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Baron Funds



Baron Focused Growth Fund Table II Performance Periods of euphoria and stress “Yesterday” Clinton Years 1992-2000 12/31/99 P/E 33x Inception 5/31/1996 to 12/31/1999 Internet Bubble 10/8/1998 to 3/9/2000 “The Long and Winding Road” Bush Years 2000-2008 9/11; Iraq; Afghanistan; Housing Bubble; Financial Panic “Here Comes the Sun” Recovery and Quantitative Easing 2009-2013 Annualized Returns 12/31/1999 to 12/31/2008 12/31/2008 to 12/31/2013 “Helter Skelter” Fed Tightening 12/31/2013 to 12/31/2016 “Any Time at All” Inception 5/31/1996 to 12/31/2016 Baron Focused Growth Fund (Institutional Shares) 27.87% 41.77% 2.72% 19.46% 0.45% 10.34% Russell 2500 Growth Index 17.60% 126.53% (3.99)% 24.03% 5.45% 7.30% S&P 500 Index 26.58% 32.29% (3.60)% 17.94% 8.87% 8.05% Percentile rank in Morningstar Mid-Cap Growth Category* 24** 94** 11** 76 91 11** # of Share Class in the Category 266** 416** 366** 531 588 86** Morningstar US Fund Mid-Cap Growth Peer Group Avg 22.34% 120.57% (3.33)% 20.97% 3.98% 7.94% * The Morningstar US Fund Mid-Cap Growth Category Average is not weighted and represents the straight average of annualized returns of each of the funds in the Mid-Cap Growth Category. Morningstar rankings are based on total returns and do not include sales charges. Total returns do account for management, administrative, and 12b-1 fees and other costs automatically deducted from fund assets. As of December 31, 2016, the Category consisted of 644, 504 and 369 funds for the 1-, 5- and 10-year periods. Baron Focused Growth Fund Institutional Share Class ranked in the 84 th ,95 th ,77 th and 11 th percentiles, respectively, in the Category for the 1-, 5-, 10-year and since inception (5/31/1996) periods (consisted of 86 funds). The Category consisted of 266, 416, 366, 531, 588 and 86 funds during the time intervals 5/31/1996–12/31/1999, 10/8/1998–3/9/2000, 12/31/1999–12/31/2008, 12/31/2008–12/31/2013, 12/31/2013–12/31/2016 and 5/31/1996– 12/31/2016, respectively. Baron Focused Growth Fund Institutional Share Class ranked in the 24 th ,94 th ,11 th ,76 th ,91 st and 11 th percentiles, for the respective time intervals. ** Source: Morningstar Direct-Performance Reporting. Table III. Performance Based Characteristics as of December 31, 2016 5/31/1996 to 12/31/1999 10/8/1998 to 3/9/2000 12/31/1999 to 12/31/2008 Time Interval 12/31/2008 to 12/31/2013 12/31/2013 to 12/31/2016 5/31/1996 to 12/31/2016 Alpha (%) 12.42 5.94 5.97 –1.47 –3.89 4.81 Beta 0.85 0.37 0.69 0.89 0.84 0.77 # of Monthly Observations 43 18 108 60 36 247 Table IV. Top contributors to performance for the quarter ended December 31, 2016 Year Acquired Market Cap When Acquired (billions) Quarter End Market Cap (billions) Total Return Percent Impact Hyatt Hotels Corp. 2009 $4.2 $7.2 12.27% 1.28% Choice Hotels International, Inc. 2010 1.9 3.1 24.81 1.00 Financial Engines, Inc. 2014 1.8 2.3 23.93 0.76 Iridium Communications Inc. 2014 0.6 0.9 15.77 0.63 Vail Resorts, Inc. 2013 2.3 6.4 3.87 0.49 Shares of global hotelier Hyatt Hotels Corp. increased in the fourth quarter as investors rotated into lodging stocks, which we think will be one of the biggest beneficiaries of higher inflation. The company maintained its fiscal year 2016 guidance for revenue per available room and indicated on-track growth for 2017, which helped boost investor confidence in the business and the continued upward trajectory of the lodging cycle. (David Baron) Shares of hotel franchisor Choice Hotels International, Inc. increased in the fourth quarter as investors rotated into lodging stocks, which we think will be among the biggest beneficiaries of higher inflation. The consistency of the company’s revenue and earnings throughout the lodging cycle, given its fee-based model and the strength of its dividend and share buyback program, also helped boost the share price during the quarter. (David Baron) Shares of Financial Engines, Inc., a defined benefits service provider, rose in the fourth quarter, as initiatives to improve enrollments appeared to be working. Cancellations declined as a new marketing program and live advisors improved communications with new members. Its acquisition of the Mutual Fund Store has been integrated and these advisors have begun conducting seminars which should also improve enrollments, in our view. The acquisition opens the service to investable assets outside of defined contribution, potentially doubling the addressable market. (Michael Baron) 50

