Q:  Why should American investors consider international investing?

There are two reasons to invest outside the U.S. -- first is the potential for additional return and the second is to lower overall portfolio risk. In terms of potential return, the U.S. stock market has been outperforming developed International markets in recent years but a look back over longer term time periods, e.g. 10 years, shows International equity returns compare favorably with those in the U.S.

95% of the world’s population and over 80% of global GDP are derived from outside the U.S. These facts lead to a vast opportunity set of investments for the investor willing to expand their horizons away from the home market bias. However, given the extent of the globalization we have witnessed in the last few decades, there are companies in the U.S. and in International markets that derive a substantial portion of their revenues from outside of their home market. This phenomenon is even greater in many international markets however as the relatively small size of some of these countries, in Europe for example, necessitated companies looking outside of their borders from early in their history. This has enabled some International companies to gain first mover advantage over many of their U.S. peers, particularly in the faster growing emerging economies.

With U.S. markets having outperformed International in recent years, a valuation discount exists on International equities. U.S. market valuations are currently at a historical cyclical high when measured in terms of GDP and profits. Whereas, International is trading below average historical valuations.

Economies globally are not completely synchronized, so the opportunity to invest in businesses outside the U.S. can bring down the overall standard deviation or volatility of your portfolio. So, we are not only opening up a vast opportunity set of International companies to invest in but we can potentially improve our position on the risk-reward spectrum at the same time.

If for example, a strong U.S. dollar was hurting the competitiveness of U.S. companies, that could potentially improve the competitive position of companies outside of the U.S. In that case, by investing in some of these overseas companies, investors can lower the overall volatility of their portfolios.

Q:  How wide you go internationally, what you cover and what you do not cover?

We essentially cover everything outside the United States from as close as Canada to as far as Indonesia. So, countries across the GDP spectrum, high-GDP countries in Europe to the lower-GDP countries like India and Brazil. So, developed and emerging economies, all sectors, all countries, except companies domiciled here in the States.

Although we might look at companies that are based and have significant activities in the frontier markets, it would be unusual, but not impossible, for us to invest in companies quoted there.

Q:  What is your investment philosophy and what core principles guide your investment thinking?

First and foremost, we are bottom-up stock pickers, so we think we have a skill set that allows us to identify great businesses at compelling valuations ahead of our peers. We are not trying to differentiate ourselves based on our view of the macroeconomics or any top-down view of the world. Our investment decisions are overwhelmingly driven by bottom-up or company-by-company analysis factoring in the quality of strategy, the credibility of management, and the outlook for profitability and, more importantly, cash flows.

Second, we invest across all market caps. We are not just looking at the largest companies in the world outside the United States but in many cases looking at smaller niche businesses or companies that are very focused. And we tend to think that the smaller, more focused, specialized companies, outperform the broader, larger and more diversified businesses over the long-term.

Third, we believe markets are volatile and as you know, the holding periods for equity investors have compressed; the time horizons have shrunk significantly. We think that’s an opportunity for longer-term oriented investors to take advantage of near-term volatility in share prices and to make an investment based on a three-to-five year time horizon. So taking a longer term view, turnover in the portfolio tends to be slightly below or slightly above 30% per year.

Q:  What is your investment style?

We’re looking for companies that are strategically well positioned with strong management teams executing on a clear strategy. We’re not fishing for fallen angels. We’re not paying up for companies that don’t have any earnings but we hope they might at some point in the future. These are businesses with clear strategies, proven cash flows, strong profitability as measured by return on capital, and effective execution.

We call those businesses with good growth and quality “trading at a reasonable price.” We tend to be focused on companies that are proven. Our investment style also has a slight growth bias. If you’re looking at a value to growth continuum – maybe slightly to the growth side of core, but we’re not aggressive growth and we’re certainly not a deep value investor.

We want profitable, sustainable growth as opposed to growth for its own sake. We are looking for cash generative, replicable, bankable growth.

Q:  How do you find and evaluate investment opportunities?

Ideas are generated in several ways. Our research staff at Neuberger Berman is actively looking for new ideas and we supplement that with what we find when we talk to companies or competitors or what we discover through our travel.

But once a company piques our interest, we then initiate a strategic due diligence process. What is this company good at? What is the market for their services? How does this translate into an attractive level of profitability? What sort of growth rate and cash flow do we think this company can achieve?

We use a three-step discounted cash flow analysis to essentially encapsulate all of our strategic thinking on a business into numbers. So if we think a company is launching new products and/or establishing new geographical subsidiaries that might grow its revenues but constrain profits and cash flow in the near term then that would be a candidate for more evaluation.

We would estimate earnings for the first three years and then apply a declining growth rate for the next five years and thereafter, use a lower flat rate of earnings growth and discount that back to understand earnings and thereby cash flow potential at the company.

