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Baron Funds

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Baron

Baron Fifth Avenue Growth Fund regarding drug prices and the uncertainty/likelihood of the repeal of the Affordable Care Act. But most importantly, all of these companies are global growth businesses that would not benefit from the new administration’s stated and perceived priorities, so their shares were used to fund the purchases of the companies that would. It is tempting to blame a disappointing result on the unpredictable election and adverse sector rotation or some short-term market dislocation. However, it is more prudent to take a step back and try to evaluate objectively the quality of the investment decisions that were made. We operate in a business that is characterized by incomplete information, high degree of uncertainty, and unpredictable events that frequently have a material impact on final results. In other words, we accept that a good or a bad result is not really in our control, especially over shorter periods of time. To use a sports analogy, a player cannot control if her shot will go in or how many goals she will score (the opposition, referees, and even the weather can have significant impact on that and the game’s outcome). But she can control the quality of her shots. Similarly, we try to worry less about the score and worry more about the quality of the decisions that we make. So over the last few weeks, we went back and tried to re-evaluate every significant investment decision that we have made over the last three years. All 58 of them. The point was not to figure out what worked and what didn’t. That part was obvious enough. The question was why, and what can we learn from it? We made a few surprising discoveries. While we fully expected cognitive mistakes arising from overconfidence, for instance (since over the years we have developed significant expertise in the field of investments and all experts are prone to an exaggerated sense of how well they understand their world), we did not expect systematic errors. Our process has been developed and tested over a multi-decade period of time and is the foundation upon which our investment decisions are based. It is rare for us to find flaws in it, so we’re pretty excited about that. Here is an example. Quality of the management team is an integral part of any investment thesis. We assess the CEO’s ability to set a vision, create a culture, and execute the business to create and maximize shareholder value over the long term. We met with Ahmad Chatila, the CEO of SunEdison, on multiple occasions. We think it was a cognitive mistake to assign him the highest marks at the peak of his company’s success, the kind of mistake that only becomes apparent in hindsight. However, it was a systematic error to not reduce the weight or the importance that we assign to great managements in the case of SunEdison. Think of Jeff Bezos of Amazon, or Howard Schultz of Starbucks, or Bruce Flatt of Brookfield Asset Management. These are proven leaders with long track records of great capital allocation and shareholder value creation. The kind of track record that Ahmad Chatila did not have. Knowing what we knew at the time, and having done as much work on SunEdison as we did, it was unlikely that we could have avoided investing in it (and this investment could have turned out differently if the price of oil did not collapse creating the liquidity crisis when it did), but had we weighted our conviction in management lower among all other variables we would have owned less, and it would have mattered. We found a couple of things like this. We re-evaluated our investment inputs and tinkered with how we weight them. That process is never easy. We believe this is necessary if one hopes to improve. We continually implement fixes that we hope lead to better, more consistent decision making. Although, there can be no assurance that it will, in fact, be the case. Table II. Top contributors to performance for the quarter ended December 31, 2016 Quarter End Market Cap or Market Cap When Sold (billions) Percent Impact The Charles Schwab Corp. $52.3 0.46% First Republic Bank 14.2 0.38 CME Group, Inc. 39.1 0.36 Synchrony Financial 29.9 0.15 Yum China Holdings, Inc. 10.9 0.10 Shares of brokerage business The Charles Schwab Corp. rose over 25% in the fourth quarter on the expectation of multiple interest rate increases in 2017, which should bode well for 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. First Republic Bank provides banking and wealth management services to affluent clients in metropolitan areas of the U.S. The stock appreciated 19% during the quarter as it participated in the post-election rally for financial companies and on expectations for faster economic growth and higher inflation. In addition, First Republic reported good financial results with 18% loan growth and 24% deposit growth. We added to our investment during the quarter and continue to believe the bank has an advantaged business model and a long runway for growth. CME Group, Inc., operates the world’s largest and most diversified financial exchanges for trading derivatives. Shares increased 14% in the December quarter due to greater post-election trading activity with average daily volumes up 24%. CME is also benefiting from investor expectations for a more normalized interest rate environment and greater hedging activity. We continue to own the stock because we expect solid earnings growth from higher trading and clearing volumes. Shares of our most recent investment, Synchrony Financial, the largest U.S. issuer of private label credit cards, were up 16%. Synchrony benefited from the post-election rally for financial stocks and on hopes for faster economic growth and higher inflation. In addition, Synchrony reported financial results that beat Street estimates, with 12% growth in net interest income, significant margin expansion, and the initiation of a capital return program. We believe Synchrony operates in a highly profitable market niche and has a long runway for growth. Yum China Holdings, Inc. is YUM! Brands, Inc.’s master franchisee in China, operating all KFC and Pizza Hut branded restaurants there. The company was spun out of YUM! Brands in October 2016 and appreciated by over 20% by late November due in part to the depressed price at which it started trading in its early days as a public company. We liquidated the shares as the very strong initial performance brought the price closer to our estimate if its intrinsic value. We continue to monitor Yum for possible future ownership and its potential for attractive long-term unit growth. 44

