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Quality Assurance:

Higher Barriers to Entry and Favorable Demographics Make Encompass Health
a Standout

Any stock can have a good quarter or two, whether it’s due to a promising innovation or a favorable industry trend. But how do you figure out which company has true staying power and hasn’t just found itself in the right place at the right time? The answer is to focus on quality, as Jensen Investment Management does. This is one of the pillars that underpins the Jensen investment philosophy; it guides the firm’s portfolio managers in assessing whether a company’s fundamentals can weather difficult market conditions.

A small universe

It’s one thing to say you prefer quality companies, but how do you find them? At Jensen, quality has a very specific meaning. Companies must clear a high bar to be considered quality, which few manage to do.

The Jensen Quality Value investment team starts with all U.S. public companies, then filters out those companies to a list of just 290 or so names. Then, they eliminate names that are too expensive and dive into the research.

One stock that made the cut in recent years was Encompass Health (EHC), a post-acute healthcare provider of inpatient rehab facilities, home health and hospice services. Encompass entered the Jensen Quality Value Strategy in 2017 when it traded at about $45 a share, says Tyra Pratt, one of the managers and the lead analyst on the stock.

Quality in a regulated environment

Pratt and her colleagues like that Encompass, the largest owner and operator of inpatient rehab facilities in the country as of March 2022, operates in an industry with relatively high barriers to entry. With federal and state laws controlling healthcare, there’s a lot of red tape involved, but companies that know how to navigate these bureaucracies can create efficiencies and gain market share that their competitors can’t match. 

In particular, the Birmingham, Alabama-based company excels in lowering readmission rates for its patients. Medicare and Medicaid, which accounts for the bulk of Encompass’s revenues, have adopted a value-based reimbursement model in recent years. Reimbursements are based in part on how well providers achieve better outcomes, such as lower costs and lower readmission rates.

Encompass has done this through a significant investment in technology to coordinate care between patients, physicians and caregivers seamlessly. By using predictive analytics, Encompass gains additional insights into the level of care that different patients need, which helps to reduce costs.

“They’ve been able to prove that they can provide quality care in a cost-efficient manner,” says Pratt. “They have the ability to lower readmission rates and treat higher acuity patients.”

Riding tailwinds, dodging headwinds

Giving Encompass an added boost is a powerful long-term trend: the aging Baby Boom generation, now between 58 and 76 years old. As this large generation moves through its senior year, they will continue to be big users of the post-acute care services that Encompass provides.

“We can’t see a scenario where their services are not going to be needed, especially as Baby Boomers continue to age,” Pratt says.

Encompass hasn’t been immune to the challenges brought on by COVID-19, however.

With staffing constraints from quarantines and industrywide shortages to lockdowns at assisted living facilities early in the pandemic, providing at home services to patients has been challenging, leading to lost revenue. Similarly, periodic halts on elective surgeries like hip and knee replacements during ongoing COVID surges mean that Encompass is not able to provide—and get paid for—post-surgical acute care. Encompass’ stock price has declined close to 30 percent over the past 12 months.

“Encompass has gone through a lot of ups and downs,” Pratt acknowledges. “It’s been beaten up, but our long-term investment thesis never changed.”

Jensen used periods of bad news to add to its position, making it one of the top holdings in the Quality Value Strategy.

Taking a pause

While Pratt and her colleagues continue to like Encompass’s market-leading position in an industry with high barriers to entry and favorable demographics, they’re also unsure of the company’s plans to spin off its in-home health and hospice care segments. They’re taking a wait-and-see approach.

“We haven’t added to our position recently,” Pratt explains. “We want to know what the business looks like post spin-off before we buy more.” 

All of which goes to show: nothing is without risk, but with careful consideration, short-term fluctuations can present long-term opportunities.

The company discussions in this article are solely intended to illustrate the application of our investment approach and is 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 Value 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.  

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. 

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