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Jensen Fund: Discount on High Quality Widening

Greg Carlson

Greg Carlson: Hi. My name is Greg Carlson. I'm a fund analyst with Morningstar. Joining me today is Eric Schoenstein, the co-manager of the Jensen Fund.

Thanks for joining us today Eric.

Eric Schoenstein: Thank you. My pleasure, Greg.

Carlson: Now, the Jensen Fund, Eric, is obviously one of the more distinctive funds out there. It's very concentrated fund, and it follows a very disciplined strategy, in that you're focusing very tightly on companies that have high returns on equity, relatively modest valuations, and a couple of other attributes.

Maybe we could first talk about the universe that you create through your annual screening?

Schoenstein: Sure. Well, as you mentioned, it is a pretty strict universe. It requires that companies have sustainable competitive advantages, that they have deep financial strength. And a manifestation of that is the measure that we use to select the universe, and that measure is, that in order to qualify for the discipline, a company has to have 15% return on equity at a minimum, and have that for every year, for 10 consecutive years.

So, you're right. It's a pretty select universe. We look at U.S. domestic companies, and today, that universe produces or that screen, I should say, produces a universe of around 140 – little more than 140 names.

Carlson: As we talk about before, the size of that universe has changed over time, right? It sounds like in the past, it was on a steady increase, but the past couple of years prior to this it declined.

Schoenstein: Yes, that's absolutely right. As we went through the economic cycle that had took place over the last two to three years, the universe, which had grown to around 180 names or so at its peak, did start to show some decline. Some folks perhaps had become a little concerned as to whether the universe was going to cause us any constrictions or problems with our investment discipline. The reality is that's not the case. Even at 140 names, we still feel that it's a very robust universe of companies that are eligible for potential research and ultimate investment.

And inside of that is, that the core qualifications still are very much in place and really what happened over the course of the economic downturn was that things that were maybe on the fringes of qualification, maybe they didn't completely make sense inside the discipline, those were companies that came out and lost that 15% return on equity track record, but they wouldn't have been companies that Jensen was looking at on a consistent basis. So, we feel very comfortable that the universe remains quite robust for investment.

Carlson: So, were those companies perhaps hitting that 15% return through leverage perhaps?

Schoenstein: Yeah, perhaps it was through leverage to a certain extent. If you think about, what was happening during the middle part of this decade, we were seeing somewhat of a return, to sort of '90s style business reflections in the marketplace, things were becoming a bit overvalued, market caps were maybe going a little bit higher than they should. Some sectors that perhaps were not the type that would normally qualify for a discipline that requires the level of consistency that ours requires, those were companies that ultimately did lose that consistency and therefore fell out. And some of that might have been created through leverage, certainly, and as that leverage had to be taken off, it made it much harder to qualify.

Carlson: We should also probably point out that the universe did not shrink between 2008 results and 2009 results?

Schoenstein: Absolutely. It stayed relatively flat. And the good news is, every year there are net new names to look at, so there are always new things for us to consider as additional ideas over and above the ideas we're already focused on between the portfolio and our bench of quality companies.

Carlson: And certainly also you narrow that universe down to a number of holdings in the fund, which is somewhere around 25 to 30 typically?

Schoenstein: That's right. There is 25 to 30. Today there is 28 names in the portfolio. There's another, say, 20 names or so, just round numbers that are what we would call our bench. Those are companies that we are at some level of process in terms of vetting them for potential inclusion, and we might be simply just waiting for a market opportunity, maybe a bit more business performance from the company before we would fully consider them for inclusion. So, today we're very comfortable with say 45 or 50 of those names, still leaves us a very robust group of companies that we can consider over and above those in the remainder of the universe.

Carlson: Right. And one of the ways you're narrowing down that universe is through valuation?

Schoenstein: Absolutely. The valuation component, that really is an equal part of the process. Really our process is about managing business risks through quality and looking for growth and understanding that when you have those two characteristics, and consistently have those characteristics, you have a very strong business model. You match that then with having an attractive valuation component so that you can manage the pricing risk. And our valuations today really look very good from the standpoint of where they are or where they've been historically.

Not quite as attractive as they were at the market lows in March of 2009, but as we've seen the volatility that's taken place the last six months or so, even perhaps before that, it's meant that the valuations are starting to look more discounted, and that discount is swinging to be a larger gap again. Not quite again like to the March '09 levels, but moving in that direction once again, which is a good opportunity for us to really find high-quality names at attractive prices.

Carlson: Right and that's partly a function of the fact that "higher quality companies" such as these, haven't performed particularly well relative to the market?

Schoenstein: No. They really haven't, and for us it's an opportunity. For investors that follow us it might be a bit of a frustration that you're not seeing market reaction that's mirroring the strong business performance. The reality today, it feels like that bad news is sort of exacerbated or exaggerated, and the good news isn't necessarily noticed.

For our portfolio, we are seeing growing top lines, good margin strength, relatively consistent margin strength, and that's translating into positive free cash flow growth. For us, that's exactly what we're looking for, that free cash flow growth that over long enough period of time translates to a market value return. Right now, it's not, and so therein lies the valuation opportunity.