For the last decade, investors have not needed to pay much attention to risk. It’s not hard to see why: Since hitting bottom in March 2009, markets have largely advanced, with some short periods of decline. With this most recent downturn, however, investors have a renewed interest in understanding risk.
As a firm founded in 1988, we have enough institutional memory to know that bull markets never last—and that no matter what’s happening in the markets, risk is always present.
We believe that quality investing with a risk-first mindset can help shield investors from some of the fallout created by the most destructive market environments. When investing on behalf of our clients, there are three risks we pay particular attention to: (1) business risk, (2) pricing risk, and (3) volatility risk.
1. Business Risks
We start our analysis of potential investments by screening for quality companies. For us, that means that each name must display at least a 15% ROE (return on equity) for each of the past 10 years. This metric is a starting point for finding consistently profitable companies that we believe have a demonstrated history of protecting and growing shareholder value.
Our reasoning is this: If companies are able to consistently hit this profitability objective for such a long period of time, it likely means they have been able to thrive in different economic cycles—fast growth cycles, low growth cycles, periods where revenue growth prevailed, and periods when margin protection was a smarter bet. A company with an enduring competitive advantage is more likely to navigate difficult times successfully.
To truly understand any investment risk, we must examine it both quantitatively and qualitatively. At Jensen, we assess business risk quantitatively in a number of ways and have found cash flow to be a canary in the coal mine; companies cannot manipulate it to show themselves in a more favorable light. Qualitatively, the quality of leadership can also help us better understand the business risk, because even an excellent company can create detrimental outcomes if it isn’t managed well.
One example of a Jensen quality company is Microsoft (MSFT). We’ve owned this name for more than a decade in our Quality Growth Strategy. The company generates consistent earnings growth. Over the last decade or so, Microsoft has unlocked greater value for shareholders by pivoting its business toward cloud services. Further, we believe that its leadership has had a disciplined approach to cash flow deployment, which we love to see.
Microsoft Revenues, EBIT & Free Cash Flow: 2017–2022
2. Pricing Risk
Sometimes we find compelling companies that we want to add to our portfolios, but we are not able to because of price. We use discounted cash flow analysis, which lets us take the knowledge we learned about the business and turn it into a valuation insight.
Our pricing discipline has been key to navigating the hot market environment of the last few years, especially in the technology sector. Being disciplined about price helped us manage the risk that comes from big price drops of a cooling market. As long-term investors, we seek to be patient—under certain scenarios, even well-managed companies sometimes see their stock prices fall, providing us the opportunity to invest.
Take for example Equifax (EFX), the provider of credit-reporting data. First purchased in 1992, Equifax shares had been a long-time holding in the Quality Growth Strategy. However, shares rose acutely in 2015, and we liquidated the position due to concerns about overvaluation. In 2017, Equifax suffered a massive data breach, precipitating a sharp decline in the company’s stock price. As risk-first investors, we carefully monitored the fallout from the data breach and the impact to our valuation models before reestablishing the Equifax position in 2020.
3. Volatility Risk
At Jensen, we seek out quality companies with earnings growth stability. We want to see evidence of a predictable pattern of growth, even if it means we may not be investing in the fastest-growing names. In our view, if a business produces stable earnings growth, its stock price is likely to also be less volatile, leading to attractive risk-adjusted investment returns over time.
As shown in the factor analysis chart below, return on equity and earnings growth stability factors have compounded returns at a higher rate than the S&P 500 Index over the past 22 years. However, the Jensen Quality Growth Strategy delivered even higher returns during the same period. We believe this long-term outperformance is a testament to our multifaceted approach to risk management.
Growth of $100: 2000–2022
Source: Style Analytics (data available upon request)
Return on Equity (ROE) and Earnings Growth Stability (EGS) sub-factors (the top 25% highest ROE and best EGS stocks rebalanced monthly from 12/31/1996 through 07/31/2022) are evaluated using the Style Analytics model investible U.S. market. The Style Analytics model investible U.S. market is designed to measure the performance of the large-, mid-, and small-cap segments of the U.S. market. With 1,000 constituents, the index covers approximately 95% of the free-float-adjusted market capitalization in the United States. 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 you cannot invest directly in an index.
Historical Performance (%) Net of Fees as of September 30, 2022
Investing in equities always entails some risk, so we will never be able to eliminate risk entirely. But by focusing on businesses, the price we pay for them, and how they fit into our portfolios together, we can help our investors remain invested in the equities market with less risk than the overall market.
For a list of the Jensen Quality Growth Strategy’s current holdings, please visit: jenseninvestment.com/growth-composite-holdings.
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. 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, expectations, or results may differ materially from those reflected or contemplated in such forward-looking statements.
The prices of growth stocks may be sensitive to changes in current or expected earnings, may experience larger price swings.
The information contained herein illustrates a facet of management’s investment process; however, management’s plans and policies in this respect may change in the future. In particular, economic, market, and other conditions could cause the process to change from the descriptions contained herein. 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. Graphs, charts, and/or diagrams cannot, by themselves, be used to make investment decisions.
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