From the November 2004 issue of Investment Advisor • Subscribe!

International to the Core

Having lived and worked on four continents, Benjamin Segal brings a worldwide perspective to the Neuberger Berman International/Investor Fund

Benjamin Segal brings a background to his job as portfolio manager for Neuberger Berman International/Investor Fund (NBISX) that is nothing if not international. He grew up in Great Britain, worked as a sales analyst in Asia for Lehman Brothers, got his MBA from Wharton, did some management consulting in South Africa, then some financial work in London before coming back to the States to join Neuberger in 1998.

Launched in 1994, the fund was given a five-star overall rating by Standard & Poor's, which considers it a global equity fund, in April of this year. For Morningstar, the category is Foreign Small/Mid Growth and the rating is three stars.

No matter how you classify it, the performance of the fund has been strong, with results dramatically outpacing both the S&P/Citigroup BMI World Ex-U.S. Index and the fund's own benchmark, the MSCI EAFE Index.

Tell me about the philosophy behind the Neuberger Berman International/Investor Fund. We're a bottom-up product with a bottom-up portfolio. I'm not an economist. In fact, Neuberger doesn't even have an economist on staff, so we don't make any strategic calls on currencies or countries or interest rates or anything else. We look to buy the best companies we can.

By "best companies," I mean those trading at discounted valuations in the world outside the United States. We pay pretty strict attention to valuation, but we also look for high-quality companies that are rarely in the deep-value end of the spectrum. We tend to be blend or core or somewhere in the middle of the growth/value continuum, and we're very much all cap. We will buy companies and are invested in companies at all ends of the market cap spectrum. I define us as quality-at-a-reasonable-price, all-cap managers.

That definition gives you a pretty broad spectrum of companies to choose from. How do you narrow it down? We're looking for high-quality companies with really strong business franchises that consistently result in strong returns--returns on capital, returns on equity--that are significantly above their cost of capital. How do they do that? Either by exploiting a sustainable low-cost position or by having a portfolio of brands or a strategy or a management structure that other people are unable to replicate. Or they can do it by dominating a niche business to such a degree that they exhibit monopoly-type characteristics. We want high-returning businesses with strong margins, strong management teams, and elements of growth.

We're running screens for earnings growth. We're running screens for returns on capital. We're running screens for profit margins. We're talking to management teams and consultants all the time to find the sustainably high-quality companies in the world outside the United States.

Those are the sorts of companies that we think have a place in the portfolio at some price--not at any price, at some price. Then the question becomes at what price are they attractive enough both from a quality perspective and from a valuation perspective to be included in the portfolio? If we think they're worth $80/share and they're trading at $100/share, we're going to watch that company. We're going to pay close attention to it and when it comes down in price, we will look to initiate a position.

So the first step is to identify those companies. The second is to value them, and then to make sure that we buy them and own them at discounted valuations. Obviously we'll sell them when the valuations become overextended.

When looking at the fund's portfolio, it becomes obvious that the biggest holdings are European companies. What's the reason for that? There are two reasons. One is that Europe is the largest component of the MSCI EAFE (Morgan Stanley Capital International Europe Australasia Far East) Index, so our universe of investable companies is dominated by Europe. If you look at the EAFE, roughly 70% of is composed of European companies, with roughly 50% in continental Europe and 20% in the U.K. Another 20% of the index is Japan, while the remaining 10% is other stuff--Australia, Singapore, Hong Kong, etc. So if 70% of our investment universe is in Europe, it's not surprising that the majority of our largest weightings are going to be in Europe.

The second reason is that a lot of people have talked about the recovery in Japan and how great the investment opportunities are there, [but] we find a shortage of high-quality, high-returning, well-managed businesses in Japan. When we do find them, they're often trading at very high valuations. The strict discipline we stick to doesn't produce a tremendous number of ideas in the Japanese market, which explains why even though Japan is 20% of the index it's not 20% [of the portfolio], and two out of the top ten holdings aren't Japanese. The economy isn't in great shape in our view, the valuations aren't compelling, and the [larger] companies themselves aren't of sufficiently high quality to be included in the portfolio in any significant way. Most of our Japanese holdings are smaller holdings that we like, but we're not as enthusiastic about them as we are some of the European and Canadian holdings.

