Ron Baron's Baron Partners Fund 3rd-Quarter Shareholder Letter

Discussion of markets and holdings

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Nov 11, 2019
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Baron Partners Fund (the “Fund”) fell in value by 1.66% (Institutional Shares) in the three months ended September 30, 2019. The Fund trailed the Russell Midcap Growth Index (the “Index”) which fell 0.67%. The Fund’s results surpassed the Morningstar US Fund Mid-Cap Growth Category average, which declined 1.80%. The S&P 500 Index gained 1.70% in the quarter.

Less robust economic growth amid a trade war with China caused investors to become more defensive in the September quarter. During the period, investors favored businesses with assets and consistent earning streams instead of rapid growth. This environment enabled us to purchase and increase holdings of high-quality growth businesses at attractive prices. However, the rotation into defensive and yield-oriented sectors caused the Fund to trail its benchmark in the quarter.

The Fund’s returns since the start of the year have been strong on an absolute basis. The Fund gained 23.48% in the first nine months of 2019. The Russell Midcap Growth Index increased 25.23%. Year-to-date, the Fund exceeded the returns of the S&P 500 Index and the Morningstar US Fund Mid-Cap Growth Category average, which increased 20.55% and 22.76%, respectively.

As discussed in prior quarterly letters, the Fund has tended to keep up in extremely strong markets, as has been the case so far in 2019. The Fund historically has more often significantly outperformed during challenging times. As Table II indicates, the Fund’s returns marginally trailed the Index from the trough of the 2007-08 Financial Panic to the present. Baron Partners Fund achieved exceptionally strong annualized returns of 16.10% from December 31, 2008 through the present, while the Index gained 16.41%. But in the more difficult period from December 31, 1999 before the Internet Bubble burst until the Financial Panic ended in December 2008, the Index lost 4.69% per year. Baron Partners Fund, in comparison, had annualized gains of 1.54%.

Further, the Fund’s relative performance has exceeded the Index over the last 3-year, 5-year, 10-year, and since inception periods.

Despite the concentrated nature of Baron Partners Fund, where the top 10 positions represent nearly 98% of net assets, the portfolio is diversified among holdings that react differently in varied market environments. We categorize our holdings into one of four segments – Financials, Real/Irreplaceable Assets, Disruptive Growth, and Core Growth. Please see Table III.

While we do not attempt to predict changes in investor sentiment, it is not surprising that various investments performed differently as investors became more fearful. Financials businesses and businesses owning Real/ Irreplaceable Assets represent 29.0% and 32.5% of net assets, respectively. The stock prices for these groups were little changed in the period and outperformed. However, faster growing and more expensive Disruptive Growth and Core Growth businesses, representing 51.0% and 17.4% of net assets, respectively, lagged the Index.

The Fund’s Financials businesses returned 0.90% this past quarter. Their returns would have been considerably greater had they not been penalized by our long-term investment in FactSet Research Systems, Inc. FactSet’s business, in many respects, borders on disruptive for the financial services industry. Arch Capital Group Ltd. was the standout performer in the period, increasing in value by 13.2%. The company benefited from improving market conditions in property and casualty insurance when competitors underestimated losses, de-risked, and reduced underwriting capacity. Arch is in a good position to capitalize on competitors’ problems. It has selectively increased its underwritings while also increasing its prices. Additionally, its well-timed acquisition of a mortgage insurance business in 2016 has proven beneficial. Increased home buying coupled with good credit is driving results in that division. Our Arch investment is a good example of a high-quality growth business expanding in a difficult environment for others. FactSet, however, had an opportunity for future growth and reinvested earnings to offer data on privately owned companies more robustly. The company announced plans to broaden its data set on privately owned businesses to reach a broader swath of financial clients. As is often the case for companies that penalize short-term earnings to grow faster, some investors reacted negatively and FactSet’s stock declined. In this instance, FactSet’s stock traded similarly to disruptive technology businesses. We believe its moderate near-term profitability hiccup should be offset by higher future earnings and sustained growth.

Businesses with Real/Irreplaceable Assets had little change in their stock prices in the period. The group declined 0.35%. Within this group, investors favored companies with slower but more consistent growth. Companies with prime real estate, such as Douglas Emmett, Inc., the largest owner of the most attractive office space in Los Angeles, and Marriot Vacations Worldwide Corp., an important timeshare resort developer, increased in value. Douglas Emmett has maintained high occupancy while increasing lease rates. It has also made strategic acquisitions that we feel will boost its growth trajectory. However, companies that were going through an investment period to enhance their product, like Hyatt Hotels Corp. remodeling various properties, or soccer team Manchester United plc acquiring players to improve on-field success, saw their stocks decline slightly.

Disruptive Growth saw the biggest divergence of companies’ stock prices that were performing well compared to those that faltered. The market continued to reward growth and penalized those businesses that had any slowdown in profitability. Tesla, Inc., the electric vehicle manufacturer, and CoStar Group, Inc., the software provider of data for real estate businesses, saw their stock prices appreciate. Demand for Tesla’s Model 3 continues to increase while the company is improving its manufacturing efficiencies. This should lead to higher profit margins. Tesla is also accelerating plans to complete its new factory in China where demand has been strong. Tesla’s local manufacturing should significantly improve its ability to lower its production costs of cars sold in that market. Tesla could soon begin construction of a similar manufacturing facility in Europe, which should achieve similar benefits in cars sold there.

Zillow Group, Inc., a business offering data services for real estate purchasing, and Spotify Technology S.A., a company offering subscriptions for streaming on-demand audio, both fell. Zillow declined when it announced its decision to expand newer service offerings for real estate agents. The investment in the rollout of these business lines will impact near-term profitability, but should materially improve the long-term opportunity for Zillow’s business. Spotify is growing its subscribers rapidly, but investors are concerned about its ability to continue to increase new users in a more competitive distribution environment.

