Neuberger Berman Mid Cap Growth Fund
US > Mid-Cap > Growth
May 01, 2013
52 Week HL
43.33 - $31.75
May 15, 2008
Q: What is the recent history of the fund?
A : I have been managing the Neuberger Mid Cap Growth Fund for slightly over 10 years, though the fund has been around since the sixties.
The fund is managed with the help of a team of three dedicated analysts based in Chicago and we managed $736 million in the fund at the end of March.
Q: What is unique about the mid cap asset class?
A : The asset class has been somewhat undiscovered, overlooked and misinterpreted. I have had the opportunity to manage funds focused on various asset classes from small to large caps but I have always preferred the mid cap asset class for various reasons.
The companies in this group have dynamic growth characteristics yet they are not small and vulnerable, and have the stronger balance sheet of a larger company with a room for a lot of growth.
Companies in the mid cap space generally have product portfolios that are more diversified with stronger balance sheets and generally better or mature business profiles and rising profitability profiles.
Hopefully there will also be a management team that has several years of experience under its belt and has learned a few lessons regarding global competition, rendering it ready to take the company to another level.
With today’s better balance sheets, mid cap companies are better able to compete against larger cap companies and to address a growing appetite for their products and services in the marketplace.
The mid cap sector over the last 20 years has outperformed the large-cap sector and performed close to or maybe slightly ahead of the small-cap sector. The sector is more volatile than the larger companies however. And many investors overlook the asset class because many consultants and advisors mistakenly have come to believe that they can replicate the return-to-risk profile of the asset class by blending the large and small cap funds.
This widespread misperception creates a certain amount of inefficiency in the marketplace and offers a unique opportunity to someone like us who is dedicated to this asset class and can try to take advantage of this perception.
Q: What is your investment philosophy?
A : Our investable universe is rather broad and includes companies with market caps typically between $2 billion and $12 billion. We prefer to invest in companies with market caps between $2 billion and $5 billion. If we get these investments right, we could potentially own them for a very long time in the portfolio as their market caps increase from the $2 to $5 billion range to, say, a $10 to $12 billion market cap.
In the longer term, we firmly believe earnings drive stock prices, and with that basic philosophy we are looking for growth companies that have long term earnings power.
In our search for quality, we are looking for companies that are experiencing a rising return on equity driven largely by a return on assets over time. What we are deemphasizing in the return on equity equation is the financial leverage aspect of it. We really do not want our portfolio companies to manufacture a higher ROE via financial leverage. We prefer our companies to have a lower total debt to equity than the average company that is out in the marketplace, or that would be in our particular benchmark.
We like companies that sell a lot more units of their products and services. We want them to be growing at a much faster rate than their competitors and to leverage those sales against fixed assets or even the variable assets of the company that are growing less than the sales rate.
Another thing we evaluate for quality is a company’s cash flow. As mentioned earlier, we believe that earnings drive the company’s stock price over time but we are also looking at the quality of the earnings for a company and cash flow is a very important component of that. We like companies that have very high rates of operating cash flow as well as free cash flow.
Another reason we like our companies to generate cash flow is that it’s the cheapest form of capital a company can access, and it can be used to reinvest back into the business to grow the franchise over time, affording a higher degree of control over the business.
The third aspect of quality for us is company management. We like to get to know our management teams as well as possible. We meet them at least a couple of times a year. For us, it is a way to check if management is sticking with the business plans, the current trends and the long-term vision of the company we have invested in. Does the management understand the competitive environment and who the competitors are? How are they going to continue to innovate and create new products in the marketplace and drive through a sales structure for the company?
Q: What is your investment strategy and process?
A : Our investment process and philosophy are rooted in fundamentals. We pride ourselves on paying attention to the fundamentals and staying ahead of the market thinking.
We run screens either bi-weekly or on a monthly basis. We are essentially screening on revenues, earnings, return on equity, and debt-to-capitalization, seeking superior growth rates in all of those metrics. Generally we are looking for companies that have double-digit topline growth rates. For us, revenue growth is all a matter of values or units. We try to take any kind of price increases out of the equation. Pricing is a very difficult thing to keep and maintain so we would rather try to measure the company on unit volume growth versus other factors. We don’t count on pricing being sustainable in the future.
