There's an old saying, "good things come in small packages." Needham Aggressive Growth Retail Fund (NEAGX), a best mutual fund, proves big gains come in small-cap funds.
Veteran fund manager John Barr runs this $670 million small growth fund. And Barr isn't a rapid-fire trader. He isn't in a rush to make his fortune on any of the pipsqueak stocks he buys, either. He's a buy-and-holder looking not for a 20% gain. Barr seeks a two-bagger or 10-bagger or, in some cases, a 100-bagger.
He's a stock picker. His winning plan? Identify what he calls "hidden compounders" before anyone else does. He then waits and waits and waits until his bet pays off. Sometimes that wait can be upward of 15 years. In fact, his fund turnover in the first quarter was 7%, which equates to a 14-year holding period.
Stocks This Best Mutual Fund Likes
Many of his top holdings and big winners, names like Super Micro Computer and Nova, Ltd, have been in the portfolio since 2009.
A review of Needham Aggressive Growth's performance on Morningstar shows just how powerful his investment process is. The fund was up 17.17% this year through April 2. That ranks the fund in the top 1 percentile of its peers. But it also topped the S&P 500's 9.54% return by nearly eight percentage points.
It's the fund's ranking over many different time periods, though, that scream excellence. Year-to-date return: It's in the top percentile. And it's one-year gain is in the top decile. The same is true for Needham Aggressive Growth's three- and five- and 10-year return rankings: all are top percentile performances.
Best Mutual Fund Wins Over Time
To put it another way, Barr's fund has beaten 99% of its peers going all the way back to Barack Obama's second term as president. IBD asked Barr about out his secret to picking stocks and making money in the stock market.
IBD: So, small caps aren't dead after all.
John Barr: I would say that there's lots of opportunities in small caps.
IBD: There's life after megacaps. Please tell.
Barr: There are companies that I've been investing in for a number of years, and it is time that some of the results will start to show through. You can overlay that with the market, which has been so top heavy, looking for alternatives, and looking for companies that are going to be showing strong performance that haven't yet. I seek the "hidden compounders."
Discovering Secret Growth
IBD: What's a hidden compounder?
Barr: A hidden compounder is a company that has been investing in a new product or service that has yet to show financial results. Most investors are focused on the next year, maybe a year and a half, which is how far out the Wall Street financial models go. But in my case, I'm prepared to wait. My turnover is very low. Last quarter it was 7%. So, a 14-year holding period. We're prepared to allow our companies to make those investments for a longer period of time. We've had a steady succession of companies that have made progress and have shown the financial results, and the market has recognized that. The most important criterion for a hidden compounder is that they also have an established business that provides support. It's either profitable or generating cash and that helps protect on the downside should the new investment not pay off.
Powering This Best Mutual Fund's Results
IBD: What factors and stocks have been driving the best mutual fund's recent returns?
Barr: (The fund manager notes that the fund has yet to file its first-quarter holdings to the SEC but says top fund holdings at the end of 2023 were among some of the low-turnover funds biggest gainers to start the year.) Super Micro Computer (the fund's top holding at the end of 2023) was up 255% during the first quarter.
IBD: But you bought that eons ago, right?
Barr: We've owned it since 2009. So, Super Micro Computer has been a long-term holding. It fit our whole process of investing in something new while having an established business. Going back 15 years, they were a computer motherboard maker looking to move into servers. (Now the company is profiting) from data centers and AI and has crossed over from a hidden compounder into the quality compounder bays.
IBD: What other stocks have been working?
Barr: Another top holding that was up 70% In the first quarter is Vertiv Holdings. They supply power and thermal management for data centers. Both Super Micro Computer and Vertiv were small caps when we bought them. But as you hold small companies that succeed, they grow into larger market-cap ranges. Vertiv, at $32.6 billion, is now at the top end of the small-cap space. And Super Micro (was added) to the large-cap S&P 500.
Finding Future Large Caps
IBD: What's the power of hanging on to winners? Eventually owning a large cap?
Barr: Exactly. Super Micro Computer is a great example. Back in 2009 (when we bought it, it was an $8 to $9 stock, and now it's north of $1,000. So, it's a 100-bagger (a term to describe its value rising by over 100 times). But it was not a steady path. There were years of underperformance and company-specific challenges. But if you're confident in what you own and you know it well, you can have the fortitude to stay with it. And then if the company succeeds in its business plan, the compounding effects are incredible.
IBD: Any other examples of the power of patient investing?
