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Baron Funds

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Baron

Baron Discovery Fund rich year we can see through our windshield, in an effort to answer the perennial question: “Why buy now?” We take pride in our deep and detailed research process. And we’ve seeded the portfolio with a lot of investments that we consider to be “terrific” under the Baron lexicon (great managements, strategies, market opportunities, competitive advantages and cash flow growth potential – all at a reasonable valuation). Our long-term viewpoint means that, by definition, not everything is hitting on all cylinders when we make a purchase (because it would then have to be at least fullyvalued in the short term as the market discounts all known information). Thus, we are always waiting for strategic growth initiatives to germinate within our companies in order to unlock incremental value. These initiatives ripen at different times, among different investments in the portfolio. While we always hope to have a good spread of catalysts across a given time horizon, we believe that the current portfolio is extremely rich in 2017. This catalyst heat map becomes all the more important given the dramatic sector rotations we laid out above. While smart beta allocations and hot sectors come and go, what remains evergreen is a high medium-to-longterm correlation of equity values with cash flow generation. And that’s our game. So let’s examine our catalyst menu. Conventionally, Health Care is viewed as defensive, but it’s also facing the headwind of the uncertainty of the reform of the Affordable Care Act (“Obamacare”). To try to mitigate the political risk in the sector, we look for companies that we believe can provide better patient outcomes for lower overall costs. That way all stakeholders can win. In the space we own: • Flexion Therapeutics Inc., which has a potential $4 billion market for injectable treatment of osteoarthritis. It expects FDA approval of its drug Zilretta by the second half of 2017 (phase 3 data from last June was positive). • TherapeuticsMD, Inc. has a potential $1-$2 billion market in vulvarvaginal atrophy treatments (VVA), and a $3-$4 billion market in drugs for the treatment of hot flash symptoms related to menopause. VVA should be approved in May 2017, and we expect the menopause drug to be approved in early 2018 (phase 3 clinical results for both drugs were excellent). • Foundation Medicine, Inc. provides state-of-the-art next generation genomic sequencing tests for advanced cancers. It has a $2-$3 billion potential market and revenues could accelerate in the second half of 2017 if the FDA approves its solid tumor test according to current timelines (which would be the first approval of its kind), and the test gets simultaneously reimbursed by CMS (Medicare payer) as part of the same process. • Sientra, Inc. is a medical device company that manufactures breast implants and sells related surgical products. It expects to get a major U.S.-based manufacturing facility approved by the FDA in the second half of 2017. Technology is ever changing, so we like companies with protected intellectual property and big market opportunities: • MACOM Technology Solutions Holdings, Inc. is an analog semiconductor design and manufacturing company. In 2017 it has the potential to see huge growth in applications of its technology to optical networking (a multi-billion dollar market), cell phone tower transmission power amplifiers (a $1 billion market in which MACOM has patent protection), defense and civil radars, and other opportunities. We see 20% revenue growth for years to come. • Everspin Technologies, Inc. is expected to launch a chip which will open up a $500 million memory market in which we believe the company has a multi-year lead. • Impinj, Inc., a manufacturer of radio-frequency identification (RFID) solutions for asset tracking, continues to make progress in its core retailer channel, and we expect more retailer customers to go live in 2017. In addition, we expect other emerging channels, such as airlines and hospitals, to show continued progress. Consumer also has some exciting surprises in store: • Wingstop Inc., a franchisor of chicken wing focused take out restaurants, is launching a national advertising campaign for the first time in March. Historically, when other chains have launched national ad campaigns, they have seen a significant pickup in same store sales over the next couple of years. • Red Rock Resorts, Inc., an operator of casinos catering to Las Vegas residents, is expected to announce its property improvement plan for the newly acquired Palms casino. The Palms’ profitability is less than half of where it was at its peak, and we believe with new amenities and upgrades (and under the management of the Red Rock team), the property can return to peak profit levels. • Liberty Media Group will complete its purchase of the Formula 1 car racing series in the first half of 2017. We then expect Formula 1’s new management to lay out an operational and profitability improvement plan that will boost profitability for the series in 2018 and beyond. We are excited for the potential of this series given that we believe it has not been fully exploited over the last few years. • Barfresh Food Group, Inc., a manufacturer of ready-to-blend beverages, continues to run product trials with large quick service restaurant customers. Trials are advancing toward full chain rollouts, with initial announcements to come this year. We could write similar bullets for nearly every one of the Fund’s investments, but we hope this gives our investors a good sense as to why we are so optimistic about our portfolio for the coming year. Table II. Top contributors to performance for the quarter ended December 31, 2016 Percent Impact Mercury Systems, Inc. 1.04% Kinsale Capital Group, Inc. 0.84 BlackLine, Inc. 0.68 Dominion Midstream Partners, L.P. 0.59 ESCO Technologies, Inc. 0.39 Mercury Systems, Inc. is a provider of complex electronic subsystems to major defense contractors. In March, Mercury made a significant acquisition of a defense unit that was part of Microsemi Corp. This unit added embedded protection capabilities that are like military hardware cybersecurity, as well as solid state storage capabilities for its systems (versus using hard disk drives). During the fourth quarter, shares performed well as Mercury continued to win contract awards. This was aided by the sentiment that a Republican administration will be more likely to increase defense spending. We agree with this theory, but believe that Mercury’s growth is likely to be driven as much, or more, by market share gains as more work is outsourced to it by major defense prime contractors. 82

