The Growth Factor

Needham Funds' Commentary

by John Barr

In This Issue
2013 - A Great Year for Equities
Opportunities are Always Around
Pursuing the Tenbagger
Needham Funds' Process
NEAGX 2013 Tenbagger Update
Prospective Future Tenbaggers for Needham Funds
Off the Tenbagger Track

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John Barr
Chris Retzler   



Vol. 11 - January 2, 2014

When we enter a new investment, our near-term price target is 50% upside over 12-18 months.  However, our real price target is an investment that multiplies tenfold over a number of years-also known as a tenbagger.  However, our investments may not meet these stated investment objectives and goals and may lose money.  

2013 - A Great Year for Equities

2013 was a great year for equities with the Dow Jones up 30%, the S&P 500 up 32% and NEEGX +35%, NEAGX +36% and NESGX +28%.  During 2013, our existing tenbagger club of Precision Castparts (PCP), Express Scripts (ESRX) and Apple (AAPL) continued to appreciate and ViaSat (VSAT) joined the club, but our big news was the expansion of our fivebagger and threebagger clubs.  Each now has seven members, up from two fivebaggers and nine threebaggers one year ago.  


Members of these clubs are:

Fivebaggers - Gilead Sciences (GILD), WageWorks (WAGE), PDF Solutions (PDFS), ThermoFisher Scientific (TMO), FEI Corporation (FEIC), Entegris (ENTG) and Financial Engines (FNGN).


Threebaggers - Dick's Sporting Goods (DKS), Comcast (CMSCA), Electronics for Imaging (EFII), CarMax (KMX), MKS Instruments (MKSI), Nova Measuring Instruments (NVMI) and IPG Photonics (IPGP).


Most of these investments have achieved this exalted status after 3-4 years in the portfolio.  The others have been growing for almost a decade.  All of these companies have successfully introduced disruptive products or entered major markets.  On the other hand, we have a few investments that have not progressed on the track to tenbagger status.


In this issue, we highlight fivebaggers FEI Corporation and Financial Engines.  We also discuss Entropic Communications (ENTR), a company off the tenbagger track.

Opportunities are Always Around

In One Up on Wall Street, Peter Lynch wrote, "The bearish argument always sounds more intelligent.  You can find good reasons to scuttle your equities in every morning paper and on every broadcast of the nightly news."   Today we worry about Federal Reserve tapering, Federal debt, rising interest rates, structural unemployment, the Affordable Health Care Act's impact on small business and a host of other concerns.  Despite these worries and that the S&P 500 is up 203% since the low in 2009, we believe there are always opportunities to invest. 


We aspire to an investment style like Lynch's. We believe that fundamental analysis of companies, including buying at attractive valuations, is the key to successful long-term investing.


Our goal is to find stocks that make it the old-fashioned way.  We look for successful companies that introduce new products, enter new markets and grow sales and earnings.  Over time, stock prices of these companies should appreciate.  If a company doesn't do these things, it may resort to financial engineering and the stock price may increase, but it's doubtful a tenbagger will result.  More likely, the stock price of a company that fails to grow will go down.


The Needham Funds need to find only a few new investment ideas each quarter.   Black Diamond Enterprises (BDE), KVH Industries (KVHI) and Clean Harbors (CLH) are a few of the stocks added to the Needham Funds' portfolios in 2013.

Pursuing the Tenbagger

Lynch devotes an entire chapter of One Up on Wall Street to the tenbagger. He cites examples of companies when an investor had years to establish a position and still achieve a tenbagger or more. 


Lynch loved small cap stocks for their tenbagger potential.  We are also big believers in small caps.  Chris Retzler's Needham Small Cap Fund (NESGX) has 80% of its assets invested in small cap stocks, other than during exceptional market conditions.  As of September 30, 2013, the Needham Aggressive Growth Fund had 56% of assets invested in small and micro-cap stocks.  The Needham Growth Fund (NEEGX) had 37% of assets in small and micro-caps. 

Needham Funds' Process

In our search for tenbaggers at Needham, we look for:

  • Management teams that have previously created shareholder value, preferably at the company we are considering;
  • Strong family or founder management and or ownership. 
  • Businesses that participate in large markets with the opportunity to grow into much larger companies;
  • Attractive valuations;
  • Unrecognized product and margin expansion potential;
  • Post-IPO companies with venture capital backing; and
  • Companies with little Wall Street research coverage.

