DPHAY - Baron Small Cap Fund Q2 2023 Shareholder Letter

2023-07-30 07:10:00 ET

Summary

• Baron is an asset management firm focused on delivering growth equity investment solutions known for a long-term, fundamental, active approach to growth investing.
• Baron Small Cap Fund had a strong performance in Q2 2023, up 6.49% and up 16.54% for the first half of the year.
• The Fund outperformed its benchmark and has a history of meaningful outperformance over 25 years.
• Small-cap stocks underperformed in Q2, but the Fund's stock selection in the Industrials, Consumer Discretionary, and Financials sectors performed well.

Dear Baron Small Cap Fund Shareholder:

Performance

Baron Small Cap Fund ^® (the Fund) was up 6.49% (Institutional Shares) in the second quarter of 2023 and was up 16.54% for the first half of the year. For the quarter, the Fund performed similarly to the Russell 2000 Growth Index (the Benchmark) and for the year-to-date period is about 300 basis points ahead. The Fund trailed the broader S&P 500 Index ( SP500 , SPX ) this quarter, as larger stocks outperformed smaller ones. Year to date, the Fund’s performance is comparable to the S&P 500 Index.

As shown in the table below, the Fund has outperformed its Benchmark for most of the relevant periods. Over its more than 25-year history, the Fund has outperformed its Benchmark by 395 basis points a year, which is meaningful outperformance and has produced a material difference in returns between the Fund and funds designed to track the Benchmark.

Table I Performance Annualized for periods ended June 30, 2023

The market continued to perform well in the second quarter, led by outsized gains in technology stocks and a handful of mega-cap stocks driving performance. The NASDAQ Composite Index rose 13.1% in the second quarter, bringing its year-to-date return to 32.3%, its best start to a year since the early 1980s, with excitement over developments with artificial intelligence ((AI)) fueling the rally. I think the main reason the market rose in the quarter, despite concerns about a banking crisis, threats of a U.S. default, and continued interest rate increases by the Fed, is because the feared worst case scenarios failed to materialize. Most prominent is that the recession/ hard landing that so many economists and market prognosticators have predicted has not happened. In fact, it has been just the opposite, as economic data has largely been better than expected. And with inflation cooling significantly, expectations are that the Fed will slow or stop raising rates in the near future. Though the economic outlook remains murky, the slowdown, which seemed to be a consensus view, almost inevitable, and what we were all bracing ourselves for, is now less likely. Investors are out of their its funk and embracing the prospect that better growth could be ahead.

Small-cap stocks underperformed for the quarter but did improve in June with a broader market rally. A healthy sign. The Fund was having a mezza mezza quarter until June when our stocks were strong on an absolute and relative basis. The strong performance came from some of our large positions that rose on improved outlooks for their business fundamentals. For the quarter, our stock selection was positive. Our holdings in the Industrials, Consumer Discretionary, and Financials sectors performed well. We are overweight in each of these sectors, so this helped our relative performance as well. Our Health Care stocks did well, but we are considerably underweight that sector….as we don’t own biotechnology stocks…which outperformed the Benchmark during the quarter and hurt our relative performance. Our Information Technology ((IT)) stocks did poorly this quarter, since we focus on service businesses and vertical software companies, and these businesses suffered as their customers are focused on cost savings, for now. We primarily invest in high-quality companies and those stocks have done relatively poorly as rallies often start with more speculative stocks. Our larger-cap orientation helped our performance.

As we suspected (and wrote about last year), many of our best performers and highest contributors year to date were some of our biggest losers last year. That has played out in spades. For instance, as interest rates rose dramatically in 2022, some of our stocks got pummeled over concerns that their businesses would collapse. But the companies are doing fine, and their prospects are now turning positive. SiteOne Landscape Supply, Inc. ( SITE ) , Floor & Decor Holdings, Inc. ( FND ) , Installed Building Products, Inc. ( IBP ) , and Trex Company, Inc. ( TREX ) each fell over 35% last year, but are up over 40% so far this year. Other stocks that were down a lot last year and are up big this year include ICON Plc ( ICLR ) , Chart Industries, Inc. ( GTLS ) , Guidewire Software, Inc. ( GWRE ) , Cognex Corporation ( CGNX ) , Vertiv Holdings Co ( VRT ) , John Bean Technologies Corporation ( JBT ) , European Wax Center, Inc. ( EWCZ ) , Altair Engineering Inc. ( ALTR ) , The Trade Desk ( TTD ) , and Dechra Pharmaceuticals PLC ( DPHAY ) .

