CME, BlackRock, Progressive: Why This Fund Likes Them

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Managers of $1.2 billion Neuberger Berman Guardian Fund think of themselves as people looking to buy businesses.

When they find prospects, they kick the tires. "We evaluate business plans and try to find plans that are best positioned for secular growth," said senior manager Arthur Moretti. Lately that process has brought the fund back to its winning way.

The fund was up 18.08% for the 12 months ended April 30. That outperformed 96% of its large-cap growth rivals tracked by Morningstar.

Over the past three and 10 years the fund ranks in the top 42% and 23% of its peer group.

This is a rebound from 2011 and 2012 when the fund topped only 42% and 24% of its direct rivals.

Moretti, 49 years old and senior helmsman of the fund since Dec. 31, 2002, talked shop with IBD from his office in Manhattan.

IBD: What are you doing differently than you did in 2011 and 2012?

Moretti: When you peel back the layers of the onion, it was the fourth quarters in those years, not the whole calendar years, that gave us trouble. There was dramatic risk-off trading, driven by events that had nothing to do with stock fundamentals.

In Q3 2011, we had the budget crisis in the U.S. Then people worried about European banks. So in Q4 investors went toward yield. High-dividend-paying stocks did well.

Our yield then and now is less than the market's. The free cash flow of our portfolio is above the market's, so our companies can pay but they choose not to. They invest their money in mergers and acquisitions or in plants or equipment. But the market didn't care. It wanted safety, yield.

The other thing was that in 2012 we did not haveApple ( AAPL ). Apple took off. It became a phenomenon. It was a driver of the index because of its size. And not owning Apple was a head wind for us.

We missed Apple five years ago. But by 2012 we felt the opportunity was overplayed and we didn't change our stripes.

We've done well since late last year because the market started to focus more on company-specific fundamentals.

IBD: What do you think about Apple now?

Moretti: I have an aversion toward boxes in tech. A lot of the intellectual property that drives disruptive change in the tech space does not come from boxes in the long run. There may be some innovation at that level. But the box gets commoditized. The box does not drive innovation. It gets copied and the value proposition of its innovator gets diminished.

The innovator gets a premium price for its innovation. But to maintain that premium, it has to keep innovating at a level that is as disruptive as its initial historic innovation. Otherwise it starts to see price compression.

We saw it with Digital Equipment, withNokia ( NOK ), Compaq, Research in Motion, nowBlackBerry ( BBRY ) and all the router companies that existed in the late 1990s. We saw it with the mainframe, the super computer, the mini.

Apple has other things going for it, but now they're the big incumbent. It might be a good trade at these prices. But the challenges they face in the near term probably have some box-maker elements (of failing to maintain disruptive innovation) I talked about.

IBD: Describe your overall approach, please.

Moretti: We try to think like owners of businesses. We are inherently long-term in focus. We evaluate business plans and try to find attractive secular growth characteristics. In each sector we own what we see as the industry leader and the company in the best position to grow at a premium to its peer group.

IBD: That pickiness is reflected in your concentrated approach, right? You usually have 30 to 40 names?

Moretti: Yes. We try to find industry leaders positioned to outgrow peers. If you have conviction around their earnings power, we try to buy them when they're statistically cheap.

IBD: You don't apply one discount to fair market value, do you? You look for various discounts in different sectors and situations, right?

Moretti: Right. Our value bias depends on revenue stream, type of business and so on.

IBD: Do you look for fallen angels?

Moretti: As we go through our process, we know the name we want to own. We just don't know when the risk-reward for the stock will make sense.

What happens typically is that there may be a valuation event. News or some dislocation. Once it makes sense from a risk-reward perspective, we introduce it to the portfolio.

We're not contrarian. We know the names we want. But we want to be valuation sensitive about when to buy.

IBD: Are all of your buys on the heels of some dislocation?

Moretti: It's probably 40-60. Forty percent of the time there's some dislocation and we react. Sixty percent of the time our research gives us a different perspective of what a company's earnings potential can be. It looks steeper to us, so we buy.

IBD: Do you play macro trends?

Moretti: We look for key risks a company may face in executing its business plan. The way macro factors impact our process comes from how we think macro risks may keep a company from executing its strategy.

IBD: So what types of stocks are you avoiding these days?

Moretti: The thing that's unique about the period we live in is that the globe has a debt problem. It's of a scale no one has seen before. And it's primarily focused in developed nations. It creates a head wind for growth.

It makes businesses cautious about spending and hiring. It makes consumers deleverage and cautious about spending.

