January 1, 2001

The Short Answer

How Peter Trapp at Needham Growth Fund uses short

Calamities are of two kinds: misfortunes to ourselves, and good fortune to others," Ambrose Bierce dryly observed in his 1911 work, The Devil's Dictionary. Bierce would have loved the Needham Growth Fund. While other technology investors spent the year getting creamed, portfolio manager Peter Trapp was shepherding his tech-centered fund to returns of more than 10%. What's more, his good fortune resulted directly from other tech investors' running smack into some pretty serious misfortune.

Shorting Internet stocks - borrowing stocks, selling them, then buying them after they decline, returning them to the lender, and pocketing the price difference - is "one of the main reasons we're up this year, despite the fact that we're technology investors," says Trapp. The fund has other characteristics of a hedge fund, too. Trapp can buy pretty much anything he wants: small-, mid-, and large-cap stocks, options, convertible securities, bonds, or mortgage securities. Should he choose to, he can put the whole portfolio into any of them at a given time.

Putting "technology" and "hedge fund" in the same sentence might make investors woozy just thinking about volatility, but it shouldn't, says Trapp. Combined with his investment discipline of "growth at a reasonable price," selling short and using hedging strategies such as cashless collars actually makes the fund less volatile. "It may seem counterintuitive - people say, 'Jeez, you can do options and derivatives, and you can hedge, that's a much riskier fund than my plain old long-only fund. And the answer is, 'Not so,'" he says. "We rise less than the long-only funds in a bull market, but we decline significantly less in a bear market." Smoother peaks and valleys don't have to make for an unfulfilling ride, however. The fund returned 79.7% in 1999, and it sports three-year annualized returns of 33.4%.

The son of an English mother and a Swedish father, Trapp came to the U.S. in 1971 to attend Columbia Business School. After working in corporate finance at First Boston, he moved on to Goldman Sachs, gaining experience with capital markets and derivative products along the way. He joined investment banking boutique Needham and Company in 1990, and in 1995 designed the fund he now manages.

The fund was created to provide some of the perks of hedge funds to clients without the disadvantages like illiquidity and high minimum balances. Needham Growth Fund is the only mutual fund offered by the company, a fact which Trapp says is partly responsible for the fund's small size (less than $100 million) and substantial expense ratio (more than 2%). But for this kind of versatility, says Trapp, it's definitely worth the price.

In what ways are you similar to a hedge fund? We are allowed to short, we are allowed to hedge, we are allowed to have significant cash balances, we are allowed to buy most securities that we want, whether it's fixed-income securities, mortgage securities, convertible securities. We can buy preferred stock; we can buy common stock. And then, obviously, we can buy derivatives, in the sense of equity options and index options. We use many of the vehicles that a hedge fund would use. That's really the greatest similarity. Our flexibility is like a hedge fund, too - you can be all cash, you can be all stocks, you can be all short, you can be anything. That creates a level of flexibility to basically take a more defensive stance. The most cash I've ever had, though, has been 25% of my portfolio - that was last April. Right now we're about 10% cash.

How about the flip side - how do you differ? The differences are that we price on a daily basis so you can buy or sell the fund any day at the net asset value, and you can get your money out any day, whereas in most hedge funds, you can only get your money out every quarter, or every half a year. Hedge funds also charge a percentage of the money under management, plus a percentage of the performance. A mutual fund like ours, on the other hand, just charges a percentage of the money under management. You'll find hedge funds hold their securities for much shorter periods of time, and therefore are much less tax-efficient than we are. We hold our long positions for a year or two, so we tend to be highly tax-efficient. We differ in structure as well. A mutual fund advises and manages the fund, and every shareholder has an undivided interest in all the securities. A hedge fund, has a general partnership that's responsible for managing, and limited partners that put up the money.

Your areas of specialty are technology, health care, specialty retail, media, and the leisure and entertainment industry. Do those focus areas change over time? No, no, those are always the areas we focus on. That's where our analytical discipline is at our firm. But I think it's fair to say that the fund is overwhelmingly technology - we're about 70% technology.

Some people would say that technology equals risk, and hedge fund vehicles equal risk. Why should they not be doubly scared of your fund? If you believe that risk is expressed by volatility - which I think there's a fair amount of literature that says that's so - we are a much less risky fund than the other technology funds, all other things being equal. We have a significantly lower volatility in an area that's known for volatility. Many mutual funds in the technology area, especially the long-only funds, have tremendous swings in the net asset value. One part of the year they'll be up 50%-60%, and you turn around six months later and they're down 50%. But by the use of hedging and shorts, what we tend to do is rise less than the long-only funds in a bull market, but we decline significantly less than the long-only funds in bear market or a down market.