When we run our screens, we like to see a company that has the ability to grow its earnings per share to approximately 20% and then a return on equity that is increasing over time. It doesn’t make too much of a difference where the actual ROE number is, as long as we see a relatively clear path that it’s moving up. And in the end, what we want from the screens is to find the incremental five or 10 names arising that are new to us, allowing us to start doing some due diligence work.
We meet with at least 250 companies during the course of a year. We are always looking for companies that are doing something that is new, unique, and different. It always goes back to the products or services they are offering in the marketplace.
There are also particular catalysts that we think will evolve in the next 12 to 24 months, which will take the company’s revenues and earnings to a somewhat higher level than the consensus is thinking about it today. Our job as analysts is to try to understand what those new products and services are going to be, understand how they fit competitively in the global market, and assess the company’s ability to take the idea and transform it into real sales.
We also identify growth themes in the marketplace. This is where we are trying to formulate potential trends that we believe can drive investment opportunities over a three- to five-year investment period. These can be demographic, industry-specific, or somehow tied to a secular change in an industry.
One that comes to mind is healthcare and the changes that are occurring, and will continue to arise, under the Affordable Care Act. This will most likely change how healthcare is delivered in the United States. The rules and regulations are still evolving but it’s an area of interest for the portfolio as we decide what companies are going to be the winners and the losers under this policy.
If all the research processes check out and we think the stock has the potential to appreciate 20%, it is a buyable stock for the portfolio. We usually start with a 50 basis point position. We monitor the company over time and if the fundamentals meet all the performance metrics we have, we just keep adding to that position in the portfolio over time.
Q: What is your research process?
A : We have owned Fastenal Company for a number of years. I think about Fastenal as partly a distribution firm, partly a retail sales company and partly a logistics provider.
Originally the company provided fasteners to manufacturing companies, but over the years the company has evolved into a multi-faceted, omni-channel distributor of all kinds of products to primarily the manufacturing sector in the United States.
The company originally screened well in our process because it was growing sales and earnings more than 20% on a consistent basis, had a clean balance sheet and the return on equity was rising over time. Again as mentioned, these are characteristics that are of particular interest to us.
Fastenal competes in a very large and fragmented addressable market that affords the company the opportunity to increase its market share over time. The company creatively attacks its market and is always looking for new ways to make its customers more efficient. It is also a performance-oriented company with a great culture.
Additionally, we are impressed with the quality of Fastenal’s management. When we first invested, the firm was still being run by one of the founders. The current CEO was a district sales manager. It is a company with a culture of training its own senior management and developing talent throughout the organization. This helps perpetuate the company culture and focus on the same goals.
The company’s philosophy to this day continues to be focused on organic growth by opening up stores in the regions where management would like to grow. Fastenal managers conduct a very detailed analysis of where they want to open up their stores based on who has manufacturing facilities in that particular area and how those companies are growing.
Also intriguing was that Fastenal had a very detailed plan of how it was going to expand its own distribution logistics to make sure it could serve new customers in a timely fashion.
The point of all this is to demonstrate the process we go through to understand the business and people in which we invest. Once we understand how the business operates and how management sees the business unfolding, we then build our own models on what we think the companies can earn over the next couple of years. When we build our models for companies, we look two calendar years forward. That way we have a fairly high degree of certainty on where we think earnings could go. We will think about what the five-year plan is but five years is a really difficult timeframe to forecast. We strive to have an earnings model that is different than the consensus, as consensus expectations are already embedded in the stock price.
Then we look at the valuation, and if we think there is the opportunity for 20% stock appreciation over the twelve months going forward, that is what we define as a buyable stock.
Q: What is your portfolio construction process?
A : It’s a diversified portfolio. The benchmark is the Russell Mid Cap Growth Index. We pay attention to what the sector weights are in the particular benchmark. Our processes are that we will not be more than two times overweight the major benchmark sectors, nor would we be less than half weight of those major benchmark sectors.
