Observations from 35 Years Managing Money
Quality growth investing is not the product of financial wizardry or a complex, algorithmic understanding of market dynamics. It’s based on the belief that the best investments are great companies with outstanding track records, compelling propositions and enduring competitive advantages. It’s about having the patience and the nerve to stick with your convictions, even when the market is moving against you. It’s about believing in the process.
At Jensen, the metrics we rely on are not fundamentally different than those used by other investors — we just use them differently. Some investors and institutions may have incentives that lead them to prioritize short-term performance metrics. By contrast, “quality” factors are more skewed to the long-term.
Put another way, just as it would be a mistake for marathon runners to measure their ultimate success based on any given mile or their position at the halfway point, it is a mistake for long-term investors to measure their financial success based on investment performance during an individual bull or bear market.
Throughout the last 35 years we have invested through many economic cycles. In that time, we have identified three common mistakes that we believe are avoidable and can significantly improve investors’ long-term performance if addressed.
1. An excessive focus on earnings
In our experience, many investors are too preoccupied with earnings per share (EPS) when evaluating a prospective investment. EPS is seen as the best available predictor for identifying companies that may deliver immediate growth and strong equity price performance.
We believe that EPS provides an excessively short-term view of the financial health of a company. As long-term investors, we prefer measures that assess a company’s ability to generate returns for investors years into the future. It’s our view that return on invested capital (ROIC) and return on equity (ROE) are the best metrics for this job.
ROE has served us well from the very beginning as the first filter in our stock selection process. We only consider investing in companies that have achieved a 15% ROE each year for at least 10 consecutive years, and we make no exceptions. It represents the cornerstone of our investment strategy — the foundation on which everything else is built — and our single biggest differentiator.
We calculate ROE as a company’s annual net income after taxes, excluding non-recurring items, divided by the average shareholder equity over the past year. This reveals what a company earns for each dollar of its equity. The figure can be inflated when companies carry a lot of debt in their capital structure and can rise and fall over the sales cycle even if the fortunes of the business itself are constant. Over a 10-year period, however, we believe ROE paints a more complete picture, providing a more complete assessment of a company’s long-term financial prospects over at least one market cycle.
ROE allows us to make like-for-like comparisons between any two companies, regardless of their size, industry or capital structure. Just as a grade point average isn’t intended to replace a resumé, but rather indicate which resumés an employer should prioritize from a large pile, ROE is our first filter. It provides a starting point, informing which companies we should research further.
We believe ROIC and ROE provide similar assessments of a company, with the crucial difference being that ROIC accounts for the entire capital structure, including debt. This makes it an even more thorough measure of a company’s financial position, but also means it is harder to determine. Making comparisons on the basis of ROIC can be more difficult because the “IC” varies so much among companies and because people calculate it differently. These factors make it less useful for us as a first filter than ROE.
Having utilized ROE to narrow our universe of interesting prospective investments, we use ROIC to evaluate the remaining companies, providing what we believe to be the best assessment of a company’s long-term financial prospects. The two measures tend to be correlated, making any divergences between the two measures worth investigating.
In our opinion, both ROE and ROIC are effective indicators of a company’s ability to generate earnings and cash flow. Cash flow is king: It can allow a company to reinvest in its business, make acquisitions and pay dividends. It represents the lifeblood of a company — and acts as our North Star when it comes to valuation.
Investors may panic when a stock they own falls in price. This can lead to poor, emotionally driven decisions. At Jensen, if a company’s ROE satisfies our requirements and our original investment case remains intact, we can see a fall in price as an opportunity. A company that generates profits above its cost of capital is creating shareholder value, not destroying it. And once a company has achieved a 15% ROE for 10 years, our experience shows us that it is likely to keep doing so.
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2. Attempting to time the market
It is perfectly rational for investors to look for the most opportune time to trade. Picking the right entry and exit points for a trade certainly boosts returns. However, timing the market is very difficult to do consistently.
The impact of timing for long-term investors is also overestimated. Investors intending to save for college tuition or retirement should be thinking over a period of decades. While it always makes sense to trade at the best price possible, a longer horizon makes it even more important to pick the right stock and stick with it.
Over time, quality reveals itself. Markets rise and fall, and based on our experience strong companies usually outperform in the end, and with less volatility than the broader market. Moreover, holding positions for the long term — seven years or longer in the case of our strategy — provides an opportunity for returns to be significantly boosted by compounding. Short-term investors risk missing out entirely on this important component of wealth creation.
Inexperienced investors can make profitable trades but doing so consistently is much harder. Timing the market is difficult, requiring either a lot of skill or luck — and preferably both. Few have enough of either to be consistently successful over a long period.
Widely reported research by Bank of America1 reveals the folly of trying to time the market. Examining S&P 500 data going back to 1930, it found that if an investor had missed the 10 best trading days in each decade since, they would have a return of 28%. If they had invested the money and not touched it, they would have made a return of 17,715%. Of course, investors who are skillful or lucky enough to enter and exit the market on precisely the right days would generate an even greater return. But that amount of skill and luck is extremely rare, if not nonexistent.
Jensen’s strategy doesn’t require the same level of luck. Instead, it relies on patience and thorough research, which is necessary because we tend to hold our positions for long periods of time. Our Quality Growth strategy features an average holding period of seven years, which is possible because we only invest when we have complete confidence in a company.
That level of confidence allows us to be patient. For example, from the start of 2022 through May 2023, the S&P 500 was heavily influenced by the fortunes of a small number of influential stocks, including Nvidia, Tesla, Meta, Amazon, Netflix, Microsoft and Apple. We don’t own the first five because they do not meet our demanding investment criteria, but we do own Microsoft and Apple.
