What Stocks Might Jensen Be Buying?

By Brett Horn | Associate Director of Equity Research

Within Ultimate Stock-Pickers, we try to marry our equity research with the approaches and stock selections of managers we admire in order to add an additional layer of validation to our stock picks. One of the managers we track is the team that runs  The Jensen Fund (JENSX). Because of the fund's strict and transparent investing philosophy, Jensen offers us a unique opportunity to compare its investment approach to our own and generate specific investment ideas by combining the fund's guidelines with Morningstar stock analysis.

The Jensen Approach
Jensen governs itself by sticking to a very simple and rigorous stock-selection criterion. The fund only invests in companies that have earned a 15% return on equity (ROE) every year for the last 10 years. The point is to limit the fund's holdings to companies that are consistent value creators. We at Morningstar also believe in focusing on quality companies, and Jensen's approach tracks fairly closely with our concept of economic moats. We prefer to use return on invested capital (ROIC) as an indicator of a moat, though, as ROICs eliminate any potential distortions in ROE through the use of debt on the balance sheet. That said, ROE is a data point that's much easier to grab, and useful as long as investors avoid situations where companies have propped up their ROEs through excessive leverage.

Jensen's performance supports the idea that sticking to companies with moats works. The fund carries a 5-star rating (note: The Morningstar Rating for Funds is distinct from our Rating for Stocks, as the former is based on funds' risk-adjusted past performance), and through the end of the first quarter, Jensen had earned an annualized 1.2% return over the last 10 years. Although this doesn't sound all that impressive, the S&P 500 sported a negative 3.0% return over the same period. Ignoring fees, $100,000 earning a 1.2% annual return would grow to about $113,000 over 10 years. If instead that $100,000 earned a negative 3.0% annual return, it would decrease to $74,000 over 10 years. The fund's approach has produced relatively good results during the current crisis as well, with Jensen down 26% over the last year, compared with 36% for the S&P 500.

Screening for Jensen-Like Picks
In order to look at the stocks that Jensen might be considering right now, we ran the fund's screen (minimum 15% ROE every year for 10 years). To simplify the analysis, we limited the results to stocks that trade on domestic exchanges, have a minimum market capitalization of $500 million, and are covered by Morningstar. The screen produced 80 results. Unsurprisingly, most of the companies that met the screening criteria have a narrow or wide moat rating, split about evenly with 45% sporting a wide moat and 41% at narrow. However, 11 of the companies have no moat, which at first glance might seem puzzling--after all, how can a company have such an excellent track record of value creation and not have a moat? But the key here is that our moat ratings are forward looking, and investors need to anticipate changes in a company's competitive position. For instance,  Ross Stores (ROST) meets the screening requirements, but we recently reduced our moat rating from narrow to none. Analyst Zoe Tan explains that "the company plans to expand its business through its new dd's Discounts concept, which competes primarily with low-cost mass merchants. We believe this changes the competitive landscape and removes the cost advantage that Ross enjoyed previously."

There's another aspect of the Jensen screen that maybe isn't quite as apparent. By sticking with firms that create value every year, the screening criteria also veers the fund toward companies that are relatively stable. Looking at our uncertainty ratings across the firms that passed the screen seems to validate this, with 68% of them carrying a low or medium uncertainty rating. The importance of looking forward is also demonstrated in the uncertainty ratings, though, as 10% of the stocks currently carry a very high or extreme uncertainty rating, clustered among the historically stable and now highly volatile financials sector.

We next screened on valuation. While it now looks at a broader range of valuation measures, Jensen historically has only purchased stocks that it believed were trading at a 40% discount to the fund's estimate of their fair value. This is a hefty discount and a slightly larger margin of safety than we look for in stocks with medium uncertainty. And while we don't know Jensen's fair value estimates, we do know ours. So, with the recent plunge in the markets, it wasn't too hard to find companies trading at attractive values. Whittling the screen results down to stocks trading at a 40% or greater discount to Morningstar's fair value estimate produced the following list:

Jensen-Like Picks
Company	Star Rating	Fair Value Uncertainty	Size of Moat	Price/ Fair Value
Abercrombie & Fitch (ANF)		High	Narrow	55%
Corp Exec Board		High	Wide	58%
Merck (MRK)		Medium	Wide	51%
Mettler-Toledo (MTD)		Medium	Narrow	48%
Novartis (NVS)		Low	Wide	50%
Patterson (PDCO)		Medium	Narrow	55%
Paychex (PAYX)		Medium	Wide	58%
Smith & Nephew (SNN)		Medium	Narrow	58%
XTO Energy		High	Narrow	57%
Data as of 04-27-09

Of these nine stocks, Jensen currently holds only one, Paychex. This low hit rate is not too surprising, given that the fund holds only 28 stocks. There is, however, one stock that Jensen holds that just missed the cut: Waters Corporation, which, despite a recent bounce, still looks attractive to us. We asked our analysts who cover these two firms to elaborate on their businesses:

 Paychex (PAYX)
Paychex has produced steady investment returns. The minimal amount of capital required for operations and the firm's significant competitive advantages have allowed it to produce returns on invested capital that have averaged 70% over the last 10 years. High customer switching costs, inherit scalability, and a respected brand image are the main drivers of the firm's wide economic moat. Switching from one payroll processing vendor to another is a very difficult task, and customers' unwillingness to do so has allowed Paychex to build a sticky client base. The extremely depressed employment market has given investors an excuse to push the stock down over the last year. We believe this provides an opportunity as the firm's rock-solid debt-free balance sheet coupled with strong free cash flow should keep it in a solid position over the long term.

 Waters Corporation (WAT)
Waters' track record of creating shareholder wealth is quite impressive--the company has averaged a 40% return on invested capital over the past decade. Waters' stellar performance is in large part due to its leading position in the small but highly lucrative liquid chromatography (LC) niche of the analytical instruments industry. Waters' superior technology, while starting to lose its sizable advantage over the competition in terms of performance and efficiency, has provided the company with a strong installed base that has high switching costs. The firm's position is very defensible as a result. The market's current preoccupation with near-term results, which are expected to be unfavorable given the tough capital spending environment, has pushed the stock down to an attractive entry point. Waters' stock rose substantially this week following the release of solid first-quarter results, such that it no longer trades at more than a 40% discount to our fair value estimate, but it is certainly worth watching.

Disclosure: Brett Horn has a position in the following securities mentioned above: Corporate Executive Board Company EXBD.