It's earnings season. Why Netflix and Nvidia have been crossed off this firm's list for quality stocks.

By Steve Goldstein

Critical information for the U.S. trading day

Earnings season steps up a notch this week with results from companies including Bank of America, Goldman Sachs, Netflix and Tesla, before third-quarter results are dumped en masse next week.

Jensen Investment Management is an employee-owned investment management firm that only runs three strategies: quality growth, quality value and global quality growth. Given a "high" parent rating at Morningstar, the firm just offered its advice on three mistakes to avoid as a long-term investor.

The first comes in to play right now -- don't focus on earnings too much. Earnings per share, they say, provide an excessively short-term of the financial health. Instead, they prefer focusing on return on invested capital and return on equity (ROE).

Jensen says it will only invest in companies that have achieved a 15% return on equity, every year, for at least 10 consecutive years. "The figure can be inflated when companies carry a lot of debt in their capital structure and can rise and fall over the sales cycle even if the fortunes of the business itself are constant. Over a 10-year period, however, we believe ROE paints a more complete picture, providing a more complete assessment of a company's long-term financial prospects over at least one market cycle," they say.

Netflix (NFLX), which reports results on Wednesday, doesn't cut the mustard. "It was relatively easy for media companies with enormous libraries of content to copy its business model, calling into question its long-term competitive advantage. For us, until it achieves 10 consecutive years of 15% ROE the jury will be out on its ability to compete with rivals," they say.

Another company the Jensen team crossed off is Zoom Video Communications (ZM). "A company with the right technology at the right time, its stock price reflected its fortunes during the COVID-19 pandemic, when it established itself as a leading provider of digital meeting spaces. However, with companies like Microsoft and Google offering similar products, it isn't clear what enduring competitive advantages Zoom possesses," they say.

Which companies do? The Jensen team highlight Broadridge (BR), an investor communications and trade processing company that it owns. "Broadridge has unrivaled access to investors, processing around 80% of proxy votes in North America. This competitive advantage would be difficult for a challenger to overcome. The company is also relatively unaffected by market cycles, as its 98% client retention rate generates strong recurring revenues," they say. Another company highlighted is Marsh McLennan (MMC), the insurance broker and risk management company.

MarketWatch ran a screen of S&P 500 and Nasdaq 100 members, in FactSet, that cleared the return on common equity bar of at least 15% for the last ten years. Including Broadridge and Marsh McLennan, there were 79 companies that met that criteria, led in sales by Apple (AAPL), which Jensen says it owns. Interestingly, Jensen does own Microsoft which didn't meet this screen, though it should be noted Jensen's 15% ROE number does exclude non-recurring items.

   Ticker           Company                              Annual sales, in millions of dollars  ROCE in 2022 (%)  ROCE in 2021 (%) 
   AAPL             Apple Inc.                           383,933.0                             175.5             147.4 
   UNH              UnitedHealth Group Incorporated      359,982.0                             26.9              25.2 
   COST             Costco Wholesale Corporation         242,290.0                             30.6              27.9 
   KR               Kroger Co.                           148,038.0                             22.8              17.2 
   VZ               Verizon Communications Inc.          135,000.0                             24.6              29.5 
   TGT              Target Corporation                   108,008.0                             23.1              50.9 
   UPS              United Parcel Service, Inc. Class B  95,859.0                              67.9              172.9 
   PEP              PepsiCo, Inc.                        91,616.0                              53.7              51.7 
   LMT              Lockheed Martin Corporation          67,393.0                              56.7              74.4 
   ACN              Accenture Plc Class A                64,111.8                              33.0              32.3 
   DE               Deere & Company                      61,353.0                              36.9              38.0 
   NKE              NIKE, Inc. Class B                   51,433.0                              34.6              43.1 
   BBY              Best Buy Co., Inc.                   44,372.0                              48.8              64.5 
   LYB              LyondellBasell Industries NV         43,053.0                              31.7              56.5 
   GD               General Dynamics Corporation         40,859.0                              18.7              19.6 
   Source: FactSet 

The firm discussed the Magnificent Seven. "All seven of these stocks were down over the course of 2022, but rather than selling on the panic, we held Microsoft (MSFT) and Apple (AAPL) because we believed in their long-term prospects. By the end of June 2023 both stocks were trading above their price at the start of 2022. All the other stocks in the group, except Nvidia, remained below where they were at the beginning of 2022. We believe this vindicates our belief in the resilience of companies that meet our investment criteria," they say.

Granted, that means it missed out on Nvidia's (NVDA) stellar returns. "Nvidia has benefited from the considerable hype around artificial intelligence this year, and an investor skillful or lucky enough to buy that stock at the start of 2023 will have seen the position deliver a return of 194% through the end of May. Some investors will certainly have made a lot of money doing that, but it is difficult to build a strategy out of such trades," they add.

The market

After a solid 0.5% gain last week for the S&P 500 SPX, U.S. stock futures (ES00) (NQ00) edged higher, as the 10-year Treasury BX:TMUBMUSD10Y yield rose by another 6 basis points. Polish assets rose after pro-EU parties appeared to have won Sunday's election.

The buzz

Israel and Hamas both denied they agreed to a humanitarian cease fire, which does show there are diplomatic efforts in the works but also points to their limited efficacy.

The economics calendar for Monday features the Empire State manufacturing index at 8:30 a.m. Eastern, which fell to -4.6 in October, ahead of Thursday's much-awaited speech from Fed Chair Jerome Powell.

Pfizer shares (PFE) fell after the drug giant cut its sales outlook, citing declining takeup of the COVID vaccine it makes with BioNTech (BNTX). Rival Moderna (MRNA)saw its stock drop by 4%.

Charles Schwab & Co. (SCHW), whose shares have dropped 38% this year on worries over deposit outflows, missed estimates on revenue, in a week that will feature more bank earnings as well as Netflix and Tesla results.

Debt-ridden drugstore chain Rite Aid (RAD) filed for bankruptcy protection.

Manchester United stock (MANU) dropped in premarket after Qatari banker Sheikh Jassim withdrew his bid, clearing the way for a partial stake buy from British billionaire Jim Ratcliffe.

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Top tickers

Here were the most active stock-market tickers on MarketWatch as of 6 a.m. Eastern.

   Ticker  Company name 
   TSLA    Tesla 
   AMC     AMC Entertainment 
   NVDA    Nvidia 
   MANU    Manchester United 
   NIO     Nio 
   AAPL    Apple 
   GME     GameStop 
   JAGX    Jaguar Health 
   TTOO    T2 Biosystems 
   TPST    Tempest Therapeutics 

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-Steve Goldstein

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10-16-23 0839ET

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