We sat down with Rob McIver, Portfolio Manager of the Jensen Quality Value Fund, an undiscovered investing philosophy that looks for value and growth.
Talking to Robert McIver and David G. Mertens of Jensen Investment Management, I quickly realized that the growth/value binary I've been using to talk about investment strategies was not going to work in this conversation.
Their new fund, the Jensen Quality Value Fund, doesn't really look like many of the value funds I've seen. There's a lot more tech, a lot less financial services. They didn't once mention price-to-book or price-to-equity in our conversation, which lasted well over an hour.
They also use the most rigorous screening process I've ever heard of. Jensen never invests outside a special universe of around 200 companies. But they also update their holdings frequently, each quarter, which also seemed unusual for what is ostensibly a very conservative strategy.
The idea is to find quality companies for the long term, that will do well in good times and bad. Last year the fund performed exceptionally well, beating the S&P handily by returning more than 43%.
So what's the deal with your universe? Do you really never consider a stock outside of these 200? Don't you get mostly the same companies each quarter?
In our universe one of the primary things we look for is a minimum 15% return on equity for the last ten years. The power of that universe is, we believe, that investing long-term needs to have a long-term view. These companies all tend to have a number of desirable characteristics in common: a durable competitiveness whether through patents, branding, or technology; robust balance sheets and growing free-cash flow. These companies also tend to be market leaders in something.
One of the things you learn when you manage your own business, and I managed two private companies in Canada before moving to Jensen, is how important free cash flow is if you're going to be master of your own destiny. That is to say, if you're going to grow and continue to grow you need to have liquidity. You need cash to grow your dividends and buy back shares to reward your shareholders, and you need it to make acquisitions and investments in the company.
It's a marathon, not a sprint. It's terrible to say, but the financial crisis of 2008 and the great recession of 2009 were actually very good for our business because they served as a very rude awakening of what happens when you're too focused on short-term gains and when you don't have enough liquidity in the system.
What kind of companies are in the fund?
Very few energy companies make it into our screen, because they are so driven by the price for commodities. Conversely you don't see any utilities or telecom because those companies are often too regulated for them to have a return on equity that high. Our screen tends to favor IT companies like Oracle (ORCL) and Accenture (ACN); healthcare stocks, and global industrial companies.
All of them tend to be market leaders with a record of growing dividends.
Click on the image below to see an interactive chart of performance for these stocks over time.
And at least some retail, right? Didn't I see Kroger in there?
We own some Kroger (KR), which is a wonderful company, but we don't usually own a lot of retail. Retail is such a low margin, high volume business they don't often pass our initial test for return on equity. One company that really does is TJX Companies (TJX) which owns T.J. Maxx and Marshalls. They are the third largest retailer in North America but we find that their real competitive advantage comes from scale.
The supply line for retail is really long, it can take between 6-9 months for products to complete it. What T.J. Maxx has done is consolidate its supply line through expertise and scale to the point where they can provide high quality goods to the kinds of people who can't afford to go to Saks. They have expansions underway in Canada and the UK. But the most remarkable thing about them is their return on equity, which is 55%. That indicates there is extraordinary real value in the business.
What's the valuation strategy that you use?
We're deliberately vague with the valuation strategy, we don't want to reveal too much of the formula we use. But speaking broadly we're looking for a constancy in business as well as a certain kind of efficiency, which is why the return on equity is such a major hurdle for us. We're interested in leveraging the market's inefficiencies as they exist (and there are plenty!) We're not looking for any sort of major catalyst.
The reason why we set the bar at 15%, usually even higher, is because that meant that the companies were very efficient at generating value in a zero-interest environment, which means they are more likely to fare well as rates go up.
What's an example of how you leverage market inefficiency?
One of our holdings I already mentioned is Accenture. They're global management consultants who have 75% of the Fortune 500 as their clients. So that already is a competitive advantage right there.
We also like them because in business, especially now, companies are always looking to decrease their margins and Accenture has all that expertise in-house. They're almost like a shadow board. But they also have an IT side they market to their clients as well. That way they can build synergy, ride the coat-tails so to speak of their clients.
