This five-star fund manager keeps beating index funds by picking ‘hidden compounders’ and holding them for years. Here’s why he held Super Micro.
The Needham Aggressive Growth Fund has a coveted five-star rating (the highest) within Morningstar’s “Small Growth” fund category. The success of the fund’s strategy is also remarkable when compared with broad stock indexes.
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John Barr, the fund’s portfolio manager, explained how selects companies for investment during an interview with MarketWatch.
Needham Investment Management is based in New York and has $990 million in assets under management. Barr joined the firm in 2009 and has run the Needham Aggressive Growth Fund since 2010. (See below for a detailed look at how well the fund has performed.)
The Needham Aggressive Growth Fund has about $600 million in assets. It has more than doubled in size over the past year, reflecting its 43% return during that period and an inflow of new money. The fund held 77 stocks as of Dec. 31, with a 30% concentration in its largest 10 holdings. The concentration has been reduced as more money has flowed in, Barr said.
He is a long-term buy-and-hold investor, who initially selects small-cap or microcap companies he believes are “hidden quality compounders.” A typical company he selects has “a legacy business or product line that is profitable or generating cash, and is investing in something new – a product or service,” he said.
Barr’s strategy is to begin by taking small positions — up to 2% of the portfolio — in the companies he identifies and see how they work out over time. Initially, their overall financial condition might appear to be unremarkable, he said, but they meet the following criteria:
Over time, as a selected company’s operating performance begins to improve, Barr will add to that stock position. He hopes to see the companies move from being hidden compounders to those making a “transition,” eventually to become “quality compounders.”
“Fewer work than don’t work,” Barr said of his stock-selection process and how he manages the portfolio. He emphasized the need for long-term investors not only to be patient but to take action and move on from bad positions.
“There are hidden compounders that never make it. But the reason we have the results we do is that enough have worked in such scale that they have produced good results,” he said.
If everything works out for a company and the share price shoots up, Barr will begin selling shares if that position has grown to be about 10% of the portfolio. Because of the fund’s small-cap focus, he will generally avoid adding to a position if a company has grown to a market capitalization of more than $10 billion.
Barr talked about several of the fund’s individual holdings. First, here’s a list of the fund’s top 10 positions as of Dec. 31:
Company | Ticker | % of the Needham Aggressive Growth Fund | 12-month return | Year shares were first purchased | Barr’s current stage category |
Super Micro Computer Inc. | SMCI | 5.1% | 1,015% | 2009 | Quality |
Aspen Aerogels Inc. | ASPN | 3.4% | 57% | 2012 | Transition |
PDF Solutions Inc. | PDFS | 2.2% | -14% | 2010 | Transition |
Vertiv Holdings Co. Class A | VRT | 2.5% | 328% | 2021 | Quality |
Unisys Corp. | UIS | 1.8% | 6% | 2021 | Hidden |
Vishay Precision Group Inc. | VPG | 1.9% | -24% | 2016 | Hidden |
Vicor Corp. | VICR | 1.6% | -19% | 2014 | Hidden |
Oil-Dri Corp. of America | ODC | 1.9% | 92% | 2012 | Quality |
Nova Ltd. | NVMI | 2.1% | 98% | 2009 | Quality |
Entegris Inc. | ENTG | 1.6% | 56% | 2010 | Quality |
Sources: Needham Investment Management and FactSet (for stock returns) | |||||
Click the tickers for more about each stock, including corporate profiles and financials.
Super Micro
Barr first purchased shares of Super Micro Computer Inc. SMCI for the fund in 2009. This is an example of how patience can be rewarded. From the end of 2009 through 2012, the stock was down 8%. But it has soared over the past few years.
Super Micro is an example of a company that has gone through the three phases Barr wants to see, he said, moving from hidden, to transition to becoming a quality compounder. The company went from making PC motherboards used by enthusiasts, to “going upmarket” by making servers, after which it added storage equipment, network-management software — and then “went to whole server racks,” he said.
“Every one of those additions took several years to play out, but there was always something ahead,” he added.
The amazing performance of the stock over the past year reflects the growth (or expected growth) of Super Micro’s business supplying server racks to AI data centers.
