What To Look For In Small Caps (And What To Avoid) by Needham Funds
Q&A with Needham Growth Fund’s John Barr on Small Caps
Q: What do you look for when selecting small caps?
A: First, I prefer to find companies with a history of earnings and strong cash generation.
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Second, I look for change, such as a new product, margin expansion or expanded distribution that is not understood by the market.
Third, as a long-term investor, I need to believe that the change can last for years. The business and its disruption must have barriers to entry to make them sustainable.
I also want to invest when the stock’s valuation provides a margin of safety. I seek to be a buyer when my estimate of the long-term intrinsic value is well above the current stock price. This can mean waiting for years before investing in a company that I otherwise like.
Finally, I look for great management. While I like to get to know management teams to look for obvious flaws, it is important to judge management on their past achievements, such as return on capital, long-term EPS growth, or the successful sale of a company.
Q: Can you give an example of a small cap stock that fits your investment criteria?
A: I believe KVH Industries, Inc. (KVHI) is positioned to be the Netflix of the commercial maritime industry, which has over 200,000 vessels. KVH has spent the last four years investing in content and technology for IP-MobileCast, its subscription-based service launched in late 2014 that provides news, entertainment and onboard training to crews on ships at sea.
KVH alone has the IP-MobileCast satellite technology and the content rights. It also has the number one market share of satellite communications antennas, and demand for communications and content should grow. I believe KVH’s installed base of antennas, news, DVD and training course customers provide an available market with years of potential growth.
Is there a margin of safety in investing now? KVH is valued at just 0.9x enterprise value/revenues. The company has been profitable for 10 of the last 11 years and had only a small loss in 2009. In addition to the maritime communications business, it is also a leader in fiber-optic gyroscopes for stabilization of self-driving cars, drones and other exciting new applications, and of TACNAV systems used on military vehicles for geo-location when GPS is out of range.
Martin Kits Van Heyningen is a visionary CEO who has led the company through a number of strategic transitions, and has a plan for improving life at sea for mariners by bringing the benefits of big data to the maritime industry. I believe the company is poised to reap benefits from years of investing in IP-MobileCast and its other initiatives.
Q: What’s the biggest trap to avoid when investing in small caps?
A: The biggest trap to avoid when investing in small caps is falling for a story. Every small-cap company has a story and every CEO is a salesman. The key to avoiding the “story trap” is to not let the story affect your investment process. If something sounds too complicated or good to be true, it probably is. If you invest only in companies that you understand, the “great story” without substance will never make it into your portfolio.
We believe it is important to speak with management, but only after preparation. I review a company’s filings with the Securities and Exchange Commission, such as the annual and quarterly reports, and I review the company’s website. I read transcripts of recent earnings reports and investor presentations. I will then look to understand a company’s peers, suppliers and competitors. Only after this preparation do I believe I am well prepared to objectively assess a CEO’s sales pitch.
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.