Many investors ask about our sell discipline.  We buy a stock expecting that a company will achieve certain objectives over time.  If our long-term expectations are not being met, we believe in selling.  As long as a company is on track to achieve our growth objectives, we should hold on for dear life.  We believe the toughest decision for a long-term investor is not when to sell, but how to hold on through the macro and company-specific challenges, which will occur over a 3-10-year holding period. By selling a winner, we are making Uncle Sam an unnecessary partner in our investment's success.  While realized long-term capital gains are great, unrealized long-term capital gains are even better.

Needham Aggressive Growth Fund - 2013 Tenbagger Update

In Growth Factor Vol. 4 on January 3, 2013, we wrote that the Needham Funds owned three tenbaggers.  So how did they do in 2013?


Precision Castparts (PCP) increased 42% in 2013 and is now an 11-year, twenty-fivebagger for the Needham Aggressive Growth Fund.  The company provides castings, forgings and fasteners for aerospace applications. In 2013, PCP closed on their $2.9 billion acquisition of Titanium Metals.  Needham Aggressive Growth Fund bought PCP in 2002 when the stock was near $10 per share and it closed 2013 at $269 per share.  The company earned $0.80 per share in 2002 and is estimated to earn $14 per  share in the fiscal year ending March 2015.  In 2002, PCP was a small cap equity with a market capitalization of about $1 billion; today it is a large cap with a market capitalization of $39 billion.  


Express Scripts (ESRX), +30% in 2013, is now an 11-year, thirteenbagger for Needham Aggressive Growth Fund and also a long-time holding of the Needham Growth Fund and Needham Small Cap Growth Fund.  Due to its innovative approach and successful industry consolidation, Express Scripts has become the leader in pharmacy benefit management services, and it is well-positioned to help its customers navigate a rapidly-changing healthcare landscape.    In 2002, Express Scripts had a $4 billion market cap and earned $0.32 per share.  It currently has a $55 billion market cap and is expected to earn almost $5.00 per share in 2014.


Apple (AAPL), +8% in 2013, remains a tenbagger for the Needham Aggressive Growth Fund.  It was a difficult year for Apple, as it saw increased competition in the smartphone market from Samsung.  NEAGX has owned Apple since 2006, when it had a $50 billion market cap prior to introduction of the iPhone.

Top Ideas for Needham Funds

FEI Company (FEIC) is a scientific instrument company.  It supplies nanoscale imaging and analysis systems for industrial, academic and research organizations (think electron and ion-based microscopes that allow the human eye to see an atom).  We have known the company for many years due to its presence in R&D labs of semiconductor companies. 


NEAGX purchased the stock in September 2010 at a near 52-week low, amidst investor concerns over U.S. monetary policy, European debt and muni bond troubles. We invested with the belief that FEI could diversify into new markets, such as life sciences and oil and gas exploration, where molecular-level understanding is quite useful. FEI improved ease of use and developed analytical software for these new markets. 


CEO Don Kania joined FEI in 2006, after the company had completed a $427 million revenue year and lost money.    In technology companies, we like CEOs that can set a technology and product vision that the R&D engineers respect.  Don has a Ph.D. in Nuclear Engineering and Radiological Sciences from the University of Michigan and he spent eight years at Veeco Instruments (VECO) as President and COO.  At FEI, he shifted the focus to new products, R&D and reducing costs by bringing manufacturing from The Netherlands to the United States. 


In 2013, FEI consensus estimates are $916 million of revenue with EPS of near $3.00.  FEI had its best new product year with the launch of the Metrio (advanced semiconductor manufacturing metrology), Talos (materials and life science applications) and Titan Themis (material properties) transmission electron microscopes.  We believe these new microscopes will position FEI with market-leading application-specific workflows.  We ask, "Can FEI become a $2 billion revenue company and earn $7.00 per share?"  We think yes. FEI's new products, new applications and new markets should help the company double in size. A $2 billion FEI could put our investment on track to become a tenbagger.


Financial Engines Inc. (FNGN) was founded by Nobel Laureate Dr. William Sharpe in 1996.  Dr. Sharpe originated the Capital Asset Pricing Model, used to illustrate the relationship of investment risk and return in pricing of securities.  He also developed the Sharpe Ratio for measuring risk-weighted returns in investment portfolios.


Dr. Sharpe's vision was that technology could provide the same risk management tools to individuals as used by institutional investors.  Financial Engines serves as an independent investment advisor that uses technology to allocate assets in retirement plans.


