February 17, 2016

Q: What is the role of a small-cap allocation in a portfolio?

A: An allocation to small cap equities complements other equity and fixed income positions by providing returns via a largely uncorrelated asset class, assuming the investor has a long-term time horizon.

Small caps can help diversify a portfolio, which should lead to lower correlation and contribute positive risk adjusted returns.

Over history, small caps have outperformed their larger cap peers by 2.4% per year as shown in "Characteristics, Covariances, and Average Returns: 1929-1997," by James L. Davis, Eugene Fama and Kenneth R. French. Modern Portfolio Theory, for which Professor Harry Markowitz won the Nobel Prize in 1990, says you can increase return, per unit of risk, by adding uncorrelated assets to a portfolio.

Q: Why use active management for small-cap allocation?

A: I believe markets are inefficient in the small cap universe. This creates opportunities for the active investor who through careful research can outperform passive management. As Warren Buffet wrote in Berkshire Hathaway's 1987 Annual Report, "When investing, we view ourselves as business analysts not as market analysts, not as macroeconomic analysts, and not even as security analysts." One should view investing as buying a piece of a company, not as buying a piece of paper that is to be traded on a whim.

Take the example of a tech widget company with one big national customer. Perhaps the company's board recognizes that other customers are not going to appear and cuts operations to manage a wind-down. The stock could still be amazingly profitable and generate lots of cash, but unfortunately for any quants and index funds that buy the stock, the company would have no real value beyond the short-term cash flow. It would not be until after the one major client halted orders that the stock would stay down. It would be too bad for the indices, which would not have listened to the conference calls or read the SEC filings where the company clearly laid out its plans. Avici Systems, a now-defunct small cap tech bubble company was an example of just such a stock.

Q: How important is a concentrated exposure when investing in small-caps?

A: A few high-conviction, heavily researched investments may make an outsized contribution to a portfolio's performance over the long-term, so we believe that a relatively concentrated portfolio is important when investing in small caps.

An investor is more likely to find a high-returning stock in the small-cap universe than in a large cap universe, as a new product or distribution strategy may have a more significant impact on a small company than a large company.

Small caps may be more volatile stocks, which is why it's important to distinguish between a company's fundamentals and the volatility of its stock price. We believe an investor's risk is not the volatility of the stock price, but of being wrong on the fundamental analysis of a company. The stock price merely gives long-term investors the occasional opportunity to buy a piece of a great business at a discount to its intrinsic value. For the long-term investor, the value in a company's fundamentals will eventually be recognized.

Ultimately, we think an active manager's job in the small cap world is to make concentrated investments in companies that have been heavily researched and that may return multiples of the original price over a period of years.

John Barr is a Co-Manager of the Needham Growth Fund (NEEGX). He has been its Co-Manager since January 2010. He also manages the Needham Aggressive Growth Fund (NEAGX). He engages in a variety of portfolio management-related activities, including stock selection, research, company visits and market analysis. He rejoined Needham & Company in August 2009 from Oliver Investment Management, LLC, a long-short hedge fund focused on small cap technology and exploration and mining stocks, of which John was the Founding and Managing Member. From 2002 to 2008, he served as a portfolio manager and analyst at Buckingham Capital Management for their diversified industry long/short domestic equity hedge fund. He focused on telecom, semiconductors and software. He also has experience with financials, energy, exploration and production, and mining stocks. From 2000 to 2002, John was a managing director and senior analyst at Robertson Stephens following semiconductor technology companies. From 1995 to 2000, he was a managing director and senior analyst at Needham & Company. He also served as its director of research. John was an Institutional Investor All-Star and was ranked by Reuters as leader of one of the top software teams. He is a graduate of Harvard Business School and Colgate University.

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. Past performance is no guarantee of future results.

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 carefully 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.

A copy of the prospectus are available at www.needhamfunds.com or by contacting the Fund's transfer agent, U.S. Bancorp Fund Services, LLC at 1-800-625-7071.

All three of the Needham Funds have substantial exposure to small and micro capitalized companies. Funds holding smaller capitalized companies are subject to greater price fluctuation than those of larger companies.

Needham & Company, LLC, member FINRA/SIPC, is the distributor of The Needham Funds, Inc.

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