Item 1. Reports to Stockholders.

Annual

Report

Seeking to build wealth for long-term investors.

December 31, 2019

Needham Growth Fund

Needham Aggressive Growth Fund

Needham Small Cap Growth Fund

www.needhamfunds.com

 

Beginning on January 1, 2021, as permitted by regulations adopted by the Securities and Exchange Commission, paper copies of the Funds’ shareholder reports will no longer be sent by mail, unless you specifically request paper copies of the reports from the Funds or from your financial intermediary, such as a broker-dealer or bank.  Instead, the reports will be made available on a website, and you will be notified by mail each time a report is posted and provided with a website link to access the report.

 

If you already elected to receive shareholder reports electronically, you will not be affected by this change and you need not take any action.  You may elect to receive shareholder reports and other communications electronically from the Funds by calling 1-800-625-7071 or by contacting your financial intermediary (such as a broker-dealer or bank).

 

You may elect to receive all future reports in paper free of charge.  You can request to continue receiving paper copies of your shareholder reports by contacting your financial intermediary or, if you invest directly with a Fund, calling 1-800-625-7071 to let the Fund know of your request.  Your election to receive in paper will apply to all funds held in your account.

 

This report is authorized for distribution to prospective investors only when preceded or accompanied by a current prospectus.  The prospectus contains more complete information, including investment objectives, risks, expenses and charges and should be read carefully before investing or sending any money. To obtain a prospectus or summary prospectus, please call 1-800-625-7071.

 

Portfolios of The Needham Funds, Inc., like all mutual funds:

 

The Needham Funds, Inc. are distributed by Needham & Company, LLC.

February 2020

 

Dear Shareholders, Friends of Needham and Prospective Shareholders,

 

The Needham Funds’ mission is to create wealth for long-term investors, and 2019 was an incredible step forward for all three of our mutual funds.

 

We are very pleased with the Funds’ annual performance.  Needham Small Cap Growth Fund was recognized in the Wall Street Journal and Investor’s Business Daily as the top performing mutual fund in any category in 2019.  According to Morningstar, Needham Aggressive Growth Fund was the second best performing mutual fund in the Small Cap Growth category in 2019.  We are very excited about these recognitions and appreciate the long term support and patience of our investors.

 

Needham Growth Fund (NEEGX/NEEIX)

 

For the year ended December 31, 2019, the Fund’s Institutional and Retail classes returned 43.13% and 42.31%, respectively.  The Russell 2000 Index returned 25.52% and the S&P 500 Index returned 31.49%.

 

PDF Solutions (PDFS) was the Needham Growth Fund’s leading contributor in 2019.  In October, PDF hosted only its second investor day since going public in 2001.  The company highlighted its four-year journey to become an analytics software company for the semiconductor manufacturing industry. Over 50% of revenue is from this fast-growing, high-value offering.  PDF’s Exensio big data platform provides access to organized data from a customer’s supply chain, as well as Exensio’s automated intelligence and machine learning capabilities.

 

Thermo Fisher Scientific, Inc. (TMO) was the second leading contributor for the year. Thermo Fisher has been the largest holding of the Needham Growth Fund for four years.  The company develops instruments and consumables used in life science and other research-oriented industries.  For the 4 quarters reported in 2019, Thermo Fisher averaged 7% organic growth, which was growth above the 4-6% Wall Street expectations.  We see continued organic growth and acquisition opportunities for the company.

 

Entegris, Inc. (ENTG) was the third-leading contributor in 2019.  Entegris supplies filters and chemicals used in advanced semiconductor manufacturing processes.  Based on confidence in its business, Entegris said the second quarter of 2019 represented a bottom, and revenue grew in the third and fourth quarters.  The company also announced $20 million in annual cost savings, which was in place by the end of 2019.

 

In April, Entegris announced a merger with Versum Materials, which was bested by an offer from Merck AG (MKGAF).  Throughout 2019, Entegris continued with its acquisition strategy by acquiring Digital Specialty Chemicals (DSC) in March, MPD Chemicals for $165 million cash in July, and Hangzhou Anow Microfiltration for $73 million in September.  Entegris is doing its own version of what might have been with Versum.

