Needham Growth Insights: Why Small Caps?

Q&A with John Barr, co-manager of the Needham Growth Fund

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Feb 18, 2016
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Q: What is the role of a small-cap allocation in a portfolio?   

 

A: An allocation to small cap equities complements other equity and fixed income positions by providing returns via a largely uncorrelated asset class, assuming the investor has a long-term time horizon.

Small caps can help diversify a portfolio, which should lead to lower correlation and contribute positive risk adjusted returns.

Over history, small caps have outperformed their larger cap peers by 2.4% per year as shown in "Characteristics, Covariances, and Average Returns: 1929-1997," by James L. Davis, Eugene Fama and Kenneth R. French. Modern Portfolio Theory, for which Professor Harry Markowitz won the Nobel Prize in 1990, says you can increase return, per unit of risk, by adding uncorrelated assets to a portfolio. 

Q:  Why use active management for small-cap allocation?

A:  I believe markets are inefficient in the small cap universe. This creates opportunities for the active investor who through careful research can outperform passive management. As Warren Buffet wrote in Berkshire Hathaway's 1987 Annual Report, "When investing, we view ourselves as business analysts not as market analysts, not as macroeconomic analysts, and not even as security analysts." One should view investing as buying a piece of a company, not as buying a piece of paper that is to be traded on a whim.

Take the example of a tech widget company with one big national customer. Perhaps the company's board recognizes that other customers are not going to appear and cuts operations to manage a wind-down. The stock could still be amazingly profitable and generate lots of cash, but unfortunately for any quants and index funds that buy the stock, the company would have no real value beyond the short-term cash flow. It would not be until after the one major client halted orders that the stock would stay down. It would be too bad for the indices, which would not have listened to the conference calls or read the SEC filings where the company clearly laid out its plans. Avici Systems, a now-defunct small cap tech bubble company was an example of just such a stock.

Q:  How important is a concentrated exposure when investing in small-caps? 

A:  A few high-conviction, heavily researched investments may make an outsized contribution to a portfolio's performance over the long-term, so we believe that a relatively concentrated portfolio is important when investing in small caps.

An investor is more likely to find a high-returning stock in the small-cap universe than in a large cap universe, as a new product or distribution strategy may have a more significant impact on a small company than a large company.

Small caps may be more volatile stocks, which is why it's important to distinguish between a company's fundamentals and the volatility of its stock price. We believe an investor's risk is not the volatility of the stock price, but of being wrong on the fundamental analysis of a company. The stock price merely gives long-term investors the occasional opportunity to buy a piece of a great business at a discount to its intrinsic value. For the long-term investor, the value in a company's fundamentals will eventually be recognized.

Ultimately, we think an active manager's job in the small cap world is to make concentrated investments in companies that have been heavily researched and that may return multiples of the original price over a period of years.

 

 

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. Past performance is no guarantee of future results.

This message is not an offer of the Needham Growth Fund, the Needham Aggressive Growth Fund or the Needham Small Cap Growth Fund. Shares are sold only through the currently effective prospectus. Please read the prospectus carefully and consider the investment objectives, risks, and charges and expenses of the Fund carefully before you invest. The prospectus contains this and other information about the Fund.

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