represented 98.9% of net assets. Leverage was 16.8%.
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 22.3%). 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 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 15.08% annualized since inception as a private partnership on January 31, 1992, beating its benchmark Index by 5.70% 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 economic cycles.
The Fund has appreciated considerably in good times (Table VI)…
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 – 12/31/1999) and the more recent 11-year period Post-Great Recession to the start of the COVID Pandemic (12/31/2008 – 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 strong economic period was 17.44% compared to the Index’s 16.84%.
The Fund has retained value in challenging times (Table VII)…
We believe what sets the Fund apart from other growth funds is its historic ability to perform in more challenging economic periods. The nine-year period from the Internet Bubble collapse through the Great Recession (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.
Today’s environment is also challenging. The COVID-19 pandemic and its lingering macroeconomic issues have caused great volatility. In such a short period of time, there were two sizable market corrections each with an approximate 35% decline in the Index. But so far, the Fund has performed admirably in both protecting and growing clients’ investments. Since the start of the COVID Pandemic through this quarter (12/31/2019 – 6/30/2022), the Fund has an annualized return of 35.74%. The Index has an annualized return of 2.15%. We do not know how long this challenging period will persist, but we are off to a good start.
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 modestly 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.
A $10,000 hypothetical investment at the inception of the Fund on January 31, 1992, would have been worth $717,253 on June 30, 2022. If invested in a fund designed to track the Index, that same $10,000 hypothetical investment would now be worth $152,759, only about 21% 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 Baron, Co-Portfolio Manager
1 Reflects the actual fees and expenses that were charged when the Fund was a partnership. The predecessor partnership charged a 20% performance fee after reaching a certain performance benchmark. If the annual returns for the Fund did not reflect the performance fees the returns would be higher. The Fund’s shareholders will not be charged a performance fee. The predecessor partnership’s performance is only for periods before the Fund’s registration statement was effective, which was April 30, 2003. During those periods, the predecessor partnership was not registered under the Investment Company Act of 1940 and was not subject to its requirements or the requirements of the Internal Revenue Code relating to registered investment companies, which, if it were, might have adversely affected its performance.
2 The Russell Midcap® Growth Index measures the performance of medium-sized U.S. companies that are classified as growth and the S&P 500 Index of 500 widely held large cap U.S. companies. 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 indexes and the Fund include reinvestment of dividends, net of withholding taxes, which positively impact the performance results. The indexes are unmanaged. Index performance is not Fund performance; one cannot invest directly into an index.
3The 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.
4 Performance for the Institutional Shares prior to May 29, 2009 is based on the performance of the Retail Shares, which have a distribution fee. TheInstitutional 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.
5 Not annualized.
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.
