John Barr manages the Needham Aggressive Growth Fund (NEAGX) and is a co-manager of the Needham Growth Fund (NEEGX). John started on Wall Street in 1995 with Needham & Co. as a sell-side analyst following technical software and electronic design automation (EDA) companies. John rejoined Needham in 2009 because of its focus on growth companies and long-term investing. Before the financial industry, he had a 15-year career in sales, marketing and management in the EDA industry.
As of June 30, 2018, NEAGX had an annualized return of 10.51% over the prior 15 years, versus 9.42% for the S&P 500, for an outperformance of 109 basis points.
We compared NEAGX to the Russell 2000 TR and Morningstar's Small Growth peer group for the 15-year period 7/1/2003--6/30/2018.
Here are the results of a $10,000 investment for the 15-year period 7/1/2003--6/30/2018:
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Result
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Avg annual return
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NEAGX:
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$45,174
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10.58%
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R2K TR:
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$44,693
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10.50%
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|
M* Sm Growth:
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$40,497
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9.77%
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|
S&P 500:
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$37,963
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9.30%
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These results are from Morningstar and were added to this article on August 14, 2018 at approximately 5pm ET.
I interviewed John last week.
Tell us about your approach to investing in small-cap growth stocks -- a notoriously difficult asset class for active managers.
Thanks Bob. I believe that finding and holding investments in compounding stocks is the path to long-term wealth creation. I like to make the initial investments when companies are small or even micro-cap stocks. There is opportunity to generate alpha over a multi-year period by investing in select small cap equities, and letting them grow. A few high-conviction, heavily researched investments can make an outsized contribution to performance.
Your investment process focuses on “compounding stocks.” What are those and how do you identify them?
Compounding stocks are companies that deliver above-market returns over a multiyear time horizon. I look for three things in companies.
First, I like companies that are managed by founders, family or long-tenured managers. CEOs with these backgrounds tend to think long-term. They are looking to create enterprises which will last for years, if not generations. In our portfolio’s technology companies, many of the founders and CEOs are Ph.Ds. They know their stuff!
Second, I look for companies which have the potential to be 5-10x, or more, larger. This means understanding their growth plans, R&D efforts, and their markets. It means these companies have reinvestment opportunities with potential high returns on capital. I recall Philip Fisher wrote in Common Stocks and Uncommon Profits, “Does the company have products or services with sufficient market potential to make possible a sizable increase in sales for at least several years?”
Finally, I look for companies with high return-on capital, or even better, I look for the potential for high return on capital. If a company is going through an investment stage, it may show no return. My job is to look beyond the investment stage and estimate what I believe the company may earn in the future.
Can you provide some examples?
Success for the Needham Funds is finding a few compounders each year. The challenge is to stay with them through the noise of the markets and the inevitable few quarters of disappointing results, and even through a multi-year R&D investment cycle.
The Needham Growth Fund opened for investment in 1996. Its largest holding, Thermo Fisher Scientific (TMO) was purchased 18 years ago, in 2000. Including dividends, it has generated a 17.6% compound annual return since our purchase. Thermo has been an astute acquirer and operator of complementary life sciences consumables and services companies.
Compounders for the Needham Funds include:
CarMax Inc., which the Fund purchased in 2009. CarMax has a small share of the pre-owned car market. They have a significant opportunity to grow for many years. The company has competitive advantages in its logistics and knowledge about how much to pay and sell cars for. These advantages come from scale. CarMax is making appropriate investments in technology for e-commerce. CEO Bill Nash has been with the company since 1997. CarMax earns an upper-teens return on equity.
The Fund purchased Entegris, Inc. (ENTG) in 2012. Entegris supplies microcontamination control products, specialty chemicals and materials handling solutions for semiconductors and other advanced manufacturing processes. Think filtering one drop out of a day’s worth of water over Niagara Falls. CEO, Bertrand Loy has been with Entegris and its predecessor companies since 1995. In 2014, Entegris acquired ATMI, Inc., a specialty chemicals company for $1 billion. In 2013, Entegris earned $0.53 per share. Estimates for 2018 are $1.55. I believe Entegris has the potential to earn 20-25% return on equity and has opportunities to acquire companies with complementary technologies.
