From the February 2007 issue of Investment Advisor • Subscribe!

More Art Than Science

At Janus Overseas, fundamental analysis and long-term, high-conviction investing shape manager Brent Lynn's oeuvre

One popular way to diversify equity assets is with international investing; there are plenty of single-country, region, and international funds around, not to mention the closed-end fund and ETF options. But not all investors are comfortable with the concentrated risk of a single country or region, and that's where an international fund may be just the ticket.

One such fund that has performed well over the long term is Janus Overseas Fund (JAOSX), which has had an average annual return of 14.42% for the 10 years ended December 29 compared to 8.73% for the S&P/Citigroup PMI World Ex-U.S. Index; 19.19% versus 15.52% for the five-year period; 32.21% versus 20.41% for the three-year period; and a hefty 47.21% versus 24.74% for the one-year period. Standard & Poor's gives the fund four stars across the board. Kate McBride spoke to Brent Lynn, executive VP and portfolio manager of the fund, in early January.

What's your investment process for this fund?

My investment philosophy is pretty simple. I believe in two things: fundamental analysis, and high-conviction, long-term investing. On a short-term basis, markets and stocks can be very volatile and sometimes irrational, but on a long-term basis we believe stock prices will move with the earnings, cash flows, and fundamental outlooks of the companies themselves.

What do you look for in a company?

I don't believe there's a formula to this business, but there are a few criteria that may be common across many of our holdings. I would point to four investment criteria in particular: a sustainable franchise; long term growth potential at the company; value creation opportunities at that company; [and] an attractive valuation.

The single most important characteristic for a company that we invest in is [that it has] a sustainable franchise. It's pretty basic: the value of any company is the net present value of its future stream of cash flows. The more confidence you have that those cash flows will materialize, the higher valuation you can ascribe to the company. Similarly in the overseas portfolio, especially for many of our larger holdings, I'm very confident in the sustainability of their businesses, competitive advantages, and cash flows. I'm confident that Sony will continue to have a strong consumer electronics and gaming franchise five years from now. I'm confident Samsung Electronics, the big Korean semiconductor company, will remain a dominant player in memory semiconductors five years from now [and] that Roche, the Swiss pharmaceutical company, will be a leader in cancer drugs five years from now. I'm confident that Potash Corp. of Saskatchewan, the world's leading fertilizer company, will still be the dominant player in potash fertilizer five years from now, even 10 years from now. Because of this confidence in its competitive advantages and the sustainability of its business, I'm willing to pay a higher valuation for that company's cash-flow stream.

The second criteria is the long-term growth potential--we're growth stock managers, so we're looking for companies that have medium- to long-term growth that is at least higher than industry averages. The best kind of growth is when a company is positioned in a growing industry or a growing market and on top of that has the ability to gain significant market share and so grow much faster than the market that it's involved in. Then what really gets me jazzed is when we see situations for what I call open-ended growth.

Are there examples?

If we're thinking about the top of the portfolio, say we talk about Li & Fung, Hong Kong's leading manufacturing logistics company. It provides manufacturing logistics for primarily U.S., but also European, companies. [Retailers] may have their shirts or pants that are made in a factory in China or Vietnam, and they will use Li & Fung as the sourcer for these clothes. With Li & Fung's very sophisticated logistics network and a network of manufacturing facilities in Asia and around the world, they can get the raw materials, and have them sewn in the right colors, and put that all together and bring them to the U.S. in a very efficient manner. But on top of that, we think there is open-ended upside from making acquisitions of many U.S., New York-based importers, who are much less efficient than Li & Fung, and on top of that there is the opportunity to penetrate some very big retailers like Wal-Mart. There's also open-ended upside from large deals like one that it recently signed with a leading German department store company.

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Your third criteria, value creation?

