Jensen Investment Management — in Lake Oswego, Ore., about as far as you can get from Wall Street — is driven by its commitment to investing in high-quality businesses at reasonable prices. The firm's successful strategy of investing only in companies that have generated a return on equity (ROE) of at least 15% every year for the past 10 years hasn't changed in more than a quarter-century.
The Jensen Quality Growth Fund has a five-star rating from Morningstar, and its risk-adjusted returns were better than 95% of its peers', the S&P 500, the Russell 1000 Growth Index, and the Morningstar Wide Moat Index during the market cycle from the previous peak in October 2007 through February 2016. Looking back even further, since 1993, the fund's risk-adjusted returns outperformed 90% of its peers, as well as the S&P 500 and the Russell 1000. The fund has more than $5 billion in assets under management and 25 holdings. The portfolio's average return on equity is about 28%, and the fund's 10-year average turnover is 14%, which implies an average holding period of about seven years.
Eric Schoenstein is a managing director and portfolio manager for the Jensen Quality Growth Fund. He's also chairman of the firm's investment committee and coordinates the fundamental research across Jensen's investment team. Motley Fool analyst John Rotonti interviewed him about finding great investments, when to sell stocks, and more.
John Rotonti: How do you define a high-quality business?
Eric Schoenstein: A high-quality business is one that has real and durable competitive advantages, a strong balance sheet, high and/or growing market share, robust free cash flows, opportunities to reinvest the free cash flows into growth, and a capital allocation policy focused on generating long-term shareholder value.
John Rotonti: How do you define a high-quality management team?
Eric Schoenstein: In almost all cases, we visit with management in person before making an investment. We evaluate a management team by trying to determine if it is doing what's best for the long-term health of the business and its owners. We want to get a sense of who they are, why they are passionate about the business, and what the corporate culture is like. It's often easier to do that in person than over the phone. In these meetings, we're not interested in quarterly estimates. Rather, we are focused on management's five-year strategic plan, capital allocation priorities, opportunities to reinvest at high rates of return, the legacy they want to leave, and how they think about value creation.
John Rotonti: How do you narrow the pool of companies you want to invest in, and how big is that pool for the Quality Growth Fund?
Eric Schoenstein: The firm's investment strategy has not materially changed in our nearly 28-year history. We just try to get better at it over time. Our initial filter screens all companies based in the U.S. with a market cap of at least $1 billion. So we are pretty much size- and sector- agnostic. This results in a list of about 4,000 companies. From there, the fund is only allowed to invest in companies that have generated a return on equity of at least 15%, as calculated by the Jensen investment team, in every single year for the last 10 years. Today, that screen provides us with an investable universe of about 220 companies. That is the pond that we fish in. Then our job is to find the most attractive fish in that pond. So we must do some work on each of those 220 businesses, which we end up narrowing down to 60 to 80, which is our core investable universe.
Our 15% ROE hurdle for the last 10 consecutive years is non-negotiable because consistently high ROE is an indicator of competitive advantage and consistent value creation. Companies that generate high ROE also tend to generate strong earnings and free cash flow to reinvest in growth, strengthen the competitive position, and return cash to shareholders. We believe companies generating high ROE can compound value creation at higher rates, and over time the share price should follow, often with less volatility. We use 10 years because it more likely shows which companies can generate high returns over a full market cycle — in other words, in both good and bad economic environments.
As the Jensen Quality Growth Fund name implies, we are ultimately looking for companies with a strong quality foundation and the ability to grow profitably over time.
John Rotonti: Why do you focus on ROE as opposed to other common performance metrics, such as return on invested capital (ROIC) or return on assets (ROA)?
Eric Schoenstein: The most straightforward answer is that ROE can be easily calculated and screened for across an entire universe of companies. But ROE is just the invitation in the door. Once they are in the door all those other measures become part of the due diligence process. In some circumstances ROE is higher than ROIC because of debt. We scrutinize a company's debt level closely. We do not shy away from debt, but we want to make sure that the companies we invest in do not need debt to operate, but rather strategically use debt to grow shareholder value.
John Rotonti: In your opinion, is one source of competitive advantage stronger and more enduring than another?
Eric Schoenstein: Every business that we invest in has its own unique advantages, but we don't favor one particular advantage over another. For us it's about identifying a real advantage, having confidence in the durability of that advantage, and investing alongside management teams that are doing a good job of investing to protect the firm's competitive advantages.
John Rotonti: How do you define a growth company?
Eric Schoenstein: We look for growth of revenue, earnings, free cash flow per share, market opportunity, etc. The mix we look for will be different for each company and industry. In this current slow-growth environment we are paying particularly close attention to organic revenue growth.
John Rotonti: Would you rather invest in a company that is reinvesting 100% of earnings into growth (or at least almost all of its earnings) or one that can both grow and return cash to shareholders through dividends and buybacks?