Why has growth outperformed value over the last decade? Do you expect this performance advantage to persist?
In a low-interest-rate environment, the discount rate used to estimate the value of a company’s future cash flows is lower than when rates are higher. The last decade has been an opportune time to be a growth company investing back in its business, and using a low investment hurdle rate to assess investments. The stock market recognized this and rewarded growth. As rates rise, so will the value of cash flows. Therefore, in a higher rate environment, companies that generate cash may outperform.
Nonetheless, the distinction between growth and value means little to me. I am looking for companies with big market opportunities and the potential for high returns on capital that the market does not yet recognize. Whether the discount rate is 1% or 4% matters little if I believe a company doing $100 million of revenue can grow to $1 billion and earn a superior return.
Patrick O’Shaughnessy of O’Shaughnessy Asset Management has done some interesting analysis on this subject. In his second quarter 2018 letter, he concluded that the last decade was a very bad period for the EPS growth of value stocks. Commodity stocks underperformed as commodity prices have been depressed. The laggards in all industry groups have also underperformed. Technology may have disrupted these laggards to such an extent that their business is just not recovering as it might over the course of a previous 10-year period.
Growth investors have been well-served over the last decade with passive products and ETFs. What advantage will active managers have going forward?
Active management in compounding small cap stocks can be a great complement to passive management.
In 2015, Dr. Martijn Cremers of the Mendoza College of Business at the University of Notre Dame and Dr. Ankur Pareek of Rutgers Business School wrote, “Patient Capital Outperformance: The Investment Skill of High Active Share Managers who Trade Infrequently.” While at Yale, Dr. Cremers created the concept of active share, which is a measure of the difference of the holdings of a portfolio from the holdings of its appropriate passive benchmark index. Active share is calculated by taking the sum of the absolute value of the differences of the weight of each holding in the manager’s portfolio versus the weight of each holding in the benchmark index and dividing by two.
Cremers and Pareek studied returns from mutual funds and institutional public equity investment managers from 1993-2013. They analyzed the impact of active share and portfolio turnover on performance. They found that outperformance of about 200 bps per year came from high active share, low turnover managers. The next best strategy was low active share, low turnover, which is basically an index. This strategy underperformed by the expense ratio, which was about 75 bps per year. The two strategies involving high turnover underperformed by about 175 bps per year.
To qualify as low turnover required an average holding period of 3.7 years, or 27% turnover. Needham Growth Fund and Needham Aggressive Growth fund have 7% turnover, or a 14 years holding period for the last 12 months as of June 30, 2018. The highest category of Active Share required a 92% or higher and as of June 30, 2018, the Needham Aggressive Growth Fund was 110% versus the Russell 2000, and the Needham Growth Fund was 107.4% versus the S&P 500.
Finding great companies and owning them for a long time may be an effective way to outperform the market and add value to a portfolio of passive investments.
Tell us about your portfolio. How is it constructed?
The portfolio is full of companies identified one at a time. I only need to add a few new investments each year. I do not employ a heavy macroeconomic view on the portfolio, or try to broadly select companies from certain industries or sectors.
My fundamental research process includes meeting with executive management at their headquarters, visiting manufacturing plants and attending industry conferences. It also includes lots of reading of 10-K and other federal filings. If my research reaches a positive conclusion, I will assess a target purchase price and wait. The Fund may wait for several years until the purchase price is reached.
The Needham Funds are “diversified” funds according to the SEC definition. Due to my strategy of holding portfolio companies for the long-term, they tend to not only grow into mid and large cap companies, but the successful ones also grow into large positions for the Funds. The Needham Aggressive Growth Fund had 60 positions, as of June 30, 2018, but the top 10 positions of the Fund were 56.8% of the portfolio’s net assets. The performance of these top 10 matter a lot to the Fund’s performance, yet I’m not trading these stocks as long as my view of the long-term opportunity remains intact.
