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. Managers of the $1.8 billion fund (symbol JENSX) invest only in companies with a 10-year history of achieving at least 15 percent return on equity (ROE is a measure of a company's profitability). The ability to clear that hurdle typically means a company has plenty of cash on hand, which it often returns to shareholders in the form of a dividend. Recently, comanager Robert Zagunis talked to U.S. News about why dividends matter in this market:
You invest in a lot of stocks that pay dividends. What's the advantage?
An interesting aspect of the market 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. 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.
What are the drawbacks to dividend investing?
You will have equity exposure, volatility, and share prices to deal with. Another risk is that if the company can't generate enough cash to fund the dividend, it'll have to start pushing on its financial resources, like borrowing more money.
How do you choose stocks?
We look for a high return on equity 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.
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.