From Needhman  Funds

One Up on Wall Street

On September 13, 2012, I was a guest on Chuck Jaffee’s radio show, Moneylife.  The subject was The Growth Factor #2 commentary on fairness in the markets. I reiterated that there is a wealth of information available to investors.  I also highlighted famed portfolio manager Peter Lynch’s classic book, One Up on Wall Street, an individual investor’s guide to success in the stock market.

Needhman on Investing Using Peter Lynch's One Up on Wall Street as Guide

In this edition of The Growth Factor, I’d like to explore One Up on Wall Street (1989) and Peter Lynch’s second book, Beating the Street (1993), and how they apply to investing in 2012. Peter Lynch managed Fidelity’s Magellan Fund from 1977 through his retirement at age 47 in 1990. Lynch wrote that his purpose for authoring these timeless books was “…to further encourage the amateur investor not to give up on the rewarding pastime of stockpicking.”

At Needham Funds, we aspire to an investment style like Lynch’s.  We believe the markets are fair for investors whether they are individuals or mutual fund portfolio managers.  We also believe that financial advisors play an important role as coaches to help determine the role of individual stocks in a strategy set by the advisor.

I will also look at the great work Carolyn and Peter Lynch have been doing with the Lynch Foundation since his retirement from the Magellan Fund.

Individual Investing Today

After the lost decade of the 2000s, individual investing in the market is hardly discussed.  For five years, equity funds have experienced outflows, while bond funds have seen inflows.  Most recently, in this extended zero-interest rate environment dictated by the Federal Reserve and other central banks, investors have been reaching for yield and investing in any securities with yield.    

Today, most individual investors buy index or exchange traded funds (ETFs).  The “fast money” crowd trades stocks, but fundamental analysis of companies and holding for long-term gains seems a lost art.  Yet, we believe that fundamental analysis, including buying at attractive valuations, is the key to successful long-term investing.  Investing requires homework – done right, it can be financially and intellectually rewarding.

Importantly, we believe technology makes it infinitely easier for the diligent investor to research investment ideas today than in 1989 or 1993, when Lynch wrote his books.

Use What You Already Know to Make Money in the Market

Peter Lynch advocates using what you know from your daily life to provide investment ideas or leads.  Lynch writes about his personal and his family’s observations about Cracker Barrel (CBRL), Body Shop (now part of The L’Oreal Group), SuperCuts (now part of RGS), Taco Bell (Yum! Brands) and others.  “The best place to begin looking is close to home – if not in the backyard then down at the shopping mall, and especially where you happen to work.”

In the 1980s and early 1990s, while Lynch was managing the Fidelity Magellan Fund, I was selling software used to design printed circuit boards and integrated circuits to electronics and semiconductor companies.  PDF Solutions* (PDFS) was founded in 1991 and went public in 2001. Based on my experience, I believed that PDF Solutions’ software and services would be needed to help semiconductor manufacturing companies ramp advanced processes.  When I rejoined the Needham Funds as Portfolio Manager, we started buying PDF Solutions in the first quarter of 2010 and continued adding to our position for 1½ years.  The stock traded between $4 and $6 per share for almost two years, giving investors plenty of opportunity to discover and purchase the stock.  It is followed by only one Wall Street analyst. The stock is currently at $14.52.

Along similar lines, we were excited to see Exa Corp.* (EXA) go public without fanfare in June.  Exa provides simulation software to the automotive industry.  The company has a business model in which it is paid each time a user runs a simulation, tying Exa’s revenue to its customers’ use of the system.  This model reminded me of many companies that I worked with in the software industry.  We also like the heavy math behind Exa’s products – they applied algorithms developed in MIT physics labs to their engineering.  Exa is followed by just three analysts.  It went public at $10 and currently trades at $9.15.

My Co-Portfolio Manager, Chris Retzler, had experience running Winterkorn, an orthopedics business, which gives him a great perspective on operations and marketing of healthcare devices and the roles of the government and other payers.

Lynch devotes an entire chapter to the tenbagger.  A tenbagger is a stock that goes up tenfold.   “The most fascinating part of any of these fast-growth retailing stories…is how much time you have to catch on to them.” Lynch cites Wal-Mart (WMT), the Body Shop and Toys R Us (now private) as examples in which an investor had years to buy the stock and still achieve tenbaggers.

Lynch loved small cap stocks for their tenbagger potential.  We are also big believers in small caps.  Except during unusual market conditions, Chris Retzler’s Needham Small Cap Growth Fund (NESGX) has 80% of its assets invested in small caps.  As of September 30, 2012, the Needham Aggressive Growth Fund (NEAGX) had 61% of assets in small (between $250 million and $2 billion market cap) and micro cap (under $250 million) and the Needham Growth Fund (NEEGX) had 47% invested in small or micro caps equities.

Our 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);
  • 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 research coverage.

The Needham Funds currently own three tenbaggers:

Precision Castparts* (PCP) is an aerospace components supplier purchased by NEAGX over ten years ago.  Mark Donegan, CEO, became EVP of Precision Castparts in 1992 and CEO in 2002.  In 2002, the company earned $0.80 per share after extraordinary items.  In the fiscal year ending March 2012, Precision Castparts earned $8.05 per share.  The company saw a fragmented aerospace supply base and the opportunity to bring scale to the market.  It has done a great job of growing and acquiring its businesses. The stock has appreciated from $10 per share to $189 per share.   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 $26 billion.

NEAGX has owned Apple* (AAPL) since 2006, when it had a $50 billion market cap.  Today’s market cap of over $500 billion is down from the $700 billion market cap of earlier this year.  Apple has had continuity of management with

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