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Baron Funds

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Baron

Baron Real Estate Fund Lastly, we anticipate that the company will supplement the growth in its operating portfolio with additional growth from new development and acquisitions. We recently initiated a position in CoStar Group, Inc., the leading provider of information and marketing services to the mammoth $50 trillion commercial real estate (CRE) industry. The company has spent 25 years building a proprietary CRE database, which has grown to include information on over 4 million properties and 9 billion square feet of property listings. The company monetizes its data through subscriptions to analytical technological tools that are deeply integrated into clients’ workflows. CoStar’s ongoing investments in R&D and a doubling of its sales force should enable it to sell an expanded array of technological tools to new and existing customers. This should enable CoStar’s core information services business to grow its revenues annually at a low- to mid-teens rate. Trends in its core business are excellent, with most recent quarter revenue growth of 14% and margin improvement of 13%. We are enthusiastic about the transformational potential from the company’s move into the multi-family marketing space. This initiative was initially undertaken through the Apartments.com acquisition, announced in March 2014. CoStar has subsequently rebuilt the entire property in order to leverage its vast content advantage. In early 2015, management announced that it would invest an incremental $75 million to build out the Apartments.com brand. In May 2015, CoStar acquired Apartment Finder, another multi-family marketer, independent listing service, and rebuilt that. We estimate that CoStar now has 10-20 times the coverage of its competitors. We are confident that the opportunities for Apartments.com and Apartment Finder are abundant and growing. We believe that competitors who currently control almost $1 billion of online marketing spending are now vulnerable. They generally have inferior product sets, lower ROIs, and are hamstrung by private equity ownership or recent management changes. We also believe that the online multi-family advertising market will grow towards $3 billion over the next decade as offline advertising dollars transition to online and vendors begin to offer advertising services to smaller buildings. CoStar is currently generating approximately $840 million of revenue, 31% EBITDA margins, and $5.25 per share of free cash flow. We expect revenue to double to $1.5 billion in less than five years and EBITDA margins to expand into the mid-40% range as CoStar leverages its combined investments in sales headcount, product expansion, and multi-family marketing. The combination of sustained revenue growth and dramatic margin expansion should lead to earnings and cash flow power almost tripling from current levels to $13 per share by 2020. We also expect CoStar to generate almost $1.3 billion of cumulative free cash flow over the next four years, which the company may use to make value enhancing acquisitions or return to shareholders. Based on the current valuation of its shares and our expectation for future growth, we believe that the shares of CoStar have the potential to appreciate more than 15% annually over the next few years. We are also confident about our recent purchases of Marriott International, Inc., the largest hotel company in the world, and Masco Corporation, one of the world’s largest manufacturers of brand-name products for the new home construction and home improvement markets. We plan to discuss both companies in future letters. Table VII. Top net sales for the quarter ended December 31, 2016 Quarter End Market Cap or Market Cap When Sold (billions) Amount Sold (millions) Gaming and Leisure Properties, Inc. $6.3 $35.1 Brookdale Senior Living, Inc. 2.2 21.8 Kennedy-Wilson Holdings, Inc. 2.3 20.1 MGM Growth Properties LLC 5.5 18.8 Toll Brothers, Inc. 5.0 18.7 Though we remain optimistic about the long-term prospects for the companies listed in Table VII above, we recently reduced our positions in four of the companies and exited Brookdale Senior Living, Inc. in order to reallocate the proceeds to other investment opportunities. Outlook Regarding the next few years, we address three top-of-mind topics: the possible ramifications from the Trump Presidency, the prospects for real estate, and the outlook for the Baron Real Estate Fund. Q. What are our thoughts regarding the possible ramifications from the Trump Presidency? A. We evaluate the possible ramifications from the Trump presidency, because, in our opinion, it may mark a major inflection point – a game changer – in ideologies with the potential for some dramatic outcomes in the years ahead for the economy, the stock and bond markets, and real estate. Based on what President Trump campaigned on, and his recent Cabinet appointments, the new administration and the Republican congressional majority will likely pursue a pro-business, pro-economic growth agenda. Possible outcomes At the time of this writing, we do not know with certainty which new legislation and initiatives will ultimately be approved or implemented. However, the introduction of pro-business policies that encompass significant fiscal stimulus, and the enactment of corporate and individual tax cuts and fewer bank and business regulations, have the potential, in our opinion, to produce the following effects: • Increases in U.S. economic growth, corporate profits, and jobs; • Rising inflation; • Increases in interest rates; and • A bullish environment for stocks, a bearish environment for bonds, and a rotation out of cash and bonds to stocks. What we don’t know At this stage, we do not know to what extent economic growth, interest rates, inflation, and the U.S. dollar may change. For example, it is not clear to what degree faster economic growth may soften the negative effects of higher inflation and interest rates. In our opinion, the likely direction of the equity, bond, and real estate markets in the months and years ahead will largely be dictated by the pace of change and the ultimate levels of key market influencing factors such as economic growth, inflation, interest rates, and the U.S. dollar. 64

