Three Solid Buy Ideas from an Ultimate Stock-Picker Screen

By Brett Horn | Associate Director of Equity Research

Aside from sifting through the holdings, purchases, and sales of our top managers, members of The Ultimate Stock-Pickers Team keep tabs on the commentary put forth by these top managers in order to get a better feel for the thinking that went into their buy, sell or hold decisions. As a byproduct of this process, we are able to construct screens based on the methodologies that are utilized by some of our Ultimate Stock-Pickers to hunt for buy and sell ideas. One of the managers we look at regularly is the team at the  Jensen (JENSX) fund, which runs a large-cap stock portfolio that has posted market-beating returns for more than a decade. Because of the fund's strict and transparent investing philosophy, we can screen for stock ideas that not only meet Jensen's strict guidelines, but which can be validated by our own equity research. That is, after all, the core objective of Ultimate Stock-Pickers: to cross-check our stock research against the opinions of professional money managers.

Understanding the Jensen Approach
The portfolio managers at Jensen govern themselves by a very simple and rigorous set of stock-selection criteria. The fund will only invest in companies that have earned at least a 15% return on equity (ROE) in each of the previous 10 years. The main point of this methodology is to limit the fund's holdings to companies that Jensen believes are consistent value creators. In their experience, "when the ROE of a business falls below 15% it likely signals an erosion of competitive edge, and a shift in the landscape within the industry."

At Morningstar, we also believe in focusing on quality companies, and Jensen's approach tracks fairly closely with our concept of economic moats. However, we prefer to use return on invested capital (ROIC) as an indicator of a moat, as ROICs eliminate potential distortions in ROE that can arise through the use of debt on the balance sheet. That said, ROE is a data point that is much easier to grasp, and can be useful as long as investors are careful to avoid situations where companies have propped up their returns through the use of excessive leverage.

Jensen's long-term track record supports the idea that sticking to companies with moats works. The fund carries a 5-Star Morningstar Rating (which is distinct from our Morningstar Rating for Stocks, as it is based on funds' historical risk-adjusted performance, as opposed to being a valuation measure), and through the end of the first quarter had earned an annualized 2.2% return over the last 10 years. While that might not sound terribly impressive, it compares quite favorably to the negative 1.0% return that the S&P 500 (SPX) Index has generated over the same time frame. As impressive as its long-term performance has been, Jensen has also been fairly consistent over more recent time periods, having beaten the S&P 500 as well over the last 1-, 3- and 5-year time frames.

It's also encouraging to note that Jensen really does stick to its knitting, with the fund eliminating stakes in  Danaher (DHR) and  Ametek (AME) during the first quarter, after both firms failed to meet the fund manager's minimum return on equity requirement of 15% last year. Jensen used the capital from the sale (as well as other cash inflows) to make a new money purchase in  C.H. Robinson Worldwide (CHRW), a leading provider of third-party logistics services, and add to existing positions in  Praxair (PX),  Abbott Laboratories (ABT),  Emerson Electric (EMR),  T. Rowe Price Group (TROW),  Colgate-Palmolive (CL), and  United Technologies (UTX).

Running a Jensen-based Screen
In order to figure out which stocks Jensen might consider buying right now, we ran a screen based on the fund's investment criterion: stocks with a minimum 15% ROE every year for the last 10 years. To simplify the analysis, we limited the results to stocks that trade on domestic exchanges, and are covered by Morningstar. The screen produced 81 results. Not surprisingly, most of the companies produced by the screen have a narrow or wide moat rating, split about evenly, with 49% sporting a wide moat, and 44% at narrow. Five of the companies do carry a no moat rating, 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 disconnect may come from the fact that our moat ratings are forward looking, anticipating changes in a company's competitive position that might not be readily apparent in historical results.

For instance,  Garmin (GRMN), a leading provider of global positioning system (GPS) devices, was one of the 81 companies that came out of our screen. While the firm may have produced ROEs in excess of 15% in each of the last ten calendar years, Morningstar analyst Mike Holt believes that "GPS-enabled navigation devices are quickly becoming a commodity. The United States Department of Defense controls the satellite system that enables GPS technology, and Garmin licenses maps from NAVTEQ, which is owned by  Nokia (NOK). Garmin delivers value by combining these technologies into a user-friendly consumer package. However, Garmin's competitors, such as TomTom and new entrants from Asia, are free to use the same satellite system, acquire maps, and deliver competing products," thereby diminishing some of the competitive advantages that Garmin may have enjoyed as an industry pioneer. As the industry matures, and more and more low-cost Asian manufacturers flood the market, Garmin will struggle to maintain an economic moat around its business.

Another aspect of the Jensen screen that is readily apparent is the fact that the results veer more toward companies that are relatively stable, a byproduct of the fund's methodology of sticking with firms that create value every year. Looking at the Morningstar Uncertainty Rating attached to each of the firms highlighted by our Jensen screen, more than 85% of them carry a low or medium rating, which means that our analysts have a greater degree of comfort with the fair value estimates derived for these firms. The importance of looking forward can also be applied to our uncertainty ratings. For example,  McGraw-Hill (MHP), whose branded information services include the likes of Standard & Poor's and J.D. Power & Associates, has historically been a fairly stable and lucrative business, primarily due to the oligopoly position that S&P and  Moody's (MCO) enjoyed as a result of regulatory practices that restricted much of the credit-rating market to just a few key players. That competitive positioning is currently being questioned, though, given both firms' roles in the financial crisis. This puts a significant question mark over McGraw-Hill's future, and is the primary driver behind our high uncertainty rating on the firm.

