Baron Asset Fund 4th Quarter Shareholder Letter

Dear Baron Asset Fund Shareholder:

Performance

During the quarter ended December 31, 2016, equity markets were meaningfully impacted by the unexpected outcome of the U.S. presidential election. The Russell Midcap Growth Index (the “Index”) fell by 3.36% during the period before the election results were known (“Pre-election”). The Index then rose 3.95% after the results (“Post-election”). Investors were presumably optimistic that the likely policies of a Trump administration would lead to increased infrastructure spending, higher inflation, higher interest rates, lower corporate taxes, and ultimately accelerated economic growth.

During the entire quarter, Baron Asset Fund (the “Fund”) Retail Shares gained 0.01% and its Institutional Shares gained 0.06%. The Index gained 0.46% and the S&P 500 Index gained 3.82%. The Fund’s performance differed meaningfully during the quarter. Pre-election, the Fund outperformed in the declining equity market. Its Retail Shares fell 2.41% and its Institutional Shares fell 2.39%; the Index fell 3.36%, and the S&P 500 Index fell 1.10%. Post-election, the Fund underperformed the rapidly rising equity market. Its Retail Shares gained 2.48% and its Institutional Shares gained 2.51%; the Index gained 3.95%, and the S&P 500 Index gained 4.98%.

Different sectors drove the performance of both the Fund and the Index during these two periods. The outcome of the election had the most pronounced impact on three sectors in the Index: Financials went from –3.07% to +13.33% in response to the prospect of higher interest rates and reduced regulatory oversight; Energy went from –12.95% to +12.84% in response to higher spot market prices and the prospect of a friendlier regulatory regime; and Industrials went from –2.28% to +7.13% in response to a potential increase in government infrastructure spending and strengthening demand among energy customers.

As discussed below, the investments that had the most significant positive impact on performance against this backdrop were investments in the Financials sector: brokerage firm The Charles Schwab Corp., insurer Arch Capital Group Ltd., and First Republic Bank. Gartner, Inc., an Information Technology (IT, Financial) research firm, rose on continued good earnings results. Several of the Fund’s Consumer Discretionary investments also rose after each reported improved business trends. These included Choice Hotels International, Inc., Vail Resorts, Inc., and CarMax, Inc. Two Health Care investments that had limited exposure to the potential repeal of the Affordable Care Act prospered–drug packaging firm West Pharmaceutical Services, Inc. and veterinary diagnostic firm IDEXX Laboratories, Inc.

The worst performers were largely stocks in the IT, Health Care, and Industrial sectors that reported disappointing quarterly earnings. These included Illumina, Inc., FleetCor Technologies, Inc., and Guidewire Software, Inc. The Fund also faced a headwind from its modest weighting in the Energy sector and its limited exposure to Industrial sector companies with large energy-related businesses.

Shares of Gartner, Inc. (IT, Financial), the leading provider of syndicated information technology research, contributed positively to performance. We believe that Gartner’s key forward-looking metrics continue to point toward improving business trends. We expect the company to experience continued revenue acceleration because of easing annual comparisons, improved sales force productivity, and sales tactics that continue to be fine-tuned to match current macroeconomic conditions. The company generates significant free cash flow and it has relatively little balance sheet leverage. As a result, we expect it will begin to deploy its capital more aggressively, either towards share repurchases or an acquisition.

Shares of The Charles Schwab Corp. (SCHW, Financial), the well-known brokerage firm, increased sharply in the aftermath of the presidential election. Interest rates and equity markets both spiked in anticipation of the likely impact of the Trump presidency on financial markets. Both these factors should be positive for Schwab’s earnings over the near term. In addition, the company continued to grow the assets it oversees at a healthy pace.

Shares of Arch Capital Group Ltd. (ACGL, Financial), the Bermuda-based specialty insurance and reinsurance company, gained on good financial results, which included profitable underwriting, modest catastrophe losses, and favorable reserve development. Arch Capital also benefited from increasing optimism toward its acquisition of United Guaranty from American International Group, Inc. The transaction makes Arch the largest provider of mortgage insurance, a market that we believe has attractive profitability and growth prospects. We continue to be impressed by the company’s strong management team and its consistent underwriting discipline.

