US > Small-Cap > Core
Q: What is the history of the fund?
A: The Small Cap Intrinsic Value Strategy was launched in July 1997. The Neuberger Berman Intrinsic Value Fund dates back to its predecessor entity at David J. Greene and Company and was originally a partnership account. The fund has changed legal entities three times over the course of 17 years. Presently, at Neuberger Berman we manage a total of $1.6 billion in small cap mandates of which the Fund comprises $270 million. I have been the portfolio manager since the strategy’s launch.
Q: What core principles drive your investment philosophy?
A: When investing in a strategy, the first question one should ask is what advantage does a manager have and how sustainable or repeatable is this advantage over time. We perceive our advantage as coming from two sources. The first is information or analyzing qualities about a company that the market hasn’t focused on. The second is behavioral, meaning that markets tend to be inefficient with certain types of companies. We love small caps because there is an opportunity for a research-based approach to gain an informational advantage due to the limited number of analysts following them. Behavioral advantages come from two sources. First, we look at companies as if we are owners versus someone who is renting a stock for a short time period. We are therefore aligned with managements of smaller companies who tend to be the companies’ largest shareholders and run their businesses for long term wealth creation. There are typically 90 names in our portfolio, of which nearly 40 are controlled by an individual, a family or a private equity group. We align ourselves with these groups by thinking longer term. This is significant because there is a meaningful business dynamic at work. Large companies for the most part do not grow organically, they grow via acquisitions This is important because many of our companies are ultimately acquired. Owner-operators whom we invest with are often confronted with a decision – do they stay in the game, turn the business over to professional management or other family members, or monetize their interests? Our portfolio holds a significant number of companies that are acquired. Each year between five and ten are taken over by larger companies. We link our investments with the behavior of the owners and that, over time, has proven to be a consistent source of return. Secondly, we have found that markets inefficiently price companies that are complex, cyclical or irregular in their growth. Conversely, we find that markets tend to overvalue consistency and predictability of return, and will pay excessive premiums for a company where they feel comfortable with long-term profit growth. Our investable pool of companies are those that have underperformed during the last year and often are complex. By complex we mean they have business segments that are unrelated to each other and as a result, investors are uncertain as to which business will drive earnings over a period of time. We also tend to focus on cyclical companies when they are financially depressed. Often times investors misread cyclical slowdowns as secular trends here is where the opportunity lies. Similarly with the interrupted-growth group, we find growth investors tend to price their companies to perfection but, when they experience product transitions or changes in the competitive landscape, investors abandon ship rather quickly. Many times, we find stock prices of growth companies are cut in half because of a change in the competitive landscape or a pause in their growth and we see a compelling long-term opportunity albeit with short-term challenges.
Q: How does your investment philosophy translate into the investment strategy?
A: The process starts with a simple screening of underperforming companies. We look at the bottom 200 performers in the Russell 2000 Value and Russell 2500 Value indices over the past year or so. We also screen by Russell sectors to see if there are opportunities inside of healthcare or technology, for example. Our research team is divided by sector. Once potential ideas are identified, analysts will focus on their sectors of expertise. It is up to the analysts to look at companies in their domain and decide from a list of 20 which are the two, four or six companies they are going to focus on. The research process involves what we call an intrinsic value analysis. Let’s use as an example a company that lags by 30%, is showing up as complex and there is a divergence of opinions among brokers. Our analyst will look at the broker research, identify the sources of confusion, evaluate the individual components of the company, examine the financial performance of those parts and then prepare a sum-of-parts analysis. The analyst will look at each individual business segment, do a cash flow analysis for each and review relevant deals in the industry. He will then compare each component or part of the business to a best-in-class publicly traded peer and look for an opportunity in any part of the business that may be struggling or underperforming. If that part began to perform well, what type of valuation could it achieve in the public market space? Our intrinsic value analysis is like a ‘fairness opinion’ from an investment bank. We look at cash flows at comparable publicly traded peers and recent relevant merger and acquisition multiples. The analyst is looking to ascertain if there is a 30% discount between the current market price and his intrinsic value estimate. If this level of discount exists, the next step is to meet with company management. For example, if a company is complex with three businesses and one of the segments is not earning its cost of capital, we want to understand the reason why. If we think management’s thinking is aligned with ours and there is a significant intrinsic value gap, we will make an investment. We invest with a three-to-five year time horizon. During that period, we expect companies to either fix themselves or heal by virtue of a cyclical recovery or corporate restructuring. As a stock’s price appreciates and approaches its intrinsic value we typically trim or eliminate the position. Often times the decision to sell is driven by ideas where we believe there is a greater intrinsic value discount. We will also eliminate a position if management loses credibility in their ability to implement positive change or our assessment of intrinsic value changes. This process creates a natural harvesting of our portfolio. Usually, 20% to 30% of the portfolio is ripe for harvesting in any given year. We run a fully invested portfolio and the source of funds for new investments is from companies that are acquired and from the proceeds of sales.
Q: Do you set a target price for holdings and for inclusion of new ideas in the fund?
A: We track the overall discount to intrinsic value for our entire portfolio. We have a value target for every holding and compare that to the prevailing market price. The new idea threshold is always a 30% discount but the portfolio itself trades at a broad discount to intrinsic value range. Currently the portfolio’s aggregated discount is 23 percent.
