The Growth Factor

Needham Funds' Commentary

by John Barr

In This Issue
Why Do Dividends Matter?
Dividends Reduce Volatility & Increase Total Return
Dividend Case Studies in The Needham Funds

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John Barr
Chris Retzler   



May 21, 2013
Why Do Dividends Matter? 

"Do you know the only thing that gives me pleasure? It is to see my dividends coming in." John D. Rockefeller, 1901


The primary objective of the Needham Funds is to identify winning growth stocks. We've had success with stocks such as PDF Solutions (PDFS), Precision Castparts (PCP), Dick's Sporting Goods (DKS) and ViaSat (VSAT), and we are always in search of the next ten-bagger stock. We've written about our research process and these stocks in previous editions of The Growth Factor.


Dividends are a by-product of our investment process and a barometer of a company's health. Companies with cash flow problems can't pay dividends; companies with shrinking earnings can't increase dividends. Dividends impose fiscal discipline on management, but unlike debt, which also imposes fiscal discipline, dividends can be suspended in lean times.


Many companies are operating more efficiently these days. From 1969 through 2005, net profit margins of U.S. public companies peaked around 5%. Today, net profit margins of the top 1,500 U.S. companies are near 7%.1 Corporate cash is at an all-time high of $1.5 trillion, up from $1.0 trillion four years ago.2 Therefore, companies are well positioned to pay dividends.


In 2013, we expect mediocre GDP growth of 1-2%. With 2-year Treasury Bill yields of 0.2% and 5-year U.S. Treasury Note yields of 0.8%, the quest for yield has elevated all types of yield-generating assets, including equities that pay dividends.

Dividends Reduce Volatility & Increase Total Return 

Since 1930, dividends have accounted for 40% of the total S&P 500 return.3 Dividend stocks also provide a hedge against volatility. In a 2005 study conducted by Henry Dickson and Charles Reinhard of Lehman Brothers, they showed that of the 1,000 largest U.S. firms, the top yielding quintile delivered a 14% total return with a 16% standard deviation. The bottom yielding quintile delivered 9% with a 29% standard deviation.  Total return includes market appreciation plus dividends, therefore dividends are a partial hedge against market declines and provide some return in a bear market.


In a February 2013 report, Dr. Adam Parker, Chief U.S. Equity Strategist, Morgan Stanley, discussed a model identifying high and low quality stocks as measured by risk-adjusted stock returns. Characteristics of high quality U.S. stocks include stable dividends, growth in dividends per share and high dividend yield. Characteristics of low quality stocks include heavy share base turnover, high beta, volatile return on equity and high debt levels.

Increase in Needham Funds' Portfolio Companies That Pay Dividends 

The number of dividend paying companies in all three of the Needham Funds has increased. As of December 31, 2012, 45% of the Needham Growth Fund portfolio companies paid dividends, up from just 12% in 2010.  The Needham Aggressive Growth Fund increased its number of dividend paying companies to 28% from 11% and the The Needham Small Cap Growth Fund grew its percentage of dividend payers to 27% since 2010. 


Dividend Case Studies in The Needham Funds

MKS Instruments, Inc. (MKSI)provides instruments and process control subsystems for advanced manufacturing processes. Semiconductor manufacturing accounts for 55% of MKS' revenues. In 2009, MKSI generated cash despite the global recession. The company changed its philosophy and recognized that it could generate consistent cash flow and pay a dividend. The first quarterly dividend, $0.15 per share, was declared in the first quarter of 2011.


For 2011, MKS earned $2.45 per share and paid $0.60 in dividends for a 24% payout ratio. Despite generating cash in 2009, MKS reported a $4.31 per share loss. MKS' underlying business is volatile, which could put the dividend at risk during a downturn. However, we believe the dividend is a part of MKS' strategy and a high priority use of capital. In July 2011, MKS also announced a $200 million share buyback program.


In the third quarter of 2012, MKS increased its dividend to $0.16 per share. As of March 31, 2013, the stock was owned by the Needham Growth Fund and the Needham Aggressive Growth Fund.


Apple, Inc. (AAPL)has been a holding of the Needham Aggressive Growth Fund since 2006.  Apple has had 50% compound growth in earnings per share and 40% compound growth in revenue from 2008 through consensus estimates for 2013.  Apple's stock is down approximately 16% in 2013, as the market fears contracting margins and slowing growth.  As a result, Apple trades at a discount to the S&P.  As of May 17, Apple traded at an enterprise value to earnings of less than 8x estimated 2013 earnings of $40 per share while the S&P 500 is valued at 14.6 times forward looking earnings with sales growth of just 2.9%.    


In 2012, Apple generated over $44 billion of free cash flow. On December 31, 2012, the company had a cash balance of $113 billion and paid two quarterly dividends of just $2.5 billion each.  With its depressed share price, strong cash flow and cash balance, Apple has been under pressure to return cash to shareholders.  On its April conference call, Apple announced that it would have "an aggressive plan that more than doubles the size of the capital return program."  The two parts of the plan are an increased stock buyback and increased dividend.  Most of the plan will be an increased buyback, but on April 23, Apple increased its dividend to $3.05 per share.  Apple's cash flow gives us confidence that the company will continue to be in a position to return cash to shareholders.


A discussion of dividends seems an unlikely topic for growth investors. However, we see more and more of our companies paying dividends and we like it. We have a bias toward dividend payers in our new investments. Like J.D. Rockefeller, we take pleasure in our dividends. Unlike Mr. Rockefeller, we enjoy things in addition to dividends....such as long-term capital gains!

1 Dr. Adam Parker, Morgan Stanley, U.S. Equity Strategy, February 6, 2013, p 18
Dr. Adam Parker, Morgan Stanley, U.S. Equity Strategy, February 6, 2013, p 46
Dr. Adam Parker, Morgan Stanley, U.S. Equity Strategy, February 6, 2013, p 49
*The Needham Funds aggregate ownership as a percentage of net assets in the stated securities as of 3/31/13: MKSI 1.12%; AAPL 1.03%.
The information presented in this commentary is not intended as personalized investment advice and does not constitute a recommendation to buy or sell a particular security or other investments.
This message is not an offer of the Needham Growth Fund, the Needham Aggressive Growth Fund or the Needham Small Cap Growth Fund. Shares are sold only through the currently effective prospectus. Please read the prospectus and consider the investment objectives, risks, and charges and expenses of the Fund carefully before you invest. The prospectus contains this and other information about the Fund.


Investment returns and principal value will fluctuate, and when redeemed, shares may be worth more or less than their original cost. Shares held 60 days or less are subject to a short-term redemption fee of 2%. Past performance does not guarantee future results and current performance may be higher or lower than these results.  Current month-end performance and a copy of the prospectus is available at or by contacting the Fund's transfer agent, U.S. Bancorp Fund Services, LLC at 1-800-625-7071.


Funds holding smaller capitalized companies are subject to greater price fluctuation than those of larger companies. Also, the Fund's use of short sales, options, futures strategies and leverage may result in significant capital loss. Total return figures include reinvestment of all dividends and capital gains. Needham & Company, LLC, member FINRA/ SIPC, is the distributor of The Needham Funds, Inc.