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Needham Small Cap Growth Fund – 1Q23 Commentary

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MACRO OBSERVATIONS

  • Inflation continues to improve from extremely high levels and we expect the Federal Reserve to end rate increases in the coming months. Global economic growth should continue to slow, and the inversion of the interest rate yield curve indicates a higher probability of a global recession. Energy, housing, food, and labor costs remain significant headwinds to lower inflation.
  • Recent U.S. dollar weakness should positively impact the future corporate earnings of companies that sell overseas. As we’ve mentioned previously, a weak dollar should improve the outlook for U.S. risk assets.
  • Corporate layoffs have accelerated as management teams prepare for a weaker economy and slower business opportunities.
  • We expect mergers and acquisitions to increase as companies recognize the impact of higher capital costs and the need for consolidation.
  • Volatility continues as the markets digest earnings and future monetary policy risks. Labor issues, logistical transportation, higher commodity prices, and supply chain constraints have hampered earnings and forward guidance for many companies.
  • Unfortunately, geopolitical risks are expected to persist for an extended period.

IMPACTS ON PORTFOLIO PERFORMANCE

  • The Fund’s Institutional (NESIX) and Retail classes (NESGX) returned 5.67% and 5.55%, respectively, in the first quarter, slightly underperforming the Russell 2000 Growth’s 6.07%.
  • Small-cap stocks have been in a bear market since March 2021. However, we became more constructive on equities over the last few months as equity valuations collapsed, the dollar weakened, and tax loss selling abated in 2023.
  • The Fund experienced a significant, positive market move in January. We raised cash levels starting in February and continued to reduce exposure throughout the remainder of the quarter. Unfortunately, the January outperformance evaporated as the small-cap asset class sold off and the Fund experienced some negative stock-specific news.
  • Companies with solid management teams that can capitalize on revenue prospects should provide leverage in business models and drive earnings and cash flow. Strong balance sheets are extremely important during economic downturns.
  • The Fund’s top five performers in 1Q23 were: Sumo Logic, Inc. (SUMO), Zuora, Inc. (ZUO), Standard BioTools, Inc. (LAB), Yext, Inc. (YEXT), and FormFactor, Inc. (FORM).
  • The Fund’s top five detractors on 1Q23 were: Aspen Aerogels, Inc. (ASPN), Telos Corp. (TLS), ViewRay, Inc. (VRAY), Upland Software, Inc. (UPLD), and ADTRAN Holdings, Inc. (ADTN).
  • In January 2023, Sumo Logic, Inc. announced its acquisition by Francisco Partners. This is a perfect example of a management team that was improving operations but realized that it is more prudent to consolidate based on economic circumstances and higher costs of capital.

OUTLOOK

  • The financial meltdown we experienced in March reminded us of the fragility of our financial system and the interconnectedness of financial institutions. While we are relieved the system did not collapse like in 2008, we are still concerned about ripple effects from the crisis and the lower expected liquidity for both retail investors and the financial markets.
  • Capital markets remain challenged, and companies needing to raise funds are finding that the cost of capital is substantially higher than in past years. This higher cost of capital weighs substantially on equity valuations.
  • The CHIPS and Science Act passed in July 2022 has not provided the benefit we had expected, as government conditions have kept companies from applying for the program. Until these conditions are amended, we don’t expect a significant boost from this Act.
  • Technology remains a long-term strength of the economy, and there are major secular trends that remain firmly in place to support continued growth. Areas of long-term investment that we continue to like are mobile electrification, communications infrastructure, defense, AI, cloud computing, 5G devices and wireless connectivity, software and security, and specialty material manufacturers.
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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. This message is not an offer of the Needham Growth Fund, the Needham Aggressive Growth Fund or the Needham Small Cap Growth Fund (each a "Fund" and collectively, the "Funds"). Shares are sold only through the currently effective prospectus, which must precede or accompany this report. Please read the prospectus or summary prospectus and carefully consider the investment objectives, risks and charges and expenses of the Funds before you invest. To obtain a copy of the Fund's current prospectus, please visit www.needhamfunds.com or contact the Fund's transfer agent, U.S. Bancorp Fund Services, LLC at 1-800-625-7071.

Investment returns and principal value will fluctuate, and when redeemed, shares may be worth more or less than their original cost. Performance data quoted represents past performance and does not guarantee future results. Current performance may be higher or lower than these results. Performance current to the most recent month-end may be obtained by calling our transfer agent at 1-800-625-7071. Total return figures include reinvestment of all dividends and capital gains.

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 Small Cap Growth Fund's ownership as a percentage of net assets in the stated securities as of March 31, 2023: SUMO: 0.00%, ZUO: 5.60%, LAB: 2.76%, YEXT: 2.97%, FORM: 1.63%, ASPN: 4.60%, TLS: 1.43%, VRAY: 4.28%, UPLD: 1.44% and ADTN: 4.57%.


The Global Industry Classification Standard (GICS®) was developed by and/or is the exclusive property of MSCI, Inc. and Standard & Poor’s Financial Services LLC (“S&P”). GICS is a service mark of MSCI and S&P and has been licensed for use by U.S. Bancorp FundServices, LLC. The S&P 500 Index is a broad unmanaged measure of the U.S. stock market. The Russell 2000 Index is a broad unmanaged index composed of the smallest 2,000 companies in the Russell 3000 Index. The Russell 2000 Growth Index includes those Russell 2000 Index companies with higher price-to-value ratios and higher forecasted growth values. An investor cannot invest directly in an index. Needham & Company, LLC is a wholly owned subsidiary of The Needham Group, Inc. Needham & Company, LLC, member FINRA/SIPC, is the distributor of The Needham Funds, Inc.

The source of the data for each of the Russell 2000 Index and the Russell 3000 Index (together, the “Indexes”) is the London Stock Exchange Group plc and its group undertakings (collectively, the “LSE Group”). © LSE Group 2022. All rights in the Indexes vest in the relevant LSE Group company which owns the Index. The Indexes are calculated by or on behalf of FTSE International Limited or its affiliate, agent or partner. Neither the LSE Group nor its licensors accept any liability for any errors or omissions in the Indexes; no party may rely on the Index returns shown; and the LSE Group makes no claim, prediction, warranty or representation about the Fund or the suitability of the Indexes with respect to the Fund. No further distribution of data from the LSE Group is permitted without the relevant LSE Group company’s express written consent. The LSE Group is not connected to the Fund and does not promote, sponsor or endorse the Fund or the content of this prospectus.