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Baron Funds

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Baron

Baron Opportunity Fund our portfolio to chase the sectors that were then in favor. We chose not to change and chase but to stick to our knitting. We continue to emphasize the businesses and secular megatrends that we believe will drive long-term growth regardless of the underlying economic environment or changes in laws or regulations. 2. Why does the market shift back and forth like this? In my view, the market’s recent gyrations are almost perfectly consistent with the voting-machine/ weighing-machine analogy of Benjamin Graham, which I have written about in the past. Short-term market shifts, which are often driven by speculation or sentiment changes between the emotions of hope and fear, are the market acting as a voting machine. And this election–no matter what side you were on–should prove more than ever before how hard it is to consistently “read the polls” and predict the “vote.” That is not what we try to do. Our investment philosophy is grounded in reading the scales of the weighing machine. We believe the value of a business in the long run is far more science than sentiment. Growth businesses, by definition, get larger over time and gain weight. You put each company on the theoretical weighing machine–measure their revenues, profits, cash flow–apply a historically appropriate multiple for a business of that type (industry group, growth rate, balance sheet, etc…)–and the machine spits out what the company weighs, i.e., what it’s worth. That is how we invest–identify the companies that we believe will grow fast and get heavier, do a lot of research to predict how much, and keep weighing them as we go. As the market leadership changed after the election and the portfolio struggled in that environment, there was pressure to toss away the weighing machine and start reading the polls. We chose not to do that–but to stay the course with our investment philosophy and approach. The Fund’s performance to start the year simply adds to our conviction that this was the right call. 3. Do you remain confident in the Fund’s strategy and approach? The end of last year was tough. The start of this year has been nice. But neither period has had any impact on our core confidence. To borrow a metaphor, investing is like sailing a ship in the stormy seas. It is far less important whether you are on the crest of the wave… and can see the horizon, or at its trough…and fear being buried underwater, than whether you can steer your ship–through the ups and downs–towards the destination of your voyage. Smooth seas rarely persist. Our confidence has never wavered that our strategy, process, and hard work is the right way to get our investors to their destination–a differentiated strategy of investing in innovative, highgrowth businesses that should outperform the broader market across longterm market cycles. While we try to stay abreast of politics, economics, geo-politics, etc., to guide our investors on this metaphorical journey, we really do remain laser focused on what we can control: our industry and company research and portfolio construction decisions. Regarding portfolio construction, we took advantage of the market dislocations at the end of the year to further concentrate the portfolio in our best ideas. We ended the year with investments in 39 businesses. Our top 20 positions accounted for 71.9% of the Fund’s net assets. We maxed out–bought up to 5% positions–in Guidewire Software, Inc. and CoStar Group, Inc., as the stocks fell for, what we believe were, misunderstood short-term reasons compounded by the market sell-off of the high-growth software sector. We also took the opportunity to add to our portfolio investments in businesses like Splunk, Inc., a big data, analytics and cybersecurity leader, and Edwards Lifesciences Corp. and Intuitive Surgical, Inc., two innovative pioneers in the minimally-invasive surgical procedure space. Regarding our industry research, the steadfast approach of the Fund has been to study and invest in powerful secular growth trends–generational, paradigm or tectonic shifts across industries and society that will drive robust long-term growth regardless of fluctuations in the underlying economy or the political party in power. These trends are persistent, impactful and close to unyielding. They are where the world’s going, not where it’s been. We believe many of the businesses that emerge as winners will possess uncapped growth opportunities, considerable moats to sustain their leadership, and capture large profit pools from the legacy way of doing things. Some of the powerful secular themes in which we invest include: • Cloud computing and software-as-a-service (SaaS) • Mobile • Big data and analytics • Digital (Internet-delivered) media • E-commerce • Genetics • Electronic medical records • Minimally-invasive surgical procedures • Targeted digital advertising • Cybersecurity • Electric drive vehicles and autonomous driving • Electronic payments By investing in this way, our portfolio companies have consistently delivered top-line growth rates that are orders of magnitude above the general economy, as reflected in broad market indexes. Below we show the revenue growth rates of the S&P 500 Index, the Russell 3000 Index, and the Russell 3000 Growth Index as compared to our portfolio for the first, second, and third quarters of 2016: Comparison of Revenue Growth (based on end-of-the year holdings) Actual Q3 2016 Actual Q2 2016 Actual Q1 2016 S&P 500 Index 2.82% 1.21% –0.40% Russell 3000 Index 2.95% 1.46% –0.01% Russell 3000 Growth Index 6.01% 5.70% 5.32% Baron Opportunity Fund 28.33% 26.68% 23.90% To conclude, I believe wholeheartedly in the strategy for the Fund: growth based on powerful, long-term, innovation-driven secular growth trends. In the highly uncertain world we live in, we believe non-cyclical, sustainable, and resilient growth should be part of investors’ portfolios. 34