All seven of these stocks were down over the course of 2022, but rather than selling on the panic, we held Microsoft and Apple because we believed in their long-term prospects. By the end of June 2023 both stocks were trading above their price at the start of 2022. All the other stocks in the group, except Nvidia, remained below where they were at the beginning of 2022. We believe this vindicates our belief in the resilience of companies that meet our investment criteria.
None of this is to discount the importance of timing entirely. Nvidia has benefited from the considerable hype around artificial intelligence this year, and an investor skillful or lucky enough to buy that stock at the start of 2023 will have seen the position deliver a return of 194% through the end of May. Some investors will certainly have made a lot of money doing that, but it is difficult to build a strategy out of such trades.
Timing does create opportunities for us, especially during periods of extreme market volatility. Defensive stocks are particularly prone to becoming overvalued, creating selling opportunities even for great companies — and we can always buy them back when their prices become more affordable. Falling markets can also create compelling buying opportunities when the shares of quality companies can become temporarily undervalued.
The challenge is having the discipline to stick to an investment framework when valuation gives a different signal. It is human nature for investors to react to market conditions. The key is to remember what Benjamin Graham once said: In the short-term the market is a voting machine, but in the long-term it is a weighing machine.
While we can’t predict how people will vote on any given day, weight is a more tangible criteria that investors can calculate. In other words, while market behavior is unpredictable in the short-term, we believe investors in quality companies can be more confident in their expectations for the long-term.
3. Focusing on the stock, not the company
When talking to investors, many give the impression that they focus primarily on the stocks in which they are invested. At Jensen we prefer to look at the companies those stocks represent. It’s a completely different mindset. While some investors start by thinking about a stock’s potential upside, we start by thinking about how best to manage risk. And the answer to that question is only investing in those that have proven their ability to thrive across entire business cycles.
Stocks and companies are different things. Stock prices constantly fluctuate for numerous reasons which are not always related to the quality of the underlying business, such as broader market sentiment, news stories or short-term earnings reports. None of these tell you much about a company’s ability to generate free cash flow or the quality of its management team.
Analyzing a company involves a deep understanding of its underlying business model and a focus on long-term prospects, not its short-term stock price. At Jensen, the first step is to identify companies with competitive advantages that we believe will endure over time. We monitor those companies, using short-term signals such as stock price, to test our hypothesis. They only qualify as potential investments once they have met our 15% ROE target over 10 consecutive years.
Consider Netflix, which as the first large-scale streaming platform has enjoyed a first-mover advantage to bolster its business and boasted short periods of strong stock price performance.2 However, it was relatively easy for media companies with enormous libraries of content to copy its business model, calling into question its long-term competitive advantage. For us, until it achieves 10 consecutive years of 15% ROE the jury will be out on its ability to compete with rivals.
Zoom is a similar story. A company with the right technology at the right time, its stock price reflected its fortunes during the COVID-19 pandemic, when it established itself as a leading provider of digital meeting spaces. However, with companies like Microsoft and Google offering similar products, it isn’t clear what enduring competitive advantages Zoom possesses. Its ability to meet our 10-year ROE criteria will ultimately answer that question for us.
One company we invest in that has proved its enduring competitive advantage is Broadridge, North America’s market leader in investor communications and trade processing solutions. Broadridge has a market cap of more than $19.8 billion as of July 31, 2023, and occupies a position between many companies and their shareholders, where it has a near monopoly.
Broadridge has unrivaled access to investors, processing around 80% of proxy votes in North America. This competitive advantage would be difficult for a challenger to overcome. The company is also relatively unaffected by market cycles, as its 98% client retention rate generates strong recurring revenues. For the five fiscal years ending June 30, 2022, Broadridge generated annual earnings growth of nearly 16% from annualized revenue growth of 6.7%.
Another example is Marsh McLennan, a relatively new addition to our strategy that we acquired in June 2021. Marsh offers a broad range of business services and has scale and relationships that cannot easily be replicated. In the five years ending December 31, 2022, it translated annualized revenue growth of 8.2% into annualized earnings growth of 11.2%, and the company enjoyed a 2022 ROE of 32% — more than double our minimum investment threshold.
We pay close attention to the quality of a company’s management team, but we are even more interested in its governance structures. Management teams are certainly more enduring than stock prices, but can still change relatively suddenly. If they do, governance structures that align incentives and thoroughly evaluate performance should insulate company performance from negative surprises.
We also pay close attention to a company’s capital allocation strategy. Unlike share price, this tells us a lot about its financial flexibility and its risk appetite over time. We have no firm rules around capital allocation, because each business’s optimal capital structure is different. However, investors should understand and be comfortable with a company’s structure before they invest. Our guiding principle is a preference for structures that maximize flexibility.
Conclusion
We have accrued a lot of experience managing money for 35 years. That doesn’t mean we have all the answers.
We firmly believe, however, that following these three principles will improve most investors’ performance over a full economic cycle. It isn’t always easy, and it’s natural for investors to doubt their convictions when the market turns against them. But by putting in the work to truly understand a company before they invest and focusing their attention on the fundamental data rather than market sentiment, we believe investors will be satisfied with the results.
1 CNBC.com, March 24, 2021, https://www.cnbc.com/2021/03/24/this-chart-shows-why-investors-should-never-try-to-time-the-stock-market.html.
2 Netflix stock price rose 39% from 3/2/20 – 8/31/20 and 38% from 6/1/21 – 10/29/21, https://seekingalpha.com/symbol/NFLX/historical-price-quotes.
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, or 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.
© 2023 Jensen Investment Management
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