The Growth Factor

Needham Funds' Commentary by John Barr, +1 212-371-8300

                                                                                                         Vol. 17 - November 30, 2014 
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Needham Funds Team
John Barr
Portfolio Manager
Chris Retzler
Portfolio Manager
Jim Giangrasso
A case for active investing in small-cap growth equities - "Second Act Investing"

Not long ago, we met with a very smart, long-time small cap investor.  Their conclusion was that investing in growth stocks doesn't work.  Identifying winning growth companies is impossible and one should invest strictly in companies with increasing cash flow.  Companies and their analysts always have a story to tell; over time, most don't work out. There is always the diamond in the rough that keeps you coming back to try to pick more stories that will work. We have a similar liking for cash flow; however, if this were strictly true, then we should all invest in a smart beta ETF or index fund that emphasizes cash flow. 


Supporting their point, the last five years of a rising market have made the SPDR S&P 500 ETF the go-to investment.  We believe it is a fine solution for market exposure, but that ultimately, a strong research process and the ability to short stocks will matter. 


We believe that active investing has an important role to play in any portfolio. In our small and mid-cap universe, we believe markets are inefficient.  We love to find companies with little research coverage and where we see value that the market does not recognize.
The case against indexing

"The case against indexing is ultimately there any security in the index that is predictably inferior?  If there is - and it could be problems with a business model, accounting fraud, overvaluation, weak management or a weak competitive hand - if there is a single security in the index that is predictably inferior, then active management has a role and it's only a question of degree and price. It's not a question of whether it is a good idea." 


- Mitch Cantor, Portfolio Manager, Mountain Lake Investment Management, published in Grant's Interest Rate Observer, November 14, 2014. 


Mr. Cantor's quote is part of Grant's cover story, "Read the footnotes."  He writes, "Why bother to read the 10-K, let alone the footnotes thereto, if one stock is essentially as good as another?"  At Needham Funds, we are readers of 10-Ks, proxy statements, conference call transcripts and footnotes.  In our fundamental research process, we find important and interesting information. Mr. Grant concludes, "So, to reiterate, this publication is cyclically bearish on passive equity investing."  We are too.


In support of Mr. Cantor and in opposition to the passive buyer of cash flow, I cite Avici Systems.  Avici was a tech bubble company that made a carrier class communications router.  AT&T was a big customer - unfortunately it was about the only customer. The company's board recognized that other customers were not going to appear and cut operations to manage a wind-down, which included supplying all the product AT&T needed.  Well, AT&T placed big orders.  The company was amazingly profitable and generated a lot of cash.  Unfortunately for the quants and index funds that bought the stock, in the 1 1/2 years following the April 19, 2006 earnings report, the company had no real value beyond the short-term cash flow.  However, it was only after AT&T's orders ended that the stock stayed down.  Too bad for the indices, which did not listen to the conference calls or read the  Federal filings where Avici clearly laid out its plans.


We do agree with our cash flow-oriented investing friend that almost every small company CEO has a great story to tell and many of these companies will fail.


However, we believe that with fundamental research, it's possible to sort the winners from losers and potentially outperform a passive ETF or index. I recently spoke with Chuck Jaffee on his MoneyLife podcast on the subject of "Second Act Investing."


The fees for actively managed funds tend to be higher due to the management fees and higher transactions costs due to higher portfolio turnover. The higher portfolio turnover typically results in higher taxes due to higher capital gains distribution. Additionally, these higher costs can negatively impact the performance of an actively managed Funds. Furthermore, ETFs are more liquid than actively managed funds as they trade intraday on an exchange.  

Second Act Investing

Herewith is our view of "Second Act Investing" and how to differentiate the great story that will create shareholder value from the great story that will not. 


Growth companies make their mark through addressing a core market with a core product or service.  We call this the "First Act."  Many companies receive a standing ovation from the audience in their First Act - they experience rapid growth and the stock market rewards them with a high multiple.  We cite WorkDay (WDAY), Twitter (TWTR) and Service Now (NOW) as a few high flyers still in their First Act. Some growth investors invest in these premium valuation companies.


We prefer to invest in the "Second Act."  Once the First Act has matured, growth companies are faced with the next step.  Management teams may choose to spend on new initiatives in distribution or research and development, which could lead to growth.  Companies in this phase are often operating near breakeven or at a loss and look expensive on a price/earnings ratio because they are investing in their business. Those that succeed create wealth for long-term investors. Those that fail may continue to put forth new initiatives that never gain traction. These failures may become targets of activist investors who push the company to cut these losing investments and return cash to shareholders. Our opportunity is to use the intermission to figure out if the Second Act will be a hit.


We believe that our Second Act investing process provides a framework for sorting winners from losers.  It is typically applied to a small-cap company with a simple organization. The company started with one revenue stream and is trying to move into the Second Act.   


We see five steps:


1)  Listen to the great story and see if we understand it.  As investors, our first job is to ignore the stories we cannot understand or where we have no expertise in the field.

2)  Decide which management teams have a record of success.  Those that are owners or think like owners are likely candidates.  If a CEO is a recent hire, brought in from outside or has little stock ownership, he or she may not have the same discerning eye to spending for growth as someone whose name has been on the door.


3)  Study the First Act and see if it can support the valuation while the Second Act develops. 


4)  Study the Second Act and see if we believe it will work.


5) Determine if the investing world is ahead of us.  An expensive stock is a good indication that we are not the first to an idea.


While we are presenting examples of successful Second Act investments, not all investments prove profitable and may lose value.  