Barr: Nova Ltd makes measurement equipment that is used for advanced semiconductor manufacturing. It was up 29% in the first quarter. It was the fund's ninth-biggest holding as of Dec. 31. We bought it in 2009 also and it was around $4 a share and the stock are now around $178. When we bought it, the stock was a $40 million market cap and no street coverage. And, today, it still is a small cap. But it's now a $5.2 billion company. They executed the business plan very, very well. And we've not had much in the way of fundamental challenges. It's been more up and down with the market at times. But the power of this compounding is that it can make up for many mistakes.
Waiting For Growth
IBD: And waiting gives you time for the seed to grow?
Barr: I buy a company as a hidden compounder on the hope that in a number of years they will emerge on the other side with great financial results and will get a multi-bagger. But that isn't the way it works out all the time. But at most we're going to lose one times that. But if we've done our margin of safety right, the loss will be much less than that. Whereas the winners can be these multiple baggers.
IBD: Are there still inefficiencies and undiscovered gems in the small cap space?
Barr: I think there are still plenty of opportunities. I've got 77 positions in the fund and about a third of them are in the early stage, a third are in the middle stage and then a third are at this point (of being quality compounders). The beauty of finding those early-stage companies is that the market doesn't have a lot of the same expectations. So, if something goes awry for a quarter or two, your downside is pretty limited because no one is focused on it. The second aspect is it gives you time to really get to know your investment. And the better you know it, the more conviction you have to enable you to stay with it.
Catching Winners Early
IBD: Any examples of stocks you own in the early stage?
Barr: Yeah, one is Arlo Technologies. They provide security cameras and home security services. They are really the leader in do it yourself. It's a $1.1 billion market cap. When we first invested in 2019, they had just been spun off from Netgear. They had a few hot years with a hot product and then the stock got crushed as the camera business became more competitive. Then, they came up with the plan to offer security monitoring services. And they have over the last three years started to build this subscription business. And they currently have about 3 million subscribers and the business is growing quite nicely.
IBD: Where's the upside?
Barr: Yeah, so (now they're) running right around break-even on EBITDA (earnings before interest, taxes, depreciation and amortization). In the new year they should be generating cash and some earnings. And it's valued at 20 times 2025 earnings and two times revenues, basically. So, should they succeed and grow this to five to 10 million subscribers this should be a nice contributor, and nice performer. And I don't think there's been any street coverage (until recently).
Best Mutual Fund Shares Secrets
IBD: So, what's the X-factor for your fund?
Barr: It is the process. It's identifying companies at an early stage that are making investments that the market doesn't yet recognize and that are able to produce results from their investments over a period of time that's beyond the market's (timeline).
IBD: What's your secret to identifying these companies?
Barr: I've been doing this for a long time. And so has Needham Funds. So, we have a long history of investing in small-cap growth companies. We know the universe. We know the investor base from the venture capital perspective. And then, to the sorting process, it really goes to understanding what I'm looking for, understanding this process.
IBD: So, what screams "dog" stock to you?
Barr: No. 1, companies that are heavily promoted. No. 2, companies that have a great story, but don't have the customer traction to back it up. Understanding that we're investing in public companies. We're not investing in ideas. Finally, No. 3. Changes in management can be great, but it's really important to understand what and who the new management is and to try to understand if they're going to fit culturally in with a company.
Amassing Wealth Over Time
IBD: Is seeking multibagger stocks a key to building wealth?
Barr: Well, the impact on the portfolio is that you can have great compound returns over time. And you can cover up for your errors, which I have plenty of. (Long holding periods are also) very tax efficient. If you haven't sold it, you're not paying taxes on it, nor are you paying transaction costs. And both of those can add up over time and subtract from your ability to generate great compound returns.
IBD: Why such a big overweight in tech in your best mutual fund?
Barr: Tech is pervasive. In looking at industry categories, it's important to look through and see what the end markets are. And technology is in various markets. Tech is really where the growth is. And I like to invest in the picks-and-shovels companies that make all these other businesses much more efficient.
Best Mutual Fund Digs Out Winners
IBD: Can you give an example of a pick-and-shovel stock you like?
Barr: One that is a nice contributor and is now in the quality compounder stage is Parsons. It was up 32% in the first quarter. There are two parts to their business. The first is architecture, engineering and construction. (For example,) they're No. 1 in airports in the U.S. They also do road work and other work. The second part of their business is government services with a special focus on defense and security. The top three-letter government agencies are all their customers. They're doing work from specifying and designing systems to cybersecurity. That's PSN. Is very much a picks-and-shovels play for both defense and security, but also physical infrastructure.
