This Small-Growth Fund's Steady Execution Has Paid Off

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Managers Judy Vale and Bob D’Alelio are poised to add to a solid track record on Neuberger Berman Genesis that spans more than two decades, earning the fund a Morningstar Analyst Rating of Bronze.

Vale and D’Alelio employ a conservative, low-turnover approach to small-cap investing. They aren’t interested in the flashiest growers; instead, they want strong companies with low debt and high returns on assets. They and their deep team of two associate managers and four dedicated analysts then pore over 10 years of financial statements to examine how firms generate and allocate cash, and they look for companies with defensible competitive advantages that allow for steady, modest rates of future growth. Once they settle on a name, the veteran duo—each has more than 35 years in the industry—wade in gradually, making sure their thesis is correct. They will buy and hold for long periods; annual turnover has averaged 18% since D’Alelio joined Vale at the helm in 1997.

Consistent execution has produced a quality portfolio and attractive results. The portfolio’s 9.8% ROA as of September 2017 outpaces the meager 0.8% for the Russell 2000 Index benchmark and the 3.7% small-growth Morningstar Category average. Its 32% debt/capital ratio is well below the index’s 38% and the 44% peer average. With such a quality orientation, the fund has held up relatively well in downturns, contributing to long-run outperformance. Its 10.8% annualized total return from August 1997 through October 2017 led the benchmark by 3.8 percentage points and bested 95% of peers.

The fund’s size bears watching, though the managers have shown they can work with a lot of money in the small-cap space. At $10.8 billion in assets, the fund ranks among the largest actively managed small-cap funds, and it has held more than $10 billion for most of the time since late 2005. Still, the managers have generated above-average returns since then while keeping the portfolio’s number of holdings, turnover, and average market cap in check. As long as those indicators remain benign, this is an attractive small-cap fund.

Process Pillar: Positive | Tony Thomas 11/22/2017 The managers' conservative approach to growth stocks leads to a high-quality portfolio, earning the fund a Positive Process rating.

The process filters out flashier growth companies in favor of moderate growers. The team begins by screening for firms with market caps below $2 billion dollars and showing signs of profitability such as above-average or improving three-year returns on assets. Ideas can also come from meetings with management, competitors, or customers. Prospects are then scrutinized through an analysis of 10 years of financial statements. The team focuses first on how each firm generates and uses cash, followed by the visibility of its earnings and the barriers to entry for other competitors. Ideal companies are deemed capable of sustainable, modest earnings growth (usually in the midteens in a normal economic environment) while trading at a discount to their historical averages and the Russell 2000 Index as a whole.

A long-term investing horizon allows the managers to scale into or out of positions gradually. They like to start individual positions at under 0.5% of assets each and add only if a few rounds of earnings reports show they’ve hit on the right opportunity. Their sell discipline usually involves trimming slowly as positions reach their expected valuations or as the managers pare existing holdings to make room for new picks.

The portfolio typically consists of 90-150 names. Individual position sizes are capped at 5% of assets each, though most positions stay below 2%. The managers prefer to buy and sell gradually, leaving numerous small positions in the portfolio. As of September 2017, 45 holdings took up less than 0.5% of assets each.

The managers are benchmark agnostic, but don’t expect high sector concentrations. Industrials were the largest sector weighting at 20% of assets as of September 2017, but this was modestly higher than the Russell 2000 Index’s 15% and the 17% small-growth category average. Technology, consumer cyclicals, and financials usually flesh out the portfolio. Healthcare stocks also appear, but speculative biotechs don’t make the cut. West Pharmaceutical WST, the top holding as of September 2017, specializes in syringes.

The unique mix of equities makes it difficult to characterize this portfolio. While the managers prefer small-cap companies, their willingness to hold winners makes this more of a smid-cap fund, with mid-caps taking up nearly 45% of assets as of September 2017. Their interest in “moderate growth” stocks keeps the portfolio from tilting too far toward growth. As a result, the portfolio often straddles the lines between blend/growth and small/mid-cap. It’s currently in the small-growth category.

