DEAR BARON FOCUSED GROWTH FUND SHAREHOLDER:
Performance
Baron Focused Growth Fund (the “Fund”) increased 10.83% (Institutional Shares) in the fourth quarter, marking a strong end to 2021 for the Fund. For the year, the Fund increased 19.16%. This compares to the Russell 2500 Growth Index (the “Index”), the benchmark against which we compare the performance of the Fund, which increased just 0.20% for the fourth quarter and increased 5.04% for the year. The S&P 500 Index, which measures the performance of large-cap companies increased 11.03% in the fourth quarter and increased 28.71% for the year. The Fund has continued to outperform its benchmarks for the 3-, 5-, and 10-year periods. Since its inception as a private partnership on May 31, 1996, the Fund has increased 14.85% annualized. This compares favorably to the Index, which has increased 9.25% annualized, and the S&P 500 Index, which has increased 10.02% annualized.
Fourth quarter performance for the Fund continued to be led by companies that are currently experiencing accelerating revenue growth such as Tesla, Inc. and FactSet Research Systems, Inc. as well as those companiesthat are benefiting most from inflation and pricing power such as Arch Capital Group Ltd., Hyatt Hotels Corp., and Choice Hotels International, Inc.
Tesla (TSLA, Financial) increased 35.7% in the quarter as its electric car deliveries and production accelerated sharply. This was despite supply-chain issues principally for computer chips and battery cells. The company overcame those issues due to its own battery cell manufacturing facility, its ability to redesign computer chip software, and its success with a more vertically integrated supply chain than competitors. Tesla’s share price increase boosted the Fund’s performance by 1,065 basis points in the quarter. Tesla is the Fund’s largest holding and at quarter end represented over a quarter of net assets. We believe Tesla sales could increase substantially when additional production capacity is added this year in Berlin, Germany and Austin, Texas. Demand for Tesla cars remains extremely strong.
FactSet (FDS, Financial) increased 23.2% in the quarter and helped performance in the period by 89 basis points. FactSet’s revenue growth accelerated due to the introduction of new tools, which the company has begun to sell to both new and existing clients. This has led to increased pricing power and new use cases. We expect further revenue and earnings growth in 2022 and beyond, as well as improved cash flow, which the company can use for additional acquisitions and share repurchases. FactSet’s prospects remain favorable due to its large addressable market, consistent execution on both new product development and financial results, and robust free cash flow.
Hyatt (H, Financial) increased 24.4% in the quarter and helped performance by 121 basis points. The company continued to pivot towards a more asset-light business and increased focus on leisure with the acquisition of Apple Leisure Group. Apple Leisure increases the company’s leisure exposure from 25% to 50% of its business. Together with the planned sale of $2 billion of owned real estate over the next two years, this acquisition should result in a business that is 80% fee-based and 20% owned-based. Hyatt plans to use proceeds from the sale of owned assets to pay down debt taken on to complete the acquisition. We think its pivot to an increasingly more asset-light business with an improved balance sheet and cash flow profile should result in more stable earnings that could result in multiple expansion over time.
Choice Hotels (CHH, Financial) increased 23.4% in the quarter and contributed 57 basis points to performance on a rebound in its business due to a surge in leisure travel and work-from-anywhere arrangements that allowed people to combine work and pleasure. Revenue per available room surpassed 2019 levels in the quarter, and unit growth accelerated overall and among higher revenue generating segments like its Cambria and Ascend brands, producing strong earnings and a robust balance sheet.
Arch (ACGL, Financial) increased 16.0% in the quarter and contributed 62 basis points to performance as the company continues to increase premiums written while raising prices. This is resulting in strong returns on investments with increased earnings and cash flow that the company is using to repurchase its shares. We continue to believe the company should continue to generate mid-teens returns on capital. Its valuation remains attractive as the company continues to use its excess cash flow to repurchase stock.
These portfolio gains were offset partly by declines in high-growth companies whose valuations were impacted by the anticipated rise in interest rates over the coming years. Rate increases make the present value of expected future earnings worth less. SmartRent, Inc. declined 25.5% in the quarter and hurt performance by 44 basis points; Figs, Inc. declined 25.8% in the quarter and detracted 36 basis points from performance; and Warby Parker Inc. declined 14.2% in the quarter and detracted 32 basispoints from performance. We believe these companies have strong competitive advantages with large market opportunities to disrupt incumbents. They all have well-respected management teams and should be able to grow their earnings despite higher interest rates. They are all consistently investing in their businesses no matter the market environment to enable them to grow. Therefore, we believe any decline in the multiple of stocks from rising rates may be offset by stronger earnings growth. .
In terms of our categories of investments, performance was led by our Disruptive Growth investments: rapid, early-stage growth businesses thatare disruptive to their industries. These stocks increased 18.2% in the quarter and represent 53.7% of the Fund. The strength was led by our investment in Tesla, offset somewhat by declines in our smaller fast-growing businesses including SmartRent and Figs, as mentioned above.