That, to me, means that management uses the cash in a smart way. The best way that management can use cash is if the company has very high return, organic growth opportunities. [One] company that can do that in a significant [way] is CVRD [Companhia Vale Do Rio Doce], (ADR on NYSE: RIO), the Brazilian mining company that is the world's largest iron ore exporter. Iron ore goes primarily into the production of steel. Not only is CVRD the low-cost producer today, it also has low-cost mines where the capacity can expand very significantly over the next three to five years. At current iron ore prices, the return is 30%, 40%, 50%, or even higher on investment from these expansions. The key reason is that it already has much of the rail and port infrastructure in place so it's simply a function, primarily, of expanding the mines and then they get some more rail cars, but it's much cheaper than greenfield expansions by any of its competitors, so [CVRD's] cost per ton is much lower and therefore its return on investment is much higher. That, to me, is very exciting because they literally can put billions of dollars to work in extremely high-return projects and as investors we'll take that any day of the week!

A second best use of cash is very accretive and strategic acquisitions. CVRD recently bought the Western world's largest nickel company, Inco, in Canada, and we believe that this is another high-return use of cash for CVRD--it might not be quite as high as some of its organic projects but even if nickel prices fall significantly from here, the return on investment from this acquisition of INCO should be very high.

The third best use of cash, if they don't have high-return organic opportunities, if they don't have inorganic acquisition opportunities, and they don't need the cash to pay down debt, then they should give it back to shareholders, either in the form of dividends or share repurchases. It's important to us that management has shareholders' interest in mind in terms of their use of cash, and a company that is hoarding its cash for a rainy day when it's not necessary, or perhaps uses the cash on a non-strategic or low-return acquisition--these are the kinds of situations that we're not favorable on.

Then the fourth criteria--valuation. I don't believe there's a single valuation criteria or methodology that you can apply to every company, every single situation, so we try to use multiple valuation approaches and hope that they triangulate towards a similar target price. We typically use a DCF [discounted cash flow] approach. In some cases we'll also look at price-to NAV, P/E, enterprise value-to-EBITDA, and sum-of-the-parts. It depends on the company.

Is there a company where your thesis just didn't work out as planned?

One example is Infineon Technologies, (ADRs on NYSE: IFX), a German semiconductor company. It's really in two businesses, memory semiconductors that go in PCs on the DRAM side, and a logic semiconductor business, semiconductors that go into automobiles, telecom, and a variety of other uses...We felt that there was a reasonable chance that Infineon could, at least, significantly narrow the gap in costs of its memory semiconductors with Samsung--not fully but partially--and by partially closing the gap, the swing in its cash flows would be dramatic. On top of that, we thought that the valuation of Infineon gave very little credit to its logic business, and in particular the chips that go into the automobile sector; it was really a pretty stable, solid business.

This is what I would call a valuation story and a turnaround situation where we thought that management would be able to make significant strides in cutting costs and they had a full roadmap for cutting the costs. Well, several quarters went by and it became apparent that the cost situation for Infineon was more dire than we had understood. Despite the fact that we thought when we bought it that the stock was inexpensive, it became even more inexpensive and we lost money. We decided that our thesis was just fundamentally wrong and therefore we sold the position.

Were would this fund fit in an equity portfolio?

The one thing I would stress with regard to the Overseas Fund is that I clearly manage the fund with a long-term time horizon and I'm willing to make high-conviction investments, if we have done the fundamental research, in the belief that our fund holders will get paid, over a long period of time. In shorter periods of time, however, there can be lots of volatility in the markets and theOverseas Fund itself can be very volatile.

What else do advisors need to know?

In line with my comments about the fund being volatile, it's because of the fund's exposure to emerging markets; over the past few years approximately 40% of the fund has been invested in the emerging markets. We've made these investments on a stock-by-stock basis and we strongly believe in the prospects of each company that we've invested in. Nevertheless, the aggregate exposure to the emerging markets makes the fund susceptible to short-term volatility and I think it's important that any investors be aware of that.

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