Valuation is never the first thing to consider and is rarely the most important part of an investment case on a company, according to Janus Henderson Investors’ Jamie Ross. 
Ross (pictured), who manages the Henderson Euro Trust, said that no one valuation method is “the right one,” and that a blended approach is best.
Below, the European equity specialist highlights his five major criteria for deciding whether a given company could be an attractive investment.
Return on Invested Capital (ROIC)
Getting an understanding of the company’s return on invested capital (ROIC) characteristics is the starting point of Ross’ assessment.
The ratio is a measure of the profitability and value-creation potential of a company after taking into account the amount of initial capital invested.
“We always ask ourselves ‘is this a good business?’ – i.e. high and sustainable ROIC – or, if not, ‘can it become a better business?’ – i.e. has it got potential to improve its ROIC profile? ”he said.
If a company does not meet one of these criteria, it’s normally discarded.
The portfolio manager noted that there are many facets to ROIC analysis, and that the majority of the work involves looking at historic margin structures, working capital, and fixed capital needs.
“We then ascertain whether the conditions that have existed to enable a particular ROIC profile are likely to be transient or sustainable in nature,” he explained.
Other questions Ross asks include: ‘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?’
Opportunities for the deployment of capital
The next step is to probe where the company is deploying the ROIC and the extent of investment opportunities available to it.
“Ideally, what we want to find is high ROIC businesses that are able to deploy lots of capital in further high ROIC opportunities,” Ross said. “However, these extremely attractive types of businesses are rare.”
At the other extreme, the Henderson Euro Trust manager pointed out, would be low ROIC businesses that have plenty of opportunities to deploy capital, adding that these companies tend to be highly value-destructive.
“These two examples highlight why a focus on ‘growth’ is far too simplistic,” he said. “In some cases, growth is highly attractive and should be encouraged, whilst in other cases growth can be unattractive and should be avoided at all costs.”
Ross and his team spend a lot of time thinking about how companies are investing and what investment opportunities they may be faced with in the future.
Management
“Can management be trusted?” That is a simple question investors should always be asking themselves, according to Ross.
He said he likes to fully understand the history of a management team, asking himself: “Where have they worked before? What is the history of their capital allocation decisions? Is there a history of value-creative or value-destructive M&A?”
Ross noted it is also important 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?”
He said this area of analysis highlights one of the reasons why meeting management teams on a regular basis is a crucial part of his job. “It enables us to look them in the eye, question them over capital allocation policy, and get a feel for their temperament and drive.”
Where we might be wrong: behavioural biases
“We think that it is extremely important to analyse mistakes on an ex-ante basis as well as on an ex-post basis,” he said. “In our opinion, investors tend to carry out far more of the latter – post-mortem – than the former – ‘pre-mortem’.”
He explained that pre-mortem analysis, which is a formal part of the investment process, forces an investor to consider where an investment could go wrong and how material an impact an event could have.
Valuation
The Janus Henderson manager indicated that although valuation should not be the first or the most important part of an investment process, “valuation is always something we that we consider carefully”.
He said his team looks at valuation through a few different lenses and does not rely on one particular method.
“For example, we will almost always construct a discounted-cash-flow-based analysis, usually considering several different sets of assumptions,” he explained.
“We then compare valuations to similar companies both within Europe and in other geographies as well,” he said. “Price-to-book multiples tally with our ROIC-focused approach and earnings, and cash flow multiples are also considered.”
In the final phase of the process, Ross may consider a sum-of-the parts (SOTP) perspective or even construct a simple leveraged buy-out (LBO) model to evaluate what the business may be worth to a potential acquirer.
Ross has been a manager on the £245.2m Henderson Euro Trust since last September having taken over from launch manager Tim Stevenson earlier this year upon the latter’s retirement.
Since Ross joined the trust, it has made a total return of 4.89 per cent against a rise of 4.99 per cent for the FTSE World Europe ex UK index and a 1.59 per cent gain for the average IT Europe peer.
Performance of trust vs sector & benchmark under Ross
Source: FE Analytics
The fund is currently trading at a 10.1 per cent discount to net asset value (NAV), is 3 per cent geared, yields 2.7 per cent, and has ongoing charges of 0.84 per cent.