In 2017, GSE Systems, Inc. (GVP), KVH Industries, Inc. (KVHI) and PDF Solutions, Inc. (PDFS) were all top 10 holdings of the Needham Aggressive Growth Fund that were in the midst of investment programs and their stocks underperformed. These companies did not show revenue growth and were at break-even or no growth in earnings per share. As a result, current earnings have been understated. Passive managers and quantitative models have no ability to assess the viability of these companies’ investment projects. If I’m correct, they should be a nice source of outperformance in the years ahead.
The Fund can also sell short up to 25% of its net asset value. Over the years, I have had a handful of select companies short, with a total short position of between 5-10% of net asset value. I short because I believe there is something wrong with a company that the market does not recognize. I do not short for valuation, as expensive stocks can get more expensive. I also do not short ETFs to “hedge” exposure. Investors can do that on their own if they believe they understand where the market is headed. I also don’t pair shorts with longs trying to match a bad stock with a good stock. I’ve seen this go wrong on both sides. Short positions require a lot of research and an extensive knowledge of a company. As of June 30, the Funds had three short positions.
Since 2010, the shorts have hurt performance. However, in the financial crisis and the tech crash of 2001-2002, shorts contributed to the Funds’ outperformance.
Your portfolio is quite concentrated relative to your peers. How do you approach risk management?
As I’m investing for a multi-year time horizon, I’m not concerned about quarterly earnings or the risk that a stock goes down for a year or even more. An investment becomes risky when I no longer believe in a company’s strategy or management. Another risk management method is to select a company that has the balance sheet to sustain its investment period. I like companies with strong balance sheets, particularly small caps that are in an investment phase.
Since inception through June 30, 2018, the Needham Aggressive Growth Fund has had a beta of 0.79, which suggests lower volatility than the market. The Fund also had a maximum decline of 38.7% during the financial crisis, which significantly outperformed the Russell 2000’s 52.9% decline. Valuation sensitivity, shorts and balance sheet focus may lead to lower downside risk than the market.
You have a heavy concentration in the technology sector. What effect will a trade war have on your positions?
I have a number of investments in the semiconductor capital equipment sector. These businesses are being driven by the technology needs for low-power semiconductors, which are used in cell phones, data centers, and in the future in artificial intelligence and smart/autonomous vehicles. These semiconductor capital equipment companies source materials from around the world and sell around the world. China has a major initiative to grow its semiconductor industry by 2020. Our companies are unique suppliers that are essential to China’s mission. We don’t believe China will do anything to impede access to products from these companies. As far as the U.S. putting restrictions on exports, our companies have international operations in China, Singapore, Europe, Taiwan, Korea, Japan, Malaysia and the ability to ship and source through any of these subsidiaries. It’s not a simple thing to stop the flow of international trade in technology.
Are small-cap technology stocks cyclical and vulnerable to a recession? How do you assess that risk?
My goal is to find companies with strong secular growth opportunities. A recession may temporarily slow adoption of a new product or service, but in the long-term, I believe the growth will occur. The risk is a more a measure of my understanding of the opportunity. If I have a strong view on a company’s opportunity, the risk as measured by the stock price volatility is irrelevant.
What are the other risks for the small-cap-growth investor?
Small caps can be dependent on a single new product or growth plan. If the plan fails, the company and the stock may suffer for a long time. Then again, the company may be making progress without showing corroborating financial results. It may be hard to tell the difference between progress and failure. There is risk mistaking failure for progress, and vice versa. For sure, a passive investor has no chance to make such a judgment.
Small cap stocks may also have limited trading volume, which may make it difficult to acquire or exit a position, leading to volatility of their stock prices.
Where are you finding investment opportunities?
In 2018, I have added investments in a handful of unique companies. I’d like to highlight SaaS company Zuora (ZUO). . The Funds invested in Zuora’s April 2018 IPO, and subsequently added to the position. Zuora is run by co-founder Tien Zuo, who was a very early employee at Salesforce.com (CRM). Tien’s vision is big. Zuora wants to lead the subscription economy. Today’s accounting and business management software is designed for companies creating and selling products, not managing subscription businesses.
