November 3, 2003

Fund in Focus: Neuberger Berman Focus Fund

Kent Simons, manager since January 1988S&P Ran

Oct. 22, 2003 -- The leader of a retreat can spearhead an advance.

Take the Neuberger Berman Focus/Investor (NBSSX), for example. The fund suffered its second consecutive loss in 2002, falling 36.4%, while the average mid-cap value fund dropped 19.8%, and the S&P 500 slid 22.1%. This year, though, the Neuberger Berman fund jumped 46.6% through September. That topped its peer group, which was up 18.8%, and the index, which rose 14.7%.

Neuberger Berman Focus's 13.5% return in the third quarter was also the best among similar funds, which rose 7.4%. By comparison, the S&P 500 index gained 2.7% in the three-month period.

"What's doing it for us this year?" asked Kent Simons, who manages the portfolio. "The answer, basically, is, it's the same things that did it to us last year."

Previously, the $1.7-billion fund was weighed down by its financial and technology stocks, but many of those same holdings have been among his best performers in 2003, Simons said.

Start with Capital One Financial (COF), then and now the fund's No. 1 stock. Shares of the credit card and banking company fell the summer before last because of concerns about an informal memorandum of understanding between Capital One and federal regulators, Simons said. The stock never recovered, ending the year down 40%, but it's more than doubled this year, he noted.

Simons remains attracted to the company because it has generated returns on equity and earnings growth of more than 20% since it went public, yet its stock trades at only 13 times projected 2003 earnings.

Similarly, Citigroup Inc (C), which currently ranks second in the portfolio, and J.P. Morgan Chase & Co (JPM), another major holding, "had their earnings dented fairly substantially," in 2002, Simons said, in part because they had been the lead banks for Enron Corp (ENRNQ) and WorldCom, which were forced into bankruptcy following disclosures of corporate scandals.

Elsewhere in the finance sector, brokerage houses like Merrill Lynch (MER), which now holds fifth place in the portfolio, were hurt by New York Attorney General Eliot Spitzer's allegations that their investment advice was tainted by conflicts of interest, which led Wall Street firms to reach a settlement with Spitzer and federal regulators.

As of October 14, however, Citigroup's stock is up 39%, and shares of Merrill and J.P. Morgan have both risen 53%.

Simons argued that the problems that weakened his financial services stocks a year ago were highly unusual and are unlikely to crop up again. Moreover, the long-term outlook for these kinds of companies is promising because demographic factors are working in their favor, he said. He explained that Americans invest most heavily between the ages of 55 and 65, "and that part of the population is probably going to be the fastest growing over the next ten years."

Citigroup and J.P. Morgan look good in particular because they're global businesses whose earnings growth exceeds that of companies in the S&P 500 while their stocks trade at a discount to the index, Simons said. Both are also benefitting as the U.S. economic recovery picks up steam, he said.

As for technology stocks, Simons acknowledges that he invested in them last year in anticipation of a turnaround, but his timing was off. "There, I think we were early, which in our business is the same as being wrong," he said.

Things are different now, though. Simons said Neuberger Berman Focus has gotten major contributions from stocks like Jabil Circuit (JBL) and Flextronics Intl (FLEX), a pair of contract manufacturers of electronic equipment. Semiconductor maker Intl Rectifier (IRF), the fund's third-largest stock, has risen 146%, and Amkor Technology (AMKR), another chip company, has surged more than 500% as of October 14.

The investment approach of the fund, which concentrates its holdings in only a handful of stocks and industries, can also result in a rough ride for investors, Simons agreed. The narrow focus can lead to big gains from winners, but it also leaves the portfolio vulnerable to blowups. (The portfolio has been twice as volatile as its peers, according to Standard & Poor's data.)

"It does make for a more volatile portfolio on a day-to-day basis," Simons said of the concentration. "But I think that over time it yields superior results."

The fund's long-term results don't contradict Simons. Neuberger Berman Focus returned an average annualized 11.3% for the ten years ended in September, while the average mid-cap value fund was up 10.8%, and the S&P 500 gained 10%.

In picking the fund's 25-35 stocks, Simons looks for companies whose stock is priced at a significant discount to the S&P 500, but whose earnings growth rate over a five-year period is projected to be higher than the index's. He also likes high returns on equity, and prefers strong revenue growth because he sees limits to how long a company can boost profits by cutting costs.

Its prospectus mandates that the fund invest 90% of its assets in no more than six of the 13 industrial sectors in the S&P 500. Currently, financial services stocks make up about 51% of its stocks. Technology stocks account for another 31%, and consumer stocks, like retailers, comprise about 13%. Those three areas are where he has been finding companies with the financial characteristics he searches for, said Simons, who also is holding some cash.

A relatively new addition to the fund is Federal Natl Mtge (FNM), which helps provide mortgages for homeowners. Simons said he invested in the stock, which he had been eyeing for a couple of years, about two months ago, when its multiple dropped to a level he found attractive. Investors had become skittish about Fannie Mae at the time because of an accounting scandal at another mortgage provider, Federal Home Loan (FRE).

Simons said he reasoned that even if Fannie Mae's earnings growth rate and its stock's P/E ratio both stayed at the low ends of their historical ranges, he'd still get a 50% return on the investment. Simons' Fannie Mae shares cost $64.77 on average. The stock closed at $72.89 on October 14.

To make room in the fund for Fannie Mae, Simons, who will unload a stock if he spots a potentially better investment, eliminated his stake in Morgan Stanley (MWD). Simons said he liquidated the position primarily because he thought the financial services giant's Discover credit card business wasn't doing as well as those of competitors.

The fund manager will also sell a company if its financial fundamentals appear to be weakening, or if its stock becomes too pricey. But Simons said he doesn't look to make wholesale changes in Neuberger Berman Focus, which he said typically has a turnover rate of about 20%.

Referring to the fund's success this year, Simons said: "It's not that I had some brilliant brain wave at the end of last year and changed the whole portfolio around. There hasn't been very much change."

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