Originally appeared in Redefining65 on October 11, 2022.
Managing Director and Portfolio Manager
Some comebacks are welcome, like the possible return of the DeLorean car as an electric vehicle. But inflation and falling stock prices? Not so much.
Yet stocks move through up and down cycles, as evidenced by the movements of the Standard & Poor’s 500 Index. Periodic corrections are inevitable and par for the course when it comes to investing. Thankfully, we have history to guide us through difficult times. Even though the 1980s gave us some questionable fashion choices, it can be helpful to draw on past periods of volatility. Your clients can benefit from this long-term perspective.
Equity declines could continue
The last dozen or so years have been a great time to be an investor. To be sure, there have been short periods of volatility, like the crash in the early days of the COVID-19 pandemic in March and April 2020. But stocks quickly surpassed their pre-crash highs. Because of this, younger investors may lack experience dealing with a protracted market decline and recovery.
The 1980s have a few lessons for us. In fact, I started my financial services career in London just two months before the stock market crash of October 19, 1987. At that time, it was the worst single-day drop since the Great Depression and it will forever be known as Black Monday. The stock market didn’t recover for almost another two years.
I recall the real panic in London and the fear that gripped everyone as global stocks tumbled day after day. There was genuine concern that the downward spiral wouldn’t stop. Suddenly, my decision to pursue a career in finance didn’t feel so smart.
During that year, the U.S. federal funds rate fell to 6.1% after rising to 19% in the earlier part of the decade. Unemployment dropped to 5.9%, the lowest in eight years. Federal tax cuts put more money in consumers’ pockets, and stock prices rose. Naturally, inflation climbed too, reaching 4.8% in 1987 after being tamed to 1.1% at the end of 1986. The Federal Reserve responded with a series of interest rate hikes. Is this starting to sound familiar?
Being new to investing, I watched what I thought was a once-in-a-lifetime market crash. Looking back now, Black Monday doesn’t stand out that much against the long arc of history. Within a few years, the Cold War ended, the Internet exploded and globalization took root, all of which helped tame inflation and interest rates and fuel a soaring stock market in the 1990s.
But sprinkled throughout were many subsequent meltdowns, some of which were also called “once in a lifetime” events. These included the Asian financial crisis in 1997, the Russian financial crisis in 1998, the bailout of the Long-Term Capital Management hedge fund in 1998, the dot-com bubble bursting of 2000, the 2007–2009 housing meltdown and the 2020 COVID-19 lockdowns. Yet on balance, stock prices continued to move higher over the decades following Black Monday.
Quality is more important than ever
One of the hard truths of investing is that much is out of our hands. The stocks of even well-established companies are not immune from the ebb and flow of market movements. Ordinary investors have no control over monetary policies, geopolitics or the emergence of pandemics.
But that doesn’t mean that investors are powerless and must take whatever the market dishes out. On the contrary, there’s a lot that investors can control, and they should focus their efforts there rather than trying to buck the course of larger forces or second-guess the market (or themselves). That old investing adage, “Time in the market, not timing the market,” has never been truer.
At my firm, Jensen Investment Management, we believe that investors’ time is better spent focusing on quality businesses. As we discuss below, we believe that businesses with strong quality attributes are in a better position to withstand difficult environments and can lay the groundwork to be in an even stronger competitive position during a recovery.
In 1987, many of the highest-soaring stocks fell the most; the investments that recovered quickly were the well-capitalized “blue chips” that had long track records and were household names. We see that pattern repeating itself during periods of market volatility.
That’s why we stress quality. Take Accenture (ACN), one of the holdings in the Jensen Quality Growth Strategy’s Model Portfolio (“Quality Growth Portfolio”). Accenture is the largest global business services firm in the world and provides business process outsourcing, management consulting and technology services for clients in approximately 120 countries. Accenture ended 2021 with a return on equity (ROE) of 30.7%. Despite the potential for a recession, we believe that Accenture will continue to grow as a result of new technology adoption and the constant demand for business productivity improvement.1
What is quality?
There are many ways to look at quality, but when we talk about it at Jensen, we are referring to a very specific measure of quality. For us, it means companies must deliver a return on equity of at least 15% for each of the last 10 years. It’s a demanding hurdle, but out of thousands of potential names, this quality screen narrows our investable universe down to just a few hundred stocks.
This is an important starting point for us, because companies with a long track record of consistently high profitability have weathered difficult circumstances during that time. While past performance is no guarantee of future results, it indicates that these companies have durable competitive advantages and business models that can achieve profitability even during challenging times. As such, we believe that they can continue doing so.
Once we have this universe of stocks, we start a rigorous research process to understand everything we can about each of the names we consider adding to the Quality Growth Portfolio, paying particular attention to the potential risks. As high-conviction investors, our portfolios have just 20 to 30 stocks, so we want to make sure that we are only investing in companies that we classify as true standouts.
