How to Explore an Expanding Universe

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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Carlson: That leads me to another question. Of the companies that just made it into the universe, are they from any particular areas?

Schoenstein: No. This year was actually, I think, pretty broadly diversified. Nothing in particular stood out. If nothing else, just the fact that there were more names than less is always a good thing. In fact, a couple of those names, which we're not really at liberty to disclose, but we're already looking even at a couple of the new names in addition to the fact that I think the other thing that the universe research that we do every year always provides us is an opportunity to reinvigorate thinking around names that have been in the universe for some time.

A company that maybe wasn't highly thought of a couple of years ago, but now on the backs of some good results, some better performance, we can maybe have an opportunity to rethink whether it does meet our additional objectives for maybe inclusion in the strategy.

Carlson: Have energy companies ever made the cut?

Schoenstein: We've had one, and it only took place about two years ago. ExxonMobil is the name of the company, which is probably not a surprise if someone were to probably guess, that would be the one. But even it nearly didn't make it. It had nine years and almost didn't achieve the 10th, even though we could see that it might.

We looked at the company. We looked at the sector obviously, as a result of it qualifying. Frankly, we certainly have always struggled with that sector because there weren't any qualifying companies, and now that there is, it's still not necessarily an area that we have been able to see the same high level of quality in all aspects of the business. Again, Exxon's obviously a very high-performing business, but you still are really working with an industry that's much more about the speculation of the price of oil than it is about really controlling supply and demand, using your competitive advantage to sort of remake markets, and that sort of thing.

So it's been one [sector] that we just haven't been able to really get that comfortable with. And I think the other flip side of that is we continue to have lots of other opportunities [in other sectors] so that we don't sort of have to force it just to get some energy in the portfolio.

Carlson: Right. The addendum to that is that you are only investing in 25-30 companies at any one particular time.

Schoenstein: That's correct. Today we have 29 stocks that are actually in the strategy. It's pretty broadly diversified across all of the other available sectors, where we have typically found very consistent, high-performing businesses that have lots of ample cash flow. And we think that diversification is certainly something very valuable in times like this.

Carlson: Let's talk about the evolution of the portfolio lately. One thing you and I have discussed is a few companies have made it into the portfolio that are perhaps using more of their cash for acquisitions, which maybe shows up as debt on the balance sheet, but it's not necessarily a bad time to take on debt if you are doing it right.

Schoenstein: Yes. I think that's true. I think naturally we've seen a bit more activity from the acquisition side, simply because with the way that things have gone, acquisitions have become a little less expensive. Whether it's less private equity activity or whatever there have been some opportunities for acquisitions to take place.

A lot of the acquisitions that we see within our businesses are much more on the side of smaller acquisitions. The classic term would be a bolt-on acquisition--3M is an excellent example of this--where the firms are constantly looking for ways to enhance their already-existing product lines or already-existing industries that they serve. Sometimes they will be able to maybe bring in something that helps them stretch into a new area, but it has some reality in something they already do. There is a natural extension, and so that bolt-on acquisition is not as difficult to say integrate or develop. We see that certainly quite a bit with some of our names.

And then there are some others that are doing things that maybe are a bit more, I wouldn't necessarily call them transformative, but a bit more unique. Take Microsoft, for instance, with its Skype acquisition, which has been widely discussed as far as whether [Microsoft] overpaid for [Skype] and all those sorts of things. But [these moves are] certainly something maybe a little different than what you might say is a bolt-on acquisition because the opportunities that [the acquisition] might provide needed more time for development or weren't as obvious to people necessarily on the front end of the acquisition. So we are seeing a bit of both, but we're definitely seeing more acquisition activity.

Carlson: The fund has had a difficult stretch of relative performance during the past few years. That's not necessarily out-of-line with its profile, in that the fund has tended to do better in very tough years because of the consistency of the holdings, and it doesn't necessarily keep up in rallies though it does tend to post positive gains during those stretches.

Schoenstein: [Management has] discussed that. Any manager can't help but discuss performance, especially as you get questions about it from your clients or prospects. As we've looked at it, quite frankly it's probably been almost little frustrating for us. I think a lot of people have talked about how the correlations in the market have been quite high in the last couple or three years, and that's meant that it's been really rather difficult for active managers to differentiate themselves. I think we have seen some of that.

But the part that I think has been a bit more frustrating for us is that the businesses actually have been as consistent as they typically are. The returns aren't at the same robust levels as they are in boom times, but they certainly haven't come down to the degree where we would say that there's anything that we should be concerned about inside of how the businesses are executing on their own business models. Many of them are still investing in new opportunities. They are still taking share in the marketplace because of their dominance. They are still producing plenty of free cash flow, far in excess of their cost of capital. That is allowing them to make a number of different decisions--concurrently dividends, acquisitions, and new organic growth--[while] keeping a relatively consistent level of earnings. And yet there's been very little recognition of that very consistency within the marketplace.

I think that certainly has had a bit of an impact on the relative return such that I think that therein is where some of that frustration comes from.

Carlson: Thanks very much for your time, Eric.

Schoenstein: Certainly, I appreciate it, Greg. Thank you.