July 8, 2016

Q: Dividends. Small caps. Growth companies. Do they go together?

A: More than you might realize. While 80% of stocks in the S&P 500 pay a dividend, about 40% in the Russell 2000 pay a dividend. Many of the dividend payers in the Russell are either utilities or financial institutions. However, as of December 2013, 30% of the growth companies in the Russell 2000 paid dividends.

A dividend can serve as a barometer of a company's health, especially in the small cap universe. Companies that pay dividends make the dividend an important part of their capital strategy. They are likely to have a higher hurdle rate on their investments and less likely to pursue self-aggrandizing projects. Being obligated to a dividend can instill fiscal discipline and cement a commitment to shareholders that is not easily broken.

Q: I thought dividends were a trait of value investing. Why are we seeing them in growth equities and the small cap universe?

A: Historically, dividends and growth investing have not gone together. Philip Fisher wrote Common Stocks and Uncommon Profits in 1958, which defined growth investing. Fisher identified fifteen questions to ask about a company and the first question was, "Does the company have products or services with sufficient market potential to make possible a sizable increase in sales for at least several years?" Small cap companies often have opportunities to reinvest their capital in new products or distribution channels, with the potential to earn high returns on that reinvested capital. However, in today's slow growth economy, some small cap companies find it possible to fund both their growth opportunities and dividends.

Apple (AAPL), Cisco (CSCO), Microsoft (MSFT) and Oracle (ORCL) are a few large cap growth companies that now pay dividends. These companies have reached a stage where they are nicely profitable and generate enough cash to fund R&D, acquisitions, stock buy-backs and dividends. A decade ago, they were not as profitable. Approximately 15% of the S&P 500 dividends now come from technology companies versus just 5% ten years ago.

Examples of small cap technology dividend payers include REIS, Inc. (REIS), MKS Instruments, Inc. (MKSI) and Brooks Automation, Inc. (BRKS). MKS and Brooks both have semiconductor capital equipment businesses that generate cash. They continue to pay dividends while making significant acquisitions and new product investments that moved them into new markets.

Q: Why is a dividend strategy valuable in small cap investing?
Can investors benefit from the above average growth potential of small cap stocks while dampening the risks associated with volatility and drawdowns?

A: We think it's possible for investors to find balance in a strategy that includes small cap stocks with above average growth rates, some of which pay a dividend.

In recent years, companies that paid dividends have outperformed non-payers. As a group, companies that have grown their dividends have outperformed the other dividend payers by a wide margin. In the chart below (compiled by Ned Davis Research), it is clear that small cap dividend growers generated higher returns with less volatility. Growing companies may also be in a position to grow their dividends.

Furthermore, not only have small cap dividend payers had lower volatility compared with the overall small cap universe, they also have lower drawdowns - winning by not losing as much.

Source: Ned Davis Research. Past performance and dividend growth rate are no guarantee of future results.

In today's yield-starved investment world, 2-year U.S. Treasuries yield 0.6% and 10-year Treasuries yield 1.0%. Germany, Switzerland and Japan have negative interest rates. And since negative interest rates require the bond holder to pay the issuer for the convenience of holding a bond, the holder is guaranteed to lose money. Against this backdrop, dividends may be an attractive form of income.

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 Needham Funds aggregate ownership as a percentage of net assets in the stated securities as of March 31, 2016: AAPL: 1.25%; REIS: 1.83%; MKSI: 2.16%; and BRKS: 0.60%. Portfolio holdings are subject to change.

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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