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By Greg Carlson | 06-22-2012 11:00 AM

How to Explore an Expanding Universe

Jensen Quality Growth comanager Eric Schoenstein has seen a growing number of companies having the fundamentals worthy of his portfolio but says the market has given them little recognition.

Greg Carlson: Hi, my name is Greg Carlson, and I am a mutual fund analyst with Morningstar. I'm joined today by Eric Schoenstein, the comanager of Jensen Quality Growth. Eric, thanks for taking the time to join us today.

Eric Schoenstein: Thank you, Greg. Good to be here.

Carlson: I wanted to talk briefly about your process. Hopefully, most folks are familiar with it by now. We've talked a lot about it. But briefly, you are searching particularly for companies that have 10-year track records of returns on equity of 15% or more, and they have to generate that every year.

Schoenstein: That's correct. They have to that really for 10 years in a row. That is a minimum requirement, so there is no averaging that takes place. The good news is that universe is one that actually is growing, regardless of what you might anticipate from the overall economic environment. Last year, fiscal or calendar 2011, if you will, the universe grew about a net of 10 or 11 companies, and it's 166 companies strong right now.

I think that's actually a good sign that strong business models can continue to sort of outperform and be high achievers, and that when those business models are executed appropriately, there is an opportunity to have this universe continue to grow. And it gives us more opportunities to look at different kinds of companies in different industries. That just gives us more options to think about when we are trying to execute the Quality Growth strategy.

Carlson: Can you talk a little bit about the evolution of that universe over the past very turbulent five years or so? We don't hold you to any precise numbers, but in just ballpark terms.

Schoenstein: Well, it did have some periods that showed a bit of decline. I think it actually reached a high coming out of 2007, but starting with the economic cycles that hit in '08 and also in '09, we started seeing some areas of the universe that were no longer investible. We saw homebuilders as an example; those all sort of fell by the wayside. Student loan lenders and a lot of the banks basically all came out of the universe.

And when you think about why those things were happening, it made a lot of sense from the standpoint that they probably weren't areas that had a high degree of relevance to our investment discipline to begin with and maybe shouldn't have been in the universe, if you really think about the foundations of those businesses. It doesn't mean they aren't good companies in their own right, but from the standpoint of the consistency, the persistency of earnings and cash flows, and the ability to grow in their markets, they weren't areas that we probably were going to be invested in any way.

So we did see some downturn in the universe for a couple of years, but it has come back since then and continues to rise year after year, like I said, on the strength of those companies that do have the long-term business models that we like to see.

Carlson: And when you initiate that screen, you are looking at companies over $1 billion inside the U.S. basically, right?

Schoenstein: That's right. It's U.S.-domiciled companies over $1 billion in market cap, and I think the one think that's been interesting about what we've seen in the last few years is that there's been a subtle shift, I think, a little in terms of more technology companies coming into the universe.

The reality is the bubble bursting 10-12 years ago was quite painful, but for some companies that actually did put in place a business strategy and that have generated revenues and free cash flow consistently, they have now started to become more mature and reach that 10-year track record. And we are seeing a few more of those kinds of companies that are starting to show up in the universe. It's a subtle shift, but it's one that we've noticed that there's more technology exposure and maybe a little less [exposure] in other sort of more broad-based areas.

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