The Growth Factor 

The Role of Founders, Family & Long-Tenured Management in Compounders

Needham Funds' Commentary by John Barr  

Volume 23 - October 11, 2016
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Needham Funds Team
John Barr
Portfolio Manager
Chris Retzler
Portfolio Manager
Does Extreme Compensation Create Extreme Risk?
"The best way to make money in a business is not to think too much about making it."
- Henry Ford

At Needham Funds, we seek to create wealth for long-term investors by investing in companies that we believe have the potential to compound returns over many years. Compounders are companies that not only generate high returns on capital, but also have the ability to reinvest their earnings at a high rate of return. They also have great management.  We believe that the success of finding a true compounder is enhanced if the CEO is a founder, family or long-tenured manager. In these cases, management is working to fulfill an emotional and intellectual charge, not to optimize their compensation.  Such CEOs tend to view their stock dearly and rarely issue shares for secondary offerings, acquisitions or employee stock options.
"Does extreme compensation create extreme risk?" asked David Larcker and Brian Tayan of the Stanford Graduate School of Business in consideration of Valeant Pharmaceuticals International, Inc. (VRX).  We posit that if you even have to ask the question, you have the wrong CEO.
The Case of Valeant Pharmaceuticals 
Valeant Pharmaceuticals appeared to be a compounder with great management, but earlier this year, it lost significant share value. On August 6, 2015, Valeant traded at an all-time high of $263.81, up 30x since 2008. A year later it traded at $22 for a loss of 92%.
What went wrong at Valeant?  In retrospect, Valeant focused on financial engineering and its stock price to the exclusion of building a business for the long term.  Michael Pearson was the head of McKinsey & Co.'s global pharmaceutical practice.  He was recruited by a hedge fund to be CEO at Valeant in 2008.   Pearson was followed by a number of other McKinsey partners.  They believed that R&D in the pharmaceutical industry was risky and could not generate a return, and that many drugs already on the market were underpriced and underdistributed.  Valeant cut R&D spending and raised prices on its drugs.  Reinvestment occurred in the form of acquisitions.  From 2010 through 2015 Valeant acquired over 30 companies and the stock rose from $14 to $264 per share.
Pearson's compensation plan included a $1 million salary and stock and option awards that would vest only if the total shareholder return over 3 years was above 15%. At a 45% per year return, he received 1.2 million shares. Pearson also bought $5 million of stock with his own money. After two years, Pearson's contract was extended and he was granted another 1.6 million options if shareholder return compounded at over 60%. At one point, Pearson's stake was worth over $3 billion. The Larcker and Tayan case asks the question, "Does extreme compensation create extreme risk?" We counter with, if you have to ask the question, you have the wrong management and you've already lost.
What Differentiates Needham Funds' Compounders?  Management! 
What was different about Valeant than what we see in many of the successful compounders in the Needham Funds? Management! Our compounders are led by founders, family or long-tenured employees. These CEOs have a passion for creating a business which will last for years, if not generations. In our technology investments, many of the founders and CEOs are Ph.Ds. They know their stuff. The compensation is secondary.
Value investors often look for high return on capital, companies with reinvestment opportunities and motivated management teams. However, if the reinvestment opportunities are only in acquisitions there is risk of becoming a financial roll-up where cost cutting, not product innovation, produces the returns. This strategy may require ever larger acquisitions and ever larger debt.  It ends when they run out of acquisitions or an acquisition fails to perform.  
We at Needham Funds are growth investors. By definition, growth companies invest in new products and small acquisitions that may benefit from the R&D or distribution capabilities of a larger company.  These investments may lead to compounding returns.   
Like Philip Fisher, we ask, "Does the company have products or services with sufficient market potential to make possible a sizable increase in sales for at least several years?"1   With our sensitivity to valuation, we look for a misunderstood new product or distribution opportunity. Or perhaps, an overall earnings picture that is depressed by an investment in a new area.
Some of our examples follow. 

1 Philip Fisher, Common Stocks and Uncommon Profits (Wiley, 2003)
Needham Funds Compounder: PDF Solutions, Inc.  
Dr. John Kibarian, President and CEO, co-founded PDF Solutions, Inc. (PDFS) in 1991. Co-founder Dr. Kimon Michaels is Vice President, Products and Solutions, and has been a board member since the company's founding.  Their vision was to provide statistical analysis software and services to lower the cost and enhance time to volume production for semiconductor manufacturers. They started this work as graduate students at Carnegie Mellon. PDF Solutions has earned 12.3% cumulative return on equity from 2013 to 2015 while investing in China, a new Design for Inspection product which has the potential to double the size of the business, and the Exsensio big data solution.     
Dr. John Kibarian
Dr. Kibarian owns approximately 8% of the company and has sold very little stock since 1991.  His salary in 2015 was $389,000 and, as usual, he took no bonus.  Dr. Michaels owns approximately 5% of the company and had a 2015 salary of $330,000.  From the PDF Solutions 2016 Proxy Statement, "Due to Dr. Kibarian's continued positive individual performance in 2014, the Compensation Committee decided to award a discretionary incentive bonus to Dr. Kibarian in the amount of $68,906. However, Dr. Kibarian declined the bonus in an effort to conserve cash for bonus awards for other, non-executive employees...The Compensation Committee did not award any equity (i) in general in 2015 to Drs. Kibarian or Michaels due to each NEO's significant ownership in the Company from their history as a founder of the Company and their corresponding, existing alignment with stockholders in general, as well as a desire on the part of both NEOs to reserve the stock pool for awards to other employees and consultants..."

