From the October 2010 issue of Investment Advisor • Subscribe!

Overexposed and Underestimated

Janus's Triton Fund focuses on an area too many advisors miss--small-cap companies that grow to mid-caps, and the returns captured along the way

We know what you're thinking; how could any Janus fund possibly qualify as "overlooked?" Their returns are the stuff of legend, as are the critical headlines the company suffers from time to time. Good or bad, one could argue the amount of publicity they receive has them dangerously close to overexposure.

The Janus Triton Fund, though, with its solid performance and relatively low assets under management, certainly qualifies. Co-portfolio managers Brian Schaub and Chad Meade are joined at the hip, so much so that "work wives" jokes invariably fly around the company's Denver headquarters; but, whatever ... the partnership works.

Schaub has been with the company for 10 years; Meade for nine. Nine years ago, when Triton Portfolio became available, the pair approached the CIO at the time and requested they be allowed to co-manage.

"We take a very collaborative approach to managing money," Schaub says. "I think there are two primary benefits to that. First, it creates checks-and-balances where if I haven't dotted all the 'Is' or crossed all the 'Ts,' Chad is there to back me up, and I'll do the same for him. Also, if we don't agree on a stock, we have a rule where we won't buy it. In most cases, when one of us disagrees, it ends up being a bad investment anyway."

All well and good, but two managers who think alike with the same investment philosophy could cause problems. How do they guard against the echo chamber?

"I'll turn the question around and say that one of the key ingredients in any successful investment process is discipline," Schaub says. "Having the two of us as co-managers with a similar philosophy and process, if we can be disciplined to the process and not stray from it in difficult times, that will serve our fund shareholders in the long term. The benefit of the discipline the co-manager structure creates far outweighs concerns of being stuck in our ways."

The discipline to which Schaub refers applies to smaller-cap companies that they believe have the opportunity to mature into the mid-cap space over time. What differentiates them from traditional small-cap offerings is that they are able to capture that entire return as the company migrates from a small cap to a mid cap. The primary tenet of their investment philosophy, according to Schaub, is the concept of "sustainable competitive advantage." Small companies that demonstrate success inevitably face competition so they believe it's important to put together a portfolio of companies that can successfully defend their turf against competition.

"Our ideal scenario is to buy a company with, say, a $1 billion market cap and own it all the way up to $10 billion in market cap," he adds. "Competitive advantage can come in many different forms, but some of our favorites are maybe a company has a patented portfolio that provides a nice barrier to entry, or maybe a company has created a database that would be difficult or costly for a competitor to recreate."

Common characteristics of companies with a sustainable competitive advantage include high barriers to entry, pricing power and differentiated products. If companies pass on price increases every year, it tells Schaub and Meade they're doing something unique or differentiated that is difficult for a competitor to recreate.

Once they're comfortable with competitive advantage and its sustainability, the team moves on to look at the addressable market.

"I think you probably hear people say they look for large addressable markets, but what differentiates us is that our ideal company has low market share today in a large market, but has the ability to materially increase market share over time," Schaub says. "If we can find a company that's going to grow from 5% market share to 20% market share, it's a fourfold increase in revenues. That's much more exciting to us than owning a company who's the market leader today with 70% market share going to 75% market share. An ancillary benefit of our focus on companies with small markets is that it creates long-duration growth. In the market environment today there are many investors who focus on short-term data points. We can find companies we think we can own for three, five or 10 years. In many cases those companies with long duration growth are undervalued by other investors."

Besides competitive advantage and market share, the duo adds the quality of the business model to the list. To them, a high-quality business model means companies that have predictable recurring revenue streams and high operating leverage, so as the top line grows and margins expand, the bottom line grows at an even faster clip.

"Management teams who are saddled with low-quality business models have to spend too much time thinking about what happened yesterday," Schaub says. "When you can find quality business models, I think it really allows you to invest with management teams who have the luxury of thinking strategically about their business and planning out for the next five to 10 years."

The team "wraps all this up" with an understanding of the risk-reward profile, which they say is more than just a point estimate of what a company is worth. It's a range of outcomes, starting with the worst case scenario about the potential downside risk. If things go well, what's the upside potential? And as they generate this possible range of outcomes, it ends up being a direct input into their portfolio construction process.

"We add just as much value, if not more, in knowing what to look out for," Schaub notes. "In small-cap investing, it's a volatile asset class. If you have a loser, it's not like the company is down 5% or 10%. Losers in small-cap investing over a five year period are down 90%. So if we can avoid the pitfalls that trip up other small-cap investors and avoid those losers, we believe it really puts us ahead of the competition on day one and almost ensures that we're going to outperform our peers."

That upside potential/downside protection, a phrase more common to the variable annuity industry, is the central philosophy in the fund's portfolio construction and risk management.

"We focus on risk before we think about reward," Meade adds. "Given the inherit volatility in the small-cap space, we think that's extremely important. Our goal is to dampen the volatility through the portfolio construction process."

Meade and Schaub do it through a diversified portfolio that typically has between 70 and 100 names, with a little over 80 currently. They look for companies across all segments of the market; it doesn't matter if it's an industrial company or a technology company or something else.

"But we're very valuation disciplined along the way," Meade says. "So we let our winners run and migrate from small-cap to mid-cap, and we do it in context of both fundamentals and valuation. The fundamentals and valuation have to make sense so that company migrates from small-cap to mid cap."

So where are they finding alpha? Today, the portfolio is overweight industrials and financials, and modestly overweight technology.

BlackBoard is a technology name that is a new position in the portfolio over the last year. The company provides e-learning infrastructure to colleges, universities and K-through-12 institutions on a global basis.

"What they're attempting to do is to help migrate education from paper-based solutions to the digital world," Schaub says. "When you look at the market they operate in, we believe it's in excess of $6 billion. Today they have less than a 10% share of that total opportunity. In terms of the competitive landscape, they've purchased the majority of their competitors, so their only meaningful competitors are open source software vendors.

"In the industrial sector, we like a company called Transdigm," adds Meade. "Not many people have heard of it, but they make mission-critical and highly engineered aerospace components. The good thing is that for 80% of the company's products, there is no competition. And they have to get FAA-certified to be put on either Boeing's platform or Airbus's platform, so the barriers to entry are very high. And when you think about highly engineered, mission-critical components, the R and D associated with that creates a nice competitive moat."

A final point Meade wished to make: Maybe the fund is overlooked because the entire mid-cap asset class is too often overlooked. This confuses them, mainly because of how attractive it could be to many advisors with smaller books of business who don't have the ability to own small-cap and mid-cap managers outright. He argues they can have the one-stop-shop by owning a mid-cap product like theirs, and not have to spend time and effort find searching for good small- and mid-cap managers.

"They can do it all at once with our Triton Portfolio. That's what gets us the most excited about being small-cap managers."

John Sullivan can be reached at jsullivan@investmentadvisor.com.

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