1 year ago

Baron Funds



Baron Focused Growth Fund Dear Baron Focused Growth Fund Shareholder: Performance In the fourth quarter of 2016, Baron Focused Growth Fund (the “Fund”) decreased in value by 0.60% (Institutional Shares) while the Russell 2500 Growth Index, the benchmark against which we compare the performance of the Fund, increased by 2.60%. For the full year, the Fund returned 0.97% while the index increased 9.73%. Table I. Performance † Annualized for periods ended December 31, 2016 Baron Focused Growth Fund Retail Shares 1,2,3 Baron Focused Growth Fund Institutional Shares 1,2,3,4 Russell 2500 Growth Index 2 S&P 500 Index 2 Three Months 5 (0.69)% (0.60)% 2.60% 3.82% One Year 0.67% 0.97% 9.73% 11.96% Three Years 0.18% 0.45% 5.45% 8.87% Five Years 7.95% 8.22% 13.88% 14.66% Ten Years 5.44% 5.64% 8.24% 6.95% Fifteen Years 10.27% 10.40% 8.03% 6.70% Since Inception (May 31,1996) 10.24% 10.34% 7.30% 8.05% The long-term absolute and relative performance of Baron Focused Growth Fund from its inception over 20 years ago has been strong… Since its inception on May 31, 1996, Baron Focused Growth Fund’s 10.34% annualized performance for over 20 years has exceeded that of its benchmark Russell 2500 Growth Index by an average of 3.04% per year. This means that a $10,000 investment in Baron Focused Growth Fund over 20 years ago would now be worth $76,000! If an investor had instead invested $10,000 in a passive index fund that mirrored the Russell 2500 Growth Index, it would be worth only $43,000. Please see Table I and Table II and the Baron Focused Growth Fund performance chart following the “Letter from Linda.” RONALD BARON CEO AND PORTFOLIO MANAGER Retail Shares: BFGFX Institutional Shares: BFGIX R6 Shares: BFGUX Baron Focused Growth Fund’s beta has averaged 0.77 from inception. This means the Fund has been 77% as volatile as its benchmark. Please see Table III. As a result of Baron Focused Growth Fund’s strong absolute and relative returns and lower risk, the Fund has achieved 4.81% annual “alpha,” a measure of risk-adjusted performance, since inception. …despite modest gains we achieved during the past three years, and, most notably, during the past six months, which negatively impacted Baron Focused Growth Fund’s relative performance over the past one-, three-, five- and tenyear periods. We believe Baron Focused Growth Fund’s recent performance is analogous to several instances when, after brief periods of underperformance, the Fund again substantially outperformed. One instance in particular stands out. Performance listed in the above table is net of annual operating expenses. Annual expense ratio for the Retail Shares as of December 31, 2015 was 1.39%, but the net annual expense ratio was 1.35% (net of the Adviser’s fee waivers) and Institutional shares was 1.09%. 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 Adviser has reimbursed certain Fund expenses (by contract as long as BAMCO, Inc. is the adviser to the Fund) for and 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. † The Fund’s historical performance was impacted by gains from IPOs and/or secondary offerings. There is no guarantee that these results can be repeated or that the Fund’s level of participation in IPOs and secondary offerings will be the same in the future. 1 Reflects the actual fees and expenses that were charged when the Fund was a partnership. The predecessor partnership charged a 15% performance fee through 2003 after reaching a certain performance benchmark. If the annual returns for the Fund did not reflect the performance fees for the years the predecessor partnership charged a performance fee, the returns would be higher. The Fund’s shareholders will not be charged a performance fee. The performance is only for the periods before the Fund’s registration statement was effective, which was June 30, 2008. During those periods, the predecessor partnership was not registered under the Investment Company Act of 1940 and was not subject to its requirements or the requirements of the Internal Revenue Code relating to registered investment companies, which, if it were, might have adversely affected its performance. 2 The indexes are unmanaged. The Russell 2500 Growth Index measures are classified as growth and the S&P 500 Index of 500 widely the performance of small to medium-sized U.S. companies that 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. 3 The performance data does not reflect the deduction of taxes that a shareholder would pay on Fund distributions or redemption of Fund shares. 4 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. 5 Not annualized. 48