Companies that we categorize as Core Growth fell the most in the period. Gartner, Inc. and HEICO Corporation, despite their ability to grow their top and bottom lines, were impacted by investor rotation to value-oriented companies. Gartner, the provider of syndicated research, had a slight reduction in top-line growth as it discontinued non-core products. HEICO, a manufacturer of alternative replacement parts for the aerospace industry, continued to show considerable organic growth, profitability improvements, and the ability to acquire niche products. However, analysts have downgraded the business based on its premium valuation (we think such valuation is deserved). This company’s recent stock price movement is a good example of how shifts in sentiment can cause a stock price to diverge from the company’s fundamentals.

While not all categories will outperform in any quarter, we believe each grouping of companies should perform better than the Index over the long term. We feel this segment diversification provides risk protection for the Fund.

Arch Capital Group Ltd. is a specialty insurance and reinsurance company based in Bermuda. Shares appreciated due to improving market conditions for commercial insurance and continued strength in mortgage insurance. Management is taking advantage of higher rates by selectively writing more business. The company reported strong earnings while book value per share increased, up 19%.

Shares of CoStar Group, Inc., a real estate information and marketing services company, contributed to performance. Business trends are excellent, with the company’s bookings improving by approximately 31% year-over-year in its most recently reported quarter to a record $59 million. We see a path for quarterly bookings to improve toward $70 million, driving revenue acceleration toward 20%. The company now has over $1.3 billion of cash, which we expect to be used for opportunistic acquisitions, which should expand CoStar’s addressable market.

Shares of Tesla, Inc., which designs, manufactures, and sells fully electric vehicles, solar products, and energy storage solutions, contributed to performance. Tesla’s stock stabilized as investors build conviction around Model 3 demand trends and expanding margins. Tesla’s China factory is ahead of schedule, and investors anticipate the Model Y will positively impact the company’s P&L. We continue to expect significant value creation for Tesla’s stakeholders.

Marriott Vacations Worldwide Corp. increased in the quarter after competitor Hilton Grand Vacations indicated it was considering the possible sale of its business to private equity, which helped boost multiples and share prices across the category. An acceleration of the company’s Starwood timeshare sales as a result of new sales channels and promising initial results from its digital marketing channels also helped boost its share price. The company accelerated its buybacks in the quarter.

Shares of The Charles Schwab Corp., a brokerage platform, rebounded in the third quarter to contribute to performance. Investors have paid close attention to interest rate changes and their impact on the company’s net interest margin. Schwab faced fee pressure on its trading business and investors have speculated on price moves, and the stock has been volatile throughout the year. We remain focused on the business fundamentals and are encouraged that the company continues to attract assets and broaden its services while expanding margins.

Zillow Group, Inc. operates leading U.S. real estate sites, a mortgage marketplace, and the Zillow Offers home-buying business. Shares declined on lowered revenue and profitability guidance for the second half of 2019, driven by Zillow’s expanded testing of success-based “Flex” pricing in select Premier Agent markets and hiring delays in the Mortgages business. We added to our Zillow investment.

Shares of FactSet Research Systems, Inc., a leading provider of investment management tools, detracted during the quarter after the company reported weak guidance for fiscal year 2020 and announced a new three-year investment plan to accelerate revenue growth. This means margins will not increase for two years, so its price fell. We retain conviction in FactSet due to its large addressable market, its consistent execution on both new product development and financial results, and its robust free cash flow generation.

Shares of Gartner, Inc., a provider of syndicated research, detracted from performance after it reduced its full-year guidance. Although forwardlooking metrics in Gartner’s traditional IT research business decelerated modestly, they remain at a robust low-teens rate. The company also discontinued several non-subscription products that are not core to its longterm strategy, but which will hurt profitability this year. Finally, the company was more successful than expected in filling sales positions, which will reduce earnings this year, but drive faster revenue growth in 2020.

Spotify Technology S.A. is a global digital music service offering on-demand audio streaming via paid premium subscriptions and a free ad-supported model. Its shares detracted from performance this quarter due to a mixed gross margin outlook, but we see potential for near-term margin upside given the company’s two-sided marketplace strategy. Over the long term, we view Spotify as a winner in the music streaming space. The company has the potential to gain over 100 million subscribers in the next five years due to its scalable and sticky core product and its growing library of podcasts.

INVESTMENT STRATEGY AND PORTFOLIO STRUCTURE

The objective of Baron Partners 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 businesses at attractive prices across market capitalizations. We attempt to create a portfolio of less than 30 securities diversified by GICS sectors. The Fund uses leverage to enhance returns, although this may increase the volatility of returns. Portfolio businesses are identified by our firm’s proprietary research. We think these well-managed businesses have sustainable competitive advantages and strong, long-term growth opportunities.

As of September 30, 2019, Baron Partners Fund held 30 investments. The weighted median market capitalization of these growth companies was $9.2 billion. The top 10 positions represented 97.9% of net assets. Leverage was 29.9%.

The long-term absolute and relative performance of the Fund has been very good. The Fund has returned 12.85% annualized since inception, and has beaten its primary index, the Russell Midcap Growth Index, by 3.02% per year annualized. Absolute annualized returns over the past three years have surpassed this historical average. The Fund’s three-year annualized returns were 16.98%, beating the benchmark by 2.48% per year annualized.

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 continuing to provide you with the information we would like to have if our roles were reversed. This is so you will be able to make an informed decision about whether this Fund remains an appropriate investment for you and your family.

Respectfully,

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.