How has your strategy of shorting stocks changed over the past year, particularly as it relates to technology? One of the main reasons that we're up this year, despite the fact that we're technology investors, is that we've had a very large short portfolio over the course of the year. The general areas we've been shorting include the Internet stocks - we've spent a lot of time on the short side in the Internet stocks, both in the business-to-business as well as the business-to-consumer stocks.

Needham Growth
Needham & Company, Inc.

445 Park Avenue

New York, New York 10022

212-705-0327

www.needhamco.com

Ticker: NEEGX

Portfolio manager: Peter Trapp, Jr.

Manager's tenure: 2 years

Fund started: December 1995

Minimum initial investment: $1,500

Load (front-end): 0%

12(b)-1 fee: 0.25%

Net assets: $84.40 million

Dist. yield (trailing 12 months): 0%

P/E ratio: 25.90

P/B ratio: 4.0

Median market cap: $771 million

Expense ratio: 2.50%

Turnover: 145%

3-year alpha: 23.02

3-year beta: 0.95

3-year r-squared: 26.00

3-year standard deviation: 45.31

Returns
1999: 79.72%
1998: 19.85%
1997: 15.66%
1996: 51.56%
1995: N/A
12-month (annualized): 36.76%
3-year (annualized): 33.10%
5-year (annualized): N/A
Top Five Holdings
Park Electrochemical Corp.: 2.50%
Thermo Electron: 2.40%
McKesson Corp.: 2.14%
Artesyn Technologies Inc.: 2.00%
Bell Microproducts: 1.70%
Equity Allocation
As reported in the December issue of Morningstar's Principia Pro.

Annualized returns are through November 30, 2000.

When did you start shorting Internet stocks? We started aggressively shorting them in January and February of this past year. We were early.

What told you it was time? First of all, you had an extremely frothy market with excess liquidity; secondly, you had valuations that were completely unrealistic. With the ability to short, and seeing the unrealistic valuations in a tulip-mania type market, those are the natural stocks that you would want to short. We were also short some of the software names, the enterprise resource software side. Recently, we've been shorting contract manufacturers, which are way overpriced - the companies that manufacture components for the major design and equipment companies in the technology area. Their stocks have been trading at about a 40 to 50 multiple. These stocks were way overvalued.

Can you give an example of how you use options to hedge? If I own a stock like McKesson HBOC - I bought it at 19, it's now trading in the mid-30s, but I'm not long-term yet. I think the stock's a bit overpriced, so what I would do is either sell calls or buy puts, or I would do what's called a cashless collar, which would be to sell calls and use the proceeds from selling the calls to buy puts, and thus creating a band around the stock which is like disaster insurance. What I'm doing there is hedging; I'm not speculating.

Do you use cashless collars frequently? I do, indeed, because I'm obviously interested in guarding my profits that I have in my stocks, and trying to keep as much of that profit as I can, and waiting to go long-term. I'm always looking to go long-term; it's a question of tax efficiency.

What are the parameters for your "growth at a reasonable price" investing discipline? We look for companies where the P/E multiple or the EBITDA multiple is about half the three-year growth rate - probably '99, 2000, 2001, or if there are 2002 estimates, it would be 2000, 2001, 2002. You have to use a period of time, or otherwise you can't pick up interim moves or interim differences. We're always looking for cheap stocks, but in the technology area - which are not always easy to find, I might add.

Obviously we want the company to be in our area of discipline, and we look for companies that have, in general, a 15%-20% long-term growth rate. We will buy companies that are growing at 20%-25%, but even then, we'll only pay a 10 or 12 multiple. If we're convinced that the company's growing at 40% for three or four years, then we'll pay, obviously, a 20 multiple. For many stocks, we'll sit and watch them, sometimes for a year or two, and wait for some event to occur that allows us to buy the stock, where the stock comes down in price so that it falls within our discipline. That could be that there was a product transition, a change of management, an earnings shortfall, a negative announcement. If we think that it's a short-term issue, and the momentum buyers kind of puke up the stock, we'll get a 50% off sale or a 60% off sale, and step in and buy it with the goal of owning it for an extended period of time.