IBD: So what are you avoiding?

Moretti: We don't want businesses that depend on the capital markets for funding and growth. Those markets have closed several times in the past four years.

We don't want companies with a lot of debt or negative free cash flow. For example, utilities don't generate free cash. They have to access the capital markets to fund their businesses and to grow. They pay high dividends and many perceive them as stable and safe. They have large regulated revenue streams. But the fact they can be shut out of capital markets makes them riskier now than they have been historically.

Or say we get inflation. A utility has no control over its revenue. It must go to a regulatory body for a rate increase. And sometimes that decision is politically driven.

IBD: What's another industry you're avoiding?

Moretti: Money center banks and brokerages. They need regular access to capital markets.

They also face regulatory risk. Dodd-Frank is law, but the implementation rules are still being written. So those financial institutions don't know how much capital they must hold and which businesses they can be in. Because of that, we don't know their long-term earnings potential.

IBD: Yet financials were your largest sector at 24% of assets as of Feb. 28. What do you have besides banks and brokerages?

Moretti: Those risks create opportunities for businesses such as exchanges. We ownCME ( CME ) andIntercontinentalExchange ( ICE ). Both are beneficiaries of a changing regulatory backdrop. Since the financial crisis, the thrust of regulatory reform has been around higher capital standards and transparency. Broker-dealers make markets upstairs, away from exchanges, in derivatives and things that weren't exchange-traded like exchange swaps. People didn't know where the risk is.

In the new world, regulators want to centralize transactions, measure them and control risk. So, much activity previously done upstairs is being compelled to be done on an exchange, where things are centrally cleared, measured and monitored. The exchanges benefit from that.

IBD: Yet you've gotBlackRock (BLK). What do you like about the giant asset manager?

Moretti: When we first got involved, asset managers were under a lot of pressure. We first purchased in the fall of 2010 whenPNC (PNC) andBank of America (BAC) opted to materially reduce their positions to raise capital. BlackRock stock had underperformed in the market's rally off its 2009 low. The share price pressure created by these two sellers set up an attractive risk-reward in BlackRock stock.

And they have a set of active equity products and a set of passive strategies. So they are somewhat uniquely positioned to grow their assets regardless of which way investors' preferences go.

IBD: You've also got insurers. Why do you like them?

Moretti: Auto insurance is like advertising. It's not something everyone thinks would be an inflation hedge. But policies are written for (a set time period). If they're not profitable, the insurer stops writing that business. It writes new policies with higher rates that give them a good return on their investment. We ownProgressive (PGR), which we think is the most innovative. We ownBerkshire Hathaway (BRKB), which owns Geico.

IBD: What else do you like about Berkshire?

Moretti: We bought Berkshire late last year. About 70% of its value was driven by its industrial businesses. Many are the best in their class. We like that. They own Burlington Northern (BNSF Railway), for example.

IBD: Why do you like names such as that?

Moretti: We see head winds to growth. So we want financially strong businesses, with strong free cash flow and strong balance sheets, which can fund their own growth.

And we want companies that can protect our purchasing power if we get policy-induced inflation down the road. Companies that have big distribution, logistics elements to them inherently let you pass through price increases.

One example is things like railroads -- Burlington Northern. They also benefit from the industrial renaissance being fueled by growing U.S. oil and gas supplies.

Other examples are less obvious, like advertising. Ads are a form of distribution model. We ownScripps (SNI) andGoogle (GOOG), which make money from ads.

Only some consumer staples fit this (distribution model) as well. We never owned consumer staples through 2008. We started to buy ones with strong brands that grew earnings in the worst environment ever. We think those companies have already been tested.

IBD: What are some examples?

Moretti: Ecolab (ECL) andPraxair (PX).

Ecolab provides things consumers would recognize in public bathrooms, such as soap and soap dispensers, disinfectants, cleaning supplies. And they provide services. They not only sell branded goods, but they deliver the goods to restaurants, office buildings, commercial and industrial establishments. They also bring them inside and install them.

One of their growth drivers comes from their 2011 purchase of Nalco, a water purification and treatment business.

Praxair sells industrial gases for consumer and manufacturing applications. Their industrial gases make industrial processes more energy efficient and they cut emissions. They typically have a facility on-site at a large customer. They also have the capacity to package industrial gases to other customers in the area from that facility. They pass wholesale costs for natural gas and electricity through in their price. They get good secular growth even in a slow-growth world.



The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Mutual Funds

Referenced Stocks: AAPL , BBRY , CME , ICE , NOK

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