December 31, 2016 Baron Fifth Avenue Growth Fund Table III. Top detractors from performance for the quarter ended December 31, 2016 Quarter End Market Cap (billions) Percent Impact Amazon.com, Inc. $356.3 –1.64% Illumina, Inc. 18.8 –1.13 Alibaba Group Holding Limited 219.1 –1.12 Facebook, Inc. 332.4 –0.60 Naspers Limited 64.4 –0.42 Shares of Amazon.com, Inc., declined 10% during the fourth quarter. After a streak of stellar quarterly earnings reports, which showed meaningful margin and profitability upside, Amazon reported mixed results with operating margins and guidance slightly below Street’s heightened expectations driven by weaker retail margins and investments in India and abroad. Amazon is continuing to invest heavily in several growth initiatives, including Amazon studios, Alexa, India, Amazon Web Services, and distribution and fulfilment center expansions. We see the company as the undisputed global leader in the two, secularly growing, multi-trillion dollar markets of e-commerce and cloud computing, and it remains our highest conviction long-term investment idea. Shares of Illumina, Inc., the leading provider of DNA sequencing technology to academic and commercial laboratories, fell almost 30% after reporting disappointing third quarter financial results. The shortfall was caused primarily by weak high-throughput instrument sales in North America and general weakness in Europe. Illumina’s growth is very much driven by new product introductions, and in 2016 sales suffered as the high- throughput instrument line reached the end of its life cycle. In early 2017, Illumina launched a new high- throughput sequencing platform that should reaccelerate growth. In addition, Grail, the start-up funded by Illumina which is developing a blood-based cancer screening test, announced it received capital commitments of $1 billion and would become one of Illumina’s largest customers over time. We continue to 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. Alibaba Group Holding Limited is the largest e-commerce and cloud services provider in China and the second largest one in the world. Its stock price declined 17% during the quarter despite reporting strong financial results. Concerns regarding the weakening Chinese economy and the further depreciation of the Yuan were weighing on investors’ confidence, which were further exacerbated by the U.S. election results. We continue to believe that Alibaba represents a unique and compelling opportunity to invest in the long-term growth of e-commerce, mobile, and cloud-computing in China. Shares of Facebook, Inc., the world’s largest social network, fell 10% over the fourth quarter due to concerns over slowing revenue growth after management announced that ad inventory is not expected to be a major driver of growth starting mid-2017. We think the company will be able to grow revenue through improved targeting, higher pricing, and greater video consumption. Facebook is in the early stages of monetizing online video and Instagram, which are both starting to contribute to revenue growth, and taking advantage of WhatsApp and Oculus as additional growth opportunities. Shares of Naspers Limited, a South African internet and media platform company, fell 15% during the quarter largely due to the weakness of Tencent Holdings, a company in which Naspers has a large ownership stake. Additionally, the company’s pay TV business was impacted by the devaluation of the South African Rand. We believe that shares will recover as Tencent grows and Naspers takes steps to provide visibility into its internet investments. Portfolio Structure The Fund’s portfolio is constructed on a bottom-up basis with the quality of ideas and conviction level (rather than benchmark weights) determining the size of each individual investment. Sector weights tend to be an outcome of the portfolio construction process and are not meant to indicate a positive or a negative “view.” During the quarter we initiated two new investments (Intuitive Surgical and Synchrony Financial) and closed out five others (Yum! Brands, FireEye, Bristol-Myers Squibb, athenahealth, and TerraForm Global). For the calendar year 2016, we purchased six new investments and eliminated 11 others. The top 10 positions represented 57.6% of the Fund, the top 20 were 80.9%, and we exited the quarter with 32 holdings. Table IV. Top 10 holdings as of December 31, 2016 Quarter End Market Cap (billions) Quarter End Investment Value (millions) Percent of Net Assets Amazon.com, Inc. $356.3 $20.7 14.8% Alphabet Inc. 538.6 9.3 6.6 Alibaba Group Holding Limited 219.1 8.3 5.9 Facebook, Inc. 332.4 7.5 5.3 Equinix, Inc. 25.5 7.0 5.0 Mastercard Incorporated 112.5 6.7 4.8 Visa, Inc. 181.5 6.5 4.6 The Priceline Group, Inc. 72.3 6.4 4.5 Apple, Inc. 617.6 4.5 3.2 CME Group, Inc. 39.1 4.1 2.9 Recent Activity Table V. Top net purchases for the quarter ended December 31, 2016 Quarter End Market Cap (billions) Amount Purchased (millions) Intuitive Surgical, Inc. $24.6 $2.9 Synchrony Financial 29.9 1.4 Expedia, Inc. 17.0 0.9 First Republic Bank 14.2 0.3 After a multi-year hiatus, we re-initiated an investment in Intuitive Surgical, Inc. Intuitive sells the da Vinci robotic surgical system, which enables surgeons to perform minimally-invasive surgery in a number of different procedure categories. Minimally-invasive surgery benefits patients because they generally experience less pain and faster recovery after the procedure. Intuitive has held an effective monopoly on robotic-assisted surgery for many years. We believe the company has durable competitive advantages consisting of patents, technology, regulatory approvals, a worldwide installed base of systems, large salesforce, and balance sheet with over $4 billion in net cash. Although Intuitive is expected to face competitors in the future, we believe it will be difficult for competitors to 45

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