Table II - Top contributors to performance for the quarter ended June 30, 2023

Vertiv Holdings Co provides critical digital infrastructure for data centers. Its shares rose sharply after Vertiv reported strong earnings, featuring 35% organic sales growth and increased 2023 guidance, which helped improve management credibility regarding margin expansion plans. In addition, the stock’s trading multiple increased on the belief that Vertiv stands to benefit from generative AI-related data center investments. Generative AI will require an increase in energy density due to the need for additional computing power, which, in turn, will necessitate new cooling solutions. Vertiv should be able to leverage its leadership position in air cooling, strong relationships with customers, and dominant service network to gain share and grow rapidly. We believe Vertiv’s earnings power will increase as the company closes the margin gap with peers and revenue grows on the back of increased investments in data centers.

Specialty insurer Kinsale Capital Group, Inc. ( KNSL ) contributed to performance after reporting consensus-beating quarterly results. Gross written premiums grew 46%, and EPS grew 49%, the fifth consecutive quarter of over 40% premium growth. Market conditions remained favorable, with rising premium rates and more business shifting from the standard lines market to the excess and surplus lines market where Kinsale operates. Recently, a major underwriter announced it will stop underwriting comparative insurance in California, which opens up more market share for Kinsale. The company is also capitalizing on disruption in the property market where rates are rising rapidly after years of industry losses and a reduction in reinsurance capacity. Kinsale is well managed and has a long runway for growth in an attractive segment of the insurance market.

SiteOne Landscape Supply, Inc. is the largest distributor of wholesale landscape supplies in North America, selling irrigation, hardscape, agronomic, and nursery products to professional contractors through its network of branches for residential and commercial maintenance, upgrade/ repair, and new construction applications. Shares rose during the quarter after the company reported positive early season order trends. Shares were also boosted by the continued broader recovery in sentiment for housing related stocks. We believe SiteOne will take share of the fragmented wholesale landscape supplies distribution industry leveraging its scale, operational efficiency, and technology, while strategically acquiring companies that expand its product offering and geographic footprint, which together will drive consistent EBITDA growth. Though we expect cash flow to be lower this year, we are modeling that it will double over the next five years, and the company will generate significant free cash flow to fund acquisitions while deleveraging its balance sheet.

Other holdings that rose 20% or more in the quarter but contributed less to the Fund’s returns include Chart Industries, Installed Building Products, Dechra, Trade Desk, Trex, Inspire Medical Systems, Inc. ( INSP ) , TransDigm Group Incorporated ( TDG ) , Bright Horizions Family Solutions, Inc. ( BFAM ) , DraftKings Inc. ( DKNG ) , and Holley Inc. ( HLLY )

Table III - Top detractors from performance for the quarter ended June 30, 2023

Shares of industrial automation software leader Aspen Technology, Inc. detracted from performance during the quarter. Aspen reported mixed financial results due to a slowdown in its chemicals end-market, caused by downstream destocking. Also, there are some integration issues related to its merger with a subsidiary of Emerson Electric Company in 2022. While the integration went smoothly for about the first six months, it has hit some speed bumps lately. We view the issues as a temporary outcome of large business transformations and the decline in the chemical vertical as a shortterm cyclical event. We believe Aspen’s long-term FCF potential is intact, and the current price offers attractive potential returns for shareholders. We also expect the company to do accretive acquisitions to add further value.

Shares of Mercury Systems, Inc. , a leading U.S. Tier 2 defense electronics integrator, declined in the quarter. The company suffered financial misses in 2022 and early 2023 due to delays in the government defense budget, and delivery failures by suppliers and other supply-chain issues. During this period, multiple activist investors bought shares of the company and acquired Board seats, pressing the company to pursue strategic alternatives. In late June, Mercury announced the process had ended without a sale and its long-time CEO was stepping down. The shares fell on the news. We were disappointed and sold some of our position. We have since spent some time with new management and Board members and see value above where the stock is trading, so we have maintained a position, albeit smaller, as we continue to assess the situation.