While we're on the subject of Asia, there's been a lot of talk in the last year or so about the growth of China and India. Where do they fit into your plans? China and India are part of the emerging markets. We focus on developed markets and we cap our emerging markets holdings at 10% of the portfolio. Where we find opportunities we will invest with them, but we consider that investors ask us to concentrate on the developed markets relative to the EAFE Index. Having said that, we do like the Chinese and to some extent the Indian story. We're exposed to companies that are selling significant amounts of product [in the Chinese market]. One of our largest holdings is a company called TPV Technology, which is based in Hong Kong, is regulated by the Hong Kong securities authority, and is managed by Hong Kong Chinese, but all of its operations, assets, and businesses are in mainland China, taking advantage of China as a low-cost manufacturing hub.

Getting investment exposure to a country like China goes along a spectrum. One end is just to be 100% invested in a Chinese company, but we are not sufficiently comfortable with the accounting and regulatory transparency in the Chinese market to expose our investors to that. The next step is to find a company that is substantially deriving business into and out of China, but quoted in Hong Kong or somewhere else. That's how we're invested with TPV Technology. The least sensitive way is to be invested in companies that are doing substantial business there, and we've got a couple of those also.

Since the fund is based in the U.S., but your investments are in international companies, what does the relative strength or weakness of the dollar do to your strategy? For many years, a strong dollar and weak international currencies were a major headwind for international returns, but in the last couple of years that seems to have reversed. We're not economists and we don't look at these things in any detail, but if I'm pinned down, I tend to think that the combination of fiscal and trade deficits in the U.S. is likely to mean a continued weaker dollar. Clearly international investors benefit from that.

Where we have historically focused and generated a lot of our strong returns is on smaller companies with very focused businesses. We generally shy away from large global companies such as Nokia, Sony, and HSBC. We're much more focused on the local companies--local banks, local service businesses in Asia, and homebuilding companies in the U.K. These are very much local businesses. In an environment where the British pound would strengthen against the U.S. dollar, these local companies are not going to be affected. We try and make the distinction between the smaller local companies versus the larger global companies. In an environment of a continued weaker dollar we tend to think our portfolio would do relatively better than some of those portfolios that are packed with the large global multinational firms that will feel a U.S. dollar impact. Many of our firms are largely immune to currency movements, but of course, that can cut both ways. We think that the companies we're invested in are earning good profits, they're well-established businesses in strong niches, and that they will earn good returns.

You mention homebuilders in the U.K. as an example. I know that's a sector that a number of investors are strong on in the U.S. market. Are there sectors like that which tend to be good investments regardless of the country? Again it comes back to the fact that these are local niches. If the local conditions are strong, the market will be strong. But conditions in one country can be radically different than in another just across the border. To the degree that they are dependent on the local economy, you can't say that [homebuilders] are globally attractive. If you think about the last 10 years in Japan, which has been going backward, homebuilding has been a horrible place to be, whereas in the U.S. and the U.K. homebuilding has been a very profitable business.

What you can say is that there are businesses like homebuilding or gaming--betting shops and casinos are another area where we're heavily invested--where the businesses are local but geared into themes that are very uniform across countries.

If you think about the homebuilding industry, for example, household sizes are getting smaller, interest rates are getting lower, new geographic areas are being exploited and developed, people are increasingly mobile, so the overarching need for housing globally is likely to increase.

But in the case of many other local sectors, banking, for instance, the local economy can override those global themes. If you think about banking, people are getting more sophisticated about investing and more people are taking care of their own retirement because government's not going to do it. So there are more savings products, more mutual funds, more home loans, more this, more that. This is a global phenomenon. But if the economy in California, for example, falls flat on its face, a bunch of companies will go under water and a bunch of bad loans will surface in the banking business. So no matter how strong the overall argument is for mortgages and consumer saving and mutual funds, a crisis in the California market will override that and cause the California banks to really suffer. That could conceivably happen in the U.K. It has already happened in Japan. It could happen in other countries as well. So there are attractive global themes, but these local businesses are driven by local dynamics, which can serve to override a global theme.

