What are the characteristics of a company potentially capable of generating reliable growth year after year? Here, Jamie Ross, manager of the Janus Henderson Horizon Pan European Equity Fund, gives insight into the team’s investment process, designed to identify good quality businesses capable of delivering sustainable and high returns over time.
When we first look at a company and think about whether it could be an attractive investment, our analysis starts with building an understanding of its return on invested capital (ROIC). We ask ourselves: is this a good business (does it have a high and sustainable ROIC)? Or if not, can it become a better business (does it have potential to improve its ROIC profile)? We are rarely interested in investing in companies that do not meet one of these two criteria.
There are many facets to ROIC analysis, but the majority of work involves looking at historic margins, working capital characteristics and fixed capital needs. We must try to ascertain whether the conditions that have existed to enable a particular ROIC profile are likely to be transient or sustainable in nature. Are barriers to entry being challenged? Is the competitive environment getting tougher or easier? Does this business have defendable pricing power? These are all important questions and form part of the complex analysis that necessarily takes up a lot of our time.
"Good is the enemy of great.” – James Collins.
"Good is the enemy of great". This is a concept that James Collins articulates in his book entitled Good to Great – Why Some Companies Make the Leap... and Others Don't. We see many companies that are simply ‘good’; the founders are capable, the end markets seem strong, the customers like the product, etc. But the majority of these companies will never be able to transition across to becoming ‘great’. Every now and then, we find a really special business that has such a powerful market position or such an attractive product that they transcend being merely good. Finding these companies is something that really drives us.
Next, we look into where a business is deploying capital, the ROIC it is able to generate from this investment and the scale of investment opportunities that it has. Ideally, we want to find high ROIC businesses with plenty of high ROIC investment opportunities. However, these types of businesses are rare. At the other extreme are ‘low ROIC’ businesses repeatedly deploying capital with little or no gain; these companies can often be value destructive.
These two examples highlight why a focus on ‘growth’ is far too simplistic; in some cases growth is highly attractive and should be encouraged, while in other cases the model for growth can be unattractive and should be avoided at all costs. We spend a lot of time thinking about how companies are investing and what investment opportunities they may be presented with in the future.
The ‘reinvestment moat’
Outstanding companies are often described as having a ‘moat’, a term popularised by Warren Buffett. It implies a durable competitive advantage that enables a business to earn a high ROIC for many years. These businesses are very rare.
We agree with the Charlie Munger-inspired approach of splitting the category further into those businesses with ‘legacy moats’ and those with ‘reinvestment moats’. Most businesses with a durable competitive advantage belong in the legacy moat category, meaning that while companies may generate a strong ROIC, they do not have compelling opportunities to deploy incremental capital at similar ROIC. For us, those companies classified as having a reinvestment moat are a far more attractive prospect. These businesses have all of the advantages of a legacy moat, but also have opportunities to deploy incremental capital with the prospect of a high ROIC.
Businesses with long pipelines of high-ROIC investment opportunities can compound capital for long stretches of time, and a portfolio of these exceptional businesses is likely to produce years of strong returns.
We like to fully understand the history of a particular management team. Can management be trusted? This is a simple question that we always ask ourselves. Where have they worked before? What is the history of their capital allocation decisions? Is there a history of value destructive merger and acquisition (M&A) activity?
It is also important that we understand the incentive structure for management. What are the key metrics they have to focus on to get paid? Do they own lots of equity in the company? Do they care if the share price goes up or down? This area of analysis highlights one of the reasons why we see meeting management teams on a regular basis as a crucial part of our job. It enables us to look them in the eye, question them over capital allocation policy and get a feel for their temperament and motivation.
Fundamental challenges for managers
“Two companies with identical operating results and different approaches to allocating capital will derive two very different long-term outcomes for shareholders” – William N. Thorndike
In his book The Outsiders, William Thorndike teaches us through eight examples how the capital allocation of a company’s managers can make a significant difference to shareholders over time. As Thorndike explains, a company’s management team have five fundamental choices when it comes to allocating capital. They can reinvest in the business, acquire other companies, pay down debt, issue dividends and repurchase their own shares.