The Fund’s Core Growth investments, which are companies that can continue to grow revenue and earnings steadily, while returning excess cash flow to investors through dividends and share repurchases, increased 4.7% in the quarter. Those investments represent 21.2% of the Fund. This increase was led by our investments in FactSet and Arch as mentioned above, each of which represented 4.8% of the Fund at quarter end. This was offset slightly by the decline in GDS Holdings Limited, which was sold in the quarter due to uncertainty regarding Chinese regulations. Our investment in GDS penalized the Fund’s performance by 61 basis points.
Our Real/Irreplaceable Assets are those companies with assets that generally have strong pricing power and are hedges against inflation. They increased 0.3% in the quarter and represent approximately a quarter of the Fund. This increase was led by our investments in lodging companies Hyatt and Choice Hotels as noted above, as well as Red Rock Resorts, Inc., which together comprised 10.2% of the Fund at quarter end.
Red Rock, a Las Vegas “locals” casino company, increased 14.2% in the quarter and contributed 27 basis points to the Fund’s performance. Red Rock’s earnings growth across its properties remained steady in the quarter, as the company continued to achieve EBITDA significantly above pre-COVID-19 levels. The Las Vegas locals market is benefiting from new higher income customers who are staying longer and spending more. The closure of some non-gaming amenities, a reduction in the workforce, and more targeted marketing has also helped increase margins and cash flow. This, combined with completing the sale of the Palms, improved the company’s balance sheet and increased its cash flow.
This strength was offset by declines in Penn National Gaming, Inc. (PENN, Financial), a regional U.S. casino company, due to investor concerns over accelerating losses from its Barstool business. Those losses were the result of high marketing expenses and questions about business profitability. We believe this expenditure represents customer acquisition costs incurred as additional states legalize online gambling. Since it is far less expensive to retain an existing customer than to acquire new ones, we think marketing costs will decline as Penn builds its customer base. Penn’s core bricks and mortar casino business remains strong, and the company has a healthy regional casino business and a strong balance sheet to fund the digital losses.
From 2014 through 2016, the Fund invested in several companies whose stocks underperformed while they were investing in their businesses to enable them to grow. Iridium Communications Inc. (IRDM, Financial) and Tesla, Inc. (TSLA, Financial) were among those businesses. Their stocks outperformed in 2020 and 2021, as those investments began to generate strong returns. These companies continue to invest in their businesses and now that they are financially stronger, are even better able to finance investments while continuing to grow their core businesses.
We believe the Fund’s underperformance from 2014 through 2016 is analogous to instances when, after brief periods of underperformance, the Fund subsequently outperformed for an extended period. For example, in the 18-month period from October 1998 through March 2000, at the height of the Internet Bubble, the Fund, which owned no internet stocks, increased 41.77% annualized while the Index increased 126.53% annualized. This was immediately prior to the Internet Bubble bursting and the Index falling materially over the next eight years. The Fund increased in value during that same period. (Please see Tables III and IV.)
Similar to the Fund’s relatively strong performance in the post-Internet Bubble period, we expect the Fund to perform well over the next several years. This is despite our expectation that there will be periods when value stocks outperform the growth stocks in which we have invested. We can certainly give no assurance this will be the case. Currently, we believe several of our growth companies are trading as if they were value stocks. So, despite having favorable growth prospects, they have unusually strong balance sheets. Their consumer facing businesses are already recovering quickly as vaccines and boosters are administered to combat the virus.
Since its inception as a private partnership on May 31, 1996 through December 31, 2021, the Fund’s 14.85% annualized performance has exceeded that of its Index by 560 basis points per year! This means that a hypothetical $10,000 investment in Baron Focused Growth Fund over 25 years ago would now be worth approximately $345,200! If an investor had instead hypothetically invested $10,000 in a fund designed to track the Index, it would be worth approximately $96,100.
(Please see Tables I and IV.)
The Fund’s beta has averaged 0.83 since inception. This means the Fund has been 83% as volatile as the Index. As a result of the Fund’s strong absolute and relative returns and lower risk, the Fund has achieved 7.37% annual alpha, a measure of risk-adjusted performance, since inception.
We did not make much money from December 31, 1999, through December 31, 2008 (amid the highs of the Internet Bubble and the lows of the Financial Crisis). But…we did make something…which gave investors a much better outcome than if they had hypothetically invested in a passive index fund mirroring either the Index or the S&P 500 Index. Both indexes lost a material amount of money during that period. (Please see Table IV.)
