Conversations With… Charles Kantor

Volatile Markets Call for a Flexible Approach

Continued economic and political uncertainty, and accompanying market volatility, underscore the importance for investors of striking a balance between participating in rising markets and seeking to mitigate the effects of volatility.

To this purpose, in December 2011, Neuberger Berman’s Kantor Group, which has for some time managed assets both on a long-only and long-short basis, introduced the Neuberger Berman Long Short Fund, which seeks to provide equity exposure with lower volatility than the broader market. We asked Charles Kantor, the group’s founder, to discuss his team’s style of investing, the merits of a long-short approach and his take on the long-term prospects of the U.S. equity market.

How do you approach investing?

Simply put, we are fundamental, bottom-up investors. Our strategy focuses on robust fundamental research that seeks to identify attractive businesses with strong management teams at compelling valuations regardless of sector or company size. We do this in an effort to construct and manage portfolios that we believe will generate attractive risk-adjusted returns. Our process organizes these investments into three categories: Capital Growth, Total Return and Opportunistic. The total return bucket may include fixed income securities, which provide diversification and income while serving to help dampen overall portfolio volatility.

What’s the benefit of being able to go short in a portfolio?

We regard shorting as a tool that has the potential to increase returns and/or reduce risk, particularly within uncertain market environments. Technically speaking, shorting involves selling a borrowed security with the expectation that the stock price will decline. Shorting allows us to express a view on companies that we think are disadvantaged or poorly positioned for current circumstances. We can also add short exposure on specific sectors, geographies or market capitalizations to reduce unwanted risk. It is important to note, however, that while shorting may hedge against certain risks, it also presents risk as the Fund may be required to buy the security sold short at a time when it has appreciated in value. Given that we are not able to execute short positions within our long-only strategies, there, we tend to hold larger cash balances when we are trying to reduce portfolio risk or when we are not finding qualified investment ideas.

Of course, while short sales may help hedge against general market risk to the securities held in the portfolio, they introduce an element of risk on an individual stock basis, since the Fund may be required to buy the security sold short at a time when the security has appreciated in value.

How are these ideas applied to the long-short portfolio?

Within the long-short portfolio, we seek to enhance returns through company-specific short positions based on our fundamental research, or to reduce risk through what we call “market” shorts, which typically include futures, ETFs or options. Generally speaking, we tend to be long-biased, and have been running the portfolios 25% to 90% net long at any given time, although the actual number will vary depending on the circumstances.

How do you manage through market volatility?

For all our strategies, the team’s mindset is to grow and protect—capital—in that order. We believe this is an important aspect of the Fund’s primary objective of seeking capital appreciation, as the more money you have at the bottom of an economic cycle, the more you have available to compound and create wealth until the top of the next cycle. On the long side, it’s essential to have a deep understanding of the companies you own and a sense of the key factors that may move the security. Equally important is the decision to avoid holding certain sectors of the market. We only allocate capital when we find qualified investment opportunities and when we believe we will be rewarded for taking such risk. The goal is to design portfolios that enjoy superior growth prospects and competitive dividend yields relative to the broader index. In the long-short strategy, our expanded toolkit gives us added flexibility to manage volatility, absorb market shocks and adapt to changing conditions; from a risk-management perspective, we are very careful about position sizes and actively monitor gross and net exposures for the portfolio overall and at sector, market-cap and geographic levels.

Can you say more about gross and net exposure and your methodology?

The gross exposure of our long-short portfolio is calculated by adding the percentage of the capital used for long positions with the amount invested in short sales. Net exposure is the long percentage minus the short percentage. So, if you have $60 invested long and $40 invested short, your gross exposure is $100 (or 100%) and your net long position is $20 (or 20%). As a team, when we become cautious on the overall market environment, our first step is to seek protection for that $100 by reducing our gross exposure. Remember, this represents the total dollar value facing the market, so, in order to protect capital we reduce the total capital deployed and will increase the cash position. Next—or concurrently—we trim our net exposure. As in our long-only strategy, we can also manage risk by shifting holdings across our three investment buckets or adding to cash.

You mentioned that you can invest in fixed income. Can you elaborate?

Our team’s investment approach has always been to focus on risk-adjusted returns, with a firm belief that, in order to truly understand a company, you need to understand its capital structure—particularly its balance sheet. In fact, when I first came to Neuberger Berman, my very first hire was a research analyst with a fixed income background. Everyone on our team is well-versed in bonds, and we benefit from this knowledge when evaluating fixed income, specifically corporate securities. Generally speaking, our approach to fixed income is grounded in similar principles to our fundamental equity research. However, what makes a fixed income security “work” as an investment is generally different from a stock. So we focus our research on factors such as the ability to generate free cash flow, a demonstrated commitment to use that cash to pay down debt and an improving credit profile. This analysis mostly translates into investments in U.S. investment-grade and high-yield bonds and, occasionally, convertible bonds. Ultimately, we believe the current income received from our fixed-income investments and the subsequent compounding of these coupons allows us to build our margin of safety while being “paid to wait.”