After this evaluation, we are looking to invest in companies where there is a potential to earn 50% total return over the next three years.

Q:  Can you give an example to explain your research process? Why did you like the company and how did you evaluate investment merits?

I’ll give you an example of a Canadian business based in Quebec that we initiated probably about 18 months ago. The independent company operates gas stations with an attached convenience retail store in the U.S. and Europe. The company acquires stores from family operators or from large oil companies who are divesting their retail operations.

This retail company can run these oil-company-owned retail stores better by bringing sharper focus to stores and running them with more innovation and efficiency. The company understands that they are not in a full-line retail business but in incremental business, and selling consumers more items like morning coffee or impulse items can generate incremental revenues and margins.

We did the full assessment of the historical financials, understanding how much of the growth came from existing store sales growth and how much from the expansion or new stores.

Obviously, the retail company that can show healthy same-store sales is a better investment because it is less capital intensive and offers higher cash flow. The retail company with stronger same-store sales is much more interesting because opening new stores requires more capex.

So we have this strict focus on companies that are generating organic revenue growth, which in the retail context is same-store sales growth out of their existing businesses. They do it, they’re innovating, they’re launching new products, they are moving customers upscale, up-selling customers to higher value-added products, they’re expanding margins by launching new private label products rather than just marking up other branded products. Understanding where the gross margins come from; understanding how the offer to the consumer has evolved over time; how that’s correlated with gross and operating profit margins for the business and cash flows - that’s about understanding the historic track record.

The second piece is discussing with management what the strategy for the business is going forward, either on the telephone or on a company visit or visiting stores in the field and making sure the strategy is actually being executed at the store level.

With that understanding, we develop earnings from the existing stores, add them from any new stores, and develop an earnings profile. We also develop an understanding of the company’s revenue by looking at the mix of products between branded goods, store brands and across various price points.

It’s important to mention that we know our base case assumptions are going to be wrong. It’s impossible to forecast with accuracy where a business will be in three or eight years’ time but that’s a base case. We run sensitivity analyses around that base case and we flex the major assumptions, whether it be around revenue growth, profit margins, or working capital investment needed, to come up with a confidence interval around our estimate of the fair value of a business. Where we can buy a company at or below the low end of that confidence interval, we have a stock that looks interesting. Where we have a company that’s trading at the high end of the confidence interval or above it, we are not likely to purchase it.

We could say, “Look, we think it’s a great business but the market’s already spotted the opportunity here and that’s one to watch from the sidelines.”

So whether it’s a retail business in Canada as I discussed, whether it’s a telecommunications company in Japan, or whether it’s a chemical company in Germany, we use essentially the same process.

Q:  How did the company in Canada stack up to other international similar retailers including Seven & I that owns retail store chain 7-Eleven?

We compare the profit margins in other companies to those we evaluate in the portfolio. Now, 7-Eleven has high profit margins because they sell sandwiches made specifically for them that are made in their own kitchens. The cost of a sandwich is $0.20 and it’s retailed at $4, so the profit margin there is very high, whereas the profit margin on a gallon of gas is much less. So the profit margin at 7-Eleven is higher but the Canadian retailer we mentioned, they sell much more per store because every time I go to the gas station, it costs me $80,whereas I walk into 7-Eleven and I’m spending maybe less than $10.

Second, the rent and capital cost of that asset is much, much lower. So I’m selling more stuff at a lower margin with less operating costs and my return on capital, which is the measure that we look at, is higher. How much profit can I generate on that revenue and therefore on that capital? Our investment is much less capital-intensive, it’s lower gross margin, but it’s efficient at the operating level. So the returns of the business are attractive.

We’ve got a number of distributors in the portfolio, chemical distributors, electrical product distributors, agricultural distributors, most of which are characterized by low gross margins and therefore low operating margins, but the reality is the amount of capital, working capital and fixed capital, whether it’s real estate or otherwise, that is required to support that revenue is tiny. So you end up with a return on capital that is very low. The amount of investment required to earn an additional dollar of sales is minuscule. The cash flow characteristics of those profits are really attractive. The cash conversion rate -- how much of the profits come back to me -- is extremely, extremely high. Those are the businesses we like, with free cash flow and high conversion of profits into cash flow.

Q:  How do you go about building your portfolio? What is your benchmark and what role diversification plays?

Our benchmark is MSCI EAFE Index Europe, Australasia, and Far East Index, which is consistent with developed markets, excluding emerging markets. We include emerging markets opportunistically where we see the opportunity but we’re looking to beat the EAFE index. In the same way, we’re looking at smaller companies that may not be in the index but we still use the EAFE because we want those companies to beat essentially their global peers, of which EAFE is the most representative indicator.