December 31, 2016 Baron Opportunity Fund Table II. Top contributors to performance for the quarter ended December 31, 2016 Percent Impact Netflix, Inc. 0.69% Gartner, Inc. 0.63 The Charles Schwab Corp. 0.47 Tesla Motors, Inc. 0.20 Sage Therapeutics, Inc. 0.19 Shares of on-demand video service provider Netflix, Inc. were up in the fourth quarter on strong quarterly subscriber additions, which, as we wrote last quarter, are historically difficult to predict and fluctuate for many reasons. The company has recently reached an all-time high after reporting a solid fourth quarter and providing favorable guidance for 2017. We expect the company to continue to differentiate itself by continuing its unmatched investment in content. Netflix’s investment in original programming could, in our view, reduce the time it takes to achieve its long-term goal of 150 million global subscribers. We retain high conviction in our core investment thesis that the way people watch TV is undergoing a major disruption from legacy time-based networks to on-demand streaming, and that Netflix will be a winner in this shift. (Ashim Mehra) Shares of Gartner, Inc., a provider of syndicated IT research, contributed to fourth quarter performance. We believe that Gartner’s key forward-looking metrics continue to be solid. We expect to see continued acceleration due to easing comparisons, growing productivity, and sales tactics that have been fine-tuned to match current macro conditions. Neal Rosenberg’s first draft of this write-up concluded: “We believe that the company has significant financial flexibility, and will begin to deploy capital more aggressively on share repurchases or M&A.” Neal was prescient. On January 5, Gartner announced the acquisition of CEB Inc., whose primary asset is the Corporate Executive Board business, in a cash and stock transaction valued at approximately $3.3 billion (about 70% cash and 30% Gartner stock). Gartner’s management team believes the deal will be immediately accretive to Gartner’s adjusted earnings for 2017, double-digit percent accretive to adjusted earnings for 2018, and enable Gartner to further expand its services beyond the IT function. (Neal Rosenberg) Shares of brokerage business The Charles Schwab Corp. increased during the fourth quarter on the potential of multiple interest rate increases into 2017, which should materially improve the company’s earnings. Charles Schwab also reported solid asset growth reaching over $2.7 trillion. The business continued to shift to fee-based advice from trading activity, a move that we believe creates more stability and the potential for increased profitability. (Michael Baron) The shares of electric-vehicle pioneer Tesla Motors, Inc. grew in the fourth quarter after its shareholders approved the SolarCity merger, aligning the company with management’s long-term vision. Tesla also started to enjoy the benefits of its multi-year investment in the Gigafactory as it becomes operational and provides a competitive advantage in scale and battery prices. We believe that Tesla, as an important U.S.-based auto manufacturer, can potentially benefit from a pro-“U.S. jobs” administration. (Gilad Shany/ Ishay Levin) Sage Therapeutics, Inc. is a biopharmaceutical company focused on central nervous system disorders. Shares of Sage were up in the fourth quarter on news that the FDA and EMA (European FDA) are allowing an expedited pathway to approval for the company’s drug to treat post-partum depression. Additionally, Sage announced an expansion into other disease indications, including other types of depression, Parkinson’s and tremor. We believe Sage is poised to become a leader in its space. (Josh Riegelhaupt) Table III. Top detractors from performance for the quarter ended December 31, 2016 Percent Impact Benefitfocus, Inc. –1.04% Guidewire Software, Inc. –1.00 Amazon.com, Inc. –0.81 CoStar Group, Inc. –0.64 Illumina, Inc. –0.60 Shares of benefits software vendor Benefitfocus, Inc. detracted from fourth quarter performance. The company provided modestly lower-than-expected guidance for the fourth quarter of 2016. The company’s management team addressed several short-term headwinds, including longer-than-expected implementation periods for new national accounts (these larger and more complex accounts will go live in the first half of 2017 rather than the second half of 2016), slower employer signings because of a sales restructuring to create a team focused on national accounts, and a revenue share with traditional brokers of BenefitStore voluntary benefit commissions. While these headwinds will likely weigh on reported growth through mid-2017, we don’t believe they impact the significant long-term opportunity. In fact, we believe the company’s success winning large national accounts is a major long-term positive, as these accounts are far larger and typically purchase multiple products. Indeed, in the third quarter, the company signed six national accounts with between 10,000-120,000 employees (vs. typical accounts that average around 3,000 employees). (Neal Rosenberg) Shares of property and casualty insurance software vendor Guidewire Software, Inc. detracted in the fourth quarter as accounting rules and commercial terms will force it to delay revenue recognition on a large new deal into next fiscal year. Guidewire is the leading P&C core systems vendor, with near-perfect retention rates, growing installed base, and accelerating adoption. The company is early in its core system replacement cycle, and has tripled its addressable market through new products and cloud delivery. We believe Accenture’s new relationship with Guidewire will help to enhance pricing and win rates and shorten sales cycles. (Neal Rosenberg) Shares of Amazon.com, Inc., the world’s largest retailer and cloud services provider, declined in the fourth quarter. The company reported disappointing operating margins and guidance below Street expectations driven primarily by investments in India and abroad. In addition to India, Amazon is investing in several growth initiatives, including Amazon studios, Alexa (voice interface), Amazon Web Services and distribution center expansions. We see the company as the leading retail and cloud provider globally, and believe it possesses both deep moats and expansive addressable markets in both of these areas. (Ashim Mehra) Shares of CoStar Group, Inc., a real estate information and marketing services company, fell in the fourth quarter on news that it is planning a $20 million investment for 2017 to expand its research, sales, and marketing capabilities. We believe this strategy will enable CoStar to upsell existing LoopNet customers to its core CoStar product, potentially driving $200 million of incremental annual recurring revenue at very high margins. We think trends in the core business are excellent, with accelerating CoStar Suite information services revenue growth of 14% and total company operating cash flow margins that improved from 19% to just over 35% year-over-year in the most recently reported quarter. (Neal Rosenberg) Shares of Illumina, Inc., the leading provider of DNA sequencing technology to academic and commercial laboratories, fell in the fourth quarter after reporting disappointing third quarter financial results. The third quarter shortfall was driven by weak high-throughput instrument sales. However, at 35

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