Performance Pillar: Positive | Tony Thomas 11/22/2017 Apparently erratic relative annual returns mask this fund's relatively consistent, solid performance over the long run.

This fund isn’t as volatile as a cursory glance suggests. Despite bouncing between different categories and turning in almost as many bottom-quartile annual returns as top-flight ones in the past 10 years, the fund’s 10.8% annualized total return from August 1997, when the manager team of Judy Vale and Bob D’Alelio formed, through October 2017 beats the Russell 2000 Index’s 8% rise. Its volatility, as measured by standard deviation, was almost 5 percentage points below the index’s tally, with the fund capturing only 56% of the benchmark’s downdrafts in the period.

The result of this steady performance is an impressive risk/reward profile and a Positive Performance rating. The fund’s Sortino ratio of 0.90 during the manager duo’s tenure surpasses the index’s 0.60. Its rolling three-year returns led the benchmark’s in more than 70% of periods, outperforming significantly in periods that included the bursting of the dot-com bubble or the financial crisis. Far from erratic, this consistent fund rewards investors through the full market cycle.

People Pillar: Positive | Tony Thomas 11/22/2017 An experienced pair of managers supported by two associate managers, a dedicated analyst team, and a centralized research unit earn this fund a Positive People rating.

The fund’s manager bench is deep, experienced, and invested in the fund. Judy Vale became a manager of the fund in February 1994, and Bob D’Alelio was named a manager in August 1997. Each has more than 35 years of industry experience. Brett Reiner and Gregory Spiegel came aboard as associate managers in 2005 and 2015, respectively, and both rose from the fund’s analyst ranks. Spiegel’s appointment preceded the retirement of Michael Bowyer, a healthcare analyst and comanager who left in July 2016. Manager ownership is excellent: Vale, D’Alelio, and Reiner each hold more than $1 million in the fund, while Spiegel has $500,001-$1 million.

The managers and four dedicated analysts research the small- and mid-cap stocks that make up this fund’s fare. Vale and D’Alelio are generalists, but the rest of the team has sector responsibilities, though these are not strict and analysts are encouraged to learn about other sectors to critique each other’s picks more effectively. Although the four analysts each joined the team in 2012 or after, they average 14 years of industry experience, and two came from elsewhere in the firm. The team also taps Neuberger Berman’s centralized global equity research unit, with 36 analysts and associates, as needed.

Parent Pillar: Positive | Tony Thomas 11/08/2017 Neuberger Berman's steady approach to its evolution earns the firm a Positive Parent rating.

The firm, founded in 1939, emerged from the collapse of Lehman Brothers with new capabilities and a new ownership structure. Lehman’s fixed-income and private-equity acquisitions became part of Neuberger Berman in the wake of Lehman’s 2008 collapse, when chairman and CEO George Walker led employees in taking the more diversified firm private. Over 460 employees now own the business, which manages $270 billion in assets.

Once known primarily as a U.S. value equities shop, the new Neuberger Berman sees growth opportunities in Europe and Asia. Clients in those regions own 30% of the firm’s assets under management. Although solely an investment manager, its retail mutual funds make up only one fifth of business. The rest is institutional and private client money, long bastions of the firm’s identity.

The firm continues to add pieces at a modest rate. It has lifted a few teams out of other firms to expand its circle of competence, including a talented emerging-markets-debt team from ING in 2013. While the firm has been selective in its acquisitions, its hands-off approach lets the new teams do what they do best. Meanwhile, the firm’s partnership structure allows these new teams to integrate more fully into Neuberger by becoming managing partners over time.

Price Pillar: Positive | Tony Thomas 11/22/2017 The fund can be a reasonably affordable way to invest in small- and mid-cap stocks, earning it a Positive Price rating. Its two largest share classes by assets, the Institutional and R6 shares, levy low fees relative to their respective peers. The Institutional shares carry a 0.85% expense ratio, 15 basis points below the median for similarly distributed shares. The no-load Advisor shares don't help the case, however; their 1.38% expense ratio is well above the 1.18% median for similar shares.

Advisors should urge investors to hold this fund in a nontaxable account. The fund sits on sizable unrealized capital gains owing to the managers’ buy-and-hold approach.