1 year ago

Baron Funds



Baron Asset Fund 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) 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. ANDREW PECK PORTFOLIO MANAGER Retail Shares: BARAX Institutional Shares: BARIX R6 Shares: BARUX 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. Table I. Performance Annualized for periods ended December 31, 2016 Baron Asset Fund Retail Shares 1,2 Baron Asset Fund Institutional Shares 1,2,3 Russell Midcap Growth Index 1 S&P 500 Index 1 Three Months 5 0.01% 0.06% 0.46% 3.82% One Year 6.23% 6.51% 7.33% 11.96% Three Years 5.13% 5.42% 6.23% 8.87% Five Years 13.23% 13.53% 13.51% 14.66% Ten Years 6.53% 6.75% 7.83% 6.95% Since Inception (June 12, 1987) 10.97% 11.05% 9.66% 4 9.45% Performance listed in the above table is net of annual operating expenses. Annual expense ratio for the Retail Shares and Institutional Shares as of September 30, 2016 was 1.31% and 1.04%, respectively. The performance data quoted represents past performance. Past performance is no guarantee of future results. The investment return and principal value of an investment will fluctuate; an investor’s shares, when redeemed, may be worth more or less than their original cost. The Fund’s transfer agency expenses may be reduced by expense offsets from an unaffiliated transfer agent, without which performance would have been lower. Current performance may be lower or higher than the performance data quoted. For performance information current to the most recent month end, visit or call 1-800-99BARON. 1 The indexes are unmanaged. 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. The indexes and the Fund are with dividends, which positively impact the performance results. 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. 2 The 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. 3 Performance for the Institutional Shares prior to May 29, 2009 is based on the performance of the Retail Shares, which have a distribution fee. The Institutional 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. 4 For the period June 30,1987 to December 31, 2016. 5 Not annualized. 18

December 31, 2016 Baron Asset Fund Table II. Top contributors to performance for the quarter ended December 31, 2016 Year Acquired Percent Impact Gartner, Inc. 2007 0.85% The Charles Schwab Corp. 1992 0.83 Arch Capital Group Ltd. 2003 0.36 West Pharmaceutical Services, Inc. 2014 0.32 First Republic Bank 2010 0.29 Shares of Gartner, Inc., 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., 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., 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., 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 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 Year Acquired Percent Impact Illumina, Inc. 2012 –1.00% FleetCor Technologies, Inc. 2012 –0.69 Guidewire Software, Inc. 2013 –0.52 Nielsen Holdings plc 2011 –0.35 SBA Communications Corp. 2007 –0.25 Shares of Illumina, Inc., 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 highthroughput 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., 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. 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 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. fell on concerns that the upcoming Trumpappointed 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 19

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