December 31, 2016 Baron Discovery Fund Kinsale Captial Group, Inc. is a specialty insurance company that focuses exclusively on excess and surplus lines, which includes risks that are unique or hard to place in the standard insurance market. The company, which went public in July 2016, outperformed in the fourth quarter after reporting excellent financial results. Earnings were much higher than expected thanks to strong underwriting and favorable reserve development. The stock also benefited from a secondary offering that increased float and a sector rotation into small-cap financials following the U.S. elections on expectations for faster economic growth, higher interest rates, and lower corporate tax rates. We continue to own the stock because of Kinsale’s niche market focus, industry-leading growth, industry-leading ROE, and experienced management team. BlackLine, Inc. modernizes manual accounting processes through a cloud solution, providing better visibility and efficiency to customers. BlackLine’s shares outperformed this quarter, as the company continued to grow its market share both in the mid- and high-end portions of the market and continued to expand its strategic partnerships. With its growing product line and investments in sales capacity, we believe that BlackLine should continue its rapid sales growth going forward. Dominion Midstream Partners, L.P., a holder of natural gas storage, processing and transportation assets, was a contributor in the quarter. The company acquired assets of Questar pipeline during the quarter, which was highly accretive to unit holders. The announced deal also removed the overhang of an equity offering that was also concluded during the quarter. We believe the company still has a large pipeline of future drop downs, and we remain comfortable with management’s 22% distribution growth guidance. ESCO Technologies, Inc. posted an impressive 20% earnings per share increase in its September quarter. Management drove solid organic growth, supplemented by four announced acquisitions that should be accretive. In addition, a major comparable company operating in its filtration segment was purchased at a very high multiple, highlighting that much value still remains in ESCO’s equity. In November, ESCO offered positive guidance for its upcoming fiscal year. Also, like many industrial stocks, it has benefited from the perception that the proposed policies of President-elect Trump will be positive for the economy. Table III. Top detractors from performance for the quarter ended December 31, 2016 Percent Impact Novadaq Technologies Inc. -0.90% Qualys, Inc. -0.73 Flotek Industries, Inc. -0.71 Cerus Corporation -0.63 Foundation Medicine, Inc. -0.57 Novadaq Technologies Inc. is a medical imaging company. Its tools, which show blood flow (perfusion), have been clinically proven to dramatically improve outcomes in many types of surgeries, including colon resection (where a segment of colon is removed and the ends are re-attached), breast reconstruction (typically in cancer surgeries), and many other general surgeries. Significant clinical trials are underway with leading medical institutions that will assess the ability of Novadaq devices in guiding complex lymph node surgeries related to the spread of cancer. The company also sells human-based tissue replacement (complementary to breast reconstruction, and potentially useful for diabetic foot ulcer treatment). Shares fell in the fourth quarter due to, what in our opinion was, a misunderstanding of the halting of a clinical trial in colon resection. The company halted the trial (which was to be a larger version of a prior successful trial in the space) because its devices have been proven to be so good that the company couldn’t find doctors willing to forego its use on surgeries needed to create a control group cohort. Another issue holding back the shares is a change of business plan to sell capital equipment to customers over three-to-four years versus an upfront payment, which defers revenue and cash flow. Thus, despite recurring revenues growing at 40-50% rates (half the business), equipment sales growth has slowed to single digits. This has caused overall revenue growth to slow to 25% from about 30%-40% growth. We are assessing the situation, but believe the current multiple reflects the change in business dynamics. Also, because of the model change, more of the company’s revenues will be recurring, making Novadaq more attractive to potential acquirers, particularly at its current valuation. Qualys, Inc. is a cloud-based cybersecurity services provider that specializes in assessing software vulnerabilities of hardware attached to internet networks. Shares were down in the quarter as investors worried that the costs of launching new products would hamper operating margins in 2017. The company has been very successful with new product offerings, particularly its cloud agent technology, which allows customers to see changes to hardware configurations in a rapid and dynamic manner. This allows for quicker responses to potential cyber-intrusions. We are not concerned, and we applaud this kind of value-generating investment. Qualys is accelerating its revenue growth to nearly 20% and continues to trade at a very reasonable multiple of real free cash flow whereas many of its cyber peers are still losing money. Flotek Industries, Inc. is primarily a supplier of chemical additives to the global oil & gas industry with some other ancillary oilfield service operations. The company has a proprietary product dubbed “complex nanofluid (CnF)” that is proving to be extremely effective at increasing oil & gas shale well productivity. The company’s shares fell in the quarter following the assertion by a short-seller that independent consultant studies commissioned by Flotek earlier in 2016 were based on incomplete data and therefore the short-seller questioned the efficacy of the CnF product. In response to these allegations, the independent consultants referenced above later incorporated additional data and still reiterated their conclusions about the positive impact of CnF on customer well productivity. We expect Flotek’s shares to rebound as the company demonstrates that customer demand for CnF remains strong. Cerus Corporation has an FDA and EU approved device that inactivates pathogens such as viruses and bacteria in donated blood. Current regulatory approvals cover use of the Cerus device for platelets and plasma from donated blood (an $800 million worldwide, and $350 million U.S. market opportunity, for which Cerus has signed up over 80% of all U.S. blood centers). If additional approvals for usage with red blood cell (RBC) components are obtained, Cerus will add an estimated $2.5 billion in market opportunity ($1 billion in the U.S., in the same blood centers), for which there is no current competition. Shares slipped in the fourth quarter as the company slightly extended its timeline (by what we estimate might be one to two quarters) to get the RBC product to market. We believe Cerus is targeting EU approval for RBC in early 2018, and we believe that U.S. approval could be obtained for RBC in 2019. We believe growth prospects for Cerus are significant for 2017 and beyond. Foundation Medicine, Inc. is a high end genomic cancer testing and information services company. Delays in obtaining reimbursement have caused guidance reductions, and shares have dropped significantly since 83

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