Q:  What is your investment philosophy? A: My philosophy’s based on three major things: my small-cap experience, which has taught me that there are both extraordinary risks and extraordinary rewards when investing in small and midcap securities; a belief that we can find growth in many different areas of the market and we should construct the portfolio in an eclectic and diverse manner; and the importance of high-quality growth with a strong emphasis on the returns of the enterprise, not solely on EPS growth. Our goal is to run an all-weather fund, to perform consistently over time, and to protect capital in difficult markets and increase it in good markets. Q:  What is your definition of highquality growth? A: Companies that can generate return on invested capital in excess to their weighted average cost of capital. Companies with increasing spread of ROIC minus WACC are the ones that really create value. Many small companies get trapped into the idea that they have to grow earnings at 20% a year and sometimes that approach leads to stupid decisions, like inappropriate acquisitions, entering a business that has lower margin structures or is more capital intensive, or overexpansion. We want to invest in companies that are growing in the right way. If you are growing your EPS, but your ROIC is declining, you are not creating value for shareholders. Q:  Do you consider leverage a positive or a negative factor? A: It depends on the case. For certain business, where the non-leveraged returns are low, some debt on the balance sheet is a positive factor. One of our winners is a company that has effectively used leverage, but that’s not required for other types of enterprises with inherently higher return profile. Q:  What is your philosophy in terms of paying for growth? Do you follow GARP or another type of strategy? A: In terms of valuation, we’re looking for free cash flow yield. Our cash flow yield requirements are lower for highly predictable businesses and higher for more cyclical businesses. Overall, we like to invest in companies that have 5% to 10% free cash flow yield. We spend a lot of time on discounted cash flow analysis and create multiple DCF scenarios. Our baseline is what the market is implying today about its expectations. Then we have 3 different scenarios: an optimistic, a pessimistic, and the most likely. Those scenarios are based on fundamental research, company visits, talking to all levels of management, to workers, competitors, customers, and suppliers. This analysis feeds into our assumption of the likely growth rate and the margin structure of the company in the future. We buy stocks when we think that the market is underestimating the potential of the company and when the most likely scenario in the DCF provides an upside of 15% to 20% or more. Q:  If a stock is underperforming your expectations, would you stick to it through several rough quarters if you still believe in the growth story? A: When we have expectations of future growth, we’re willing to be patient with a company, but it depends on the case. If we see future growth slowing or the value of the stock in the marketplace being fair, we may trim it down. But as long as the competitive nature of the industry and the company hasn't changed, we’re willing to be patient. Q:  How do you implement your philosophy into an investment strategy? A: I’m looking for large and growing markets, not for companies locked into small niche markets. I emphasize predictable revenue streams and businesses that have lots of smaller transactions that occur throughout the quarter, versus a few large transactions that occur at the end of the quarter. We pay close attention to operating margins. Companies should be able to grow their margins in good times and defend them in difficult times. In the last several years, people realized that many industries, like the IT industry, are more cyclical than previously expected, so the broad approach to portfolio construction is crucial. Concentrating in just one or two industries is a risk that I don't want to take. We are also looking for improving working capital. Frequently, the balance sheet can be a precursor to problems that might appear in the income statement in later quarters. Companies that are growing their inventory or their accounts receivable faster than the sales, undergo a deterioration of the business quality. Overall, the companies that we invest in should be growing their revenues, expanding their margins, and thus increasing their net operating profit after tax. The denominator of this equation is the invested capital base. If net operating profit after tax is increasing and the invested capital base is shrinking, this leads to an improving ROIC. Q:  What are the milestones of the portfolio construction process? A: We typically hold between 90 and 100 positions in the portfolio. That's a change from the previous manager, who was running between 40 and 50 names, but that concentration was too extreme for my philosophy. The maximum position size is at 3% of the assets, which gives me the comfort that even if we make a mistake in the investment analysis, we can still recover without materially hurting the performance of the fund for a long time. For example, we have had a spectacular disaster that is illustrative of the risks of small and mid-cap investing. Elan, a biotech company, was down more than 70% in one day this year. The company received approval for a multiple sclerosis drug called Tysabri, but there were two deaths in a clinical trial when combining it with another approved drug. Both drugs have shown to be safe on their own and there was no reason to believe that together they would cause life-threatening problems. Elan didn’t have any other marketable drugs