Needham Small Cap Growth Fund – 3Q26

Market Review & Macro Observations

• Late July correction exposed fragility in AI hardware. A sharp market correction triggered the collapse of Situational Awareness, L.P., a $45 billion leveraged AI-focused hedge fund. The resulting forced selling hit technology hardware stocks that had led in the first half of 2026.
• Rotation and dispersion beneath the surface. First-half winners saw profit-taking outflows as capital moved into industries that had not yet participated. Major indices masked the churn, and the bottlenecks that constrain long-term technology growth remain unchanged.
• The Fed tightened, with more expected. The Federal Reserve raised rates a quarter point at its most recent meeting, and further increases are expected in 2026. The goal is to cool inflation expectations.
• Energy and commodity costs keep inflation a significant risk. Oil is above $100^[1] a barrel and diesel in the U.S. is well above $6.00^[2] a gallon as of this writing. Steel, copper and aluminum prices add pressure, which will weigh on company margins and end customers. Rate hikes alone won’t lower global energy costs; and a resolution of the Middle East conflict would do the most to ease them.
• Global funding conditions are shifting. The Yen required intervention to stabilize its decline, and the decades-old “carry trade” appears to be at an inflection point. Federal borrowing needs now face significant competition from corporate borrowers.
• Consumers, housing and capital markets are under strain. Higher energy and food prices pressure consumer spending. Housing transactions are limited by higher mortgage rates and homeowners’ reluctance to give up low existing rates. Capital markets were strong early in the year but are slowing as large IPOs are postponed and the cost of capital rises, though M&A remains active.

Portfolio

• The Fund’s Institutional (NESIX) and Retail classes (NESGX) returned -20.27% and -20.35% respectively in the third quarter, compared to the Russell 2000 Growth’s -9.39% and the Russell 3000’s 1.41%. Year-to-date, the Fund’s Institutional (NESIX) and Retail classes (NESGX) returned 49.20% and 48.60%, compared to the Russell 2000 Growth’s 10.71% and the Russell 3000’s 12.42%.
• We believe there is significant value within the small-cap asset class. Management teams continue to focus on improving cost structures and margins, accelerating revenue, expansionary planning and strengthening balance sheets.
• The Fund ended the quarter with a 7.9% cash position.
• The Fund’s top five performers in 3Q26 were: Netskope, Inc (NTSK), 908 Devices, Inc. (MASS), Lantronix, Inc. (LTRX), Super Micro Computer, Inc. (SMCI) and Unusual Machines, Inc. (UMAC).
• The Fund’s top five detractors in 3Q26 were: Arteris, Inc. (AIP), Vishay Intertechnology, Inc. (VSH), nLight, Inc. (LASR), Harmonic, Inc. (HLIT) and Veeco instruments, Inc. (VECO).

Outlook

• The micro picture is stronger than the macro sentiment. The market appears to be climbing a “wall of worry.” Oil volatility and restrictive rates keep sentiment cautious, but corporate fundamentals tell a more robust story, and domestic reindustrialization is moving forward.
• Semiconductor manufacturing and capital equipment show the greatest strength. Revenue and earnings are growing despite valuation-multiple compression. Chip complexity is driving higher tool density per wafer, and immediate beneficiaries report order visibility through 2027 and into 2028, a level that veterans haven’t seen before.
• AI demand should sustain capital investment. Agentic AI inference is just beginning, and enterprise and sovereign spending are broadening AI’s global reach. Cybersecurity will be critical, and predictions that AI will kill software companies look overblown, with technological moats separating winners from losers.
• Data centers and power remain a long-term build-out with near-term headlines. Demand is not expected to slow for years. November midterm elections have made data centers a local political issue in multiple states, and that risk will likely persist after election season. Ultimately, we expect most projects to be built, with “Behind the Meter” power generation requiring substantial infrastructure investment.
• Defense modernization and policy backdrop offer support, with risks to monitor. Military modernization is shifting to rapid ramp-ups in autonomous systems, drones and directed-energy weapons. A divided Washington may limit new policy uncertainty and let companies invest with more confidence. Key risks include rare earth supply constraints (China), tariff and trade negotiations, and geopolitical exposure around Taiwan.
• Positioning favors quality. Investors should focus on companies with good balance sheets, strong management teams and boards, and technological moats that sustain long-term margins.