Needham Funds Compounder: IPG Photonics Corporation   
Valentin IPGP
Dr. Valentin Gapontsev
Valentin Gapontsev, Ph.D., is Chairman of the Board and CEO of IPG Photonics Corporation (IPGP). Prior to founding the company in 1990, he was a senior scientist in laser material physics at the Soviet Academy of Science's Institute of Radio Engineering and Electronics in Moscow. He had a vision that fiber optic lasers could be used for cutting and welding in industrial applications. Fiber optics had the potential to be easier to use and more energy efficient than the older carbon dioxide lasers. However, the cost of the lasers would need to come down by orders of magnitude.   Dr. Gapontsev broke from convention with a vertical integration strategy. By manufacturing the laser diodes themselves, IPG was able to lower the cost and create a barrier to entry with the cost curve.
Dr. Gapontsev believes a technology CEO should be the best engineer with business sense.  We wholeheartedly agree. With a strong technologist as a founder, we believe a technology company has a much better chance of investing appropriately for the future.

Needham Funds Compounder: ViaSat, Inc.   
Miller, Dankberg and Hart
Mr. Mark Dankberg is the Chairman of the Board and CEO of ViaSat, Inc. (VSAT), which he co-founded in 1986 with Mark Miller and Steve Hart. Mr. Dankberg has a BSEE and MSEE from Rice University and is a member of the Rice University Electrical and Computer Engineering Hall of Fame. Messrs. Hart and Miller are still active at ViaSat as Chief Technology Officers.  

In its beginning, ViaSat provided electronics for satellite communications. In 2008, after failing to convince any of their satellite operating customers to invest in new technology, ViaSat decided to design and operate its own satellite network which would have as much communications capacity as all of the other satellites in orbit. ViaSat had no experience marketing satellite services and no one saw a need for as much capacity as ViaSat proposed. However, ViaSat-1 successfully launched in 2011 and has been a commercial success; ViaSat-2 and ViaSat-3 are in the works and will further ViaSat's competitive advantage as a satellite operator.

Needham Funds Compounder: Super Micro Computer, Inc.  
Charles Liang
Mr. Charles Liang founded Super Micro Computer, Inc. (SMCI) in 1993.   Co-founders Wally Liaw, SVP International Sales, and Sara Liu, SVP Operations, are still active employees and members of the Board of Directors.  They founded Super Micro with a mission to design and manufacture high-performance, high-quality server solutions. That meant competing with the likes of Dell, Hewlett Packard, IBM and others in Taiwan. 

Super Micro competes on time-to-market, technology and price. It has grown revenue from $480 million in 2007 to $2.1 billion in 2015. The company has never lost money including in 2008 and 2009. Charles has an M.S. in Electrical Engineering and was a semiconductor and computer motherboard designer. He built Super Micro without any outside capital until raising $73 million in a 2007 IPO. Charles has a vision for the company's growth to $5 billion, which means capturing additional market share. In 2013, to accommodate growth, they bought the former San Jose Mercury News printing plant, contiguous to their existing San Jose facility, and they are currently building it out.

Needham Funds Compounder: Oil-Dri Corporation of America, Inc.  
Dan Jaffee
Nick Jaffee co-founded  Oil-Dri Corporation of America (ODC) in 1941 to make for a safer shop floor. Manufacturing plantsused sawdust to clean industrial fluid spills, and Nick saw an opportunity to provide a better, clay-based solution. 75 years later Nick's grandson Dan Jaffee is President and CEO. The Jaffee family controls 75% of the voting rights. 

The company is in the midst of an advertising campaign to establish the lightweight cat litter market. They have partnered with actress Katherine Heigl and are doing direct to consumer advertising. A company concerned about quarterly earnings would not be making this investment. At the Oil-Dri 75th anniversary celebration, Richard Jaffee, Chairman and son of the founder, said he hoped that he had set in place the foundation for the company's next 75 years.
Needham Funds' Compounders & Their Long-Tenured Management  
In Conclusion  
We revisit the question, "Does extreme compensation create extreme risk?" The CEOs of our compounders have worked at their companies for a minimum of 23 years. We think it would be difficult for a company's management to have 23 years of success in their organization without thinking for the long term.
If a company's board is worried that the management compensation plan might encourage one type of behavior over another, potentially causing trouble for the company, we'd argue that the company has the wrong CEO, not the wrong compensation plan. The Valeant board went to great detail to derive a shareholder friendly compensation package for Mr. Pearson. They got great stock performance for eight years. They did not get a company built to last and compound for the long-term. 
Please note that not all of The Needham Funds' investments have been profitable.  

The Needham Funds aggregate ownership as a percentage of net assets in the stated securities as of September 30, 2016: PDFS: 5.39%; IPGP: 0.56%; SMCI: 3.73%; ODC: 0.42%.

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.
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 F und carefully before you invest. The prospectus contains this and other information about the Fund.
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