Competitive Advantage

Janus Capital tells BENCHMARK how its investment philosophy leads it to undervalued gems.

Patrick Brophy

Jonathan D. Coleman

Jonathan D. Coleman

Maneesh Modi

Maneesh Modi

 


Investment process

BENCHMARK (BM): How do you generate stock picking ideas?

Janus Capital Group (JCG): We generate new ideas from several sources, but most of our new ideas come from our bottom-up process – meeting with companies, attending industry conferences and looking at an entire industry’s supply chain to find the most interesting companies within a space. We supplement this with quantitative screens as well. Our experienced group of analysts who meet with hundreds of small cap companies, many of which end up on our watch list, often proves to be fertile ground for new ideas.

BM: What are the characteristics of the companies you like?

JCG: The key metric we’re focused on is return on capital. If a company has high returns on capital, then they’re likely doing something that differentiates them and is hard for others to replicate. That gets us excited. Beyond this, we look at the company’s potential for growth, its free cash generation and how much we are paying for that. We are a US focused fund, so geography isn’t really a screening criterion.

BM: What qualities do you look for in a company’s management?

JCG: When meeting with company management, there are a few things that can excite us: 1) executives that understand competitive advantage and how to create it; 2) executives that understand return on capital and make decisions based on that; 3) being able to see a long runway for growth in a company’s existing and adjacent markets; and 4) CEO’s that are intellectually honest and have created a strong culture at their companies.

BM: How are price targets being set and how are they re-allocated after targets are met?

JCG: Price targets are set using discount cash flow analysis, though we check this with other metrics (implied P/E ratio, competitor multiples, etc.). We also conduct scenario analysis to understand the upside and downside risks in the case of better than expected or worse than expected outcomes. As a company nears our price target, we generally start to trim our position and recycle the proceeds into more attractive ideas. For a truly special company, we may hold on to our position, even after the price reaches our target, recognizing that valuation is an imprecise science and great companies find ways to create value that we can’t always foresee.

BM: What is the average holding horizon – what happens when these small cap winners have grown into the mid-cap territory? Do you hang on, trim or add to their price targets? What is the trimming policy?

JCG: On average, a name is in the portfolio for about three years though its position size will vary depending on the stock’s relative risk/reward. As companies transition from small to mid-cap, we’ll generally start trimming our position and recycle the proceeds into smaller cap names.

BM: What is the average number of holdings and turnover, and what triggers them? What happens when the fundamentals of a company start deteriorating? How is exit of a stock executed?

JCG: Holdings range from 80-120 names. When the fundamentals of one of our holdings start to deteriorate, what we do depends on whether the deterioration is caused by macro or company specific factors. If it’s caused by macro factors, we’ll probably be a little more forgiving knowing that the macro-economy is hard to predict and is likely to rebound at some point. If, however, the issue is caused by poor execution, we will revisit our analysis and afterwards will decide whether the situation is fixable or if we should sell our position and move on.

BM: Does the fund have sector and capacity position size constraints? Can you explain why the fund continues to be significantly overweight in industrials and technology, especially as some underlying holdings are showing relatively above-average price multiples?

JCG: Typically, we limit our largest position to 3%-4% of the fund in order to minimize the negative impact any one holding can have on our performance. Historically, we’ve been able to find good ideas in all sectors, but have been overweight in industrials and technology. Within industrials, we have been able to find a lot of high-quality companies that compete in fragmented industries and this fragmentation will allow our companies to grow and take share for a long period of time. Within technology, we own several software as a service (SaaS) companies. There are two main things we like about these businesses: one is that we see software continuing to increase its penetration into the workflows of all industries; second, most of these companies operate under a subscription business model which provides stability and visibility to their revenues.

BM: Please share your risk control process, especially during short-term fluctuations.

JCG: We believe there are two core components of our risk mitigation strategy. The first is investing in high-quality companies with strong competitive barriers to entry, large addressable markets and high returns on capital at appropriate valuations. The second is a portfolio construction process that controls risk by seeking to place the steadier companies and business models towards the top of the portfolio, while also getting exposure to fast growth companies with a wider range of risk and reward toward the bottom half of the portfolio.

BM: How will the recent departures of managers Brian Schaub and Chad Meade, who have jointly taken the funds to new heights over the past three-year period, affect current strategies?

JCG: The philosophy and process of the fund remains unchanged with the departure of the two managers. The entire team of seven research analysts supporting the fund is exactly the same. Additionally, Jonathan Coleman pioneered the high quality, risk-controlled approach to small cap investing at Janus over a decade ago when he first managed in this asset class. He hired, trained and promoted Schaub and Meade and
they both followed an identical approach to that which Coleman had established. This approach has resulted in strong risk-adjusted returns across a long period of time under various portfolio managers.

US outlook

BM: Are you still spotting strong pricing power in small caps and which sector appears to be standing out in 2014? Where do you see key drivers for growth in small caps for 2014?

JCG: We still see pricing power in well positioned small cap companies with strong competitive advantages versus their peers. We believe that earnings growth will be the predominant driver of small company performance in 2014, coming off 2013 when P/E multiple expansions were responsible for a large percentage of the return in the small cap market.

BM: What is the house’s view on small-caps for 2014?

JCG: We view the risk-reward for small caps as more balanced in 2014, compared to 2013, when the small cap market experienced very robust returns. Valuations are higher than average relative to historical norms. We believe that individual security selection will matter most in 2014, and we feel that plays to our process: investing in high-quality small cap companies with strong competitive barriers to entry and constructing a portfolio to mitigate downside risk.

Real estate fund

BM: Please explain your allocation to various subsectors. Is the fund likely to maintain its growth levels in 2014?

JCG: Currently, we are overweight in the following subsectors: real estate services, mortgage REITs, industrial REITs and homebuilders. This is a function of our individual security selection and our belief that these specific areas represent the greatest opportunity for the real estate market to outperform over the course of 2014. Specifically, we look at the regional dynamics to determine which specific subsector provides the greatest potential in regards to creating value for our shareholders. Overall, our allocation to subsectors is primarily dictated by the individual security selection with a secondary focus on the top-down opportunity represented by the subsector allocation.

Although the Janus Global Real Estate Strategy has little exposure to residential real estate, as we prefer the stability of the commercial sector, we believe that overall rental housing has been a good investment in the residential real estate market. The reason we believe this to be so is, as the economic recession decimated so many homeowners’ balance sheets, the belief that home ownership always provided long-term value has become less valid.

Instead, many people, especially in the US, believe that they have better opportunity cost in investing in other assets as opposed to their primary residence.

BM: Can you explain the circumstances where you are willing to pay for relatively above-average price multiples?

JCG: We seek to add value versus the benchmark by actively pursuing pricing inefficiencies in real estate and real estate-related securities. Our bottom-up, fundamental research process focuses on real estate companies with the best locations and highest quality management teams, as well as companies undervalued by the market and those benefitting from improving fundamentals – both from a company and real estate market perspective.BM


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