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Needham Small Cap Growth Fund – 2Q23 Commentary

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MACRO OBSERVATIONS

  • Inflation has improved, but the headwinds of elevated costs in housing, food, and labor remain. We anticipate that the Federal Reserve will end rate increases in the coming months, which should allow the economy to digest the impact of higher interest rates.
  • Global economic growth should continue to slow as the impact of the higher cost of capital slowly filters throughout the economy. The inversion of the interest rate yield curve indicates a higher probability of a recession, although the timing is difficult to predict.
  • Corporate layoffs continue as management teams prepare for the possibility of a weaker economy and slower business opportunities.
  • Companies continue to adjust inventory levels to meet new end demand and higher cost of capital to retain inventory levels. Lingering disruptions from the pandemic continue to have ripple effects throughout supply chains, and we expect that a downturn would rebalance inventories.
  • Unfortunately, geopolitical risks will persist for an extended period.

IMPACTS ON PORTFOLIO PERFORMANCE

  • The Fund’s Institutional (NESIX) and Retail classes (NESGX) returned -2.83% and -2.63%, respectively, in the second quarter, significantly underperforming the Russell 2000 Growth’s 7.05%.
  • I want to address the extreme disappointment the Fund suffered from ViewRay (VRAY), a long-time holding of the Fund, and an unprecedented event in my 18 years of portfolio management. ViewRay experienced a perfect storm of liquidity pressures. We were hopeful that the announced strategic review would have led to a sale of the company to a larger platform; however, after months of efforts, that was not the final result. The rapid and shocking decline of VRAY serves as a valuable lesson for future high-growth small-cap companies that may encounter liquidity risks in a tightening economic environment.
  • The market sold off in March, recovered in April, and the theme of artificial intelligence (AI) became a household name. Semiconductors are at the center of this technological advancement, and we believe this theme is one that will persist. Semiconductor capital equipment suppliers should also benefit long-term from AI and from the geographical expansion of semiconductor manufacturing plants away from Taiwan.
  • Companies with solid management teams capable of capitalizing on revenue prospects should provide leverage in business models and drive earnings and cash flow. Strong balance sheets are crucial during economic downturns.
  • Finally, small-cap stocks have begun to share in the market upturn that larger-cap companies have enjoyed year-to-date. We believe there is significant value within the asset class after years of selling pressure and investor avoidance.
  • The Fund’s top five performers in 2Q23 were nLight, Inc. (LASR), Vicor Corp. (VICR), Veeco Instruments, Inc. (VECO), Aspen Aerogels, Inc. (ASPN) and Photronics, Inc. (PLAB).
  • The Fund’s top five detractors on 2Q23 were ViewRay, Inc. (VRAY), Intevac, Inc. (IVAC), Adtran Holdings, Inc. (ADTN), KVH Industries, Inc. (KVHI) and Cambium Networks Corp. (CMBM).

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 that the system did not collapse like in 2008, we remain concerned about potential ripple effects from the crisis and the lower expected liquidity for both retail investors and the financial markets.
  • Capital markets continue to face challenges, and companies needing to raise funds are finding that the cost of capital is substantially higher than in past years. The higher cost of capital weighs substantially on equity valuations.
  • Technology remains a long-term strength of the economy, and several major secular trends 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.

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 June 30, 2023: VRAY: 0.49%, LASR: 5.51%, VICR: 4.45%, VECO: 0.75%, ASPN: 6.08%, PLAB: 0.00%, IVAC: 1.72%, ADTN: 5.97%, KVHI: 2.62% and CMBM: 3.98%.

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 2023. 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.