Finance

The Baron Discovery Fund experienced a challenging first quarter in 2026, recording a 10.65% decrease in institutional shares, significantly underperforming the Russell 2000 Growth Index. This downturn was largely attributed to a sector-wide slump in software, fueled by market fears of AI disruption. Despite these headwinds, the fund managers maintain a conviction that the current market presents attractive long-term investment opportunities, especially in software companies with robust competitive advantages. They highlight the potential for market re-evaluation through catalysts such as increased merger and acquisition activities, the emergence of AI-related cyber-attacks, and strategic partnerships between traditional software providers and large language model developers. The fund also diversified its portfolio with new investments in critical infrastructure sectors, including electrical distribution equipment and industrial technology, aiming to capitalize on broader economic growth drivers.

Amidst the market volatility, the Baron Discovery Fund has strategically positioned its portfolio to capitalize on companies with inherent strengths. The fund emphasizes investments in software firms that leverage proprietary data, benefit from strong network effects, or integrate with specialized hardware. These companies are believed to be more resilient to the transformative changes brought about by AI. New acquisitions like Forgent Power Solutions, a leader in electrical distribution, and Enpro Inc., an industrial technology innovator, further underscore the fund's strategy to tap into robust growth areas. The fund managers are committed to their long-term, fundamental approach, diligently researching companies to identify those with sustainable advantages and exceptional management teams, confident that their efforts will lead to future outperformance despite short-term fluctuations.

Navigating Market Headwinds and Identifying Opportunity

The first quarter of 2026 presented significant challenges for the Baron Discovery Fund, which saw its institutional shares decline by 10.65%. This performance lagged the Russell 2000 Growth Index by a notable 7.84%, primarily due to a widespread downturn in the software sector. The market's apprehension regarding the disruptive potential of artificial intelligence on traditional software-as-a-service (SaaS) models led to a re-pricing of many technology stocks. This sentiment created a difficult environment for the fund's holdings in IT, consumer discretionary, and healthcare sectors. The underperformance was also exacerbated by the fund's limited exposure to the energy and materials sectors, which experienced a surge during the period. Despite these short-term setbacks, the fund managers view the current valuation levels of software companies as exceptionally attractive, presenting unique opportunities for long-term growth for those with strong, defensible competitive advantages.

The fund's strategic response to the market's re-evaluation of software companies involves a deep dive into firms that possess intrinsic value beyond mere code. Investments focus on businesses with deterministic data, offering precise and verifiable information crucial for regulated industries such as healthcare and finance, where external large language models (LLMs) may pose security or compliance risks. Companies like SentinelOne, specializing in AI-driven endpoint protection, and Dynatrace, providing observability software with internal AI for network and application fault prediction, exemplify this strategy. Furthermore, the fund values companies with strong network effects, like ServiceTitan and Procore Technologies, whose platforms create substantial switching costs for customers within specialized industries. Hybrid software and hardware solutions, such as those offered by Netskope, also form a key part of the investment thesis, as they are less susceptible to pure software replication. The fund anticipates that emerging catalysts, including increased M&A activity, cyber-attacks leveraging LLM vulnerabilities, and strategic partnerships, will highlight the distinct advantages of these portfolio companies, leading to a significant re-rating in their valuations.

Strategic Portfolio Adjustments and Future Growth Drivers

In response to the market's dynamic landscape, the Baron Discovery Fund has undertaken strategic adjustments within its portfolio, focusing on reinforcing positions in companies poised for long-term growth and divesting from those with diminished competitive advantages. The fund made significant net purchases in companies like Forgent Power Solutions, a leading manufacturer of electrical distribution equipment critical for data centers and the power grid. This investment reflects a conviction in the robust capital expenditure trends in infrastructure and the company's unique positioning to address supply/demand imbalances with its custom, "engineered-to-order" products and advanced manufacturing capabilities. Similarly, the fund increased its stake in Enpro Inc., a diversified industrial technology firm that benefits from recurring aftermarket revenue and exposure to high-growth end markets like semiconductors, particularly driven by AI demand. These acquisitions underscore a broader strategy to capitalize on fundamental shifts in industrial and technological landscapes.

The fund's investment philosophy emphasizes identifying companies that exhibit resilience and growth potential even in turbulent markets. The focus on software companies with distinct competitive moats—such as proprietary deterministic data, strong network effects, and integrated hardware components—aims to mitigate risks associated with rapid AI advancements. The fund's commitment to companies like Dynatrace and Heartflow, which leverage AI for critical functions in complex environments or highly regulated industries, demonstrates a belief in their enduring value. Despite recent underperformance, the fund managers are confident that these strategically chosen investments, characterized by solid financial performance, attractive valuations, and robust free cash flow generation, are well-positioned for substantial outperformance in the years to come. The proactive approach to portfolio management, including the sale of positions in companies facing acquisition or potential disruption by LLMs, further reflects a commitment to optimizing returns based on rigorous due diligence and a long-term investment horizon.