Jeff Maggioncalda was employee #1 and became CEO shortly after Financial Engine's founding.  It was backed by top-tier venture capital firms, NEA and Foundation Capital.  CFO, Ray Sims joined in 1999 from Raychem, a great company acquired by Tyco in 1999. 


Financial Engines grew to $85 million of revenue before going public in March 2010 at $12 per share.  The IPO was not hot and we added to our position throughout 2010.  NEEGX and NEAGX still hold the shares received from the IPO. 


Financial Engines' ultimate customers are investors in company-sponsored 401k plans.  The company offers its advisory services for employees of Fortune 500 companies, including Alcoa, Altria, Comcast, Delta Airlines, Dell, Ford, IBM, Raytheon, Travelers Companies and Texas Instruments.  Furthermore, Financial Engines provides fiduciary protection for the employers.


Financial Engines successfully launched an entry into the 401(k) retirement market called Income+.  They also have just 13% penetration of the 401(k) assets in their customer accounts and we believe this penetration rate can increase over time.   The company receives basis points on its assets under management, so it has strong recurring revenue.  Longer term, Financial Engines has the potential to enter the IRA and Defined Contribution markets.  Each of these opportunities is as large as the 401(k) market.


Financial Engines is estimated to achieve $285 million of revenue and $0.93 EPS in 2014.  Financial Engines is no longer an undiscovered, underfollowed stock; however, we believe it can be a much larger company with expanding margins and we hate to share our return with the government by recognizing capital gains while we believe the company is still early in its growth opportunity.

Off the Tenbagger Track

Unfortunately, the funds have some stocks that are off the tenbagger track.  We still hold them because we see value and upside potential, but it is unlikely that they will join the tenbagger club.  Entropic is a stock that the funds have held for three years but that never gained tenbagger traction we hoped for.


First bought in 2010, Entropic Communications  (ENTR) has been a top holding and periodic top performer for the Needham Funds, but it has also been a bottom performer.  The stock was down 11% in 2013.  Entropic provides semiconductors which support the Multimedia over Coax (MoCA) standard used by cable, telco and satellite communication service providers for in-home applications such as multi-room digital video recorders.  In 2010, Entropic rode the wave of Verizon's FiOS build-out.  We thought Entropic MoCA semiconductors would see major uptake by cable companies, but it has been sporadic.  Our thesis was that Entropic could be a strong #2 to market leader Broadcom (BCOM).  While this is still true, business has been too boom and bust.  Earnings were $0.55 per share in 2010 and are estimated to be a loss of $0.28 per share in 2014.  


We are ahead on the shares we purchased in 2010, but the Funds' purchases from 2011 and 2012 represent losses.  To be a threebagger for our funds, we believe Entropic would need to have earnings of $1.00 or more per share in 2014, and the company is a long way from that.  We believe Entropic could see year-over-year revenue growth in the second half of 2014. 


As we've written before, we believe this can be a golden age for investors.  Information on companies is readily available.  Investing requires work, but we believe there are always opportunities. 


The markets have had a great year in 2013 with hardly a pullback.  It's likely there will be a correction at some point in 2014.  However, we believe the Federal Reserve and its international counterparts will continue to have accommodative monetary policies and that entrepreneurs will continue to develop new products and services and take them into new markets.  The markets are full of inefficiencies, particularly with small cap stocks.  We see new opportunities every day and add a few select new positions to the Needham Funds every quarter.  We hope that in 3-4 years these new investments can become the threebaggers on their way to tenbaggers as Precision Castparts, Apple and Express Scripts once were.


Happy Investing in a Happy New Year!

*The Needham Funds aggregate ownership as a percentage of net assets in the stated securities as of 9/30/13: ESRX - 5.70%; GILD - 5.35%; PDFS - 4.29%; TMO - 4.16%; KMX - 3.28%; VSAT - 3.07%; FNGN - 2.47%; ENTR - 1.91%; EFII - 1.76%; ENTG - 1.65%; MKSI - 1.33%; WAGE - 1.31%; CMCSA - 1.07%; AAPL - 1.03%; DKS - 0.95%; KVHI - 0.91%; NVMI - 0.81%; FEIC - 0.52%; PCP - 0.45%; CLH - 0.35%; BDE - 0.31%; TREE - 0.16%; IPGP - 0.11%.
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.