Equally important to the choices made are the way they are financed. Issuing debt, raising equity capital or using cash generated by the business – each option will have a different impact on the shareholder. Capital allocation is not a trivial issue and must be given the attention it deserves as part of a sound investment process.
Through reading historic financial statements we try to assess whether capital deployment has been value accretive or destructive. Not surprisingly, what we have found out as we conduct our research is that alignment of interests goes a long way into predicting whether management’s actions will be value creative or destructive.
“What matters isn’t what a person has or doesn’t have; it is what he or she is afraid of losing” — Nassim N. Taleb
‘Skin in the game’ is a concept recently popularised by Nassim Taleb, an author we closely follow, in his book Skin in the Game: Hidden Asymmetries in Daily Life. However, it is not a new concept in the world of investment. Warren Buffett has advocated for years that managers should be shareholders of the companies they represent, investing their money alongside other shareholders. In this way, they will have a clear incentive not to make decisions that destroy value.
For this reason, when looking for companies with appropriate capital allocation, we often find companies in which the management team has a significant stake, in many cases the founding family. This is not possible for the entire set of opportunities we consider, hence why we often focus on management incentives.
"Show me the incentive and I’ll show you the outcome" – Charlie Munger
The business world is no stranger to the power of objectives or incentives. A management team with an incentive system based around generating value for its shareholders will tend to allocate capital sensibly. A good remuneration system should have long-term incentives aimed at maximising shareholder returns.
This can be achieved by establishing direct incentives, such as variable remuneration based on movement of the company’s stock price – either in absolute terms or by comparison to its peers. However, we prefer indirect incentives focused on long-term ROIC, profitability, cash generation, etc. In the end, if the business performs well operationally, the share price will end up reflecting this. Indirect incentives should also stop managers from focusing excessively on the evolution of the share price in the short term.
We think it is extremely important to analyse mistakes on an ex-ante basis as well as on an ex-post basis. In our opinion, investors tend to carry out far more of the latter (post-mortem) than the former (pre-mortem). Our pre-mortem analysis, which is a formal part of our investment process, forces us to consider where an investment could go wrong and how material an impact this event/occurrence could have. There are several ways in which any analysis can become negatively impacted by behavioural biases. We believe this is a very important area and we always try to add an element of introspection into our work.
This concept is taken from the discipline of social psychology. The exercise involves reverse-engineering explanations for how a company could hypothetically become the worst investment we have ever made. It is an interesting exercise because it can test the strength or weakness of an investment thesis; the harder it is to come up with a plausible pre-mortem scenario, the more likely it is that an investment can work well.
Finally, although it is never the first thing we consider, valuation is always something that we carefully assess before making a final decision. We try to look at valuation through a few different lenses, rather than relying on one particular method. For example, we will almost always construct a discounted cash flow based analysis, considering several different sets of assumptions. We will then compare valuations to similar companies, both within Europe and beyond. Price-to-book multiples tally with our ROIC-focused approach, while earnings and cash flow multiples are also considered. We may consider a ‘sum-of-the-parts’ perspective or even construct a simple Leveraged Buy-Out model to assess what the business may be worth to a potential buyer. We generally take the view that no single valuation method covers all the bases and a blended approach is best.
Margin of safety
“Confronted with a challenge to distil the secret of sound investment into three words, we venture the motto – Margin of Safety” – Benjamin Graham
Seth Klarman comments that the best investments tend to have a considerable margin of safety. This was investor Benjamin Graham’s strategy – buying at a sufficient discount that bad luck or the vicissitudes of the business cycle are unlikely to derail an investment. Just as when you build a bridge that can hold 30-ton trucks, but only drive 10-ton trucks across it, you never want your investment fortunes to be dependent on a perfect environment, with every assumption proving accurate, and every break going your way.
Scenario analysis and stress testing are crucial parts of our valuation work. We try to keep estimates conservative and focus on high-quality companies where business surprises tend to be positive, rather than cause pain to shareholders