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Entegris sees 2020 as a healthy year for its logic and foundry customers, led by Taiwan Semiconductor (TSM) and Intel Corporation (INTC), and an increasingly positive year for its memory customers.  Over time, we believe that semiconductors will increase as a percentage of industrial output and that Entegris’ filtration and specialty materials products will grow even faster.

 

Aspen Aerogels Inc. (ASPN) and FormFactor Inc. (FORM) were other top contributors to the Fund’s performance in 2019.  Aspen Aerogels makes aerogel insulation used in the energy, infrastructure and building materials markets.  Its aerogel is a superior alternative to conventional fiber and foam insulation, yet the market has been slow to change. After a disappointing 2018 with $104 million of revenue, we estimate Aspen will have revenue of $135 million in 2019 with continued growth in 2020. Aspen Aerogels’ stock was at an all-time low on December 28, 2018 as the market was concerned about Aspen’s liquidity.  In April, Aspen announced a second phase of their partnership with BASF SE (BASF), which included a cash prepayment for the new SLENTEX aerogel used in commercial construction.  We are excited about Aspen’s prospects in the electric vehicle battery market.

 

FormFactor reported second quarter results at the high end of revenue, gross margin and earnings expectations.  FormFactor makes probe cards that are used to test wafers for new semiconductor designs.  At the start of the year, the company suffered from a delay in Intel Corporation’s (INTC) latest generation 14/10 nanometer manufacturing process.  Demand at Intel recovered in the second quarter and stayed strong throughout the year.  Over the last seven years, FormFactor has diversified its business by acquiring leading probe card companies for RF (radio frequency) design and logic/system-on chip design.

 

In 2019, the Fund’s short position in Ubiquiti, Inc. (UI) was the only major detractor.  The company’s limited float and stock repurchases funded with bank debt have supported the stock price at a premium valuation.  The stock spiked in November as the company reported 14% year-over-year revenue growth.  While we remain skeptical about Ubiquiti’s business model and governance, it is time to move on from this short position.  As of December 31, 2019, the Ubiquiti short position is down to 0.4% of net assets and it will no longer have a significant impact on the Fund.

 

Compounding returns come from owning great businesses for years.  While the Fund has a mandate allowing short sales, short selling has only contributed to returns in a few years of the Fund’s 18-year existence.  In the near future, we plan to do even less short-selling than we have in the last 10 years.

 

Additions to the Fund in 2019 included Cambium Networks Corporation (CMBM), FARO Technologies, Inc. (FARO), Intevac, Inc. (IVAC) and Wabtech Corp. (WAB), all of which were 50 basis point or above positions on December 31, 2019.  The Fund exited only three positions that were over 50 basis points as of December 31, 2018 – Amber Road, Inc., Aquantia Corp., and Electronics for Imaging Inc. were all acquired.

 

The Fund added to only a few positions; its addition to its position in Vicor Corporation (VICR) was the most significant.  The Fund reduced positions in many of its top holdings including FormFactor, Inc. (FORM), Photronics Inc. (PLAB), Super Micro Computer Inc. (SMCI), Thermo Fisher Scientific (TMO) and ViaSat, Inc. (VSAT).

Annual Report 2019

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At December 31, 2019, the Fund’s top 10 positions were 55.42% of net assets. The Fund had an Active Share of 96.9% versus the S&P 500 and had trailing 12-month turnover of 13%.  Active Share represents the proportion of portfolio holdings that differ from those in the benchmark index. The Fund was short 0.7% of total investments and held a cash position of 1.7%.  Cash is included in Short-Term Investments on the Schedule of Investments, and in Investments in Unaffiliated Securities on the Statement of Assets and Liabilities.

 

Needham Aggressive Growth Fund (NEAGX/NEAIX)

 

For the year ended December 31, 2019, the Fund’s Institutional and Retail classes returned 44.79% and 43.93%, respectively.  The Russell 2000 Index returned 25.52% and the S&P 500 Index returned 31.49%.

 

PDF Solutions (PDFS) was Needham Aggressive Growth Fund’s leading contributor in 2019. In October, PDF hosted only its second investor day since going public in 2001.  The company highlighted its four-year journey to become an analytics software company for the semiconductor manufacturing industry. Over 50% of revenue is from this fast-growing, high-value offering.  PDF’s Exensio big data platform provides access to organized data from a customer’s supply chain, as well as Exensio’s automated intelligence and machine learning capabilities.