A successful example of Second Act investing - Electronics For Imaging

Electronics for Imaging (EFII), a leader in the transformation from analog to digital commercial printing, is a great example of the Second Act investing process and a success story for The Needham Funds.   We've owned the stock for five years and it is a four-bagger.


As stated, our first job is to ignore the stories we can't understand or have no expertise in the field. We understand commercial printing.  Advances in technology are allowing print shops to do amazing things with printed materials that look more like art than advertising.  Print shops benefit from an improving economy. 


Our second step was to decide if the management team had a record of success. Guy Gecht joined EFI in 1995 as Director of Software Engineering. He became CEO in 2000. He knows the company, its products and customers.  He set the direction to build on the First Act, Fiery Print Controllers, where growth had stalled. 


We started our research on EFI's First Act in 2009.  EFI's Fiery business appeared to be bottoming and was generating cash.  The company was operating at breakeven.  We concluded the downside was limited. 

Bus printed with an EFI digital printer. 


We then studied EFI's Second Act, which was digital printers and print shop software.  Digital printers for print shops were a new idea.  We believed EFI would succeed with both of those initiatives and they have been a big success.  Ink for their printers will be the Third Act.


In 2009, EFI had been a $10-11 per share stock for several years. The company had $6 per share in cash and another $2 per share of real estate.  It was only followed by a few analysts.  We determined that we were ahead of the investing world on this idea. 


From a portfolio perspective, it was important to stay as a long-term investor in  EFI.  By achieving four-bagger status, it can make up for a portfolio mistake.

The future - KVH Industries, Inc. 
KVH Industries (KVHI) is a company about which we have great hopes for its Second Act. KVH supplies antennas and voice and data services for ships, a story which we understand. Headquartered in Middletown, RI, just a few miles from Newport, the sailing capital of the world, KVH has little research coverage.


The CEO is Martin Kits Van Heyningen.  His father started the company in 1982.  We wish Martin owned more than 4% of the company, but his name is on the door.  Most importantly, he's led the company through earlier acts, including the focus on the maritime market and the move into voice and data services. The trend toward the "Digital Ship" with increasing communications requirements is strong as is KVH's market position.


KVH's Second Act is to offer movies, sports, news, training and other content over the KVH satellite communications network.  Called IP-MobileCast, this new service has staged them to become the combined Comcast and Netflix of the commercial maritime market.  IP-MobileCast just launched in the fourth quarter of 2014.


KVH's stock has been $12-14 since mid-2012.  With a market cap of $185 million, KVH has an enterprise value/revenue of just 1.  They have been investing in the IP-MobileCast service for several years.  While profitable, KVH's earnings do not support the stock price on a P/E basis.  Only two research analysts follow the company. 


Over the next few years, we believe KVH could double its maritime business and could earn $2 per share.  If KVH earned $2 per share, we believe the stock price could be well above $12-14 per share.


The future - Oil-Dri Corporation of America

Oil-Dri Corporation of America (ODC) is another example of a well-positioned company in its Second Act. Headquartered in Chicago, Oil-Dri owns mines and processes the clay used in cat litter and for absorption of industrial spills.  This is a business we can understand.


CEO Dan Jaffee is the grandson of the founder.  He has been with Oil-Dri for most of his working life and he knows the business.  The Jaffee family controls 75% of the voting rights and owns about $60 million of stock.  Dan Jaffee thinks like an owner because he is one.


Managed through 73 years, Oil-Dri has a successful First Act business, with branded and private label cat litter and industrial absorbents.


Oil-Dri's Second Act is to create a new category and introduce a lighter, highly absorbent cat litter.  The lower weight is great for the typical young, female cat litter buyer and for the likes of WalMart, which can reduce the number of trucks carrying cat litter by 20%.  This is a major green initiative for retailers.  Oil-Dri has a dominant position in calcium bentonite clay reserves, which are necessary to make this new type of cat litter. 


Oil-Dri announced the light-weight cat litter initiative in July 2011.    This category was 17% of the market last quarter.  If it accelerates, like concentrated laundry detergent did, Oil-Dri could benefit from its own Fresh & Light brand, from private label manufacturing and potentially as a calcium bentonite clay/royalty supplier to competitors.  Cat litter is a $2 billion business at retail.  Oil-Dri currently has about $60 million of cat litter revenue.  Light cat litter has the potential to triple the size of the company.


Oil-Dri has no research coverage.  Its market cap is $200 million.  Fully diluted earnings per share were $2.07 in fiscal 2013.Sales in the fiscal year ending July 2014 were $266 million and earnings were down to $1.17 per share of earnings due to Oil-Dri's investment.  At $27 per share, the stock is at the same price as two years ago. Oh, and they pay a dividend. Common stock-holders received $0.77 per share in the fiscal year ending July 2014.  We believe investors have yet to discover Oil-Dri. 
In Conclusion

We believe in active investing in growth equities. While passive index and ETF investing is great for market exposure, active investing can play an important role in a portfolio in areas that are not heavily researched. In our valuation-sensitive corner of the small-cap growth universe, we believe that recognizing a company's Second Act story and having an educated point of view is critical for sorting the winners from the losers and providing the benefits of active management.    

*The Needham Funds aggregate ownership as a percentage of net assets in the stated securities as of 9/30/14: EFII: 2.13%, KVHI: 3.57%, ODC: 0.29%   

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.  Short sales present the risk that the price of the security sold short will increase in value between the time of the short sale and the time the Fund must purchase the security to return it to the lender. The Fund may not be able to close a short position at a favorable price or time and the loss of value on a short sale is potentially unlimited.


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 are 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.

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