A Strong Choice Among Small-Growth Funds

The following is our latest Fund Analyst Report for Baron Discovery BDFFX.

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Two up-and-coming managers make Baron Discovery a strong choice, earning cheaper share classes a Morningstar Analyst Rating of Silver, while the more expensive retail shares earn Bronze.

This strategy's focus on young, innovative companies is a bit of a deviation from Baron Capital's more conservative approach to long-term growth investing, but its emerging duo of managers has made it work without forgetting the firm's roots. Like their colleagues, managers Randy Gwirtzman and Laird Bieger look for competitively advantaged businesses with prudent management teams whose stocks can double in price over the next five years. They similarly eschew screening as a method to identify opportunities, preferring to rely on industry conferences, meetings with management, and personal networks. Investments are made with conviction based on bottom-up analysis.

While the framework is similar, investing in the lower ranges of the U.S. small-cap universe presents unique challenges. Other Baron funds like Silver-rated Baron Small Cap BSFIX invest in larger small-caps and will hold them as they mature into mid-caps or even large caps. These companies typically enjoy better access to the capital markets, more-diversified product lines, and higher levels of profitability and cash flow. In contrast, this strategy focuses on newer, faster-growing companies that may have less established business models. Such characteristics typically lead to higher levels of stock price volatility, making this strategy riskier than its siblings at Baron.

Gwirtzman and Bieger have made this foray successful. Since their September 2013 start, the fund's institutional share class gained an annualized 19.7% through November 2020--over 8 percentage points greater than the Russell 2000 Growth Index's return. Its performance has also consistently shone relative to small-cap growth Morningstar Category peers.

Backed by a deep team of like-minded small-cap growth investors, these promising managers have plenty of support and resources to continue their success.

Process | Above Average This strategy builds off a proven long-term growth approach but makes sensible adjustments to fit a more volatile universe. It earns an Above Average Process rating.

The focus here rhymes with that of other Baron Capital strategies that search for steady, competitively entrenched businesses, but expands its sights to companies earlier in their growth cycles. Like their colleagues, the managers leverage their experience as analysts, personal networks, meetings with management teams, and ad-hoc research to find ideas. They target stocks primed for long-term growth that they think can double within five years. However, they focus on smaller companies, often below $2 billion in market cap, which may have an innovative product or service quickly taking market share. These companies may rely on external financing to support their businesses or depend on one or a handful of products. These traits can make them more susceptible to changes in competition or future expectations, leading to higher stock price volatility.

Cognizant of these risks, the managers maintain smaller position sizes than their peers at Baron and take gains more aggressively from their winners. Turnover here runs around 50% to 70%, higher than most Baron strategies. The managers also mix in an allocation to classic "Baron" stocks to tamp down risk. These include steadier businesses in areas such as real estate and industrials.

A look across this portfolio highlights its managers' risk-conscious approach to volatile stocks. The portfolio holds around 60-70 stocks, but usually keeps less than 30% of assets in its top 10 holdings. These larger positions are usually in steadier businesses like SiteOne Landscape Supply SITE, a leading distributor of landscape products, and Utz Brands UTZ, a snack food company.

But the broader portfolio focuses on emerging companies often found in the healthcare and technology sectors. The strategy owns stakes in specialized companies like Silk Road Medical SILK, which makes devices that clear arterial plaques, and Pacific Biosciences of California PACB, which creates DNA sequencing systems. The managers will invest in the typically hit-or-miss biotech segment, though it is consistently the largest industry underweight relative to the Russell 2000 Growth benchmark.

The weighted-average market cap of the fund was $3.3 billion as of September 2020, a touch higher than the Russell 2000 Growth benchmark's $3.0 billion. Earlier in its history, the strategy invested more heavily in micro-caps, but shifted to small caps as its asset base grew. The portfolio's holdings sport higher trailing revenue-growth rates than the benchmark, along with higher valuations like price/sales.

People | Above Average An emerging duo of portfolio managers has impressed, earning an Above Average People rating.

Managers Randy Gwirtzman and Laird Bieger both started at Baron Capital in the early 2000s as analysts, helping support successful strategies like Silver-rated Baron Small Cap. They developed a desire to research younger companies typically passed over in other Baron strategies because they were either too small or too early in their growth cycles. Their passion led to the launch of this fund in September 2013. Strong stock selection has since driven stellar results relative to the benchmark and small-cap growth category peers. Gwirtzman's background is centered in healthcare and technology, while Bieger focuses on consumer and real estate companies. Both have played important roles in the strategy's success, as the portfolio's best-performing stocks came from both of their areas of expertise.

Having worked together first as analysts and then comanagers, the two have developed a strong rapport and feel they know each other's strengths well. They leverage Baron Capital's team of 14 domestic analysts and 13 other portfolio managers. While the firm has expanded into international markets and large-cap stocks, the U.S. small- and mid-cap roots of founder Ron Baron remain its greatest strength.

Parent | Above Average Baron Capital's deep bench of stock-pickers keeps the firm moving forward as founder Ron Baron progresses through his long career, leading to an Above Average Parent rating.

The firm has grown meaningfully in personnel and scope since its 1982 inception. More than 30 research staff now support 17 strategies representing $33 billion in assets under management as of June 30. While founder Ron Baron's roots are in small-and mid-cap U.S. equities, he has successfully overseen expansion into other areas such as international equities.

While much has changed, the firm’s commitment to patient long-term growth investing has endured through the development of new generations of managers and analysts. Baron stepped down as CIO in February 2020, appointing longtime portfolio managers Cliff Greenberg and Andrew Peck to the now-shared role. Baron remains engaged in his portfolio-management duties and as CEO, but the firm has planned ahead by naming comanagers on several funds, including his two sons, who also serve on the firm's eight-person management committee and are slated to inherit his majority ownership in the firm. Five other key employees have small stakes.

Baron has long emphasized investing alongside clients, explaining the firm's high levels of manager ownership. The firm's above-average fee levels remain a drawback.

Performance Since the institutional shares' September 2013 inception through November 2020, the fund's 19.7% annualized return trumped the 11.6% return of both the Russell 2000 Growth Index and the small-cap growth category average. The strategy typically excelled during the market's upswings but tended to lag during sharp declines such as in late 2015 and in 2018's small-cap bear market. Despite greater volatility, the excess returns more than compensated for the risk: The fund posted a higher Sharpe ratio (a measure of risk-adjusted returns) in over 90% of rolling three-year periods versus its benchmark.

The strategy's lone blemish was calendar-year 2015 when it trailed the benchmark by about 13 percentage points. Poor stock selection and exposure to energy infrastructure were the culprits. The managers have since reduced their investments in biotech companies, which have produced mixed results here, and commodity-sensitive industries to focus on their strengths in more predictable, capital-light businesses. From 2016 onward, the fund posted stellar results, particularly in 2020. Key winners for the year-to-date period through November included CareDx, a molecular diagnostics company, and casino operator Penn National Gaming PENN, whose shares spiked since their purchase in the first quarter of 2020.

Price It's critical to evaluate expenses, as they come directly out of returns. The share class on this report levies a fee that ranks in its Morningstar Category's second-costliest quintile. That's poor, but based on our assessment of the fund's People, Process, and Parent Pillars in the context of these fees, we still think this share class will be able to overcome its high fees and deliver positive alpha relative to the category benchmark index, explaining its Analyst Rating of Bronze.