 

Entegris, Inc. (ENTG) was the second-leading contributor in 2019.  Entegris supplies filters and chemicals used in advanced semiconductor manufacturing processes.  Based on confidence in its business, Entegris said the second quarter of 2019 represented a bottom, and revenue grew in the third and fourth quarters.  The company also announced $20 million in annual cost savings, which was in place by the end of 2019.

 

In April, Entegris announced a merger with Versum Materials, which was bested by an offer from Merck AG (MKGAF).  Throughout 2019, Entegris continued with its acquisition strategy by acquiring Digital Specialty Chemicals (DSC) in March, MPD Chemicals for $165 million cash in July, and Hangzhou Anow Microfiltration for $73 million in September.  Entegris is doing its own version of what might have been with Versum.

 

Entegris sees 2020 as a healthy year for its logic and foundry customers, led by Taiwan Semiconductor (TSM) and Intel Corporation (INTC), and an increasingly positive year for its memory customers.  Over time, we believe that semiconductors will increase as a percentage of industrial output and that Entegris’ filtration and specialty materials products will grow even faster.

 

Apple, Inc. (AAPL) and MKS Instruments, Inc. (MKSI) were also leading contributors in 2019.  What a year it was for Apple.  It’s hard to remember, but Apple fell to $143 per share on January 3, 2019 (the stock closed at $293.65 on December 31, 2019).  Entering 2019, the market was concerned about weakness in China for Apple’s new, high-end phones.  Apple reported revenues for iPhone and Services and gross margins above Wall Street estimates for the March quarter.  It also increased its share buyback and raised its quarterly dividend.  In June, Apple saw iPhone sales in emerging markets stabilize and near 50% growth in Wearables, which now account for nearly 10% of revenue.  The September quarter brought strong iPhone, Wearables and Services results.  Throughout the year, Apple showed increasing leverage and higher operating margins.

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In the fourth quarter, MKS Instruments reported strong revenue and earnings, benefitting from unexpected business from Taiwan Semiconductor (TSMC), as TSMC ramped leading-edge 7nm (nanometer) and 5nm manufacturing.  As an aside, a 5nm transistor is about 10 atoms wide.  Manufacturing these semiconductor devices is absolutely a miracle of science.  The benefit of these leading-edge semiconductors is that they use less power and extend the battery life of smartphones and other devices.

 

DIRTT Environmental Solutions Ltd. (DRTT and DRT:TSE) was a leading detractor to the Fund’s performance in 2019. DIRTT is the future of semi-custom construction.  DIRTT designs interior office spaces on its incredible virtual reality CAD system. DIRTT manufactures the walls and interior components, which are shipped and assembled on-site.  As a result, there is less on-site waste and a more predictable schedule.  DIRTT competes with dry wall and the requirement for skilled workers.

 

DIRTT is undergoing a management transition.  Co-Founder & CEO Mogans Smed was dismissed by DIRTT’s board of directors in September 2018.  New CEO Kevin O’Meara was a co-founder of Builders FirstSource, Inc. (BLDR) and was CEO of private equity-backed Atrium Corporation, North America’s largest vinyl and aluminum window manufacturer.  O’Meara has also been affiliated with the private equity firms American Securities and Hicks, Muse & Co.  We believe he’s a strong CEO to take DIRTT to the next level.

 

DIRTT’s third quarter revenue and earnings were disappointing, down year-over-year.  DIRTT also guided to continued weakness in the 4th quarter.  The company pointed to the sales force and distribution partner changes which first started in 2018.  O’Meara and his new management team are professionalizing DIRTT’s customer engagement model, but it is taking time.  DIRTT added a second major manufacturing facility in Rock Hill, South Carolina, which could lead to better margins.

 

Additions to the Fund in 2019 included Bruker Corporation (BRKR), Smith-Midland Corporation (SMID) and Wabtech Corp. (WAB), all of which were over 50 basis points of net assets on December 31, 2019.  The Fund exited only three positions that were over 50 basis points of net assets as of December 31, 2018.  Amber Road, Inc., Ecology & Environment, Inc. and Electronics for Imaging Inc. were all acquired.

