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Baron Funds



Baron Real Estate Fund expect to benefit from other secular and/or cyclical tailwinds. Examples include: (i) Infrastructure-related companies that should gain from increased government spending on infrastructure projects and improvements in residential and non-residential construction. Examples include Vulcan Materials Company, Martin Marietta Materials, Inc., and Brookfield Asset Management, Inc. (ii) Student housing companies that should profit from a growing number of universities that are transitioning to outsourcing student housing needs to developers. An example is American Campus Communities, Inc. (iii) Residential-related companies that are expected to benefit over time from the release of pent-up housing demand from the cyclically stagnant residential market. Examples are highlighted above. 6. Number of Fund holdings At December 31, 2016, we were invested in 37 companies, which is a bit lower than the 41 companies we held at the end of 2015. Our 10 largest holdings represent 48.6% of the Fund. 7. Market Capitalization We invest in companies of all market capitalizations. At December 31, 2016, the median market capitalization of the Fund’s investments was $12.6 billion. Companies with a market capitalization of less than $2.5 billion represented only 12.1% of the Fund. 8. Real Estate-Related Categories: The Baron Real Estate Fund currently has investments in 11 real estate-related categories (see Table IV below). The Fund’s diversification is in contrast to most other real estate funds that limit their investments primarily to one real estate category, REITs. We maintain that the Fund’s broader approach and diversity is a long-term competitive benefit. Table IV. Fund investments in real estate categories as of December 31, 2016 Percent of Net Assets REITs 30.4% Building Products/Services 26.5 Hotel & Leisure 10.1 Cruise Lines 3.5% Hotels & Timeshare/Leisure 6.6 Real Estate Service Companies 6.7 Casinos & Gaming Operators 6.3 Data Center Operating Companies 1 6.1 Infrastructure-Related Real Estate Companies 3.8 Real Estate Operating Companies 3.6 Tower Operators 2 2.8 Homebuilders & Land Developers 1.5 97.8 Cash and Cash Equivalents 2.2 100.0% 1 Total would be 11.2% if included data center REIT Equinix, Inc. 2 Total would be 7.6% if included tower REIT American Tower Corp. The Fund’s top 10 holdings as of December 31, 2016, are as follows: Table V. Top 10 holdings as of December 31, 2016 Quarter End Market Cap (billions) Quarter End Investment Value (millions) Percent of Net Assets Mohawk Industries, Inc. $ 14.8 $65.0 6.8% MGM Resorts International 16.5 59.6 6.3 InterXion Holding N.V. 2.5 58.0 6.1 Equinix, Inc. 25.5 48.1 5.1 American Tower Corp. 45.0 46.1 4.8 Hilton Worldwide Holdings, Inc. 26.9 44.0 4.6 Home Depot, Inc. 163.3 40.5 4.3 CBRE Group, Inc. 10.6 36.2 3.8 Macquarie Infrastructure Corporation 6.7 35.8 3.8 Vulcan Materials Company 16.6 28.4 3.0 In the most recent quarter, we initiated positions in five companies that we have long admired. Recent Activity Table VI. Top net purchases for the quarter ended December 31, 2016 Quarter End Market Cap (billions) Amount Purchased (millions) The Sherwin-Williams Company $25.0 $26.0 Prologis, Inc. 27.9 19.7 CoStar Group, Inc. 6.1 18.3 Marriott International, Inc. 32.3 17.0 Masco Corporation 10.4 14.6 The Sherwin-Williams Company is a global leader in the manufacture, development, distribution, and sale of paint, coatings, and related products to professional, industrial, commercial, and retail customers. The company manufactures products under well-known brands such as Sherwin-Williams, Dutch Boy, Krylon, Minwax, Thompson’s Water Seal, Valspar (pending acquisition), and a number of other brands. Sherwin-Williams products are sold exclusively through more than 4,100 company-operated stores and facilities, while the company’s other brands are sold through leading mass merchandisers, home centers, independent paint dealers, hardware stores, automotive retailers, and industrial distributors. We believe Sherwin-Williams is an attractive long-term investment opportunity because: 1. Paint/coatings tend to possess compelling business traits: (i) (ii) Pricing power: Historically, manufacturers have been able to raise prices to offset increases in raw material costs because the price of paint/coatings tends to be a small portion of the overall cost of a typical new construction or renovation project (approximately 10% to 15% of the total cost is paint, the rest is labor). High margins: Due to the high number of customized and highly specified paint/coating formulations that are typically required for consumers, manufacturers have the capability to generate strong profitability margins. 62

