How should financial advisors prepare their clients for a difficult market?
As head of client services at Jensen Investment Management, I often hear firsthand from financial advisers what’s keeping their clients up at night. With the Standard & Poor’s 500 Index down by 18.11% in 2022, there’s a lot to worry about.
At almost every meeting, advisors ask if we have any insight into how long this downturn will last. That question is closely followed by how they can best prepare their clients for potentially even bigger losses down the road. They also want to know how to structure their portfolios in this challenging environment, given that both equities and fixed-income investments have suffered, leaving them without a good investment option.
While we can’t predict the future, we can provide a framework to put the current environment in perspective to help advisers communicate what’s happening to their clients and how to prepare for whatever comes next.
When will this end?
We wish we knew. But the reality is, the economy is facing unprecedented headwinds, and current stock prices are a reflection of that. The ongoing war in Ukraine, oil supply–demand imbalances, inflation, rising interest rates—these are just some of the issues hammering stocks. Any one of these alone would be concerning, but today they’re coming all at once.
The Federal Reserve’s tightening posture may result in a soft landing, but a recession is by no means off the table. If inflation, though moderating, remains elevated, the Fed has made it clear it will continue to raise interest rates, which could end up causing a recession.
Against this backdrop, we believe more than ever that Jensen’s approach, refined over the last 35 years, provides a framework for dealing with uncertainty. Throughout the years, we have followed these four steps, no matter what the market has thrown at us.
1. Know what you own
With stocks rising over the last decade (interspersed with short periods of decline), broad passive strategies were a winner. For the most part, investors didn’t need to be picky about where they put their money.
But by adopting this strategy, investors can end up owning a lot of weak businesses alongside the true standouts. At Jensen we manage a concentrated, high-conviction portfolio, so we spend a lot of time on knowing our portfolio companies inside and out.
To do this, we start with a strict quality discipline by screening for companies that post at least a 15% return on equity for each of the last 10 years. This rigorous process is meant to isolate companies that have withstood challenging periods in the past while still managing to be profitable. While that’s no guarantee of future success, the fact that these companies have such long track records speaks highly of their managements’ ability to repeat it.
After screening for market cap and valuation, what starts as an investable universe of thousands of names gets winnowed down to just a few hundred potential investments. From that list, our portfolio managers and analysts research names they might want to include, culminating in writing a 30- to 50-page report on each name to present to their colleagues.
By the time we decide to initiate a position, the investment team has spent months—sometimes even years—researching it.
2. Focus on cash flow
In our experience, the companies that have performed well in previous periods of volatility tend to have ample free cash flow, which is cash that a company maintains in excess of expenditures on fixed assets.
Cash flow gives companies enormous flexibility. They can use that money to pay down debt, increase dividends, repurchase shares, or reinvest in their business. Take debt, for example. These companies don’t have to go to the capital markets to finance operations at a time when interest rates are higher if they have the cash flow to fund it themselves. Alternatively, they can take advantage of economic weakness to scoop up competitors and emerge from a downturn in a better competitive position.
We see this in our portfolio companies like Apple (AAPL) and Microsoft (MSFT). In their most recent fiscal years, Apple has a staggering $106 billion in free cash flow on its balance sheet, while Microsoft is sitting on $31 billion, giving both companies a lot of room to maneuver.
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3. Reward pricing power
Because the inflationary pressures are mounting, we believe that successful companies will be those that are able to pass on higher prices to their customers. That means their products or services are so valuable that customers are willing to pay up for them.
Again, Apple comes to mind. Despite weakness in some of its markets, demand for Apple’s phones, tablets, computers, and peripherals continues to soar. Apple’s revenue for its fiscal 2022 fourth quarter was a record $90.1 billion, 8% higher than the year prior.
Likewise, Procter & Gamble (PG), another of our portfolio companies, has been able to pass on higher prices to the consumers, because the company sells staples that consumers buy regardless of the economic environment.
4. Don’t pay too much
Despite our desire to find quality businesses with a track record of growth in even the most challenging climates, we don’t want to pay more than what we believe a company is worth. We use a discounted cash flow model to find a stock’s intrinsic value and only buy when the price is trading at a discount to that.
The last few years have been unkind to price-conscious buyers. With money flooding into the market, we believe stock prices didn’t always reflect companies’ underlying fundamentals. While some stocks can coast in a bull market, when conditions are less favorable, overvalued stocks are particularly vulnerable to declines as investor sentiment turns negative. On the other hand, in our experience reasonably priced stocks tend to hold up better because their prices are closer to the value investors perceive as reasonable.
For that reason, we might wait years before an opportunity presents itself. One stock we had our eyes on for several years was Equifax (EFX), which sells consumer credit data. Our investment team had done the research and liked the business, but the price was too high. When Equifax suffered a data breach in 2017, its stock price fell, and we saw a compelling entry point.
Bottom line
Investors can’t duck a bad economy entirely. Even stocks with sound businesses will get hammered in a broad selloff. But by focusing on quality businesses with ample cash flow trading at what Jensen believes are reasonable values, investors may minimize losses and prepare for a rebound.
For a complete copy of current holdings in the Jensen Quality Growth Strategy, please click here: Jensen Quality Growth Strategy holdings.
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. The specific securities identified are taken from a representative account of the Jensen Quality Growth Strategy and do not represent all of the securities purchased and sold for the Strategy. 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.
This information is current as of the date of this material and is subject to change at any time, based on market and other conditions.
The S&P 500 Index is a market value weighted index consisting of 500 stocks chosen for market size, liquidity, and industry group representation. The Index is unmanaged, and one cannot invest directly in the Index.
Jensen Investment Management, Inc., is an investment adviser registered under the Investment Advisers Act of 1940. Registration with the SEC does not imply any level of skill or training. Although taken from reliable sources, Jensen cannot guarantee the accuracy of the information received from third parties.
© 2023 Jensen Investment Management
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