New York (Hedgeco.net) JAB Capital Management is based in Washington D.C. and they run the JAB Fundamental Value model on the HedgeCoVest platform. We recently had the opportunity to speak with John Barnett, the founder of the firm.

HedgeCoVest: John, thank you for taking the time to speak with us today.

John Barnett: You’re welcome and thanks for taking the time to speak with me to find out more about our approach.

HCV: Speaking of your approach, if you would, tell us about your investment philosophy.

JB: Our model is a highly-concentrated long-only contrarian value model. We look for companies that show a long history of providing good returns on capital and with clean balance sheets. We then look to buy these stocks when they are out of favor for one reason or another. Most of the time we are getting into the position when the stock is at or near its 52-week low. We also stay away from companies that face any sort of obsolescence or technology risk.

HCV: How do you determine if a company provides a good return on capital and whether it has a clean balance sheet?

JB: I look for companies with a long history of profitability and normalized returns. I also avoid companies that may have hidden leverage in the form of big pensions, operating leases or purchase commitments.

HCV: With the depth which you go to in researching the financials, how do you reduce the stocks you are researching to a manageable amount when there are thousands of stocks out there?

JB: We have a filtering process that we use and it starts with four basic questions.

1. Does the business generate free cash flow on average?
2. Does it have high financial leverage at the level we invest?
3. Does it face significant technological or obsolescence risk?
4. Can we understand the economics and competitive position of the company and its industry 5-10 years into the future?

HCV: If a company meets all of these requirements, where do you go from there?

JB: That is when I really start digging into the financials of the company. I spend a majority of my time reviewing companies the model will ultimately never own. But this is one way of avoiding big losses in the portfolio. By knowing the company intricately, we are rarely caught off guard by a financial surprise.

HCV: What is it that differentiates your model from other investment models?

JB: I think there are really three things that are differentiating factors for our model. First, I take a long-term focus rather than looking at the short-term, month to month changes in a stock or the market as a whole. Second, I have a background in forensic accounting and that allows me to delve deeper into the financial statements of a company than most fund managers are going to do. Third, due to avoiding companies that may have obsolescence risks or technology risks, I don’t invest in tech companies or healthcare companies. These two sectors are among the more volatile.

HCV: Given the depths of fundamental analysis that you go to, how many stocks do you typically keep in the portfolio?

JB: Ideally it will be in the 10-12 range. That isn’t a rule, but rather just a target. We have a target holding period of five years and we look to add two to three names per year, so that gives us the target number of holdings.

HCV: If you are looking to rotate two to three stocks out of a portfolio of 10 to 12 stocks, is safe to say that your annual turnover is in the 20-25% range?

JB: That is probably pretty accurate. That isn’t something we really measure because we aren’t short-term investors. We look for long-term opportunities and our analysis style doesn’t really create a lot of turnover.

HCV: What do you think are the strengths of your model?

JB: Today, it seems that so many investors are focused on the short-term movements in stocks and the overall market that it is actually creating better long-term opportunities if you know how to find them. The forensic accounting background is a great asset when it comes to finding those opportunities and I believe it is one of our greatest strengths. The short-term traders are creating greater price discrepancies and therefore when you find the right company, you can get them at a lower price to relative value as a result.

HCV: What about weaknesses of the model?

JB: Because the model is highly concentrated, it can be difficult at times. If one or two stocks take a hit, it can be detrimental to the overall portfolio. Like leverage, concentration can work both ways. When you are right the portfolio does really well and when you are wrong it can really hurt. But we believe in our filtering system and we stick with it.

HCV: What steps do you take to eliminate or reduce risk?

JB: It really starts with our filtering system and the deep analysis of the financials. We don’t use leverage, so that practice helps reduce risk as well. We don’t use stop-losses, but we monitor positions closely and we make sure that the drivers that got us in to the position are still in place and working in our favor. And like I said before, we don’t invest in the tech sector or the healthcare sector.

HCV: With such a concentrated portfolio, do you have position limits in terms of the percentage of the portfolio?

JB: Yes, no one position, at cost, can be more than 20% of the portfolio. A position can become greater than 20% through appreciation.

HCV: Thank you for speaking with us today and explaining your model and your process in great detail. Before we go, there is one last question. What was it that made you want to join the HedgeCoVest platform?

JB: I felt like it was a great opportunity to reach a broader base of investors. I love doing the research and really studying companies before making an investment decision. Being on a platform like HedgeCoVest allows me to do what I love and yet still have the ability to attract new investors.

HCV: I have heard that from other managers on the platform. John, thanks again for speaking with us today and welcome aboard.