December 31, 2016 Baron Real Estate Fund (iii) Low risk of disintermediation from e-commerce competition: Choosing a paint color tends to be an iterative process that does not lend itself to online purchases because computer screens do not render paint colors accurately. Further, unlike most products which can be shipped by air, solvent-based paint must be shipped by ground because of the hazard its high chemical content presents. (iv) Above average growth over the long term: Over the course of an economic cycle, architectural coatings growth has often grown twice as fast as overall GDP growth because painting tends to be a relatively costeffective redesign option. 2. Sherwin-Williams is a best-in-class company with competitive advantages: ThereareseveralreasonswhywewouldcharacterizeSherwin- Williams as a best-in-class company. A few considerations include: (i) (ii) (iii) Leading market share position with strong brands: The Company manages the largest network of dedicated paint stores in North America with more than 4,100 stores nationally, which equates to a 40% market share that is three times the size of its nearest dedicated store competitor (PPG). Home Depot and Lowe’s, with 2,275 and 2,119 stores, respectively, also sell paint in their home centers, but do not have dedicated paint stores. We believe there is an opportunity for the company to increase market share through additional store openings and deeper penetration of its customers. The company has the highest global brand awareness among architectural paint manufacturers, with brands such as Sherwin-Williams, Dutch Boy, Krylon, Thompson’s Waterseal, MinWax, Valspar (pending acquisition), and others. Scale advantages through its unique retail distribution model: A key competitive distinction for Sherwin- Williams is that the company supplies its own label paints, coatings, and peripherals primarily to professional paint contractors rather than do-it-yourself customers. Approximately 80% of sales are generated by professional painters, defined as a contractor who generates at least 75% of its business from paint. The quality service that Sherwin-Williams can provide to professional paint contractors through its more than 4,000 stores and its national network of 2,500 customer service representatives is a considerable competitive advantage. Historically, the company’s high level of service and ability to be responsive to customer needs in a timely fashion has contributed to enduring relationships with professional painters and an ability to increase prices to offset any increases in costs. Well-managed business: Management has a strong track record of delivering solid financial results and shareholder friendly capital allocation. 3. The company is positioned to benefit from a cyclical rebound in residential construction and higher U.S. infrastructure investment: Given that demand for paint tends to track new home construction, home prices, and existing home sales (home owners paint before and after moving), we anticipate that Sherwin- Williams will benefit from a continued rebound in economic and housing construction activity. Further, we believe the company could benefit from a recovery and new initiatives in U.S. and state governments’ infrastructure spending because Sherwin-Williams manufactures protective coatings that are used for bridges, highways, and other commercial infrastructure end markets. 4. The $11 billion Valspar acquisition has several strategic merits: The company expects to finalize its acquisition of Valspar, the fifth largest global coatings company in the world, by the end of the first quarter of 2017. We are bullish about the merits of the acquisition because: (i) Sherwin-Williams will become the largest global paint and coatings company in the world and should attract more global customers; (ii) The combination of the two companies will be complementary (per management, ‘they are strong where we are not, and vice-versa.) Notably, Valspar will expand Sherwin-Williams’ geographic and industrial coatings presence; and, (iii) Sales and earnings growth plus cost savings opportunities should accelerate over time. We recently began acquiring shares in Prologis, Inc., the world’s largest owner, operator, and developer of industrial logistics real estate. The company’s real estate portfolio is concentrated in major global trade markets, regional distribution markets, and large population centers across the Americas (78%), Europe (19%), and Asia (3%). We are optimistic about the long-term prospects for the company because of the benefits of its large global platform and attractive outlook for growth. Prologis’ large global portfolio allows it to manage larger customer relationships across geographic regions and positions the company for more investment opportunities. We expect the prospects for future occupancy and rent growth to be aided by demand trends that continue to outpace new construction. Demand is increasing from solid U.S. consumption, a continued recovery in growth from housing-related tenants, and the structural tailwind of online sales growth. It is estimated that e-commerce businesses require three times as much warehouse floor space per dollar of sales versus traditional brick and mortar retailers for several reasons, including a wide product assortment, greater inventory levels, and higher merchandise returns. Further, it is estimated that the e-commerce industry increased the demand for industrial real estate by 20% in 2014 and 2015 and by 30-40% in 2016 (Amazon is an example of a company that has been actively seeking industrial logistics sites). The outlook for new construction activity appears to be more favorable than in the past because same-day shipping demand has required logistics facilities to move closer to urban centers to reduce transportation times. There is a lack of quality real estate locations in and around cities and long approval timetables to receive real estate permits. Further, more restrictive lending standards for construction loans are also limiting the pool of potential developers. 63

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