Eric Schoenstein, managing director at Jensen Investment Management, joins Morningstar's The Long View podcast to talk about the firm's flagship strategy Jensen Quality Growth JENSX, quality stocks, and how to evaluate capital allocation.
Here are a few excerpts on competitive advantages and quality investing from Schoenstein's conversation with Morningstar's Christine Benz and Jeff Ptak:
Jensen Quality Growth and What to Know About ETFs
Ptak: I wanted to shift and talk about quality, which is another, I would say, telltale aspect of your investment process. I'd be remiss if I didn't ask about one of the things that's changed about quality investing, which is the availability of low-cost mechanized options for getting "quality." There are quality-screen ETFs--they charge a fraction of what you do at a Jensen Quality Growth--and mechanized stock selection. What do you think those who might be tempted to choose one of these ETFs might want to bear in mind before they take the plunge speaking is somebody that's spent years and years actively investing in stocks through a quality lens?
Schoenstein: This is a question that we've certainly heard over time, and I think it's increased in time more recently. I think the challenge with factor-based, or I guess, mechanized, to use your term, strategies, where they're trying to load, for instance, on a quality factor, the challenge is, what we've seen over our research and some of those strategies is, one, the quality factors, frankly, have seemingly changed over time. In other words, they haven't remained consistent. Partially because, I think, as return profiles don't measure up, they look for different ways to manage the quality factor and how it's loaded. I think another distinction would be that if you're investing in those kinds of strategies, inevitably, they begin to look a bit more like indexes--far more holdings, certainly than what we have. We generally will only hold 25 to 30 companies in our high-value-creation, actively managed, high-conviction strategy. And I don't think that would be the case with some of those factor-based strategies. And the issue becomes then in an effort to load those strategies where they capture similar performance in terms of downside participation, you end up exposing the strategy perhaps to a lower amount of participation when markets go up. And that's almost exactly the opposite of what you want to be doing.
So, they're very different. They have not necessarily proven themselves. And I think the other issue here, and this is perhaps maybe the more important one I should have led with is, the factor basis for those kinds of investment products is backward-looking. I'll be the first one to tell you. Our return-on-equity requirement of 15% a year for 10 consecutive years is backward-looking, but our research doesn't stop there. If you were to go back to 2008, the financial crisis, you probably would have had a quality factor that would have ranked banks and homebuilders quite highly. And yet, in 2008, the banks and the homebuilders that would have been present in our universe at the time, those all fell out, and it became something that was a real distinction between legacy moats and true durable competitive advantages. And I think that's one of the distinctions that quality-factor-based ETFs have a harder time trying to capture in looking forward.
Earning Excess Returns and Higher Multiples
Benz: High-quality firms possess traits that most investor investors covet. Can you explain the mechanics of earning excess returns in names that generally tend to trade at higher multiples than the broad market? Does it come down to expecting the firm to outgrow the expectations you believe that market has priced in?
Schoenstein: I don't know that I would say it's about outgrowing the expectations of the market. Although, certainly, that could be a component of it. Our thesis in valuation has always been around discounted cash flow. These are mature companies. Because they've had that minimum 10-year track record, they're generally mature companies. And in many cases, they've had track records longer than that. The effort here is to participate in the value creation of the business models. Our research has shown to us over three decades that competitive advantages matter and competitive advantages are correlated with the ability to create value. And ultimately, consistent value creation can be correlated to stock price appreciation from a long-term perspective.
For us, it's really not about trying to capture expanding multiples. Multiple expansion for us has generally been more of a bonus to our returns, rather than a foundation of our returns. The foundations of the return profile have largely been based upon the value creation in the business. And then, you've got, in a lot of cases, a dividend payment that acts as a supplement to that value creation, and frankly, can also act as a compensation to shareholders during those periods where they may need to be patient with the investment. And then, multiple expansion, as I mentioned, becomes sort of the bonus. So, in a high-multiple environment, in a low-multiple environment, ultimately, we're still trying to look at: Do we have reason and justification for strong growth expectations in the future, or sound value creation opportunities in the future, and are those opportunities priced appropriately at today's market price? And if we can find those kinds of businesses--and for 30 years, we think, we've done that--then that will generally overcome the vagaries of what multiples might do and also allow us to focus on what our expectation for the business is, rather than trying to overly concern ourselves about what might or might not be priced in from a market expectation.