Eric Schoenstein: It depends on where the company is in its growth cycle. Some younger businesses have the opportunity to reinvest all cash back into growth at high rate of returns. But remember that we need 10 years of high returns before we can invest. Most of the companies that we invest in have such high free cash flows that they can maintain a strong balance sheet, invest in growth, and pay a dividend and/or buy back stock. So our investments have the ability to do it all and it's managements job to balance and prioritize between them. We like dividends because there are periods when the market doesn't cooperate, but the dividend allows us to generate some return on our investment while we wait. We also like dividends because it is a commitment. We all know how the market responds to a dividend cut or suspension. Dividends are different from buybacks in this regard.
John Rotonti: How do you come up with an estimate of intrinsic value?
Eric Schoenstein: We look at valuation from different perspectives, but our primary valuation tool is discounted cash flow analysis, and we discount those cash flows using two different discount rates. In the first case, we use the same discount rate across our entire universe, which in effect is similar to an internal rate of return. One component of this is the risk-free rate. We don't normally use the 10-year or 30-year U.S. government bond. Instead we use an interpolated 20-year rate and the 2-year moving average of the 20-year rate, which adjusts for the current environment and dampens some of the volatility. Given historically low interest rates, today the discount rate that we are using across our universe is about 8%.
In a second scenario, we use data from Duff & Phelps to calculate a unique discount rate for each company in our universe. We have higher conviction when the share price looks undervalued using both approaches as opposed only one or the other.
We then check our thinking using valuation multiples, as well as other metrics. Given that we focus on free cash flow more than reported earnings, we tend to favor cash-flow oriented multiples.
John Rotonti: What common characteristics or patterns do you recognize in your winners?
Eric Schoenstein: The quality characteristics that I mentioned at the beginning all show up in our winners, but the single most important thing is the consistent historical performance. Our research and portfolio returns indicate that consistency in the past leads to a higher likelihood of persistency in the future. This leads us to be very patient, long-term holders. We currently have 25 companies in the fund and nine of those have been in the fund for 12 years or more. The hallmark of the companies that we invest in is that they reinvest their cash flows at high rates of return which leads to compounding of value over time, assuming the rate of return is above cost of capital.
John Rotonti: What have you learned from your losers?
Eric Schoenstein: The biggest challenge for a high-conviction, concentrated, long-term oriented manager is to know when the tide may have turned and when to get out. In the previous question we talked about patience. But it is not blind patience. We must monitor our holdings diligently and be willing to exit the position when our analysis tells us to do so. We do post mortems every time we sell a position and try to learn from both our winners and our losers.
John Rotonti: Are there any industries you tend to prefer — or avoid?
Eric Schoenstein: We try to identify companies with competitive advantages and consistently high returns and free cash flow across cycles. So we have historically not invested in utilities or energy. They just have a difficult time meeting our quality criteria. ROE at utilities is regulated so they don't meet our ROE requirement. Energy companies are dependent on commodity prices so they do not control their own destiny and their returns and free cash flows are very inconsistent.
The big four that we focus on are consumer staples (which are supported by strong brands), healthcare (supported by patents), global industrials (benefits from global scale), and technology (which may have network effects, scale, or high switching costs).
John Rotonti: Do you have any performance metrics that you prefer management compensation be based on?
Eric Schoenstein: We prefer compensation based on the performance and growth of the underlying business rather than stock price performance. If the business performs well, the stock price should follow.
John Rotonti: When do you sell?
Eric Schoenstein: We sell if (1) the company fails to meet our ROE requirement, (2) the shares become overvalued, or (3) we want to exit a lower quality company and invest the funds into a higher-quality opportunity from our bench.
We have a seven-member investment team and we require consensus on all buy and sell decisions. This may sound like a high hurdle, but remember that we are very long-term holders so we get to know the businesses, industries, and management teams very well over time. So for sell decisions there is usually a clear deterioration in competitive position (business quality) or clear over-valuation. And, of course, if the company fails to generate a 15% return on average equity in any year, then we must sell, so that case is easy. Incidentally, we do very little selling for breaking the ROE rule because companies that have a long history of doing well tend to do well going forward. We continue to believe that consistency leads to persistency.
We monitor our watch list or bench of high-quality companies very closely, so for buy decisions there is generally a clear consensus on under-valuation.
John Rotonti: How do you think about portfolio diversification?
Eric Schoenstein: In the fund, no single position can grow larger than 7.5%. We also have a 30% cap on any one sector. But below that we are really focusing on diversification by industry. So, for example, we own both Microsoft (NASDAQ: MSFT) and MasterCard (NYSE: MA). They are clearly not in the same industry, but both fall under the technology sector.
John Rotonti: Can you discuss the research process at Jensen Investment Management?
Eric Schoenstein: Each of the seven members of the team is a portfolio manager. We are predominately generalists, but some of us are more comfortable with some industries over others. Four of the seven are assigned primary coverage of companies, both current holdings and names on our bench. The other three have other firm-related responsibilities such as meeting with our large investors. Those four analyst/PMs cover between 15 to 20 companies each. So our core universe of current holdings and top new ideas is about 60 to 80 names. So, we do extensive research to narrow 220 companies down to only 60 to 80 of the highest-quality/highest-conviction ideas and that becomes our core investable universe. We meet as a team on a daily basis to discuss holdings and updates. All of our research is performed in-house.