The Beauty Health Company , owner of HydraFacial, is an innovative skin care and beauty health company providing consumers with the benefits of a professional medical treatment combined with the experience of a consumer brand. Shares fell after reporting weak top-line results due in part to the lingering impact of COVID-related lockdowns in China at the start of the year. In addition, some providers held back orders in advance of an upcoming product launch. Despite these temporary headwinds, the company raised its revenue guidance for the year, a testament to the strong demand for the brand. We believe the company has a long growth runway ahead, as it expands the number of delivery systems globally. We also believe it can increase its consumables-related revenue as it introduces new boosters and builds brand awareness. We like operating management and respect the executive chairman, who has overseen the building of highly successful franchises in the sector.

Other holdings that declined over 20% in the quarter but detracted less from the Fund’s returns were Endava plc and Sprout Social, Inc. ( SPT )

Portfolio Structure & Recent Activity

As of June 30, 2023, we had $4.4 billion under management and held 61 stocks. The top 10 positions made up 35.6% of net assets. The portfolio is somewhat more concentrated and top heavy than in the past. This is the result of the strong performance of most of our larger holdings.

Our largest positions are usually a collection of long-term holdings whose returns have compounded well and are familiar to followers of the Fund. As you peruse the present list below, you will notice some stocks that are more recent purchases (Chart bought in 2022, Vertiv and Kinsale bought in 2019).

Table IV - Top 10 holdings as of June 30, 2023

At the end of the quarter, the sectors with the highest concentration were Industrials (30.4%), Consumer Discretionary (15.7%), IT (15.6%), and Health Care (14.0%). Compared to the Benchmark, we are notably overweight in Industrials, overweight in Consumer Discretionary, and meaningfully underweight in Health Care. We don’t own any Utilities or Energy stocks and are underweight in IT, Materials, and Consumer Staples.

To reiterate points we have made in the past, the Industrials companies we own are high-quality franchises that are benefiting from secular tailwinds and/or are unique leaders in their niches. Their success and our investment are an expression of their market position and long-term opportunity, not a view on the economy. In the Health Care sector, we don’t own biotechnology stocks as their financial results can be binary or speculative in nature, and as we prefer to invest in what we consider established winners. Biotechnology stocks performed particularly well this quarter, which was a headwind to our relative performance, but we prefer to live with that as opposed to contravening our discipline. We are underweight the other sectors mentioned because there are fewer differentiated special businesses in those sectors.

We believe that we have executed our differentiated approach well…which is to invest for the long term in high-quality, special, well-managed businesses…leading to good long-term results. We believe we have the experience and expertise to identify and invest in companies with big opportunities that can grow from small operations into large successful enterprises. Our in-depth research enables us to understand these businesses well through regular extensive dialogue with operating management, and also through monitoring industry and competitive dynamics, so that we have an ongoing view of the present and future outlook of our investments. To truly invest for the long term, to look past the market noise and focus on business fundamentals, takes courage and conviction. That courage comes from understanding the businesses in which we invest and the opportunities they have better than most. We manage the Fund having learned from our past successes, to stick with our winners…. what we call watering our flowers and sell the stocks in which we have less confidence… cutting our weeds .

We have had some extraordinary winners over time. For instance, we bought DexCom, Inc. ( DXCM ) at a $950 million market cap in 2012, and it is now valued at $50 billion (the stock has appreciated 41% annually since the Fund’s initial purchase). TransDigm Group Incorporated has grown from $1.1 billion at purchase to $49 billion presently (and the stock has appreciated 29% annually since the Fund’s initial purchase 17 years ago). IDEXX Laboratories, Inc. ( IDXX ) has gone from $2 billion at purchase to $42 billion over almost 15 years and the stock has appreciated 26% annually during that time frame. The Trade Desk is now valued at $38 billion and was $433 million when we first purchased shares over 6 years ago. The stock has appreciated almost 60% annually since our initial purchase. Pretty amazing. All four stocks have been solid performers this year, contributing nicely to the Fund’s returns.

Since we run a small-cap fund but want to hold on to these great investments as they continue to compound and perform, we reduce the positions sizes over the holding period so that the overall market capitalization of the Fund is palatable. For each of the four stocks mentioned above, we presently own 11% or less of our peak positions. We take the proceeds from the trimming of these positions to fund new small-cap investments, with the hopes of somehow replicating these results.