 

At December 31, 2019, the Fund’s top 10 positions were 63.02% of net assets. For the first time in a long time, the Fund is not fully invested and held 6.7% of net assets in cash.  Cash is included in Short-Term Investments on the Schedule of Investments, and in Investments in Unaffiliated Securities on the Statements of Assets and Liabilities.  This is not a top-down allocation, but rather a decision to wait for our target prices in potential investments.  The Fund had an Active Share of 99.8% versus the Russell 2000 and had trailing 12-month turnover of 9%.  The Fund was short 0.5% of total investments.

 

Morningstar categorizes the Fund as Small Cap Growth, and Lipper categorizes it as Small Cap Core. When you hold companies for 10-15 years, and they succeed, they grow to larger market cap categories.  The Fund’s mission is to find companies that match the three criteria and may be compounders over many years, independent of their industry or market cap.

 

Needham Small Cap Growth Fund (NESGX/NESIX)

 

For the year ended December 31, 2019, the Needham Small Cap Growth Fund Institutional and Retail classes returned 55.31% and 54.45%, respectively.  The Russell 2000 Index returned 25.52% and the S&P 500 Index returned 31.49%.

Annual Report 2019

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While headline and market volatility continued throughout 2019, we deployed a flexible investment approach that allowed the Fund to take advantage of the market environment.  We employed disciplined risk management and continued to evaluate each stock individually as price targets were met and new risks arose.  The interest rate curve finally steepened, sparking a market rally from the end of the summer months. I did not believe a recession was looming during the summer, which allowed the Fund an opportunity to deploy substantial capital at reasonable prices.

 

While global economic growth slowed in 2019, I remain constructive on the overall global economy as it adjusts.  With the announcement of the Phase 1 U.S.-China trade deal and an accommodative Federal Reserve, the markets ended the year on a positive note, although the full effects of these developments will not be known until later in 2020.

 

As we write this letter, we are observing the potential economic impacts that may occur from the spread of the Coronavirus, and expect to see cautious outlook from many companies.  Healthcare risk aside, which we believe will be temporary, we expect companies to be generally upbeat on their 2020 outlook, since global economic growth is expected to accelerate.  However, will it be enough to support the significant market moves and elevated valuations we enjoyed in 2019?  We believe there could be rotation from 2019 stock winners into more value-oriented names.  We have adjusted the Fund to harvest some of our gains and look for better entry points to redeploy capital.

 

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.  During the month of December, the Fund experienced sizeable inflows of new capital and therefore, we ended the year with a large cash balance.  Cash is included in Short-Term Investments on the Schedule of Investments, and in Investments in Unaffiliated Securities on the Statements of Assets and Liabilities.  Although we believe that, under normal conditions, the Fund’s assets will be invested in accordance with its policy with respect to the investment of at least 80% of its net assets (as disclosed in the Fund’s prospectus), high levels of new investment inflow, such as that which occurred during the month of December, can lead to periods of higher cash levels that are invested in due course as appropriate opportunities are identified.  Typically, we find these opportunities during and after earnings season, which kicks off more significantly for small cap companies in late January and into February.

 

The Fund’s top holdings as a percentage of net assets at December 31, 2019 included II-VI, Inc. (IIVI), FireEye, Inc. (FEYE), Zuora, Inc. (ZUO), Cambium Networks Corp. (CMBM), and Cohu, Inc. (COHU).

 

The Fund’s top contributors for the year ending December 31, 2019 included Aspen Aerogels, Inc. (ASPN), PDF Solutions, Inc. (PDFS), Amber Road, Inc. (AMBR), Photronics, Inc. (PLAB) and Ultra Clean Holdings, Inc. (UCTT).  The Fund’s top detractors for the year ended December 31, 2019 included Zuora, Inc. (ZUO), Genmark Diagnostics, Inc. (GNMK),  Emcore Corp. (EMKR), 2U, Inc. (TWOU) and NeoPhotonics Corp. (NPTN).

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The markets have recovered nicely from the summer lows of 2019 and it would not surprise me to see a pause in the market recovery.  However, our outlook for 2020 remains positive.  We look forward to a year of patience rewarded, and we continue to believe that a favorable environment remains for investment in equities.