December 31, 2016 Baron Focused Growth Fund Table V. Top detractors from performance for the quarter ended December 31, 2016 Year Acquired Market Cap When Acquired (billions) Quarter End Market Cap (billions) Total Return Percent Impact Benefitfocus, Inc. 2014 $0.7 $0.9 –25.60% –1.42% CoStar Group, Inc. 2014 6.2 6.1 –12.95 –1.25 Caesarstone Ltd. 2013 1.5 1.0 –24.03 –0.90 Manchester United plc 2012 2.3 2.3 –15.08 –0.81 Guidewire Software, Inc. 2013 2.7 3.6 –17.76 –0.64 Shares of benefits software vendor Benefitfocus, Inc. detracted from fourth quarter performance. The company provided modestly lower-than-expected guidance for 2017. We see several short-term headwinds, including longer implementation periods for national accounts, slower employer signings because of a sales restructuring, and a revenue share of BenefitStore commissions. While these headwinds will likely weigh on reported growth through mid-2017, we don’t believe they impact the significant long-term opportunity. (Neal Rosenberg) 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 annual recurring revenue. We think trends in the core business are excellent, with revenue growth of 14% and margin improvement of 13% in the most recently reported quarter. (Neal Rosenberg) Shares of Caesarstone Ltd., a global manufacturer of quartz surfaces for kitchens and bathrooms, detracted from fourth quarter performance. The stock declined after the company reported quarterly financial results that missed Street expectations and lowered its full-year guidance. We believe this was the result of startup costs incurred in a new plant that significantly increases its production capacity. We remain optimistic based on Caesarstone’s respected brand and continued expected secular shift to quartz from other countertop materials. (David Kirshenbaum) Investment Strategy & Portfolio Structure The objective of Baron Focused Growth Fund is to double its value per share in five years. Our strategy to accomplish this goal is to invest for the long term in a focused portfolio of what we believe are appropriately capitalized, well-managed, small- and mid-cap growth businesses at attractive prices. We attempt to create a portfolio of less than 30 securities diversified by GICS sectors and other qualitative factors that will be approximately 80% as volatile (beta) as the market. These businesses are identified through our Firm’s proprietary research efforts. As of December 31, 2016, Baron Focused Growth Fund held 18 investments. The weighted average market capitalization of these companies was $8.9 billion compared with $4.4 billion for the Russell 2500 Growth Index. The Fund’s average portfolio turnover for the past three years was 21.1%. This means the Fund has an average holding period for its investments of approximately five years. This contrasts sharply with the average mid-cap growth mutual fund, which typically “turns over” its portfolio every 16 months. From a quality characteristics standpoint, the Fund’s investments have higher sales and earnings growth than the average holdings in the benchmark, are more conservatively financed (evidenced by lower debt to market cap ratio), and offer more consistent earnings (lower beta and lower standard deviation of EPS growth). We believe these metrics are important to help limit risk for this concentrated portfolio. We think the businesses in which Baron Focused Growth Fund has invested have the potential to double in size over five years and double again over the subsequent five to six years. We think these well-managed businesses have attributes that make them appealing investments, including sustainable competitive advantages and strong, long-term growth opportunities. Considering current stock price valuations, we believe we have the opportunity to meet our performance goals during the next decade, although there is no guarantee that we will do so. While concentrated, the Fund is diversified by sector. The Fund’s weightings are significantly different than those of the Russell 2500 Growth Index. The Fund is further diversified by investments in businesses at different stages of growth and development. We believe the diversity of businesses owned in the portfolio should result in steadier results for the Fund across various business cycles. For example, we classify the holdings of Baron Focused Growth Fund as one of three types (Tables VII-IX below): 1) early stage growth businesses; 2) companies with irreplaceable assets that offer pricing power and a hedge against inflation; and 3) foundational, long-term investments that continue to steadily grow sales and earnings while using excess free cash to return value to shareholders. Rapidly growing and still immature businesses account for approximately 39% of the Fund’s assets. On current metrics, these businesses look expensive; however, we think they will continue to grow and have the potential to generate exceptional returns. Examples of these companies include electric vehicle manufacturer Tesla Motors, commercial satellite company Iridium Communications Inc., commercial real estate database Costar Group, and corporate benefits software provider Benefitfocus. Companies with what we believe represent irreplaceable assets comprise approximately 28% of the Fund’s assets. Vail Resorts, owner of the premier ski resort portfolio in the world, upscale lodging brand Hyatt Hotels, and storied soccer franchise Manchester United are all examples of companies we believe possess meaningful brand equity and barriers to entry in their businesses that equate to pricing power over time. Steady growers that continually return excess free cash to shareholders represent the remaining 25% of the portfolio. Choice Hotels employs a capital-light franchise model for its mid-tier hotel brands that allows the company to return cash to shareholders through buybacks and dividends while still achieving strong revenue and earnings growth. Leading industrial supplies distributor Fastenal Co. delivers exceptional customer service through the use of on-site facilities and vending machines to capture an increasing share of its customers’ spend. Specialty property and casualty insurer Arch Capital continues to generate above-average returns due to profitable underwriting and favorable reserve development. The company’s recent acquisition of AIG’s United Guaranty division makes Arch Capital the nation’s largest underwriter of mortgage insurance as well. 51

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