How important is the macro environment to your approach? Are there specific metrics that may affect your positioning?

While we think of ourselves as bottom-up stock pickers, we also believe it’s important to be “macro-aware.” Given global uncertainty and the stock price volatility that accompanies it, we believe a global perspective is essential. Also, we closely monitor the credit markets, paying particular attention to the direction of high-yield credit spreads. Credit investors are always more focused on “what could go wrong,” and I think there is merit to the notion that credit leads equities.

We also actively monitor equity risk premiums, regularly assessing daily and intraday stock market movements as well as our own portfolio’s real-time behavior. In this regard, we are ensuring that our actual portfolio behavior is consistent with how we would have anticipated it to be. Simply said, we respect market volatility because it means that uncertainty around a company’s earnings—and the economy—is rising. Ultimately, this will pressure equity prices as investors seek higher returns to compensate for the greater risk they perceive they are taking, which in turn pushes down valuations. We would generally anticipate reducing exposures within the context of greater uncertainty.

An investor should consider the Fund’s investment objectives, risks and fees and expenses carefully before investing. This and other important information can be found in the Fund’s prospectus or summary prospectus, which you can obtain by calling 877.628.2583. Please read the prospectus or, if available, summary prospectus carefully before making an investment.

All stocks are subject to investment risk, including the risk that they may lose value. Small- and mid-capitalization stocks are more vulnerable to financial risks and other risks than stocks of larger companies. They also trade less frequently and in lower volume than larger company stocks, so their market prices tend to be more volatile. Large-cap stocks are subject to all the risks of stock market investing, including the risk that they may lose value.

Short sales involve selling a security the Fund does not own in anticipation that the security’s price will decline. Short sales may help hedge against general market risk to the securities held in the portfolio but theoretically present unlimited risk on an individual stock basis, since the Fund may be required to buy the security sold short at a time when the security has appreciated in value. The Fund may not always be able to close out a short position at a favorable time and price. If the Fund covers its short sale at an unfavorable price, the cover transaction is likely to reduce or eliminate any gain, or cause a loss to the Fund, as a result of the short sale.

The Fund may invest in fixed-income securities. Investment in these securities may offer opportunities for income and capital appreciation, and may also be used for temporary defensive purposes and to maintain liquidity. Fixed-income securities are subject, among other things, to the risk of the issuer’s or a guarantor’s inability to meet principal and interest payments on its obligations (i.e., credit risk) and are subject to price volatility due to such factors as interest rate sensitivity, market perception of the creditworthiness of the issuer and general market liquidity (i.e., market risk). Shares in the Fund may fluctuate based on interest rates, market condition, credit quality and other factors. In a rising interest rate environment, the value of the Fund’s fixed income investments is likely to fall.

Investing in foreign securities may involve greater risks than investing in securities of U.S. issuers, such as currency fluctuations, potential social, political or economic instability, restrictions on foreign investors, less stringent regulation and less market liquidity. Securities issued in emerging market countries may be more volatile and less liquid than securities issued in foreign countries with more developed economies or markets as such governments may be less stable and more likely to impose capital controls as well as impose additional taxes and liquidity restrictions. Exchange rate exposure and currency fluctuations could erase or augment investment results. The Fund may hedge currency risks when available though the hedging instruments may not always perform as expected.

Derivatives contracts on non-U.S. currencies are subject to exchange rate movements. Derivatives may involve risks different from, or greater than, those associated with more traditional investments. Derivatives can be highly complex, can create investment leverage and may be highly volatile, and the Fund could lose more than the amount it invests. The Fund’s investments in the futures markets also introduce the risk that its futures commission merchant (“FCM”) would default on an obligation set forth in an agreement between the Fund and the FCM, including the FCM’s obligation to return margin posted in connection with the Fund’s futures contracts. The use of options involves investment strategies and risks different from those associated with ordinary portfolio securities transactions. If the Fund’s Portfolio Manager applies a strategy at an inappropriate time or judges market conditions or trends incorrectly, options may lower the Fund’s return. Derivative instruments and short sales may also have an effect similar to that of leverage and can result in losses to the Fund that exceed the amount originally invested in the derivative instruments. Leverage may amplify changes in the Fund’s net asset value (“NAV”).

ETFs are subject to tracking error and may be unable to sell poorly performing stocks that are included in their index. ETFs may trade in the secondary market at prices below the value of their underlying portfolios and may not be liquid. Through its investment in exchange traded funds, the Fund is subject to the risks of the ETF’s investments, as well as to the ETF’s expenses.

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The individual fund names in this piece are either service marks or registered service marks of Neuberger Berman Investment Advisers LLC, an affiliate of Neuberger Berman LLC, member FINRA.