 

We are 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 we believe that they should create long-term shareholder value.

 

We expect increased volatility to continue into 2020.  We 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.  We reiterate from past quarterly letters that mergers and acquisitions continued in the small cap universe, and we expect to see increased M&A activity to improve and benefit our portfolio of stocks in 2020.

 

Conclusion

 

We believe the U.S. remains the best place in the world to be investing, and we continue to see an opportunity to invest in small and mid-cap stocks. Most importantly, we see a revolution happening in technology that has created and continues to create investment opportunities.  We see opportunity in our strategy of investing in companies that we know well and that we believe are positioned with secular growth drivers.

 

We welcome our new investors and thank all of our investors for their continued support. If you have any questions, thoughts or concerns, please contact us at (800) 625-7071 or jbarr@needhamco.com and cretzler@needhamco.com. For information about the Needham Funds, please visit our website at www.needhamfunds.com.

 

Sincerely,

 

Fact Sheet Links:

 

Needham Growth Fund

Needham Aggressive Growth Fund

Needham Small Cap Growth Fund

Annual Report 2019

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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. The views of Needham Investment Management L.L.C., the Funds’ investment adviser, and the securities described in this report are as of December 31, 2019; these views and portfolio holdings may have changed subsequent to this date. The specific securities discussed may, in aggregate, represent only a small percentage of a Fund’s holdings. It should not be assumed that securities identified and discussed were, or will be, profitable, or that the investment decisions made in the future will be profitable, or equal the investment performance of the securities discussed herein.  There can be no guarantee as to the accuracy of any outlooks for markets, sectors and securities as discussed herein.

 

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 or summary prospectus carefully and consider the investment objectives, risks and charges and expenses of the Funds carefully before you invest. The prospectus and summary prospectus contain this and other information about the Funds and can be obtained on our website, www.needhamfunds.com or by contacting the Funds’ transfer agent U.S. Bancorp Fund Services LLC doing business as U.S. Bank Global Fund Services (“Fund Services”) at 1-800-625-7071.

 

Investment returns and principal value will fluctuate, and when redeemed, shares may be worth more or less than their original cost.  Performance data quoted represents past performance, and does not guarantee future results. Current performance may be higher or lower than these results. Performance current to the most recent month-end may be obtained by calling our transfer agent at 1-800-625-7071.  Total return figures include reinvestment of all dividends and capital gains.

 

All three of the Needham Funds have substantial exposure to small and micro capitalized companies. Funds holding smaller capitalized companies are subject to greater price fluctuation than those of larger companies.  Needham & Company, LLC, member FINRA/SIPC, is the distributor of The Needham Funds, Inc.

 

The Russell 2000 Index is a broad unmanaged index composed of the smallest 2,000 companies in the Russell 3000 Index. The Russell 3000 Index is a market-capitalization-weighted equity index that provides exposure to the entire U.S. stock market. The Russell 3000 Index tracks the performance of the 3,000 largest U.S.-traded stocks. Please see the disclaimer regarding these indexes under “Supplementary Information—Index Disclaimer” on page 56 of this report.

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Comparison of Change in Value of a $10,000 Investment

The chart above assumes an initial gross investment of $10,000 made on January 1, 1996. The Fund’s performance figures are for the period ended December 31, 2019.  The Performance data quoted is historical. Past performance is no guarantee of future results. Current performance may be higher or lower than the performance data quoted. The principal value and investment return of an investment will fluctuate so that your shares, when redeemed, may be worth more or less than their original cost. To obtain performance information current to the most recent month-end, please call 1-800-625-7071. The returns shown do not reflect the deduction of taxes that a shareholder would pay on Fund distributions or on the redemptions of Fund shares. In the absence of fee waivers and reimbursements, when they are necessary to keep expenses at the expense cap, total return would be reduced.  Performance figures for periods greater than one year are annualized.

 

The Global Industry Classification Standard (GICS^®) was developed by and/or is the exclusive property of MSCI, Inc. and Standard & Poor Financial Services LLC (“S&P”).  GICS is a service mark of MSCI and S&P and has been licensed for use by U.S. Fund Services.