Due to the power of compounding and of not losing money from the Millennium Internet Bubble to the Financial Panic period and outperforming the market during upswings from the Financial Panic to Present, $10,000 hypothetically invested in Baron Focused Growth Fund at the Fund’s inception on May 31, 1996, was worth $345,215 on December 31, 2021. That is more than three times the value of a hypothetical investment of the same amount in funds designed to track the S&P 500 and Russell 2500 Growth Indexes. (Please see Table IV.)
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 offer meaningful growth opportunities in the future.
Space Exploration Technologies Corp. (“SpaceX”) designs, manufactures,and launches rockets, satellites, and spacecrafts. Its mission, ultimately, is to enable people to live on other planets. SpaceX is commercializing its broadband offering by rapidly deploying user terminals and its satellite constellation. It continues to reliably provide reusable launch capabilities, including crewed flights, and advancing the development of its newest and larger rocket, Starship. We value SpaceX using prices of recent transactions and a proprietary valuation model.
Shares of global hotelier Hyatt Hotels Corp. increased as the company continued to pivot towards a more asset-light business and greater focus on leisure with the acquisition of Apple Leisure Group. The deal increases the company’s leisure exposure from 25% to 50% of its business. Together with the planned sale of $2 billion of owned real estate over the next two years, this acquisition should result in a business that is 80% fee-based and 20% owned-based. Hyatt plans to use proceeds from the sale of owned assets to pay down debt taken on to complete the acquisition.
Shares of FactSet Research Systems, Inc., a leading provider of investment management tools, contributed to performance. The company reported strong earnings with accelerating revenue growth and expressed confidence in its pipeline. FactSet also announced the acquisition of CUSIP Global Services, which is an accretive deal that we view as a smart use of capital. 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.
Arch Capital Group Ltd. is a specialty insurance company based inBermuda. Shares increased on earnings that exceeded analyst estimates and 13% growth in book value per share. Pricing trends remain favorable in the property & casualty insurance market, and margins for the mortgage insurance business improved substantially from last year’s cyclically depressed levels as delinquencies declined. We continue to own the stock due to Arch’s strong management team and our expectation of continued strong growth in earnings and book value.
Penn National Gaming, Inc., a regional U.S. casino company, detracted dueto investor concerns over accelerating losses from its Barstool business due to high marketing expenses and questions around profitability. We believe this is money well spent to acquire more customers as more states legalize online gambling. As it is far less expensive to retain an existing customer, we think marketing costs will decline as it builds out its customer base. The core bricks and mortar casino business remains strong, and Penn has a strong balance sheet to fund the digital losses.
Manchester United plc (MANU, Financial) is the best known team in the English PremierLeague and generates revenue from broadcasting, sponsorship, and licensing. Shares were down following some lackluster match performance, even with Cristiano Ronaldo’s return to the team. Management announced plans to change the coaching structure to better develop the team. With the stadium back to full capacity and Cristiano back on the roster, we view Manchester United as a unique media company with over 1.1 billion fans globally and broad appeal that should compound value.
Chinese data center operator GDS Holdings Limited (GDS, Financial) detracted from performance as a result of the overall sell-off in Chinese technology-related companies due to tightening government regulations/restrictions, increased investor fears of U.S. market delisting, higher energy costs, and slower customer move-ins. We sold our position during the quarter due to ongoing regulatory uncertainty in China.
Zillow Group, Inc. (Z, Financial) operates leading U.S. real estate sites. Shares were downfollowing the announced closure of its home-buying business, along with hundreds of millions of dollars in write-downs in the segment as a result of overpaying for homes. This was a rapid change in narrative, and we still do not have a good answer as to what went wrong. We lost a significant amount of trust in management and their ability to execute. We chose to exit our position.
SmartRent, Inc. (SMRT, Financial) is an enterprise software company enabling the connectedhome. Shares fell due to a broad sell-off in companies that went public via SPAC, weakness in high-valuation stocks, and deferral of hardware revenue recognition due to supply chain issues. We retain conviction given SmartRent’s significant pipeline of embedded growth, existing relationships with the top multi-family landlords, and a relationship with venture capital firm Fifth Wall, which will allow the company to access customers who are limited partners in Fifth Wall’s funds, in our view.
Investment Strategy & Portfolio Structure
Despite current market volatility and investor angst, we have continued to manage the Fund the same way we have historically–looking for companies with large addressable market opportunities that have the potential to disrupt industries and take market share given strong competitive advantages inherent in their businesses.
In the fourth quarter, we initiated a small position in MGM Resorts International (MGM, Financial), a global casino gaming company with assets in the U.S. andMacau. The company is seeing a strong rebound at its Vegas properties with EBITDA above pre-pandemic levels, has a robust balance sheet improved by the pending sale of the Mirage casino at a highly accretive multiple, and has a strong growth opportunity in the online gaming market via its betMGM sportsbook. While management expects betMGM to generate losses for the next two years as it invests in its growth, we believe the company should be able to easily fund all losses and the segment should be profitable by 2024. We believe this growth opportunity to penetrate a potential $30 billion market combined with strong cash flow generation from its Las Vegas and U.S. regional casinos along with a robust balance sheet should make MGM an attractive investment for the next several years.