and had debt outstanding due in 2008, so we sold the stock. But the position in the portfolio was very small, only about 0.35%. It was a tough day and it cost us 0.20% in the overall performance, but it shows the virtue of the broad portfolio construction process. Q:  What do you think are the inherent advantages and disadvantages of the market sector you work in? A: I feel very fortunate to be a manager in the mid-cap space. The mid-cap world is like the middle child that is occasionally overlooked, but inappropriately so. It has the best attributes of both the small and the large-cap worlds and very few of the drawbacks. It is a very wide spot in which you can find growth companies on their way to doing greater things. The revenue base is still relatively small as compared to large caps, so there is attractive potential revenue growth. Unlike the small caps, these companies are already mature, with experienced management teams, and better infrastructure. They have graduated out of some of the problems that small-caps face when undergoing fast growth. At some point the entrepreneurial culture has to morph into corporate culture and that often creates difficulties for small companies. But the risk of being wrong can be severe, just like in the small-cap space. If you are investing in Microsoft, there is no single piece of news that can cause the company to drop 30% or 40% overnight. Unfortunately, in our world, there are events that can lead to a substantial drop. It is prudent to be cognizant of that reality and that's what I try to do with the portfolio construction. Q:  You work in a market segment that is not thoroughly researched by Wall Street. Does the alpha of your return reflect your research process? A: One of the advantages of the bear market for growth stocks was that a lot of Wall Street firms decreased their coverage of smaller and mid-cap stocks. That's a great benefit for us, because it creates opportunities to find undiscovered gems. Janus is a very research-focused firm and I feel very lucky as the prime beneficiary of the work of the analytical team. Over the last 4 years Janus has increased the size of its research team by over 50%. My research team consists of six dedicated small and mid-cap analysts, but I am also able to draw upon the resources of over 32 analysts. About half of the stocks in the portfolio are covered by one of the other 32 analysts in the firm, so I view myself as having research staff of about 40 people. Analysts are heavily motivated to find ideas that can significantly outperform. A $5-billion company has a much better chance of 30% or 40% appreciation than a $200-billion market cap company and analysts are encouraged to find those with the big potential. Q:  What kind of analysis do you emphasize? Regimented quantitative work, fundamental analysis, or macro view analysis? A: We try to blend a number of these philosophies. The core has always been bottom-up research - going out there, visiting the companies, meeting with all levels of management within the organization, calling customers, competitors, suppliers, industry experts, and making sure that what the company is telling you is not too optimistically biased. Nevertheless, we look at macroeconomic indicators and discuss them, because it is prudent to understand the environment in which the company is operating. Looking at the financial statements, we make very detailed financial modeling for most companies we own. The DCF is only the end result of that financial modeling, which includes product lines, divisions, growth rates, margin opportunities by division and product if possible. We are building that into a revenue assumption that feeds into forward-looking income statement, balance sheet and cash flow statement. Q:  Could you give us some examples of stock picks where your research process worked out well? A: Marvell Technology, the semiconductor company, is a perfect example of an enterprise that can grow well even in tough times. It navigated through a very difficult market in 2001 - 2003 by finding new end markets for its products. It was primarily focused on the storage market within PCs, but moved its technology to the laptop market, wireless Internet access market and to power management products. In most recent quarters, the Apple iPod and the new Sony Playstation Portable have also started using Marvell's technology. The company has grown its revenue from $140 million in 2001 to over $800 million last year. Most of the growth was achieved on an internal basis; there was only one acquisition of $100 million revenue. Operating margin has increased to more than 20% and profits have followed on. It is primarily an organic growth story. It is about the ability to innovate and enter new markets that drive growth even when times are rough. Q:  What is your sell discipline? A: When we realize that our assumptions for an investment have been incorrect, we sell to move on to a different idea. Second, when the market price reflects the most likely DCF scenario or the optimistic one, we start trimming the position. We also sell if we observe deteriorating fundamentals through our research. Another reason would be if inventory and accounts receivable are growing much faster than revenues. The last, and probably the best reason, is if the market cap has grown too large. When the stocks graduate and move to the next asset class, that's a good problem to have and something to celebrate. Tax efficiency is also tied to the sell discipline and it is a huge benefit to new investors in the fund. The net asset value is about $37 dollars, but the accumulated losses and the tax shield is approximately $90 a share. For a new investor, the fund can more than double without significant tax consequences.