Shares of West Pharmaceutical Services, Inc. (WST, Financial), a manufacturer of packaging components and delivery devices for injectable drugs, gained after reporting impressive quarterly financial results. Management provided solid guidance for 2017 and reaffirmed its goals for strong growth through 2020. We continue to believe that West can double its earnings over the next five years, driven by sales of higher margin packaging components and proprietary products to the pharmaceutical and biotechnology industries.

First Republic Bank (FRC, Financial) provides banking and wealth management services to affluent clients in select metropolitan areas of the U.S. Its shares rose, as it participated in the post-election rally for financial stocks. We think the bank’s earnings should benefit from the expected increase in economic growth, along with higher interest rates and inflation. In addition, First Republic reported good financial results during the quarter, with 18% loan growth and 24% deposit growth. We believe the bank has a long runway for growth, as it expands its differentiated business model into additional geographies.

Table III.

Top detractors from performance for the quarter ended December 31, 2016

Shares of Illumina, Inc. (ILMN, Financial), the leading provider of DNA sequencing technology to academic and commercial laboratories, fell after reporting disappointing financial results. The quarterly shortfall was driven by weak sales of its high-throughput instruments. We reduced the size of our position but continue to own the stock because we believe Illumina has a long runway for growth driven by increasing adoption of DNA sequencing in clinical markets such as cancer screening, diagnosis, and treatment. We are encouraged that the shares have had a meaningful recovery in early January, as the company provided encouraging earnings guidance for 2017 and launched a powerful, new DNA sequencing platform.

Shares of FleetCor Technologies, Inc. (FLT, Financial), a global payment processing firm serving the fuel card market, fell following disappointing quarterly results and a modest reduction in its full-year revenue guidance. Investors had expected an acceleration of organic growth during the second half of 2016, but instead it modestly decelerated. Investor sentiment was also tarnished by a large contract loss and intensifying foreign exchange market headwinds into year end. We expect these headwinds to abate and strong earnings growth to persist.

Shares of property and casualty (P&C) insurance software vendor Guidewire Software, Inc. (GWRE, Financial) fell, as the company was forced to delay revenue recognition on a large new deal. Guidewire is the leading P&C core systems vendor, with near-perfect retention rates, a growing installed user base, and accelerating customer adoption. The company is early in its core system replacement cycle, and it has tripled its addressable market through new products and cloud-based delivery. We believe Accenture’s new relationship with Guidewire will help to enhance its pricing and win rates, while also shortening its sales cycle. We believe the recent drop in the stock was not warranted, given the company’s meaningful long-term growth trajectory.

Shares of global information and measurement company Nielsen Holdings plc (NLSN, Financial) fell on disappointing financial results and guidance. End-market conditions for its large consumer packaged goods clients slowed, leading to tighter budgets. Nielsen management is divesting non-core products and restructuring the remainder of its portfolio to be more data and software platform-oriented, rather than project consulting-oriented. Although this strategy will create near-term headwinds to growth, we expect it to be ultimately accretive to Nielsen’s margins and multiple.

Shares of U.S. and Latin American wireless tower owner SBA Communications Corp. (SBAC, Financial) fell on concerns that the upcoming Trump-appointed FCC and Justice Department will encourage consolidation among SBA’s U.S. customer base. We believe this risk is likely misunderstood, as U.S. carriers have strengthened over the past few years, making carrier consolidation a less attractive alternative. Further, we believe that SBA will continue to benefit from significant equipment additions and share repurchases, in the event that additional acquisition opportunities do not present themselves.

Portfolio Structure

At December 31, 2016, Baron Asset Fund held 55 positions. The Fund’s 10 largest holdings represented 43.1% of assets, and the 20 largest represented 64.5% of assets. The Fund’s largest weighting was in the Information Technology (IT, Financial) sector at 22.6% of assets. This sector includes software companies, IT consulting firms, and data processing firms. The Fund held 22.0% of its assets in the Health Care sector, which includes investments in life sciences companies, health care equipment and supplies companies, and health care technology companies. The Fund held 17.9% of its assets in the Financials sector, which includes investments in insurance companies, investment brokers and financial exchanges. The Fund also had significant weightings in Industrials at 14.6% of assets and Consumer Discretionary at 13.5% of assets.

