Quality is important in a market like this. That's a no-brainer. But the folks at Jensen Portfolio take this quality business to an extreme. Stocks must clear a high hurdle to be included in the $1.8 billion fund (symbol JENSX), which has just 28 holdings: Companies must have a 10-year history of achieving at least 15 percent return on equity (a measure of a company's profitability). Jensen tends to outpace most of its peers in bitter markets, and this one is no different. The fund has lost 25 percent over the past year, but that's better than 98 percent of its peers, which invest in large, fast-growing companies. Robert Zagunis, chairman of the investment committee at Jensen Investment Management, recently talked strategy with U.S. News:
You invest in a lot of stocks that pay dividends. What's the advantage there?
One interesting aspect of today is—as someone has already said—there is no place to hide. If you want to stay in cash, you can put it in a 90-day T-bill and get nothing. Longer-term bonds give you a lot more, but people aren't doing that because of risk concerns. Compare a muni-bond yield or a corporate-bond yield to the dividend yield on very good companies. Push into the mix that a lot of companies we track have free cash flow that allows them to very easily increase dividends each year. You're almost better off buying the dividend stream than anything else out there. There are some fairly attractive dividend yields and very high-quality companies; compare that to fixed-income yields in the market, and you might be attracted to the dividend stock. If you're truly a long-term investor, a lot of these dividends actually go up year over year. Essentially, you have a longer-term equivalent to fixed income and possible appreciation.
The drawbacks are that you still have equity exposure, volatility, and the market price of shares to deal with. Another risk is that the companies can't generate enough cash to fund the dividend and have to start pushing on their financial resources, like borrowing more money.
How do you choose stocks?
We look for a high return on equity [also known as ROE] and a high return on invested capital. The whole idea is that you're earning more than what it cost you to get the cash in the first place. That's the classic definition of a good investment. If companies do that consistently, and if you start putting together a string of good years, the compounding effect takes hold and creates significant shareholder value that may or may not be reflected in the market. Right now, the market isn't reflecting what these companies will produce in terms of value. Specifically, we require at least a 10-year history of at least 15 percent ROE. That leaves us with a universe of companies that can actually absorb a down cycle like we're in and still be profitable. They're able to adjust and remain profitable irrespective of economic conditions.
What are some examples of these companies?
Medtronic is one. Oddly enough, Wells Fargo has done quite well, even though it's in the banking sector. Johnson & Johnson continues to do well. It has a high ROE and strong free cash flow that gives it a lot of opportunity to reinvest for the future. So , essentially, the extra cash allows these companies to be opportunistic in down markets?
Yes, it's beyond just staying afloat. Some companies are in the stay-afloat mode, but those with a strong base, free cash flow, and good balance sheets are strong. They have a lot of financial flexibility coming into a downturn like we're in, and, in many cases, they'll gain market share. Johnson & Johnson just announced the acquisition of a cosmetic company called Mentor. Essentially, companies like these are going into the recession in a very strong condition. Do your requirements tend to exclude tech stocks?
A couple of things: Historically, they've been too expensive, and, secondly, because we require a 10-year record, not all make it to the age where we can start considering them. But we like technology directly and what technology can do for various business applications. We own Microsoft and Adobe. We're generally invested across most sectors, except for utilities and energy.