As of the second quarter of 2022, the average ROE of the portfolio companies in the Quality Growth Portfolio was 38%, compared to 28.9% for the average stock in the Standard & Poor’s 500 Index.2
For example, Mastercard (MA), a Quality Growth Portfolio company, is the world’s second largest electronic payments processor. Mastercard earns a small percentage of the value of each transaction on its network. In 2020, Mastercard processed over 90 billion transactions worldwide. We believe that global electronic purchasing volume will continue to grow as economies become increasingly cashless.3
Masters of their own destiny
With so many stocks advancing over the last decade or so, investors haven’t needed to pay too much attention to risk. But it’s during periods of volatility that we see why being mindful of risk always matters. In our stock analysis, we pay attention to three risks in particular: business risk, pricing risk and volatility risk. Being aware of these factors won’t eliminate risk entirely, but they can help investors manage their exposure by focusing on names with less risk than the overall market.
How do we judge how well companies are insulated from threats to their financial health? Typically, it comes down to free cash flow, the life blood of any enterprise. Unlike other measures, such as earnings, free cash flow can’t be manipulated to make things appear rosier than they truly are. In our experience, during periods of volatility everything generally stops without free cash flow.
Companies with strong free cash flow can continue paying dividends, buying back shares and investing in their businesses, all without taking on excessive debt. Given the rising interest rate environment, that’s quite compelling, as it allows companies to define their own futures. As of June 30, 2022, our Quality Growth Portfolio companies’ average debt-service coverage ratio of 20.2x was almost twice that of the companies that comprise the S&P 500 Index.4
Another example of the type of business we favor is a name like Procter & Gamble (PG), the maker of Tide laundry detergent, Dawn dish soap, Crest toothpaste and many other personal and home care product brands that are global household names.
Procter & Gamble may not have the fastest growth rate among the companies in the Quality Growth Portfolio, but we think of it as one of our “battleship” holdings. Because of its lineup of consumer staples, Procter & Gamble sells the type of products that consumers will buy even in a recession. How do we know that? Because Procter & Gamble has been doing it not for years or decades, but for more than a century. During that time, it has successfully weathered quite a few cycles. In fact, Procter & Gamble has paid a dividend for 127 consecutive years and raised its dividend for 65 consecutive years.5
Nobody likes going through a bear market. Seeing portfolios decline month after month is unsettling for most investors, and it takes steely nerves to stay the course. But helping your clients understand the nature of economic cycles can give them much-needed perspective. History teaches us that these periods of volatility are inevitable, and that eventually, the quality of each company tends to dictate their recovery following these periods.
In the meantime, you can help your clients avoid panicking by focusing their attention on the factors they can control: Picking companies with durable business models that can survive — and sometimes even thrive; not paying too much for them; and then getting back to the future when stocks recover.
Rob McIver is a managing director, president and portfolio manager with Jensen Investment Management. He has 29 years of experience in banking and investing, including 10 years with Schroder Investment Management in London. He joined Jensen in 2004.
1 Jensen Investment Management
2 Russell Mellon
3 Jensen Investment Management
4 Russell Mellon
5 Jensen Investment Management
For a full list of the Jensen Quality Growth Strategy’s current holdings, please visit www.jenseninvestment.com/growth-composite-holdings.
Stocks: We use the Standard & Poor’s 500 Index as a proxy for the stock market throughout this piece.
For a complete copy of current holdings in the Jensen Quality Growth Model Portfolio, please email [email protected] The Jensen Quality Growth Strategy Model Portfolio is a representative account of the Jensen Quality Growth Equity Composite. The companies discussed in this article are solely intended to illustrate the application of our investment approach and are not to be considered a recommendation by Jensen. Our views expressed herein are subject to change and should not be construed as a recommendation or offer to buy or sell any security and are not designed or intended as a basis or determination for making any investment decision for any security. Our discussions should not be construed as an indication that an investment in a security has been or will be profitable, or that the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance of any security discussed herein.
Past performance is no guarantee of future results. The information contained herein represents management’s current expectation of how the Jensen Quality Growth Strategy will continue to be operated in the near term; however, management’s plans and policies in this respect may change in the future. In particular, (i) policies and approaches to portfolio monitoring, risk management, and asset allocation may change in the future without notice and (ii) economic, market and other conditions could cause the strategy and accounts invested in the strategy to deviate from stated investment objectives, guidelines, and conclusions stated herein.
Certain information contained in this material represents or is based upon forward-looking statements, which can be identified by the use of terminology such as “may,” “will,” “should,” “expect,” “anticipate,” “target,” “project,” “estimate,” “intend,” “continue,” or “believe,” or the negatives thereof or other variations thereon or comparable terminology. Due to various risks and uncertainties, actual events or results or the actual performance of a client account may differ materially from those reflected or contemplated in such forward-looking statements.
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