Ten Potential Buy Ideas Generated by the Jensen Screen

Stock Price and Morningstar Rating data as of 06-18-10 unless otherwise noted.

Seeking to narrow the list of 81 firms down to a more manageable size, we looked more closely at valuation. While Jensen is willing to consider a broad range of valuation measures, the fund has historically only purchased stocks that the managers believed were trading at a 40% discount to their estimate of the company's fair value. This is a very hefty discount, especially considering the quality and stability of the companies that the screen identified. At Morningstar, we look for only a 30% margin of safety on stocks with medium uncertainty. While we don't know Jensen's fair value estimates for these companies, we do know ours, which allowed us to narrow the list down to 10 stocks that are trading at the steepest discount to Morningstar's fair value estimate (which we've included in the table that has been inserted above). Of these ten stocks, Jensen currently holds three:  Johnson & Johnson (JNJ),  Stryker (SYK) and  Paychex (PAYX). This low hit rate is not at all surprising, given that the fund has traditionally held fewer than 30 stocks, and historically had relatively low portfolio turnover. Believing that these three stocks warrant further consideration, we collected some commentary from our analysts reflecting their current thinking on these holdings.

 Johnson & Johnson (JNJ)
Morningstar analyst Damien Conover is impressed with Johnson & Johnson, believing that the firm stands alone as a leader across several major health-care industries. He feels that the firm's diverse revenue base, robust research pipeline, and exceptional cash flow generation capabilities provide Johnson & Johnson with a wide economic moat around its business. While many of its competitors are approaching a major patent cliff, Johnson & Johnson has successfully surmounted this hurdle, and is on the verge of returning to growth with several new potential blockbusters. This well-positioned company has survived the loss of patent protection on the anti-psychotic drug Risperdal and neuroscience drug Topamax by bringing forward a robust set of replacement drugs. Damien believes that the company will deploy its enormous cash flows to fund small acquisitions that will augment its own internal development efforts. Additionally, J&J's medical devices and consumer health products greatly reduce the company's earnings volatility, and offer investors an opportunity to own a health-care conglomerate.

 Stryker (SYK)
According to Morningstar analyst Julie Stralow, around 60% of Stryker's annual revenue comes from orthopedic implants, where the firm is a top-tier provider of knees and hips, and a growing provider of spinal implants. By providing caregivers with essential medical tools, particularly to enable orthopedic procedures, Julie believes that Stryker has dug itself a wide moat. In her view, the orthopedic device industry has high barriers to success, with industry players able to compete primarily on factors other than price. As a result, significant market share shifts in the industry are rare, leaving top-tier competitors like Stryker to reap the benefits of the growing demand that exists for their products and services. Demographic trends in developed countries, which face aging populations and issues with obesity, should drive solid industry volume growth longer term. Another big plus is the fact that Stryker has a nearly $3 billion net cash position on its balance sheet, which Julie believes the firm could return to shareholders, or use to make acquisitions in fast-growing niches.

 Paychex (PAYX)
Our analyst Vishnu Lekraj remains impressed with Paychex's ability to hold its own during what has been one of the harshest employment environments on record. While the firm may derive its wide economic moat from the high customer switching costs and inherit scalability associated with its business, Paychex's results (unlike most other staffing-related firms) do not depend on the marginal need for employees, but on the aggregate level of employment, which does not vary greatly. As the market tends to lump Paychex into the same category as other employment services companies, though, he sees continued improvements in the employment market acting as the main catalyst for the stock. With the firm carrying no debt, generating strong free cash flows, and having only minimal capital requirements, Paychex has actively returned excess cash to its shareholders through a robust dividend and share repurchases; a tradition that Vishnu believes will not change even in the face of a difficult employment environment.

Looking at the remainder of the list, and cross-referencing it against Jensen's current holdings, we believe  Novartis (NVS) and  Becton Dickinson (BDX) could find a home in the fund's portfolio, but with health care already making up one-quarter of Jensen's stock holdings, it would have to come at the expense of one of its other holdings from the sector, which included Abbott Labs,  Medtronic (MDT),  C.R. Bard , and  Waters Corporation (WAT) at the end of the first quarter. Jensen has been willing to make room for business services firms, like its recent purchase of CH Robinson Worldwide and its existing positions in Paychex and  Automatic Data Processing (ADP), which could open the door for a for-profit education firm like  ITT Educational Services (ESI).

The fund could also find some value in  Alliant Techsystems  and  Rio Tinto , but much like with health care, the managers would need to do it at the expense of its current holdings in the industrial materials sector--Emerson Electric, Praxair, United Technologies, and  3M Company (MMM)--given that these four stocks account for nearly one fifth of Jensen's portfolio. Less likely additions, in our view, would be  ExxonMobil (XOM), which is subject to the vagaries of the oil and energy markets, and  Itau Unibanco (ITUB), the largest nongovernment-controlled financial institution in Latin America. That's not to say that Jensen does not invest in energy or financial services firms, it's just that these two names don't seem to fit in readily with a portfolio that has close to two thirds of its assets tied up in just three sectors: consumer goods, health care, and industrial materials.

Disclosure: Brett Horn does not own shares in any of the securities mentioned above.