As I mentioned at the start, we are bottom-up stock pickers rather than top-down investors. Therefore, we do not want the macro-economic decisions to drive performance of the portfolio and the risk. We want the vast majority of our performance to be driven by stock selection rather than asset allocation.

As a result, we constrain our deviation from the benchmark by sector and by country within defined parameters and in both cases, that’s 15 percentage points. So it’s a pretty wide band but we want to make sure we have companies in Japan and we have companies in Germany and we have companies in the U.K. and we have companies in the energy sector and we have companies in the financial sector.

So at present, if you think about twenty of the major countries in EAFE, say, down the left-hand side, and you have the ten MSCI sectors, kind of in columns across the top, you’ve got therefore two hundred different sales, different individual buckets. We tend to have approximately 90-95 names in the portfolio. So it means that we are present in roughly half of those different combinations of country and sector, precisely to be broadly diversified to have the portfolio performance be driven by the performance of the individual stocks rather than concentrated in one geographic region or one sector niche.

Q:  What is your buy discipline and what are upper limits per stock?

Typically we initiate, certainly for a smaller business, at 50-75 basis points. For a large, well-known name that may be an important index constituent, we’ll probably initiate at 75-100 basis points; but rarely, if ever, I can’t think of any recent example, will we initiate it less than 50 and I can’t think of an example where we have initiated at more than the 1% position. We will typically add to holdings as we gain greater conviction, as we see another quarter or two of results and we are confident that the business is tracking in line with our expectations, on the assumption the performance of the stock has not gotten ahead of itself, and we’ll add in typically 25, maybe 50 basis point increments from there.

The maximum position size is typically 4% of the portfolio, regardless of where we bought it. At current market price, if a position is getting close to 4% of the portfolio, we will trim such that it never hits 4% of the portfolio. We don’t want to have more than 4% exposed to any one name. Accidents happen, mistakes get made, earnings get restated, regulators come in -- we think that’s an unnecessarily large risk to run. By the same token, when we’re skidding out of position, typically it’s in 25-50 basis point increments and we will typically sell out of the position when it’s at or below 1% of the portfolio. The purchase and the exit tend to be relatively symmetrical.

Q:  What are the reasons that will make you sell the stock?

Well, we’re all cap managers. Smaller companies tend to make such choice targets for acquisition, so the best reason to sell is because someone comes in with an offer for the business at a 70% premium and we’re forced to sell. We’ve had a number of examples of that in the history of the portfolio where companies have been acquired. That’s forced upon us but obviously we tend to be happy sellers to settle that premium.

The other related reason to sell is, it’s a great business and we bought it at a discount to fair value. However, other people seemed to have discovered it and the valuation has risen well ahead of what we think the fundamentals merit and we will sell the company. Great business still? We still love the company, love the business model. We may well buy it back again but at current valuation, it is just too expensive.

The reason why we might sell for negative reasons is a regulation comes in, a change in business or a competitor that really disrupts the market, disrupts pricing, and causes us to either downgrade our assumptions for the business, or reduce the fair value estimate for what we think the company’s worth, and therefore the upside is either reduced or eliminated. So, some fundamental change that undermines our estimate of the upside potential in any given name.

Q:  How do you define risks and what risks do you focus on and then what do you do to manage it?

There are three main types of risk as we think about it. One is stock-specific risk: understanding the company and understanding what can go wrong. As I mentioned earlier, we get explicit forecasts for every single company but modeling a plausible and even an implausible downside and understanding what, if anything with the company could go wrong did go wrong, what would that mean? Preserving a margin for safety, I think, is important. So that’s how we mitigate risk number one.

There are economic risks and macro-economic risks, which is the sort of thing that we can do by being broadly diversified. We’ve got companies in Germany to benefit from a strong euro because they’re importers of raw materials that are based in U.S. dollars. However, there are other companies that benefit from a weaker euro, exporters for example, because their goods become cheaper for overseas customers.

So having a range of companies, whether it be in Japan, Canada, Europe or wherever else, is important. Some would benefit from a stronger currency, some should benefit from a weaker currency; some benefit from higher interest rates, some benefit from lower interest rates. So essentially controlling, not eliminating risk, because that’s impractical, but offsetting one kind of risk with another in terms of the underlying exposure. We make sure we’re not excessively exposed to any one sector or country, but also that within the country, we’re not all in exporters or importers, not all financials and so on.

The third way that we control the risk is using the third-party risk program which helps us understand the risk that we might not have appreciated, maybe across different sectors; via companies that are very sensitive to commodity prices or currencies that we might not fully appreciate. This third-party software is quite good at picking up companies that are risks in the portfolio that we might not have noticed at the first or the second level and understanding where the risks are from a quantitative standpoint. Then we try to understand them from a fundamental standpoint and adjust the position size accordingly.