Volatile Markets Are an Important Reminder about Three Big Investing Risks

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.

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 since 2000. 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.