Q: What analytical steps involve your research process? Could you illustrate with a few examples?
A: The focus of our research process is on discovering and analyzing out-of-favor companies. Applying a consistent, private equity-style investment framework, we look at a company's long-term outlook and strategic catalysts that can potentially unlock value. We learn the business dynamics, management inclinations and track record in allocating capital. Here is an example of an historical holding that has both complexity and cyclicality working in tandem. In 2010, we made an investment in office products retailer, OfficeMax, largely under the thought that employment growth in the broader economy would start to recover. Historically, as economic activity grows, the general consumption of office supplies grows with it. We looked at this retailer as its share price had fallen dramatically and when we delved deeper we noted that complexity was hurting the share price. OfficeMax was part of a larger company that ultimately split up into two separate companies – a building materials company, Boise Cascade, and a paper products company renamed OfficeMax Inc. OfficeMax had the appearance of much more debt than it in fact carried. On the balance sheet, the company had $1.8 billion of debt that was non-recourse to OfficeMax, sitting there because of a tax strategy to defer a gain on an asset sale. OfficeMax consisted of three separate parts, a 1,000 store retail chain, a wholesale and contract supplies business and last, an investment in a private equity venture unrelated to either of the office supplies businesses. We saw the complexity of the balance sheet, the operations and the assets and determined there was a possibility for the company to cyclically rebound with employment as well as simplify its balance sheet. We are patient investors. A new management team came onboard at OfficeMax and was doing its best to enhance the company’s profitability and participate in the recovery in employment. However, they were facing challenges like a long-term secular decline in paper consumption and a competitive landscape with too many retail stores. Owning more than 5 percent of OfficeMax at the time, in an SEC Schedule 13-D filing, we urged management to take a much more skeptical view of the industry’s future. We suggested a course of action that included divestment of international operations and monetization of their private equity investment. In the event that management was unwilling to pursue this plan we were prepared to seek Board representation. Management decided to pursue a plan that involved the sale of their non-core asset and declared a special dividend of $1.50. Ultimately, Office Max merged with their competitor Office Depot, who was also under pressure from an activist shareholder. This was a natural outcome, as the two companies could reduce their cost structures much more quickly through a merger rather than a stand-alone strategy. The net result for us has been very positive. All in, there was about a $14.50 value realized for the company. For each share of OfficeMax, we received the special $1.50 dividend and 2.69 shares of Office Depot valued at around $13 per share. The company’s cyclicality and the secular decline in paper consumption turned off investors and created an opportunity for us to have this successful contrarian long-term investment. On the flip side, there is always a risk when two companies integrate in a business that is fundamentally challenged. Acknowledging this risk with the secular trend, we have since reduced our investment by two-thirds.
Q: How do you build your portfolio?
A: We have persistent sector biases. We tend to have a lot of manufacturing companies because of the cyclicality of this industry, and a lot of technology companies because of their interrupted-growth component. Generally speaking we will not have much exposure to plain vanilla yield plays like REITs, MLPs or utilities. Recently we have increased our financial sector weighting by adding a number of regional banks, which have over the past three years made a cyclical recovery. The portfolio sector weights have been consistent. In manufacturing, we gear toward producers of durable goods, materials, and processing and handling companies. In technology and healthcare, we look for companies that have interrupted-growth profiles. We acknowledge that momentum is a valid factor in the near- and intermediate-term. Purely systemic or short term trading strategies can depress our companies to extreme levels of undervaluation so we try to mitigate that by investing in out-of-favor companies slowly. However, it should be noted that just like momentum works on the downside, it also works on the upside. We like to build our positions over time, typically in 25 to 50 basis point increments over a period of a year. Short term pullbacks in stock price are not triggers to sell, but more so opportunities to add to positions. Once our companies return to growth or cyclical prosperity, we exit gradually over time. We try to mitigate some of the contrarian risks with our ideas by having this phase in/phase out approach to our investments. Our biggest investment in an individual company is usually never more than 3% of the portfolio. Regardless of our conviction level, our top ten holdings over time average 20% to 25% of the portfolio. The bottom quarter of the portfolio consists of a large set (45+ companies) of interesting out-of-favor value ideas that we gradually increase our exposure to.
Q: Do you have a benchmark you refer to?
A: We are benchmark aware but the benchmark does not drive our decisions. The Fund’s primary benchmark is the Russell 2000 Value, and the secondary benchmark is the Russell 2000 Index. We like companies that are asset rich and earnings light. Our current weighted average market cap is around $3 billion.
Q: How do you define and manage risk?
A: The risk in our strategy has emanated from two sources – at the company level it is specifically associated to the balance sheet, and a company’s ability to fund or access funding over time. We do our best to make sure we understand a company’s access to capital, covenants in the balance sheet and loan agreements. We monitor the high yield markets for trends in rates and covenants. Secondly, macroeconomic issues have become increasingly important because they have been driving the broader markets. While the best companies have maintained their access to capital they still operate in a macro environment. Also, what happens in one part of the globe impacts other parts of the world as economies get more tightly integrated. As a result, we have increased our sensitivity to global macro developments and we are aware of the economic metrics of several economies that impact U.S. stocks.