We also added to our positions in Space Exploration Technologies Corp. and Guidewire Software, Inc. (GWRE, Financial) Both companies have large addressable markets with strong brands that should allow them to take significant market share over time. We believe they are both appropriately financed and should generate significant cash to continue investing in their businesses for further growth.
While we have made other changes on the margin, the Fund’s strategy remains the same. We continue to invest for the long term in a focused portfolio of what we believe are appropriately capitalized, competitively advantaged, well-managed, small- and mid-cap growth businesses at attractive prices. We attempt to create a portfolio of between 20 and 30 securities diversified by GICS sectors that will be approximately 80% as volatile (as measured by beta) as the market. Since inception, the Fund has generated approximately 98% of the upside when the market rises but just 79% of the downside when the market declines. Businesses in which the Fund invests are identified by our analysts and portfolio managers using our proprietary research and time-tested investment approach.
As of December 31, 2021, we held 28 investments. The Fund’s average portfolio turnover for the past three years was 22.6%. This means the Fund has an average holding period for its investments of approximately 4.4 years. This contrasts sharply with the average mid-cap growth mutual fund, which typically turns over its portfolio every 16 months. From a quality standpoint, the Fund’s investments have stronger sales growth than the holdings in the Index, higher EBITDA, operating, and free cash flow margins with stronger returns on invested capital. We believe these metrics are important to limit risk in this focused portfolio.
While focused, the Fund is diversified by sector. The Fund’s weightings are significantly different than those of the Index. For example, the Fund is heavily weighted in Consumer Discretionary businesses with 52.4% of its net assets in this sector versus 15.4% for the Index. The Fund also has much less exposure to the Health Care with just 1.0% of the portfolio in this sector versus 22.3% for the Index, as we believe the sector changes quickly making it difficult to invest in these stocks in a concentrated portfolio. The Fund is further diversified by investments in businesses at different stages of growth and development as discussed above and shown below.
Disruptive Growth firms accounted for 53.7% of the Fund’s net assets. Oncurrent metrics, these businesses may appear expensive; however, we think they will continue to grow significantly and, if we are correct, they have the potential to generate exceptional returns over time. Examples of these companies include electric vehicle leader Tesla, Inc., commercial satellite company Iridium Communications Inc., and systems software provider to the insurance industry Guidewire Software, Inc. All of these companies have large addressable markets relative to the current size of those competitively advantaged businesses.
Companies that own what we believe are Real/Irreplaceable Assets represented 24.8% of net assets. Vail Resorts, Inc., owner of the premier ski resort portfolio in the world, upscale lodging brand Hyatt Hotels Corp., and the largest U.S. regional casino gaming company Penn National Gaming, Inc. are examples of companies we believe possess meaningful brand equityand barriers to entry that equate to pricing power over time. Penn’s state-granted licenses for its regional casinos provide important protection from competitors. Online sports betting and i-casino gaming offer large opportunities for future growth for the company.
Core Growth investments, steady growers that continually return excessfree cash flow to shareholders, represented 21.2% of net assets. Examples of these companies include CoStar Group, Inc. and FactSet Research Systems, Inc. CoStar continues to add new services both in the commercialand residential areas of real estate that have grown its addressable market and added new services for its clients further improving retention and cash flow.
As one of the leading financial intelligence systems for the asset management industry, FactSet continues to grow into new areas via fixed income, risk management, and, most recently, private equity. This should enable the company to grow while generating a steady stream of recurring cash flow that it uses for acquisitions, dividends, and buybacks.
Portfolio Holdings
As of December 31, 2021, the Fund’s top 10 holdings represented 71.1% of net assets. A number of these investments have been successful and were purchased when they were much smaller businesses. We believe they continue to offer significant further appreciation potential, although we cannot guarantee that will be the case.
The top five positions in the portfolio, Tesla, Inc., Space Exploration Technologies Corp., Hyatt Hotels Corp., CoStar Group, Inc., and FactSet Research Systems, Inc. all have, in our view, significant competitiveadvantages due to irreplaceable assets, strong brand awareness, technologically superior know-how, or exclusive data that is integral to their operations. We think these businesses cannot be easily duplicated, which enhances their potential for superior earnings growth and returns over time.
Thank you for investing in Baron Focused Growth Fund. We continue towork hard to justify your confidence and trust in our stewardship of your family’s hard-earned savings. We also continue to try to provide you with information we would like to have if our roles were reversed. This is so you can make an informed judgment about whether Baron Focused Growth Fund remains an appropriate investment for your family.
Respectfully,
Ronald Baron
CEO and Lead Portfolio Manager
David Baron
Co-Portfolio Manager