They're also leveraged to the growth of emerging markets in a way that firms in other industries can't necessarily be. And that is important because, while the growth is certainly slowing down there as it probably had to, we're still hearing from management teams that strategically it's the place to be for growth, just maybe not at the rapid pace we once had.
And in those places, we believe that the "Made in America" sticker still counts for a lot.
Yes. Let me tell you a story about one of our holdings. We hold Varian Medical (VAR) which is a leading manufacturer of X-ray technology for cancer patients. They recently opened a new factory in China, where cancer rates are growing as the population gets wealthier and older. Now, Varian's products are very expensive, priced at around $1.5 million on the low end, and over $3 million on the high end.
Varian set up a plant thinking it could sell its lower-end products to a growing Chinese middle class. But they didn't want the lower end products. They wanted the higher-end ones. Not only that, but they wanted Varian to say that all of them were built in Palo Alto.
Varian also controls 60% of the world market for its technology.
So if it's a market leader, wouldn't the stock be pretty expensive? (It is, I checked, its P/E is around 20) Isn't that pretty atypical for a value investor?
Right. We are very atypical in that sense. We change the portfolio every quarter. Other deep value investors look for a catalyst or something like that before they buy but we operate a little differently, and besides, catalyst-driven gains are usually short-term anyway which is not what we're about. We're not looking for turn-around companies, we're looking for good quality companies with a measure of consistency.
To use another example, Oracle disappointed earnings this season but that didn't change that it was the largest enterprise software vendor in the world. There's a consistency to its business that we think will make it competitive for the long term.
What are you guys looking for in 2014?
What we saw last year and what we are challenged with this year is the Fed backstopping equities with its quantitative easing. The fundamental businesses were disconnected from profits; a rising tide lifted all boats.
With 2014 and tapering the Fed is slowly starting to take the crutches out. The easy money has been made. And what we think we've been seeing in the last month (the Turkish lira isn't to blame) is markets trying to come to terms with the fact that companies are going to have to start growing revenues, especially on the top line, in order for share price to grow.
How do you look for top-line revenue growth?
Well the companies we like are also very transparent, which is very important as well. We look for trends in sales growth over the long term, of at least 10 years or more. A lot has been written about how high margins are, and whether they can keep getting higher. When we see companies making cuts to research and development just so they can keep hitting earnings, we look at that as a bad sign.
In 2014 we think investors are going to be a lot more selective. Arguably, that means that companies that do well will do even better. It's the companies with free cash flow that will benefit while lower quality competitors will struggle more. In 2009 investors were reminded very rudely the importance of liquidity which is why we're so focused on free cash flow.
And as you pointed out we've also got a very basic allocation system, we never weight anything much more than 1%, which de-risks the portfolio even more. We're at least humble enough to know we aren't going to be right all the time. We're a pretty conservative shop that way.
Click on the image below to see an interactive chart of analyst ratings for these stocks over time.
Do you see investing opportunities in these five holdings from the Jensen Quality Value Fund? Use the list below to begin your own analysis, or peruse the entire portfolio here.
1. Varian Medical Systems Inc. (VAR, Earnings, Analysts, Financials): Designs, manufactures, sells, and services equipment and software products for treating cancer; and x-ray products worldwide. Market cap at $8.70B, most recent closing price at $81.68.
2. Accenture plc (ACN, Earnings, Analysts, Financials): Provides management consulting, technology, and business process outsourcing (BPO) services worldwide. Market cap at $51.52B, most recent closing price at $80.32.
3. The TJX Companies, Inc. (TJX, Earnings, Analysts, Financials): Operates as an off-price apparel and home fashions retailer in the United States and internationally. Market cap at $41.00B, most recent closing price at $57.25.
4. Oracle Corporation (ORCL, Earnings, Analysts, Financials): Develops, manufactures, markets, distributes, and services database and middleware software, applications software, and hardware systems worldwide. Market cap at $168.79B, most recent closing price at $36.97.
5. Western Digital Corporation (WDC, Earnings, Analysts, Financials): Develops, manufactures, and sells storage products and solutions that enable people to create, manage, experience, and preserve digital content. Market cap at $20.55B, most recent closing price at $84.20.
(List compiled by James Dennin based on holdings in the Jensen Quality Value Fund. You can visit their website, and see the entire portfolio, here.)
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