Five key areas come into play when considering a potential investment.
- Return on invested capital
When we first look at a company and think about whether it could be an attractive investment, our analysis always starts with building an understanding of its return on invested capital (ROIC) characteristics. We always ask ourselves: Is this a good business – does it have a high and sustainable ROIC? Or, if not: Can it become a better business – has it got potential to improve its ROIC profile? We are rarely interested in investing in companies that do not meet one of these criteria.
There are many facets to ROIC analysis but most of the work involves looking at historic margins structures, working capital qualities and fixed capital needs. We then try to ascertain whether the conditions that have existed to enable a particular ROIC profile are likely to be short-lived or sustainable. We ask ourselves questions, such as: Are these barriers to entry being challenged? Is the competitive environment getting tougher or easier? Does this business have pricing power and can it be maintained? This is complex analysis that takes up a lot of our time.
"Good is the enemy of great” – James Collins
This is a concept articulated by James Collins in his book, 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 – but most will never transition to greatness. Every now and then, we will come across a really special company that has such a powerful market position or attractive product that they transcend being merely “good”. Finding these companies is something that really drives us.
- Opportunities for spending
This is an important area that looks into where a business deploys its capital, the ROIC it can generate from it and the scale of investment opportunities it has. Ideally, what we want are high ROIC businesses that can deploy lots of capital in further high ROIC opportunities. However, these are rare.
At the other extreme would be low ROIC companies that have plenty of opportunities to deploy lots of capital – these tend to be highly value-destructive. These two examples highlight why a focus on “growth” is far too simplistic. In some some cases growth is highly attractive and should be encouraged, while in other cases it 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 faced with in the future.
The reinvestment moat
Outstanding companies are often described as having a “moat”, implying 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 group further. Those with a “legacy moat” earn strong ROIC but with no compelling opportunities to deploy incremental capital at similar ROIC. Those with a “reinvestment moat” have all the advantages of a legacy moat but with opportunities to deploy incremental capital at high ROIC. Businesses with long runways 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. It takes a lot of work and discipline to identify these true compounding machines. In future write-ups we will outline the factors we look for and how many of these “bargains” hide in plain sight.
Can management be trusted? This is a simple question that we are always asking. We like to fully understand the background of a management team, where they worked before, the history of their capital allocation decisions and whether there is a pattern of value-destructive or creative M&A?
It is also important for us to understand the incentive structure for management teams. 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 regularly meeting management teams as a crucial part of our job. It enables us to look them in the eye, question them over their capital allocation policy and get a feel for their temperament and the things they are driven by.
“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
The skin in the game is a concept recently popularised by author Nassim Taleb but it is not new in the world of investment. Warren Buffett has for years defended the idea that managers should be shareholders of the companies they manage and invest their money along with other shareholders. In this way, they will have a clear incentive to not make decisions that destroy value for their shareholders. When looking for companies with appropriate capital allocation, we often find companies in which the ownership is controlled by its management team but realise this is not always possible. Hence, we often focus on management incentives.
- Behavioural biases
We think it is extremely important to analyse mistakes based on forecasts as well as actual returns. 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 much of an impact it could have.
In addition, there are several ways in which our analysis can become negatively impacted by behavioural biases. We see this as a very important area and always try to add an element of introspection into our work. We will be writing on this subject in a future thought piece.
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 show how strong or weak our investment thesis is. The harder it is to come up with plausible pre-mortem scenarios, the more likely an investment is to work well.
Valuation is always something we consider carefully. We try to look at it through a few different lenses and do not rely on one method. For example, we will almost always construct a discounted cash flow (DCF) based analysis, usually considering several different sets of assumptions. We will then compare valuations to similar companies both within Europe and elsewhere; price-to-book multiples tally with our ROIC-focused approach and earnings and cash flow multiples are also considered.
Finally, we may consider a sum-of-the-parts (SOTP) perspective or even construct a simple leveraged buyout (LBO) model to consider what the business may be worth to a potential acquirer. We generally take the view that no one valuation method is “the right one” and a blended approach is best.
“Confronted with a challenge to distil the secret of sound investment into three words, we venture the motto, margin of safety” – Ben Graham
Seth Klarman comments that the best investments tend to have a considerable margin of safety. This is Ben Graham’s concept of buying at enough discount that even bad luck or the vicissitudes of the business cycle would not derail an investment. As when you build a bridge that can hold 30-ton trucks but only drive 10-ton trucks across it, you would never want your investment fortunes to be dependent on everything going perfectly well, every assumption proving accurate, every break going your way. Hence, 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 ones that tend to cause pain to shareholders.
Janus Henderson have been managing investment trusts since 1934 – over 80 years. Janus Henderson are one of the largest managers of investment trusts in the UK, managing a well-established range of 13 investment trusts covering different geographies and asset classes. We take pride in what we do and care passionately about the quality of our products and the services we provide, helping clients achieve their long-term financial goals is at the heart of what we do. With a dedicated team, solely focused on investment trusts, we provide extensive knowledge and experience. This is reflected in our Knowledge. Shared ethos, we believe in the sharing of expert insight for better investment and business decisions.