December 31, 2016 Baron Focused Growth Fund During 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 in value 41.77% annualized while the index increased 126.53% annualized. For the next nine years through December 2008, however, Baron Focused Growth Fund outperformed its index by nearly 700 basis points per year. Of course, past performance cannot reliably predict future results, but we expect this Fund’s investments to soon again outperform. We attribute the Fund’s recent modest performance principally to four factors as follows: 1. During the past three years, 52.4% of Baron Focused Growth Fund’s assets were invested in 10 businesses whose stock prices significantly underperformed the growth of their businesses, resulting in a temporary disconnect between the companies’ fundamentals and their share price performance. For example, soccer club Manchester United plc’s licensing, sponsorship and media revenues have grown significantly during the past three years, resulting in cumulative revenue and EBITDA growth of 34% and 58%, respectively. Meanwhile, Manchester United’s share price fell 6.7% over the same time period. Leading electric vehicle manufacturer Tesla Motors, Inc. has more than tripled its annual pace of vehicle deliveries over the past three years, an astounding feat, while its share price rose only 42.1% over the same period. Further, we think Tesla’s growth is about to accelerate as it introduces the mass market Model 3. Human resources software vendor Benefitfocus, Inc.’s revenues increased 125% during the past three years, while its share price fell 48.6%. We think its business is likely to continue to grow strongly…as is the case for all the companies mentioned above…and the other companies in which we have invested whose share prices did not reflect the growth in the business over the past three years. We do not expect this disconnect to continue to be the case. 2. Nearly 60% of Baron Focused Growth Fund’s portfolio is comprised of businesses that we have owned for less than five years. Virtually all of these “newer” investments are incurring significant expenses that penalize their current earnings, and probably their present stock prices, in order to become much larger businesses. Whether it is by hiring more sales staff, developing new products, building new plants, investing in new databases, integrating acquisitions or producing new products at lower gross margins than will be achieved at scale. While all businesses make such expenditures, the amount of such expenditures by businesses in which we have invested relative to the size of those businesses is unusual. As an illustration, 60% of Baron Focused Growth Fund’s investments have made significant strategic acquisitions in the past two years. We expect these transactions to substantially enhance their businesses’ overall profitability and growth over the next few years. Examples of these investments include specialty insurance company Arch Capital Group Ltd., which acquired mortgage insurance business United Guaranty from AIG at what we believe was an unusually attractive price. We regard that business as one of AIG’s “crown jewels,” and one that pairs extremely well with Arch Capital’s existing mortgage guarantee business. Vail Resorts, Inc. purchased Canadian ski resort Whistler Blackcomb and Utah’s Park City and Canyons ski resorts, in what we regard as two highly synergistic and strategic transactions that will enhance results across the company’s portfolio, add to its industry leading customer database, and increase its ability to grow annual ski pass sales. Investments services provider Financial Engines, Inc. is increasing enrollments following its recent acquisition of the Mutual Fund Store, which dramatically boosts the company’s addressable market to include investable assets outside of defined contribution. 3. The Fund’s exposure to Information Technology (IT) has hurt performance in the past three years. Baron Focused Growth Fund has 14.7% of its portfolio invested in successful IT growth companies like Benefitfocus, CoStar Group, Inc. and Guidewire Software, Inc. These companies are penalizing their rapidly growing, non-cyclical earnings to enhance their businesses’ long-term growth. In 2016, the Fund’s IT investments fell in price on average by 13.0%. As these businesses leverage the investments they are making, we expect earnings to accelerate and their stock prices to eventually reflect this. 4. The surprising results of the November 8, 2016 U.S. presidential election immediately impacted domestic stock markets. Baron Focused Growth Fund did not benefit materially. Following the election, topdown investors purchased stocks in sectors they believed would benefit from Trump programs. Cyclicals such as Financials, Energy, and Industrials did well. Less economically sensitive Consumer Staples and Health Care stocks did not perform as well. Real Estate and fast growing IT investments also did not fare as well. Especially noteworthy, in our opinion, was the 31.0% increase in the valuations of regional banks that would benefit from less regulation and wider net interest margins when interest rates increase. Baron Focused Growth Fund has no investments in regional banks, because we believe that their balance sheets are opaque and competitive advantages are unclear. Baron Focused Growth Fund is a bottom-up, fundamental, long-term investor in what we believe are fast growing, competitively advantaged, well-managed businesses. We believe that over the long term the stock market and economy are closely linked and both will continue to double in value about every 12 years…as has been the case since 1960. We think our long-term investment strategy is different than most other small- and mid-cap managers. We are not trying to beat our benchmark in the short term by making “macro” judgments. We invest only in growth businesses that we think have the potential to double in value on average about every five or six years. 49

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