Recent Activity

During the past quarter, the Fund established two new positions and added to five others. The Fund also sold two positions and reduced its holdings in 13 others.

Headquartered in Milwaukee, where it was founded over 140 years ago, A.O. Smith Corporation (AOS, Financial) is a leading manufacturer of residential and commercial water heaters, boilers, and water treatment products. The company derives about 60% of its sales from water heaters in North America. This is an attractive market, with only three major players that have demonstrated a history of rational pricing policies. A.O. Smith is the largest participant with more than a 40% share in residential heaters and a 55% share in commercial heaters. Few homeowners or businesses consider hot water to be a discretionary item; generally a heater is replaced as soon as it breaks, and price is often a secondary consideration. As a result, the bulk of the company’s heater sales are comprised of steady replacement revenue (85% to 90% of residential sales). Additional growth comes from new housing starts, commercial construction, and customers’ desire for new products with increased energy efficiency.

An additional 10% of A.O. Smith’s sales come from its North American boiler business, Lochinvar, which is expected to grow 8% per year, driven by the increased adoption of more energy efficient products. The remaining 30% of A.O. Smith’s sales come from China, where the company has established a dominant presence over the past 20 years. Sales in China are anticipated to grow 15% per year, anchored by its 26% market share in the Chinese water heater market. In China, water heaters are a considered a consumer appliance and A.O. Smith has built a premium brand, along with impressive distribution and manufacturing capabilities. The company is also entering nascent, faster growing product categories such as water treatment and air purification to expand its growth there.

The company expects to achieve 8% top-line growth over the next several years. We believe that earnings growth should be faster, as a result of margin expansion from price increases, operating leverage, and the accretive use of its substantial free cash flow.

After the company reached an all-time high (resulting in an approximate six-fold return on our initial investment 10 years ago), we trimmed our position in veterinary diagnostic company IDEXX Laboratories, Inc. The company remains one of our largest investments. We reduced our investment in DNA sequencing firm Illumina, Inc. after the company reported a shortfall in its business. We continued to reduce our investment in contract research organization and health care data firm Quintiles IMS Holdings, Inc. on concerns about the wisdom of its recent merger. We reduced our position in FleetCor Technologies, Inc. on caution surrounding its slowing growth rate. We further reduced our holdings of SS&C Technologies Holdings, Inc. on concerns about negative business trends impacting its hedge fund clients.

Outlook

We are optimistic that the economic policies of the incoming presidential administration will continue to provide a beneficial backdrop for equities. The administration’s likely focus on lower corporate tax rates, increased infrastructure spending, and reduced regulatory burdens will hopefully lead to accelerated corporate earnings growth. We are encouraged that equity markets have moved up in tandem with interest rates since the election. We believe this should quell what has perhaps been investors’ greatest recent concern – that higher rates would inevitably lead to lower equity prices. In addition, employment and housing trends improved throughout 2016, and there are signs that the industrial economy is now following suit. We think that our portfolio of what we believe are well-managed, competitively advantaged, fast growing companies will continue to perform well in this environment, although we cannot guarantee that they will.

Furthermore, we continue to believe that high quality, mid-sized growth stocks represent a compelling long-term investment opportunity. During the past 30 years, mid-cap growth stocks, as a category, have outperformed small-cap and large-cap growth stocks. However, mid-caps have underperformed these asset classes during the past five years. We are hopeful that this trend will reverse, presenting an attractive opportunity for the mid-cap growth asset class in the future.

Thank you for investing in Baron Asset Fund.

Our entire Firm and our research department, in particular, are committed to justifying your ongoing confidence and support. I remain a significant investor in the Fund alongside you.

Sincerely,

Andrew Peck

Portfolio Manager