This is a stock Barr may have started to trim since the fund disclosed its Dec. 31 portfolio. Its market cap is now $63.5 billion, which is way above his target range for a small-cap fund. But he would stick with the position if it weren’t close to his 10% portfolio position cap.
”We hold for a really long time. When the thesis is on-track, we hold on,” he said.
Vicor
On the table you can see each company’s current stage, according to Barr’s analysis. He said that Vicor Corp. VICR, which he first purchased for the fund in 2014, was an example of a company that had “gone from hidden, to transition, to quality and now back to transition.”
Vicor makes equipment used to convert higher-voltage electricity sources to the lower voltages needed to operate servers and other computer equipment. Barr said Vicor had missed an industry product cycle as it worked to build a “fifth-generation product, later than expected.”
He expects the company’s new plant in Andover, Mass., to come online soon, enabling Vicor to provide power converters “necessary for future processors and datacenters, particularly AI datacenters.”
Unisys
Unisys Corp. UIS is a name that might be familiar to you — the company’s roots go back to the 1870s, although it was named Unisys in 1986 when it was formed through the merger of Sperry and Burroughs.
The company’s legacy business has been making mainframe computers and the software that runs on them. More recently it has evolved its ClearPath Foward transaction-processing system so that it can run on cloud networks, in addition to mainframes.
”It has all the modern capabilities,” Barr said.
Unisys has a market cap of $352 million. The stock is volatile because of legacy pension liabilities that Barr said total about $1 billion. He said he believes the company should be valued on a sum-of-the-parts basis as high as $20 a share, and ”certainly” $10 a share. The stock closed Monday at $5.12, and might be a takeover target, Barr said.
Oil-Dri
Oil-Dri Corp. of America ODC hit its stride to become a quality compounder in 2022, when its sales began it increase rapidly, Barr said. The company’s legacy business is absorbent clay products used for industrial purposes. It was founded in 1941 by Nick Jaffee, whose family still controls Oil-Dri; Daniel Jaffee now serves as chief executive.
Years of investment in two newer businesses are now bearing fruit, Barr said. These include premium light-weight cat litter sold under the Cat’s Pride and Jonny Cat brands, as well as private labels. Another long-term initiative bearing fruit is clay-based food supplements for livestock, meant to lower reliance on antibiotics.
Even though Barr considers Oil-Dri to be a company that has hit its stride, the stock flies under the radar with no coverage among analysts working for brokerage firms, according to FactSet.
Barr said that he is impressed with Oil-Dri’s management, which conducts a quarterly conference call but doesn’t present at industry conferences. “They focus on running the business,” he said.
nLight
Another stock Barr discussed that is not among the top 10 holdings of the Needham Aggressive Growth Fund is nLight Inc. LASR, which makes fiber laser components and systems. The stock closed at $12.77 Monday, well below its initial public offering at $16 in 2018.
The company was established in 2000 and its founder, Scott Keeney, still serves as chief executive. Its legacy business has been making fiber lasers using optical components for industrial uses, to replace older and less-efficient carbon-dioxide lasers.
More recently, nLight has been developing lasers for use by the U.S. armed forces to shoot down enemy drones. Acquisitions over recent years have positioned the company to compete with other defense contractors — including Lockheed Martin Corp. LMT, General Atomics and Northrop Grumman Corp. NOC — for new business with the U.S. Department of Defense, Barr said.
In May, nLight entered into an $86 million contract with the DoD to make a high-energy laser prototype. The DoD exercised options to increase the total value of the contract to $171 million in November.
With annual revenue of $210 million in 2023, this is a very important contract for nLight.
Over the past three years, nLight’s stock has dropped 62%. Barr said this reflected the revenue declines in 2022 and 2023 as the company’s business in China declined and as it geared up its new defense business.
He doesn’t expect the new defense laser contracts to bear fruit in the company’s financial performance for the next year and a half, putting nLight “beyond the scope of most investors.”
But he believes nLight “has a good prospect” to be “a multibagger years out.”
Remarkable performance
All of the following total returns assume the reinvestment of dividends, and are after funds’ expenses.
