Needham Funds commentary for the second quarter and the first half ended June 30, 2016.
Dear Shareholders, Friends of Needham and Prospective Shareholders,
We are pleased to report results for the second quarter and first half of 2016 for the Needham Growth Fund, Needham Aggressive Growth Fund, and Needham Small Cap Growth Fund. Our mission is to create wealth for long-term investors.
Needham Funds’ Second Quarter and Semiannual Review
In the second quarter, the Needham Growth Fund (NEEGX) returned 0.61%, the Needham Aggressive Growth Fund (NEAGX) lost 0.80%, and the Needham Small Cap Growth Fund (NESGX) returned 0.90%. The Russell 2000 Total Return Index returned 3.79%, the S&P 500 Total Return Index returned 2.46%, and the NASDAQ Composite Index declined 0.22%.
For the half-year, the Needham Growth Fund returned 0.88%, the Needham Aggressive Growth Fund returned 1.43%, and the Needham Small Cap Growth Fund outperformed and returned 8.44%. The Russell 2000 Total Return Index returned 2.22%, the S&P 500 Total Return Index returned 3.84%, and the NASDAQ Composite Index declined 2.61%.
First Half 2016: Fears Overcome
Our theme for the first half of 2016 is “Fears Overcome.” 2016 started with an unprecedented sell-off amidst fear of a stock market crash, devaluation in China, and a slowing world economy. Energy companies and their bankers were hurt as West Texas Intermediate oil hit a low of $26.21, down from $37.04 at year end. The oil industry was hurt by a slowing world economy and fears of extra supply coming on-line from Iran.
In late January, Japan announced a surprise interest rate cut, which placed rates at -0.1% for financial firms with deposits at the Bank of Japan. In late January, we learned that 4Q15 GDP growth was just 0.7%. At the low in mid-February, the Russell 2000 was down 16% and the S&P 500 was down 11%. On February 10, Janet Yellen reiterated to Congress the Federal Reserve’s cautious stance in raising interest rates and wouldn’t take negative rates off the table. On February 11, The Guardian called the bottom and wrote, “Global stocks enter bear market after another rout.” This was followed a few days later by Russia, Saudi Arabia, Venezuela and Qatar announcing an oil production cutback, which at the time appeared to have teeth. Oil closed the first quarter at $40 per barrel. The rebound was aided by the weak dollar, which fell 4.5% versus the DXY index, a basket of currencies. All three Needham Funds outperformed during the sell-off and trailed the averages on the rebound.
In the second quarter, the markets continued to overcome fear. In April, we learned that first quarter GDP growth was just 0.5%. The employment report for April showed just 160,000 jobs added. April ended with the markets down seven days in a row, including a big down day to close the month. Apple, Google and Microsoft reported disappointing first quarter earnings, and the Bank of Japan surprised by not easing further. The yen appreciated 5% vs. the dollar on one day. Japan instituted negative interest rates in January. Much more easing is hard to imagine.
Nonetheless, in mid-May, the Federal Reserve minutes read, “It likely would be appropriate to raise rates in June if the economy shows clear signs of a rebound.”2 The report for May showed a disastrous 32,000 jobs created. Just a few weeks later, Barron’s wrote an article titled, “Watching for a Market Crash.”
Needless to say, a June interest rate hike seemed off the table.
While the market overcame the previous fears, Brexit was the unanticipated monster. On June 22, the people of the United Kingdom unexpectedly voted to leave the European Union and turmoil filled the markets… for all of two days. The CBOE Market Volatility Index spiked 49%. The S&P 500 fell 5.3%. By July 8, the S&P 500 had regained these losses. The one lasting impact may be that the devalued pound, which fell 10% in those 2 days to $1.315, will be good for companies with more expenses than revenues in the U.K.
To top it off, we had fears of terrorism from attacks in Brussels, Orlando, and Nice, to name a few. Finally, we had the unusual circumstances of two Presidential primary elections more befitting of reality TV shows.
Again, we see no hope for a growth-oriented domestic policy built on an internationally competitive corporate tax regime, lower regulatory and policy barriers to private sector hiring, lower marginal tax rates, and a lower rate of increase of government spending. At best, we believe the economy will muddle along.
These continuing fears make us continue to believe that monetary policy will remain accommodative across the world. The market has climbed a wall of worry that we believe will return with the slightest of market drawdowns.
Even the much-publicized Brexit came to near no impact on the markets. As our investors know, we believe our time is better spent researching companies than worrying about most macro factors, over which we have no control. We continue to see opportunity in our small and mid-cap universe.
Why Small Caps and Why Now?
1. Small caps complement other equity and fixed income positions, which can lead to lower correlation and positive risk-adjusted returns. Professor Harry Markowitz of the University of Chicago posited this thesis and won the 1990 Nobel Prize for his Modern Portfolio Theory.
2. Over time, small caps can outperform. Eugene S. Fama (University of Chicago, Nobel Prize 2013) and Kenneth R. French (Tuck School of Business, Dartmouth) compared the performance of the average small-cap value stock to the average large-cap growth stock and found that the small caps outperformed by 2.4% per year since 1926.
3. “You pay a very high price in the stock market for a cheery consensus” was the headline of an article written for Forbes by Warren Buffett in 1974 in the midst of the market crash. It was republished on November 9, 2008.5 The macro-environment seems chaotic, but then doesn’t it always?
4. Small caps have lagged the S&P 500 for the last year. The Russell 2000 has underperformed the S&P 500 by about 8% for the year starting May 31, 2015. Mean reversion alone would suggest outperformance relative to the S&P 500.
5. The Needham Funds and small caps can provide growth at attractive valuations. As shown in Table 1, the Needham Funds have lower average valuations than the indices, with the exception of NEAGX having a slightly higher multiple to sales than the Russell 2000. NEAGX and NEEGX have superior cash flow growth relative to their benchmark indices. They also have superior sales growth compared to the S&P 500.
Table 1: Superior Growth at Attractive Valuations
6. Advice from Warren Buffett, Charlie Munger and Philip Fisher:
a. Pay little attention to the macro. “If you find yourself discussing and debating … STOP.”
b. “Does the company have products or services with sufficient market potential to make possible a sizable increase in sales for at least several years?”
c. “Hold a small piece of an outstanding business with the same tenacity that an owner would exhibit if he owned all of that business.”