Q: What is the history and mission of the fund?
Val Jensen founded Jensen Investment Management 29 years ago, back in 1988, as an independent employee-owned investment management firm. Jensen Investment Management is the manager of the Jensen Quality Growth Fund, as well as the Jensen Quality Value Fund and separate institutional and private client accounts.
The Jensen Quality Growth Fund started on August 3, 1992, to accommodate high net worth investors looking to access our strategy on a smaller scale. The fund’s goal, and the firm’s overall strategic goal, is to help our investors mitigate business and pricing risks, the primary risks all investors face. It’s an overarching strategy that has remained relatively unchanged throughout our history.
In terms of evaluating our performance against a benchmark, it’s not something we focus on, because we see ourselves as more of an absolute return manager, but the S&P 500 Index is the more commonly used one as it more closely correlates to what we do versus, say, the Russell 1000 Growth Index. We believe there is a slightly higher quality bias within the S&P 500, and less exposure to smaller names, which can be more volatile in terms of return.
Q: What core beliefs drive your investment philosophy?
We believe that consistent high-performing businesses with strong quality characteristics and growth profiles are best positioned to allow investors to weather any kind of negative economic climate while performing reasonably well in positive climates.
Accordingly, we seek quality companies boasting durable competitive advantages, strong financial positions, consistently high levels of growing free cash flow, and management teams that understand the tradeoffs and benefits of long-term free cash flow investment into the business for future opportunities, because this allows a business to consistently perform at a high level regardless of economic environment. We believe that is how we mitigate business risk.
Companies that can do that for a long period of time tend to have much lower risk of failure. The way management reinvests cash flow, whether it’s through organic growth opportunities, strategic acquisitions, or share buybacks and dividends, displays a foundation of quality. But we also want to see evidence of growth potential, where it achieves a business return above its cost of capital. A consistent, long-term business return above cost of capital means we avoid periods of value destruction.
Mitigating pricing risk means investing in a quality stock without overpaying, finding a margin of safety between what the stock is trading at today versus what we think it’s ultimately worth. We calculate that using the future cash flows the company is capable of producing.
Q: How would you describe your investment process?
We start with a single qualification screen. After that, everything else is predicated on our own research and subject to the process and decisions of our investment committee.
We start with companies that are publicly traded in the U.S., not necessarily domiciled here, and that yields a universe of roughly 4,000 companies. Within that, being that we are sector- and relatively size-agnostic, we filter out any that are not at least $1 billion in market cap. Those are our primary qualifications.
In order to qualify for our investment discipline, a company must have generated a return on equity greater than 15% for each of the last 10 years, as determined by our investment team. That reduces our list sharply, to roughly 230 companies.
The 10-year criterion is important because a business with that consistency can aim to assure us of lower portfolio turnover and volatility, the latter being a secondary risk we want to reduce. And the 15% return on equity, effectively the business return measurement, is high enough to help to ensure it remains above the cost of capital in virtually any economic environment.
Investors sometimes ask why 10 years, why not just five? But if we sought 15% for merely five years, we run a higher risk of that business being subject to some value destruction. Just looking at the past five years of the current market illustrates that it’s not a reliable long-term barometer for all types of economic climates.
Q: How do you further winnow that list?
Our investment team of seven professionals identifies which companies merit further due diligence by assessing the growth potential, margin strength and consistency, the historical business returns, and financial strengths, as well as other quality characteristics. That boils the possibilities down to just 40 to 50 growth companies.
From there, we create an investment thesis on each, assessing the sustainability of its competitive advantages, growth drivers, the free cash flow potential, the management team, and the board of directors, just as if we were going to buy the business itself.
The team operates as generalists, with more than one person having responsibility for any particular sector. That creates the opportunity to discuss critical issues related to the industry rather than one person, one perspective, making those recommendations. And, to keep things fresh, we periodically change things up and shift responsibilities around.
The investment team meets every day to discuss the 24-hour news cycle, as well as weekly and quarterly depending upon market activity, constantly sifting through and talking about prospective candidates. We also conduct management visits, because we want to test our thesis, to potentially address concerns we may have about the business, or uncover risks that we might not have considered. Our discussions with corporate management extend well beyond asking them to project the next quarter’s earnings to reveal the strategic backdrop, their long-term approach.
From there, we analyze the discounted cash flows and go through a series of valuation analyses to determine whether the current market price is attractive relative to the discounted cash flow work we’ve done. We look at a company based on a Jensen hurdle rate, a rate that’s generally the same for every opportunity, but also do company-specific discount rate work to reflect the different types of risks within a given business.
No particular individual has the final vote, including me, the investment committee chairman. If someone on the team expresses concerns about a particular buy or sell decision, we do more due diligence to see if we can allay those concerns. Sometimes, those concerns are valid enough to change the rest of the committee’s minds. Ideally, we want everybody to support the decision, to believe that what we’ve decided is the right thing to do.