You mention betting shops and casinos. Is that a business that you see as strong across borders? Coming back to the argument we made before--we see more consumer confidence, increasing wealth, more time for leisure, people traveling more for vacation--all these things are playing into the gaming and leisure sector, whether it's betting shops or lotteries or casinos, and we're very positive about that. It's a very profitable industry and government is realizing it can be a valuable source of revenue. State lotteries here in the United States have been a tremendous source of revenue for the local states in the same way that betting industries outside the United States are valuable sources of revenue and are being discovered as such by the governments.

So that's the global argument in favor of this industry--more consumer appetite for these types of products, more supply, and more government willingness to tolerate it because they're getting nice tax revenues. But you can always have, and it could vary from market to market, a change in legislation. You get a different government coming in that doesn't like gambling. There is a very strong global theme, but on the local level the government could do something that derails it in any particular market, which could overwhelm the long-term sector growth. We think that if we're spread across different markets and different leisure formats that we can offset that. But it's always a risk in the same way that a banking crisis is a risk or a housing crisis is a risk. Those risks are going to be very much local risks rather than global risks in most cases.

Are there any countries about whose economies you're particularly excited these days? We've been excited for some time about a few of the economies in Europe--Greece, Spain, and Ireland in particular. They're all countries that are part of the EU with the euro currency. Historically they all had fairly high interest rates and now with the single currency everybody's interest rates are set by the ECB, which is driven substantially by the Germans. So everybody in Europe that has the euro has 4% interest rates, and in these countries people were used to 10%, 15%, even 20% interest rates. So there's been a huge boom to investment, to the banking system, to consumer confidence, to spending power, to real estate development, and to the economies overall in these countries. They're smaller and they're not as constrained from a policy perspective as countries like Germany and Austria and Italy are by the labor unions and political structure. They have low tax rates and they're attracting investment. They're getting reputations as very easy places to do business.

Would you care to talk specifically about some of the fund's larger holdings, such as Anglo Irish Bank? That's our number-one holding and has been for some time. It's really just a tremendously profitable business and it fulfills all the criteria that we look for in a business. It's based in Ireland but it's not your typical bank. It focuses on supplying banking services to high-income entrepreneurs. Their prototypical customer is a dentist or a doctor who says "I want to buy my surgery," or "I want to buy out my partner," or "I want to invest in a property development." They focus on delivering high-quality service to this very attractive customer base. These customers don't want to be treated like a commodity. They don't want to be put in front of somebody who doesn't know what they're talking about or talk to somebody from a call center. They want to know they only have to make one phone call to one person to get the deal done. The entire business model is tailored to customer service, which is the exact opposite of what most of the banking business is doing. This is pure relationship banking. It's a very successful model making a 30+% ROE.

They've done very, very well in the Irish market and moved, as the name would imply, into the U.K. market, which is roughly 10 or 20 times the size [of the Irish]. They are now incrementally moving into the East Coast of the United States with a very clear focus on whom they serve and with what products. They've been growing at 20% a year in the context of declining rates, which is always very good for banks, and they've been tremendously efficient. Most people say if you've got a cost/income ratio of 50% it's pretty attractive, while anything in the low 40s is phenomenal. With these guys it's a cost/income ratio below 30%. It's just an incredibly profitable, focused business.

What can you tell me about your investment in Vodafone? Vodafone is the other end of the spectrum that I talked about before. As I mentioned, some companies we like because they're focused on their niches, while others have a competitive advantage just by the nature of their scale and size. Vodafone, which is the world's largest cellular operator, falls into that second category. It's in all the major markets, including Japan and the U.S., which is pretty unusual for a European-based operator, and they're still growing customer bases. The cellular operator industry is moving from a pure focus on customers at any price and pure growth into a much more stable returns-based mindset, where they're looking for the right customers, with the right offer and to serve them profitably. They're doing this by focusing on better customer care, better customer retention, better customer service, and better scale.

There was a CEO change at Vodafone just under a year ago and [Arun Sarin's] very much focused on returns and doing the right thing with the cash flow. I think that's going to drive the performance of that company. It's trading at a discount to the market, so you get pretty attractive growth on the top line, and leveraged growth on the bottom line. The free cash flow from this business is very strong and it has a management team that appears to be committed to doing the right thing with that cash flow, whether it's buying back shares or doing intelligent acquisitions rather than overpriced acquisitions.

Staff Editor Robert F. Keane can be reached at bkeane@ia-mag.com.

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