December 31, 2016 Baron Real Estate Fund Q. Real estate has performed well in the last seven years. What is the outlook for the real estate market going forward? A. U.S. commercial and residential real estate have been recovering from the Great Recession for approximately six to seven years. As the historical average length of a real estate cycle is approximately seven years, this raises the obvious question of whether the real estate cycle is in its final innings. Our view is no. We remain bullish about the outlook for real estate for the following reasons: 1. The factors that have fueled the resurgence in real estate largely remain in place: • Demand continues to outstrip supply in most U.S. markets and real estate categories (e.g., office buildings, industrial warehouses, malls, hotels, single family homes, data centers, gaming, etc...) • Balance sheets are in solid shape • Credit remains available at attractive interest rate levels 2. Business conditions are solid for most of our real estate companies – both residential and commercial real estate – and the outlook does not portend a recession. 3. We anticipate that the length of the real estate cycle will persist for another few years. Real estate is clearly past the 1 st or 2 nd inning of its recovery – a period that is typically characterized by (i) the opportunity to buy real estate at distressed prices or large discounts to replacement cost; (ii) low occupancy levels and home sales; (iii) an accommodative Federal Reserve and declining interest rates; and, (iv) the beginning of an economic cycle. We do not believe, however, that real estate is in the 9 th inning of its recovery, because we are not witnessing the broad excesses and warning signs that typically signal the end of a cycle such as: (i) overheated economic and business growth; (ii) a number of spikes in construction activity (commercial and residential); (iii) significantly relaxed bank lending standards and aggressive assumption of debt; (iv) over exuberance for acquisitions; and, (v) euphoric market sentiment (often a telltale sign that a cycle is coming to an end). Our view is that the length of the current real estate cycle will last longer than most prior cycles – perhaps an extra inning game – because the cycle to-date has been devoid of the excesses that typically characterize most real estate cycles. We anticipate an extended economic and real estate cycle due to anticipated pro-growth initiatives such as lower taxes, additional infrastructure spending, and fewer financial regulations. 4. Substantial private capital is still in pursuit of real estate ownership supported by widely available debt capital at low interest rates. If real estate prices were to correct meaningfully due to economic, interest rate, or other concerns, we believe large amounts of capital – from private equity investors such as Blackstone Real Estate, sovereign wealth funds, endowments, pension funds, and others – will step in and capitalize on the opportunity to buy quality real estate at depressed prices. This “embedded put” scenario should limit downside valuation and pricing. 5. Any chinks in the armor are, in our opinion, manageable. Key warning signs that we always monitor include increases in construction activity, deceleration in demand, increased restrictive lending policies, spikes in interest rates, and elevated valuations. Construction activity has increased in a few real estate segments and markets, lenders are requiring wider credit spreads with lower leverage, the Fed is likely to increase interest rates further, and the real estate cycle is in its sixth or seventh year of a sustained recovery. Lastly, with the Trump Presidency, we are also closely monitoring the prospects for changes to the tax code and the possible implications for real estate. While our antenna remains up, we maintain a favorable outlook as our research continues to confirm that the opportunities for real estate outweigh the issues or possible chinks in the armor. 6. We continue to identify several real estate-related companies that are attractively valued. Q. What are the prospects for the Fund over the next few years? A. We are optimistic about the prospects for the Baron Real Estate Fund. Our view is due to three key considerations: 1. Contemplated new business-related legislation has the potential to be particularly favorable for the Baron Real Estate Fund. Simply put, the goals of lower taxes, less regulation, and more fiscal spending; the possibility of faster economic growth; and a normalization of interest rates could bode well especially for the Baron Real Estate Fund. Why? Unlike REIT funds and other dividend-yielding securities that tend to shine brightest in a declining interest rate environment, the Baron Real Estate Fund (which does not limit its real estate investments solely to REITs) has also been structured to perform well in more of a growthoriented, pro-cyclical, and rising interest rate environment. Since the launch of the Fund at the end of 2009 through 2016, there have been four periods when the U.S. 10-year Treasury yield increased by at least 80 basis points. In each instance, the Fund generated strong absolute and relative returns: O O O O 10/8/2010 – 2/10/2011: Interest rates increased 134 basis points. The Fund increased 16.61%, outperforming the MSCI US REIT Index which gained 9.04% and the MSCI USA IMI Extended Real Estate Index which gained 13.85%. 7/24/2012 – 12/31/2013: Interest rates increased 165 basis points. The Fund increased 60.33%, outperforming the MSCI US REIT Index which gained 3.47% and the MSCI USA IMI Extended Real Estate Index which gained 32.83%. 1/30/2015 – 6/10/2015: Interest rates increased 84 basis points. The Fund increased 3.76%, outperforming the MSCI US REIT Index which declined 10.62% and the MSCI USA IMI Extended Real Estate Index which declined 1.36%. 7/8/2016 – 12/15/2016: Interest rates increased by 124 basis points from a historic low of 1.36% this past summer to 2.60% on December 15, 2016. The Baron Real Estate Fund increased 0.08%, outperforming the MSCI US REIT Index which declined 9.19% and the MSCI USA IMI Extended Real Estate Index which declined 2.60%. We believe the Fund, with its broader real estate categories, has the ability to navigate a rising interest rate environment successfully. Please see the “Portfolio Structure” section for our more detailed thoughts on this topic. 65