Looking at the stocks in the Fund at the end of June, we have 13 investments that have appreciated more than five times since our initial purchase. These stocks make up 29.1% of the portfolio, and 19 more stocks that make up another 35.7% of assets whose share prices have more than doubled since our initial investment. So, about half of our holdings and about two-thirds of our assets have gone up a lot already, and we believe they will continue to be strong investments going forward.

Table V - Top net purchases for the quarter ended June 30, 2023

During the quarter, we did not add any new positions. I can’t remember when that last happened. We like what we own and are comfortable running a somewhat more concentrated portfolio, so not perturbed. We do have some dry powder, carrying a little over 4% in cash. The IPO market is starting to come back to life, which has always been a fertile hunting ground for new investments for us. Some fine companies will be the first to go public, but so far, the pricing has been frothy, so we haven’t participated.

We did add to existing positions, namely Neogen Corp. ( NEOG ) , The Beauty Health Company , and Driven Brands Holdings Inc. ( DRVN ) We have gained more conviction in their businesses, and sometimes we are buying more when the stocks have been weak for reasons that don’t affect our long-term thesis.

Table VI - Top net sales for the quarter ended June 30, 2023

We sold out of our small position in Hilman Solutions Corp. as the leverage in the business remains high partly preventing a pathway to inorganic growth (a value driver in the past) to supplement a low organic growth profile. We believe other opportunities offer better upside and more dimension. We trimmed other names to manage their respective position sizes in the portfolio, like Gartner, Inc. ( IT ) , SiteOne Landscape Supply, Inc. ,

The stock market remains very strong in July, defying expectations. Investors are encouraged by the rate of decline in inflation and the continued strength of the economy. The June CPI figure was the latest impetus to the rally. Inflation cooled to its slowest pace since 2021, registering 3.0% for the year ended June 2023, down from a peak of 9.1% just a year earlier. Core inflation, which the Fed has focused on, was just 0.2% in the month of June.

The most recent employment report also pleased market participants. Hiring slowed but wage growth was solid. The 3.6% unemployment rate reinforces the resilience of the economy. The Fed is expected to raise the Fed Funds rate at its next meeting, after pausing at the last one. Though inflation is still above its 2% target, it is trending sharply in the right direction, so it seems like we are nearing the end of rate hikes.

Could it be that inflation will get back in line without having to suffer through an economic slowdown? That scenario, dubbed “immaculate disinflation” by one economist…. that we can have lower inflation and no recession… now seems like a possible, maybe likely, outcome. This result wasn’t given much possibility earlier in the year. The thesis is grounded in the idea that severe inflation was caused by shockwaves from the pandemic, which led to excessive stimulative fiscal and monetary policy, creating a buying binge in a time of troubled supply chains and distortions in the commodity markets from the war in Ukraine. Now all that is passing, and inflation is naturally abating. Well, maybe. This possibility is behind the recent optimism driving stocks higher in my opinion.

The flip side is that a recession is coming, even if it is not evident. We just lived through unprecedented quantitative tightening, and monetary policy works with lag effects usually of 18 to 24 months, and we are just 16 months from the start of the rate hikes. Many economists we respect are convinced that higher rates will weigh on the economy and odds are high the economy will roll over soon. Other elements of the bear case are that consumers are running through their resources and inevitably will cut back spending. Financing shocks or crisis situations are bound to recur. The Fed will likely continue to raise rates or hold rates high until inflation registers at the Fed’s stated goals, so as not to repeat past mistakes, which helped result in runaway inflation. Corporate earnings are about to weaken significantly, and stock multiples will contract.

We are seeing a broadening of the market rally. The capital markets and IPOs are coming back to life. Consumer confidence is improving. Housing has rebounded, even in the face of much higher mortgage rates. All healthy signs. And though small caps are now outperforming, they are still far off their record highs, twice the differential of other indexes. Is this a bear rally or the beginning of a bull run? We will see.

We look forward to hearing from our companies about what they are seeing in their businesses and broader economy. We suspect some continued moderation in growth, but we don’t foresee major headwinds. How our companies do will determine how their stocks perform. Over the longer term, we have great confidence in the future earnings growth of our holdings and think their stock prices do not reflect where we believe their businesses are heading.

Thank you very much for your interest and investment in the Fund.

Cliff Greenberg

Portfolio Manager

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