Is Multiple Expansion an Opportunity to Create Value?
Ptak: I was actually going ask about multiple expansion, in what role that assumption might play in your process. But you kind of answered it. But I guess my next question is, when you've done performance attribution analysis, looking at the strategy's performance and has that borne itself out where the bulk of your performance has come from dividends and fundamental improvement rather than multiple expansion over time?
Schoenstein: Yes, generally speaking, that's been the case, Jeff. It's shown itself, and it's not--again, these are not things that will be absolutes. Look, I will be the first person to say that I have no problem enjoying and accepting multiple expansion as an opportunity to create value, but to use that as the primary in terms of how we would view our strategy or if that were to be the primary logic behind what our return profile is, I think all of us would have a very, very difficult time with that as a statement. And the research would definitely show from our perspective and from our research that multiple expansion, again, it acts as a kicker. We will absolutely take it when it comes. But it's also something we need to recognize isn't going to be there over time, and what will be there, in our minds over time, are durable competitive advantages; consistent cash flow generation that's used to reinvest into those competitive advantages, supplement them, or perhaps even add to them; and then ultimately, through those competitive advantages you get execution in a business model that allows for real value creation that isn't reliant, frankly, on multiple expansion. And our research has shown that that's very much been the case.
How Durable Are Competitive Advantages?
Benz: We've spoken to other guests about the durability of competitive advantages. It seems like economic moats aren't lasting as long as before given the speed of innovation and other factors. Have you seen that in the research that you do? For example, has your eligible stocks list shrunk?
Schoenstein: Actually, if anything, our ultimate list of companies that we can invest in has grown. I've been here nearly 20 years. And certainly, some of it is better data, better tool sets that we have at our disposal to dig into the fundamental data information that we have. But anecdotally, I can tell you that in September 2002, when Val Jensen, our founder, sat down with me on our first day, my first day, and handed me the Jensen universe it was 119 names. Today, it's over 320. So, I think it's pretty clear the universe has grown over time.
To your point around competitive advantages, yes, I think disruption is clearly something that happens. New entrants come in. That's the whole point of business competition: You start with something that you identify the market doesn't have but needs and that you can provide, and you ultimately hope you get paid for what you create, and eventually somebody may try to do it better than you. And that can change the competitive advantages. I would say, though, that the durability of those, I think that still remains a very strong statement. And the strongest firms, the ones that really understand the long-term nature of what they're trying to do are constantly reinvesting to shore up those advantages. And while there will be disruption, I think those competitive advantages can remain somewhat elongated more than people might be willing to appreciate.
And then, the other component of this is that reinvestment. These are hallmark firms--hallmark businesses that have consistently reinvented themselves, or maybe said another way, have seen the threats on the horizon and have constantly tried to invest in new opportunities to stave off that competition. I think the importance here is making sure that we are critically assessing that durability, and in some cases, the very disruption that could take place becomes a new opportunity for expansion. I think about technology firms today, and frankly, I look at something where cloud has become a huge driver of growth for companies like Microsoft MSFT, and Google [Alphabet] GOOGL, and Amazon AMZN and others. And in some respects, cloud and the investments in cloud have actually become an extension of competitive advantage rather than some sort of disruptive threat. Because you end up driving economic scale and economic scope by selling incremental customers into your cloud-based environment. And I think that's something that almost extends the competitive advantage rather than shortening it. I'd say another example might be Mastercard MA. Mastercard most people think of as your credit card. But the reality is, Mastercard sees and recognizes that there are constant regulatory threats and constant new entrants trying to infringe upon their business. And they are themselves reinvesting the large cash flows that they produce into new ways to participate in all kinds of non-cash-based transactions in a way to expand their footprint and profile and advantages, rather than having them shrink.