Wall Street and the financial media are fixated on the short term. But investors who look past the “noise” can take advantage of long-term opportunities created when the stock market temporarily undervalues well-run companies, according to George Maris of Janus Henderson Investors.
Maris took over as the lead manager for the Janus Henderson Overseas Fund JAIGX, +0.73% and the Janus Henderson Global Select Fund JORFX, +0.55% in January 2016. The co-managers of the funds are Julian McManus and Garth Yettick.
The two funds have essentially the same strategy, except that the Overseas Fund is limited to companies outside the U.S., while the Global Select Fund includes U.S. companies.
During an interview April 1, Maris said he, the funds’ co-managers and Janus Henderson’s internal proprietary equity-research team focus on “identifying the companies whose free cash flow growth is underestimated by the market.” The analysts “eliminate any accounting conventions and artificialities” in financial statements to normalize the numbers to better understand actual “cash-on-cash” returns. The team also emphasizes free cash flow growth. “We are not interested in buying declining annuities,” he said.
A company’s free cash flow is its remaining cash flow after planned capital expenditures. This is money that can be used to fund organic expansion or acquisitions, repurchase shares or increase dividends.
In addition to the bottom-up analysis used to value prospective companies for investment, Maris and the team seek an edge by doing more analysis when the overall market’s view of a stock differs from theirs.
“We think the market is smart,” Maris said, so his big question is: “What is the behavioral anomaly that is permitting the arbitrage?”
Either Maris and his team are missing something or the market is incorrect — temporarily.
“We are focused on the spread identified by our fundamental and behavioral analysis,” he said.
Three stock opportunities presented by the market
Maris discussed three stocks held by the Janus Henderson Overseas Fund and the Janus Henderson Global Select Fund that illustrate how he has been able to take advantage of special circumstances when the market is temporarily undervaluing companies:
ASML
The semiconductor-manufacturing subsector has been lucrative for long-term investors, but also difficult for short-term investors with bad timing or a lack of patience.
Here’s a three-year price chart for the iShares PHLX Semiconductor ETF SOXX, +2.21% which tracks the PHLX Semiconductor Index SOX, +2.27% :
The total return for SOXX over the past three years has been 118%. However, it was down 15% in the fourth quarter. For all of 2018, SOXX fell 6.5%, as hypersensitive investors worried about an economic slowdown.
Sell-side analysts’ ratings are based on 12-month price targets and media headlines scream panic every single day. The action for SOXX clearly illustrates how short a year can be for long-term investors in a rapidly growing industry. Maris said: “What we really focus on are three-year and five-year rolling periods.”
ASML Holding NV ASML, +2.01% is based in the Netherlands and makes equipment used by semiconductor manufacturers, including Taiwan Semiconductor TSM, +1.26% 2330, +0.20% Samsung Electronics 005930, +1.86% SSNLF, -3.07% and Intel INTC, +2.06%
Here’s a one-year price chart for the ADRs:
And a three-year chart:
With dividends reinvested, ASML’s ADRs have returned 97% over the past three years. Over the past 12 months they are up 1%, after staging a 24% rally in 2019, following a 17% fourth-quarter decline.
Here’s where the Janus Henderson team’s behavioral analysis comes into play. The market tossed ASML overboard with the rest of the semiconductor industry, despite ASML’s incredible advantage over its competitors.
“ASML is the key enabler for advancing high-performance computing, especially at the leading edge,” Maris said. “We had bumped up to a roadblock for Moore’s Law.”
Moore’s Law is named for Gordon Moore, the co-founder of Intel, who wrote a paper in 1965 projecting a doubling of the number of transistors in an integrated circuit about every year for at least a decade. In 1975, he changed the forecast to a doubling every two years.
“ASML focused on developing EUV [extreme ultraviolet lithography]. None of their competitors invested in it because they didn’t think it was possible. This allowed [the largest semiconductor manufacturers] to get back to shrinking chip sizes aggressively again,” Maris said.
”So just by pure R&D, they have a natural monopoly and now own the high-end computing segment and likely will for at least a decade,” he said.
The next question was obvious — whether or not, especially in light of this year’s partial recovery for the stock, that “monopoly” has already been built into ASML’s share price. “You’d think this would be priced in, but what is happening is, the cyclical decline in equities — [from] worries about growth, trade wars and China — has made this act like a typical semiconductor stock. People are worried about the cycle over the next six to 12 months.”
“The semiconductor business is a tough business, but the niche they have carved out has no competition,” with the above-mentioned big-three chip manufactures needing ASML “no matter what,” Maris said. So he expects many years of backlogs for the company. This makes ASML something to be committed to, long term, through whatever “noise” affects semiconductor stock prices over relatively short periods.