In addition to SaaS companies, Zuora sees traditional industries moving to subscriptions - think thousands of sensors gathering data on General Electric (GE) jet engines, and GE selling subscriptions to the analytics resulting from that data. GE’s Predix service does exactly this and this subscription business is managed on Zuora.
While Zuora is investing in growth today, I believe the unit economics of its customer wins could lead to a high return on capital in the future. Zuora is the dominant leader in its market. It has limited competition and it would cost hundreds of millions of dollars to replicate Zuora’s capabilities. Once Zuora is in use, it will be very hard to replace.
In the first half of 2018, I added to the Needham Aggressive Growth Fund’s investment in DIRTT (Do It Right this Time) Environmental, Ltd. (TSE:DRT). DIRTT supplies semi-custom manufactured office interiors, designed using its incredible ICE virtual reality computer-aided design system. Using DIRTT replaces on-site, sheet-rock construction and eliminates the associated waste. It also reduces the schedule variability of on-site construction. The construction industry has yet to benefit from the technology revolution. I believe DIRTT is a disruptor of the $50 billion interiors construction industry, with an opportunity to grow much larger than its current $250 million of sales. I highly recommend the DIRTT website and the ICE virtual reality website ICE Virtual Reality website to see what digital construction is all about.
Mogens Smed is the charismatic Co-Founder, Executive Chairman and visionary for DIRTT. Until the end of December 2017, he was also CEO. The Board of Directors decided that a change in CEO was necessary and Mogens’ role was changed. Mogens continues to be the company’s visionary leader. This ongoing leadership change has created what I believe to be an opportunity to add to the Fund’s position, as the stock is down 7.1% year-to-date as of June 30. I like the valuation and the company’s long-term opportunity.
Are you avoiding any areas?
In general, I avoid commodities and other businesses where it is hard, over the long-term, to earn an above-average return on capital. I also avoid most financials since it’s hard to understand the value of their assets, while their liabilities are for certain.
Can you give us an example of a successful long-term investment that you identified early in its growth trajectory?
IPG Photonics (IPGP) is a great example of a compounding stock. The Funds invested in IPG in 2010 at $21 per share when revenue was $299 million and the company’s market cap was under $1 billion. We believe 2018 revenue could be $1.6 billion and with a $13 billion market cap, IPG is no longer a small cap. As of June 30, 2018, the stock price was $241 per share, or a 35.6% compound return over the 8 years of ownership. On July 31, IPG announced guidance for the third quarter that was below expectations and the stock fell to $164. IPG pointed to weakness in China and Europe. My view of IPG’s opportunity remains unchanged.
CEO Dr. Valentin Gapontsev founded IPG in 1990, to be “The Fiber Laser Company.” Fiber-optic lasers held the promise of utilizing less energy, performing more exact cuts and welds and being much easier to operate in an industrial setting. When Gapontsev started, the fiber-based lasers were orders of magnitude more expensive than traditional solutions. He had an idea that through vertical integration and volume, he could drive down the cost of fiber-optic lasers so much that they would be competitive with traditional carbon dioxide lasers and other industrial welding, cutting and marking solutions.
He was right. Fiber lasers have been very successful in cutting applications, but are still new in addressing the $15-20 billion welding market, and IPG is addressing other growth markets such as marking, defense and cinema.
When I invested, IPG had world class returns on equity, ex-cash, in the mid 40%s. Management has reinvested its retained earnings at comparable high rates for years. With its successful strategy and the size of its markets, IPG has put its growing capital back to work in capacity and small technology acquisitions. With these returns, the stock market has been worried about competition. I believe IPG’s vertical integration gives it a cost advantage that grows with scale.
Read more articles by Robert Huebscher
John Barr manages the Needham Aggressive Growth Fund (NEAGX) and is a co-manager of the Needham Growth Fund (NEEGX). John started on Wall Street in 1995 with Needham & Co. as a sell-side analyst following technical software and electronic design automation (EDA) companies. John rejoined Needham in 2009 because of its focus on growth companies and long-term investing. Before the financial industry, he had a 15-year career in sales, marketing and management in the EDA industry. 