Those primary sectors are consumer discretionary, industrial, healthcare, and technology. The next ones would be energy, financials, and consumer staples. We don’t take big sector bets at any point in time, so we’re typically well within those particular guardrails.
Our expectation from an attribution standpoint is that 90% plus of our performance will come from stock selection in the portfolio and the rest, typically under 10%, would come from any kind of sector allocation.
Again as mentioned, we usually invest in companies with market caps of between $2 and $12 billion. We also run a small cap fund in our office, so I have a lot of exposure to what’s going on in the small cap sector. We don’t mind dipping down below $2 billion to participate in a particular company. We typically don’t buy any stock with a market cap above $12 billion. We like to make sure this is a pure mid cap product.
The portfolio turnover has been between 40% and 50% for the last few years.
Our weighted market cap is below the benchmark and we like it that way. We typically skew a little bit smaller than the benchmark capitalization. We’re more willing to buy companies a little bit smaller perhaps than some of our competitors.
Q: What is your buy and sell discipline?
A : Every stock has a target price when we buy it. If we bought a stock today, our target price is looking one year forward. In the next year, if the stock hits that target price, people often ask if we automatically sell it. The answer is typically “no,” because over time things change. Hopefully things are getting better for that particular company which means that our earnings per share is moving higher as well and the target price also moves with that over time.
Just hitting a target price is typically not the reason that we sell a stock in the portfolio. There are periods of time when the stock has had a very good run and is probably exceeding our expectations by a fair margin, one where we are apt to start to sell the stock. It doesn’t mean we will sell the position completely but we will book profits in a situation like that. If the fundamental characteristics of the company are still in place and the earnings continue to rise, we will probably keep some type of position for that stock in the portfolio.
The reasons we might sell a stock out of the portfolio completely are varied, but the most typical reasons include when a company is not meeting our earnings expectations; when there is a material change to the company’s business prospects and/or when there is a significant change to our overall investment thesis. If the answer is “yes” to some or all of those questions, then that is the reason for the stock to sell.
It is a growth stock portfolio and we are going to have disappointments at some point during the year when a company announces a truly poor quarter. We aren’t what I would call knee-jerk sellers of a stock just because the company has one disappointing quarter. If a company misses by a little bit and it’s explainable and understandable in the context of a competitive world, we are not just going to blow the stock out of the portfolio just because of that.
We spend a lot of time getting to know the management team and understanding the business and certainly we are going to give everybody a second chance. On the other hand, if there is a significant, material change in the company’s business prospects, we will sell that stock out of the portfolio.
We are also open to selling our weakest ideas if we find better ideas that enhance our portfolio. It is all about adding value, and if we can improve the portfolio with better ideas and better values we may also sell out our weakest links in the portfolio.
Q: What risk control measures do you take?
A : Certainly we look at the risks inherent in the current stock price and if things go wrong, we ask ourselves, “What is our risk to earnings?” But we are more qualitative in this analysis than quantitative and are not stuck to some formulaic approach.
I have been doing this for a long time and I am cognizant of what the downside risk is for the companies that we own if they do not meet our expectations or fail to meet consensus expectations.
When we look at a company, we also don’t assume that the Price-to-Earnings ratio for the company is going to expand in the foreseeable future. We take a view of what is the normalized price-to-earnings ratio for the company. If a company does exceed expectations over the investable horizon envisioned, there is typically some P/E expansion and that, to us, would be some additional valuation from our basic evaluation of the company.
I just know that 80% of the time the market goes up and that’s all I really care about. We try to understand the business risk of each of the enterprises that we invest in. The fallout of that in the actual portfolio is that if we look at standard risk profile or a measure of volatility, our beta in the portfolio typically runs between 0.9 and 0.95 to the benchmark.
Our standard deviation has typically also been at least a couple of basis points lower than the benchmark over time. I think both of those are a function of the quality of the companies we have in the portfolio and the diversification of the overall portfolio as well.
The reason that we have 100 stocks in the portfolio is that we like to be diversified. We believe it tempers the volatility of the portfolio over of time. It generally hasn’t hurt us and I think it has definitely helped us in periods when the market is much more volatile than normal. It gives us not only individual stock diversification, but it allows us to have more sector diversification as well.