The Needham Aggressive Growth Fund has two share classes. The Class R shares have annual expenses of 1.88% of assets under management and have been available since the fund was launched in September 2001. The Class I shares have been available since the end of 2016. For most investors considering the fund, the Institutional shares are the ones to buy because they have a lower expense ratio of 1.21%. They are available through advisers and large brokerage platforms for a $50 transaction fee. Morningstar considers both expense ratios to be “high.”
Here’s a comparison of performance for the fund’s two share classes for various periods through Monday, against those of several exchange-traded funds that track broad indexes, with detailed explanations below:
Fund or index ETF | Ticker | 12-month return | three-year return | Five-year return | 10-year return | 15-year return | 20-year return |
Needham Aggressive Growth Fund – Class R | NEAGX | 43% | 53% | 200% | 279% | 1035% | 943% |
Needham Aggressive Growth Fund – Class I | NEAIX | 43% | 56% | 209% | N/A | N/A | N/A |
iShares Russell 2000 Growth ETF | IWO | 12% | -9% | 37% | 99% | 669% | 379% |
iShares S&P Small-Cap 600 Growth ETF | IJT | 9% | 4% | 45% | 128% | 801% | 525% |
SPDR S&P 500 ETF Trust | SPY | 27% | 38% | 97% | 224% | 882% | 539% |
Source: FactSet | |||||||
We can also look at average annual returns for the same time periods:
Fund or index ETF | Ticker | 12-month return | three-year average return | Five-year average return | 10-year average return | 15-year average return | 20-year average return |
Needham Aggressive Growth Fund – Class R | NEAGX | 43% | 15.3% | 24.6% | 14.2% | 17.6% | 12.4% |
Needham Aggressive Growth Fund – Class I | NEAIX | 43% | 16.0% | 25.3% | N/A | N/A | N/A |
iShares Russell 2000 Growth ETF | IWO | 12% | -3.2% | 6.5% | 7.1% | 14.6% | 8.1% |
iShares S&P Small-Cap 600 Growth ETF | IJT | 9% | 1.2% | 7.7% | 8.6% | 15.8% | 9.6% |
SPDR S&P 500 ETF Trust | SPY | 27% | 11.4% | 14.6% | 12.5% | 16.5% | 9.7% |
Source: FactSet | |||||||
In these performance comparisons, the indexes are all represented by large exchange-traded funds that track them. These make for more useful comparisons because the index funds’ performance reflects their own expenses.
The fund’s performance benchmark is the Russell 2000 Growth Index XX:RUO, which is a subset of the full Russell 2000 Index RUT. The Russell 2000 is made up of the smallest 2000 companies by market capitalization in the Russell 3000 Index RUA, which itself is designed to track 98% of the U.S. stock market.
The Russell 2000 Growth Index includes companies in the Russell 2000 that have higher price-to-book values, have achieved higher five-year growth rates for sales per share and have higher projected growth rates going out two years. You can read about this index’s selection criteria here.
It is also fair to compare the Needham Aggressive Growth Fund’s performance to that of the S&P 600 SmallCap Growth Index XX:SP600G, which can be considered a higher-quality index than the Russell 2000 Growth Index because initial inclusion in the S&P Small Cap 600 SML requires companies to report four subsequent quarters of profitability, among other criteria.
Then we might as well compare the fund’s performance with that of the S&P 500 SPX, the large-cap index, because it has performed so well over recent years and looms so large in coverage of the stock market as a whole. This benchmark is represented in the table by the SPDR S&P 500 ETF Trust SPY, the largest and oldest ETF, with $496 billion in assets under management.
Read: Passive funds have overtaken active. What’s next for the long-running trend?
In an industry in which it is difficult for any active manager to outperform a broad stock index, this type of consistent outperformance is unusual. The Needham Aggressive Growth Fund’s Class R shares (the ones with the higher expenses) rank within the first percentile among more than 500 funds within Morningstar’s “Small Growth” category for one, three and five years. They rank within the first percentile among more than 400 funds in the category for 10 years, and within the fifth percentile among more than 300 funds for 15 years.
