A banking crisis has caused a big headache for investors in early 2023, but our quality value investment approach may provide a tonic.
Another day, another bout of market volatility. Central banks used cheap money to prop up confidence for so long, now the market no longer seems able to stand up on its own. A series of interest rate hikes—to levels that remain modest by long-term standards—and it quickly slumps again. How central banks will wean investors off this cheap money dependency is far from clear.
Until then, the symptoms of the malaise keep coming, most recently with the collapse and takeover of Silicon Valley Bank (“SVB”) and Signature Bank. The specifics of how rising rates led to the latest runs on U.S. banks have been well-covered elsewhere. The more pressing issue is what lessons investors should learn from it.
For the Jensen team, times like these help to reaffirm our investment approach. As markets panicked in 2022, the Jensen Quality Value Strategy outperformed its benchmark.1 How? The most obvious answer is that we avoided investing in banks—and historically have been underweight2 in financial institutions. That meant we largely avoided the investments most affected by the rout over the past quarter.
The decision to avoid investing in banks was an easy one. Few of them make it through our investment screening process, which requires that companies must achieve a 15% return on equity each year for 10 consecutive years3 to even be considered.
At the end of 2022, there were 278 companies in our value universe, only three of which are in the lending business—two small banks and one consumer finance company. These three companies made up 0.3% of the market capitalization of our investable universe as of December 31, 2022. The other financial companies in the group provide services other than lending, including software, analytics, transaction and payment processing, insurance brokerage, and investment management.
Avoiding banks isn't enough
Many mid-cap equities investors have suffered large losses in Q1 2023, even if they didn’t invest in banks directly but were invested in companies that survive on bank financing. By targeting companies with strong free cash flows, and by extension the ability to finance their operations without bank borrowing or other external sources of financing, we avoided the worst of the losses suffered by the Russell Midcap Index.
All companies are exposed to the vagaries of the markets in the short term, of course. But those with strong cash flows have more options when market sentiment is poor. They can use their cash on hand to finance dividends or share repurchases, or even to acquire distressed competitors. All else being equal, this may help them recover from the volatility sooner. Over the long term, we believe these companies will outperform the market—and our investment horizon is long-term.
This is the philosophy that has always underpinned the Jensen investment process. Admittedly, it can mean we miss out on some upside when markets are surging, but times like these remind us of why we do what we do. As banks scale back their lending activities, we believe the relative outlook for our investments is increasingly bright. Many banks were already pulling back from lending before the crisis at SVB. Our expectations are that this process is likely to accelerate going forward.
The unique role banks play in the economy makes banking crises all-encompassing and unpredictable. Even our rigorous investment approach will not fully insulate Jensen from a loss of confidence in banks, at least in the short term.
Examples from the portfolio
Several companies in which the Value Strategy invests are exposed to a reduction in lending activity. Equifax, for example, provides credit data and analytics to lenders in order to help them improve their lending decisions. A decline in overall lending activity will undoubtedly have an impact on the revenues Equifax earns from these products and services—at least in the short term.
However, Equifax also provides data and services for other business lines outside of lending. These include employment and income data that companies use to inform hiring decisions, employment and income data that governmental agencies use to verify eligibility for social services, and identity theft and fraud detection services for online retailers. This type of diversification creates an opportunity for resilience. Our analysis indicates that it has a strong market position in an oligopolistic industry that has formidable barriers to entry. It also enjoys solid free cash flows and favorable growth opportunities tied to new product introductions and geographical expansion. All this makes Equifax a great example of what Jensen looks for in a company, and we believe Equifax’s long-term outlook remains favorable.
CBRE Group, a diversified real estate company, provides another example. CBRE Group offers a portfolio of services including sales and leasing brokerage, loan servicing, property management, real estate development, valuation, facilities management, and commercial mortgage originations. A decline in lending activity will sting, particularly for its sales brokerage and mortgage origination businesses. Problems in the banking sector and limited financing availability will mean fewer properties change hands, particularly in the office space market. Generally, falling commercial real estate values reduce the number of transactions, although we believe this is already widely known to investors.
However, we believe the problems in the banking sector should have a more limited impact on CBRE Group’s loan servicing and valuation businesses. We expect CBRE Group’s base of recurring revenues to continue expanding, driven by its facilities and project management business. A growing number of companies are outsourcing their facilities management needs, and once the function has been outsourced, companies rarely want to take it back in. Contract renewal rates in the facilities management business are around 90%, as reported in the CBRE Group Q4 Earnings Call. Coupled with its diversified operations and scale, strong free cash flow, and solid balance sheet, we remain upbeat about CBRE Group’s long-term prospects.
Two more companies in our portfolio stand out right now.
FactSet provides software products for investment managers, banks, and corporations, including capital markets data. But its revenues are largely subscription-based, with multi-year contracts and high renewal rates mitigating the likely impact.
Verisk Analytics provides data services and analytics tools, primarily to property and casualty insurance companies. But we believe its offering is unique and is deeply integrated into the workflows of its customers, making them unlikely to switch providers. We remain comfortable with both investments.
When people lose confidence in banks, history has shown that the short-term market impact tends to be indiscriminate. We cannot eliminate this risk from the portfolio altogether, but we can try to minimize it. We are confident that companies with low direct exposure to banks will outperform in the long-term. Times like these are tough for all investors, but it is precisely because of them that Jensen remains committed to its investing approach.
1 For 2022, the Russell Midcap Index returned -17.32%, while the Value Strategy returned -15.43% net of fees.
2 Vs. the Russell Midcap Index for the last five years as of 3/31/2023.
3 As determined by the Investment Team.
Click here to view a list of the Jensen Quality Value Strategy’s current 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.
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