Investing In Small-Cap-Growth Companies With A Long-Term ViewAdvisor Perspectives
John Barr manages the Needham Aggressive Growth Fund (NEAGX) and is a co-manager of the Needham Growth Fund (NEEGX). John started on Wall Street in 1995 with Needham & Co. as a sell-side analyst following technical software and electronic design automation (EDA) companies. John rejoined Needham in 2009 because of its focus on growth companies and long-term investing. Before the financial industry, he had a 15-year career in sales, marketing and management in the EDA industry.
As of June 30, 2018, NEAGX had an annualized return of 10.51% over the prior 15 years, versus 9.42% for the S&P 500, for an outperformance of 109 basis points.
I interviewed John last week.
Tell us about your approach to investing in small-cap growth stocks -- a notoriously difficult asset class for active managers.
Thanks Bob. I believe that finding and holding investments in compounding stocks is the path to long-term wealth creation. I like to make the initial investments when companies are small or even micro-cap stocks. There is opportunity to generate alpha over a multi-year period by investing in select small cap equities, and letting them grow. A few high-conviction, heavily researched investments can make an outsized contribution to performance.
Your investment process focuses on “compounding stocks.” What are those and how do you identify them?
Compounding stocks are companies that deliver above-market returns over a multiyear time horizon. I look for three things in companies.
First, I like companies that are managed by founders, family or long-tenured managers. CEOs with these backgrounds tend to think long-term. They are looking to create enterprises which will last for years, if not generations. In our portfolio’s technology companies, many of the founders and CEOs are Ph.Ds. They know their stuff!
Second, I look for companies which have the potential to be 5-10x, or more, larger. This means understanding their growth plans, R&D efforts, and their markets. It means these companies have reinvestment opportunities with potential high returns on capital. I recall Philip Fisher wrote in Common Stocks and Uncommon Profits, “Does the company have products or services with sufficient market potential to make possible a sizable increase in sales for at least several years?”
Finally, I look for companies with high return-on capital, or even better, I look for the potential for high return on capital. If a company is going through an investment stage, it may show no return. My job is to look beyond the investment stage and estimate what I believe the company may earn in the future.
Can you provide some examples?
Success for the Needham Funds is finding a few compounders each year. The challenge is to stay with them through the noise of the markets and the inevitable few quarters of disappointing results, and even through a multi-year R&D investment cycle.
The Needham Growth Fund opened for investment in 1996. Its largest holding, Thermo Fisher Scientific (TMO) was purchased 18 years ago, in 2000. Including dividends, it has generated a 17.6% compound annual return since our purchase. Thermo has been an astute acquirer and operator of complementary life sciences consumables and services companies.
Compounders for the Needham Funds include:
CarMax Inc., which the Fund purchased in 2009. CarMax has a small share of the pre-owned car market. They have a significant opportunity to grow for many years. The company has competitive advantages in its logistics and knowledge about how much to pay and sell cars for. These advantages come from scale. CarMax is making appropriate investments in technology for e-commerce. CEO Bill Nash has been with the company since 1997. CarMax earns an upper-teens return on equity.
The Fund purchased Entegris, Inc. (ENTG) in 2012. Entegris supplies microcontamination control products, specialty chemicals and materials handling solutions for semiconductors and other advanced manufacturing processes. Think filtering one drop out of a day’s worth of water over Niagara Falls. CEO, Bertrand Loy has been with Entegris and its predecessor companies since 1995. In 2014, Entegris acquired ATMI, Inc., a specialty chemicals company for $1 billion. In 2013, Entegris earned $0.53 per share. Estimates for 2018 are $1.55. I believe Entegris has the potential to earn 20-25% return on equity and has opportunities to acquire companies with complementary technologies.
Read the full article here by Robert Huebscher, Advisor Perspectives