But we don't always get it right. I can assure you, there have been stocks that I've bought where there was a 50% off sale - but they never told me they were going to have a second 50% off sale. We tend to sit with the stocks - we'll add if the numbers go up. Once the multiple gets to be equal to the growth rate or so, we'll review and evaluate it. If we feel the numbers will go up, or that the growth rates are better, then that's fine. If it gets to where the P/E is about one and a half times the growth rate, I would say that by that time, we should be gone - we would have sold the stock by then.

What else do you look for when you're buying a stock? We like companies that dominate their niche, or are one of the over-riding, controlling players in the area. We like companies where management is visionary, hard-working, ethical, all those good things. And that's where getting out on the road counts. I'm on the road for a week every month and a half. Meeting managements and kicking tires is absolutely the best way to get to know companies, get to understand the management, what their thoughts are, what their vision is, what their business plan is.

Does meeting management really help? After all, they're not going to tell you, "Hey, guess what, guys! Our company is run by morons and doomed to fail!" IR people are not going to help you, because they're just a mouthpiece for the company. The important part is to be able to meet the chairman, the CEO, the CFO - the people that are running the company. It gives you a sense of . . . well, you know, we all judge people. And it's very important in our business to know the people you're dealing with.

Park Electrochemical Corp. is your top holding. What appeals to you about it? Park Electrochemical is a manufacturer of laminates and resins that are used in the manufacture of multilayer printed circuit boards. The circuit boards go into all kinds of technology devices, anything from PCs to communications equipment. First of all, it's a company that we know well, and they have good-quality management. In a strategically important industry, they're one of the three world players. They have a very, very good customer list. They have been capacity-constrained, so they've been adding capacity. And finally, the other reason that we like it is that it's very cheap.

Let me pull out the numbers. You're looking at 2000, $3.08; 2001, $4.15; and the stock closed at 37 and change today. So let's see, 37 3/8, plus $4.15 for next year: That's a 9 multiple, it's a 20% grower. And it's still cheap. That would be a classic example of a GARP name.

What are your other favorites? Advanced Micro Devices - they make semiconductor chips - is one; Merix is one. These are very cheap stocks. And what's happened is the momentum guys have decided to sell these stocks. But sometimes you just have to take a bit of pain - or else hedge the stocks - and wait for better times.

We're always looking for companies that are trying to reorganize themselves, or do some type of spin-out. We were very active last year with Varian Associates, which is a conglomerate that divided itself up into three companies, and distributed the shares in the three companies to the shareholders. One was a semiconductor capital equipment company, one was a medical devices company, and one was a health care company. And the money made on Varian was incredible.

How about Thermo Electron? Thermo Electron is very similar. This is a company that is not well understood - it has a very complicated structure. It owned a whole series of minority interests in small, single-product companies, and the structure got so complicated that the Street kind of gave up on trying to analyze it. The company decided they would spin in these companies to create one company, and reorganize into divisions, and then spin out non-strategic assets. They have now created a medical devices and imaging equipment company, and they're going to spin out their non-strategic businesses, like artificial wood and kitty litter, stuff like that. The stock is going to be much easier for the street to understand - it will have proper earnings, a proper growth rate, it'll have easy comparisons, proper analyst coverage, and, to the extent that the management does a good job and the company prospers, the stock will do very well.

Your 2000 year-to-date returns are 11.6%, but for the past three months, they're minus 21%. Why? Despite our shorts, we're very active in the semiconductor area, and obviously the semiconductor area was very challenging in the second half. I think we're in an inventory correction now, but once the inventory channels are cleared, the growth will come back, and these stocks will go back up.

Your expense ratio is more than 2%. It's 2.19%, and the reason is we're a small fund, and we have certain expenses that have to be offset. As as we both short and hedge, we feel it is just compensation for the kind of returns we can generate.

Morningstar categorizes you as a small-cap fund, but you mentioned that you use many different investment vehicles. Is this a relevant categorization? We view ourselves as kind of a multicap fund. The areas that we traffic in the most are mid- and small-cap stocks, but that does not mean that we don't own securities in the large-cap area.

What's your benchmark? The most representative one is the Nasdaq Mid-Cap Index. There isn't an index of long/short funds, to my knowledge.

What is the outlook for funds like yours? We're moving back to more value-oriented investing where cash flow and earnings matter, balance sheets are going to be more critically analyzed, and people are going to scrutinize the accounts more carefully than they have in the last few years of easy money and quick profits. It's going to become a stock-picker's market again, which is good for us, because that's what we are. We like to find good-quality companies, buy them cheap, and then sit with them and enjoy the ride.

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