We don’t need more than a majority, however, when simply shifting position size, because trying to gain full consensus could slow us down, and prevent us from being relatively nimble.
Ultimately, that drives us toward a list of the 25 to 30 companies that make up the Jensen Quality Growth Fund. At the moment, the fund holds 27 names.
Q: Are there any macro overlays to your investment process?
Not really. It’s a bottoms-up philosophy based on the combination of business fundamentals and valuation opportunity. That’s not to say that macro never plays a role, but it’s more about whether our thesis makes sense from a macro perspective versus influencing any specific investment choices.
There are some sectors whose volatility precludes them from becoming part of our selection process. We have virtually never owned utilities, telecom, or energy companies because they don’t consistently produce the business returns we seek. Ours is a long-term investment philosophy, with an average turnover of about 15% since inception.
This makes us less sensitive to top-down, macro thinking. We focus more on long-term performance over entire investment, business, and market cycles.
Q: Can you provide an example of your research process?
Becton, Dickinson and Company, a medical technology company that focuses on devices and diagnostic systems, would be a good example. Their primary focus is on relatively low-tech products—needle syringes, basic diagnostic tests, things like that. It was not a company that was well known to us.
Back in 2009, we realized it had the track record we were looking for, and, more importantly, as we penetrated further, it sported some interesting competitive advantages from a size and manufacturing scale perspective, which has enabled them to become the acknowledged low-cost producer of roughly 30 billion-plus syringes per year, a dominant 70% market share.
The variety of end-uses, spanning basic diagnostic tests to diabetics’ insulin injections, infusion pumps, and other low-tech products, positions them very well with hospitals—they’re by no means a niche producer. This is coupled with their low-cost manufacturing footprint and recognized technological advances, like safety engineering to avoid accidental needle sticks and hospital-spread infections, something that is mandated through regulatory efforts here in the U.S. and followed by most developed European markets and Asia.
Another attractive component is that it’s a highly consumable product, disposable, with nominal or no repeat use of its products, creating a fairly stable demand in their end markets: hospitals, healthcare facilities, and even individual users.
Their high returns on capital and the consistent to growing demand/consumption of their products has produced a steady rate of company growth less susceptible to economic environments, less momentum driven. This represents a real opportunity, not just from a developed market perspective but also from an emerging market perspective.
They supplement their growth by acquiring companies that also have broad product offerings, like CareFusion a few years ago, which produces pre-fillable syringes suited to consumers, like diabetics who have begun to take more direct responsibility for their healthcare.
In addition, their production is spread out, in the U.S. and globally, instead of being centered in any one particular geography, making them less susceptible to cataclysmic events, such as those occurring in places like Puerto Rico.
Q: What is your portfolio construction process?
We build the portfolio one company at a time, with typically no more than 30% in any one sector. Generally, initial starting positions are 1% or higher, and we don’t allow positions to exceed 7.5%. While the 27 names may make it look like a concentrated fund, it is well diversified across a broad array of industries.
Certain sectors, as I mentioned earlier, don’t meet our most basic qualifications, like energy and utilities. We are more concentrated in consumer staples, global industrials, technology, and healthcare, with their more implicit and obvious competitive advantages and deep free cash flow.
We look at where we have our highest and lowest convictions, and whether they make sense from fundamental and pricing perspectives, and periodically trim when our valuation work reveals something approaching too high a price for us, although not necessarily all at once. That said, if a company breaks the 15% return on equity 10-year track record, by definition they no longer qualify as part of our eligible universe, and so we sell.
The real discussions center on better opportunities from our bench list of companies, ones that might upgrade the portfolio based on overall fundamentals or valuation opportunities. We also gauge whether there exist tactical opportunities within the portfolio itself to move a position higher when we see market disconnects.
The earnings season is a good example of the disconnects that can occur. Sometimes the markets speculate dramatically higher or lower, based on some short-term dynamic, giving us an opportunity to add to a name if we think the market has overreacted to the downside, or take profits if the market takes the price up too high. While we don’t make a move every day, this evaluation is part of our daily process.
Q: How do you define and manage risk?
Our core focus is to mitigate business and pricing risks. How the portfolio is constructed is one way we mitigate risk. We focus more on companies that feature less potential risk to their earnings profile than those displaying greater risk.
Capital preservation is important to us, so we build the portfolio in such a way that we aim to all but eliminate volatility. Our process of finding fundamentally sound companies that are priced attractively and produce a return pattern that, on a risk-adjusted basis, has less variability and less volatility to it, both of which add risk to a portfolio, is a primary way we take potential risk out of the portfolio.