Takeda
Takeda Pharmaceutical 4502, +0.18% TKPHF, -0.76% is the largest industry player in Japan. The company acquired Shire PLC in January, and according to Maris, this combination has confused or discouraged some investors in Japan and Europe.
European institutional investors with mandates to stay within Europe were no longer able to hold shares of the former Shire, while leverage-averse Japanese investors didn’t like to see the combined company take on “a level of debt that would be acceptable to U.S. and European investors,” Maris said.
“So you had this very strange situation of what we thought was a great acquisition of a really good company, and you were also going to extract [cost] synergies. And they didn’t overpay for Shire. And yet, shares of Takeda were trading super low compared to competitors, especially Japanese ones, at the end of 2018,” he said.
Maris said that, after the deal was completed, Takeda was trading for about eight times estimated earnings for 2021, “with a 13% free-cash-flow yield,” while the company’s major competitors in Japan were trading for “somewhere around two to three times that multiple.”
Takeda’s shares have rallied 26% this year, but are still “trading low, at 8.4 times the 2021 estimate,” Maris said, while calling the current disconnect between the market’s view of the shares and his own “technical and short-term in nature.”
Safran
Safran SA SAF, +2.21% SAFRY, +1.88% makes aircraft parts, mainly engines. The stock has been a good performer, returning 17% this year following a 25% gain in 2018, because an accounting policy that previously held back the shares has now resulted in steady profit increases.
According to Maris, the problem was that Safran expensed the development costs of the LEAP airplane engines (co-developed with General Electric GE, -1.37% and used in Boeing BA, -1.54% 767 jets) up front, which made it take longer for the company to show profits from the sale of the new engines than many sell-side analysts would have normally expected.
“People didn’t take the time to understand the accounting,” he said, adding that the stock was “really susceptible to strange reports from the sell-side saying there were problems with the engines. Our own research showed there were no material problems with the engine,” Maris said.
“In this market, which is so short-term-oriented, nobody bothered to think about the true economics behind these engines. We thought this engine would be in all the new 737s and would really take advantage of the air-cycle jump that was benefiting Airbus AIR, +1.13% EADSY, +1.16% and Boeing,” he added.
Even with Safran now showing good profitability for the LEAP engines and the stock having risen so much, Maris said he remains “happy with the valuation because earnings trends continue to be good.” The earnings trend is supported by “operational improvements” that followed Safran’s February 2018 acquisition of French aircraft-seat maker Zodiac, at what Maris thought was a very low price.
Finally, Maris cited Safran’s decades of engine-maintenance contracts that lie ahead, as backing a steady and “really predictable” business.
Steps taken to improve performance
In addition to the stock-selection style described above, Maris emphasized two changes in portfolio-management style that have led to better performance for the Janus Henderson Overseas Fund and the Janus Henderson Global Select Fund since he took over as lead manager of both in January 2016.
First, he focused on liquidity, because the funds were holding some securities that weren’t easy to trade. This meant that a poor performer might be impossible to sell without the trade distorting the market for that particular stock and pushing it down significantly further.
“We fully understand that the world will evolve in ways that will be different from what we predict. When we are wrong, we need to accept that reality and move on. That is part of behavioral analysis,” he said, adding that “it took us two years to get out of illiquid positions with substantial losses.”
Maris also reviews the portfolio to manage risk — not only to be diversified by industry and geography, but also to “test the downside” of investment cases and assess “the risk/reward across the portfolio.”
“This is almost the way a Wall Street trading desk would work,” he said. “We worry about the fundamental risk of each stock, and we worry about balancing risk. This provides better downside protection.”
For three years through April 1, the average annual return for the Janus Henderson Overseas Fund’s class I shares JAIGX, +0.73% was 9%, compared with 9.2% for its benchmark, the MSCI All Countries World ex-USA Index 664211, +0.74% according to Morningstar. The fund has a two-star rating (out of five).
The fund returns mentioned here are after expenses and don’t include sales charges, which are quoted but typically not paid by investors purchasing the class I shares through an investment adviser or broker. Each fund has many share classes, and you should learn about them all to assess expenses and charges before considering an investment — as you should do for any mutual fund, for that matter.
The Janus Henderson Global Select Fund’s class I shares JORFX, +0.55% have a three-year average annual return of 12.8%, ahead of the 12.3% average return for its benchmark, the MSCI All Countries World Index 892400, +0.45% The class I shares for this fund are rated three stars by Morningstar.
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