Needham Small Cap Growth Fund: Review of the Third Quarter 2019
In the 3Q19, the Needham Small Cap Growth Fund Institutional and Retail classes returned 3.26% and 3.13%, respectively. The Russell 2000 Index returned -2.40% and the S&P 500 Index returned 1.70%.
I am very pleased with the Fund’s quarterly performance, as headline and market volatility continued. The interest rate curve inverted, sparking market fears of a recession. I did not believe a recession was near, allowing the Fund an opportunity to deploy capital at reasonable prices. While global economic growth has been decelerating, I remain constructive on the overall global economy as it adjusts. As the market recovered toward the end of the third quarter, the Fund reduced specific positions that achieved price targets.
While volatility may seem to be a bad word for the overall markets, it is a great chance for active managers to find buying and selling opportunities. In volatile markets, a cash position is truly strategic for small cap fund managers. Many small cap investment opportunities “trade by appointment,” and the Needham Small Cap Growth Fund likes to capitalize on these opportunities when liquidity is available to both buy and sell stock positions.
The Fund continued its lean toward a concentrated portfolio of stocks, with the top 10 holdings representing 51.04% of net assets at September 30, 2019. Top holdings at September 30, 2019 included Photronics, Inc. (PLAB), PDF Solutions, Inc. (PDFS), Aspen Aerogels, Inc. (ASPN), Vicor Corporation (VICR) and Cohu, Inc. (COHU).
The Fund’s top third quarter contributors included Photronics (PLAB), MACOM Technology Solutions Holdings, Inc. (MTSI), Akoustis Technologies, Inc. (AKTS), TTM Technologies, Inc. (TTMI), Navigator Holdings, Ltd. (NVGS) and Intevac, Inc. (IVAC). The Fund did not have any M&A announcements in the quarter. The Fund’s largest third quarter detractors were 2U, Inc. (TWOU), Aspen Aerogels, Inc. (ASPN) and Cohu, Inc. (COHU). Aspen Aerogels remains the Fund’s top performing holding year to date.
After a good first half of 2019, the markets, due for a pause, experienced weakness mid-summer. Increased volatility continued throughout the quarter, due in part to headlines focused on trade disputes and restrictions, with particular attention paid to the Huawei ban on both the supply chain and end-customer markets. While these impacts are meaningful and will have negative consequences for industries, such as semiconductors, optical and communications, I also believe that companies have creative plans to balance their exposure to such headwinds. As the market digested almost daily updates from trade uncertainties, patience paid off, and the Fund was able to deploy a significant amount of its cash position into stocks at good value points. The Fund ended the quarter with a cash position of 16.2%, as it sold positions and received positive inflows. I will remain patient as I deploy the Fund’s cash position.
My outlook for the remainder of 2019 remains positive, with the possibilities of a phase 1 U.S.-China trade deal, an accommodative Federal Reserve, and value recognition in the Fund’s small cap companies that lagged in 2018. I look forward to a year of patience rewarded, and I continue to believe that a favorable environment remains for investment in equities. However, the markets have recovered nicely from the year-to-date lows and it would not surprise me to see a pause in the market recovery.
I am focused on the following three themes: 1) continuation of the growth in the semiconductor capital equipment industry; 2) 5G communication infrastructure build-outs; and 3) military and defense modernization. These three areas of investment impact much of the Fund’s portfolio, and I believe that they should create long-term shareholder value.
I expect increased volatility to continue throughout 2019 and into 2020. I also expect the Federal Reserve to remain vigilant in setting interest rate policy that remains a tailwind to risk assets. While global trade negotiations have been painful headlines for many, any resolution to these disagreements should provide a nice tailwind to the global economy as we enter the U.S. general election of 2020. The high-yield markets remain strong, which is also supportive of small cap asset class valuations. I reiterate from past quarterly letters that mergers and acquisitions continued in the small cap universe, and I expect to see increased M&A activity to improve and benefit our portfolio of stocks in 2020.