Wednesday, February 24, 2010

The Jensen Portfolio

We had a call with the Jensen Portfolio (JENSX) on February 19th 2010. We spoke with Richard Clark Director of Sales and Marketing and Bob Millen, the Chairman and Portfolio Manager. Here is what we found out:

Jensen wants to own 25-30 quality growth companies in the fund. In order to find those names it looks for companies with a minimum market capitalization of $1 billion. It narrows this universe of stocks by looking for those companies that have generated a minimum of a 15% return on equity (ROE) for at least ten consecutive years. The 15% ROE for ten years is based on academic research from a Harvard professor who studied firms with these two characteristics over the period 1965-75. The research indicated that ten years of 15% ROEs was long enough and sufficiently difficult to achieve to demonstrate that the business had a sustainable competitive advantage. Jensen has continued to examine this conclusion over its 21 years in existence and finds the 15% ROE continues to be a good proxy for a return greater than the cost of capital. Ten years also seems to show a good time period for a sustainable completive advantage.

Quality for Jensen means:
• Good financial strength
• Consistency in business performance
• Sustainable competitive advantage
• Shareholder friendly management and

The 15% ROE for 10 consecutive years hurdle limits their universe to about 200 stocks. The fund only buys US based companies as they find them easier to analyze. Jensen feels they can obtain foreign exposure through foreign sales of these companies.

Finalists for inclusion in the portfolio have a 40-50 page business report prepared with detailed models. The reports contain the information you would want “if you were considering buying the whole company.” They then visit management and determine a target price.

Jensen values companies based on a discounted cash flow (DCF) analysis and only will buy those companies that trade at a significant discount to this value. Jensen’s DCF analysis has grown more sophisticated over time by incorporating year-by-year cash flows and alternative DCF models, some using industry and others company specific discount rates. Jensen also enhanced its analytical capabilities by adding three experienced analysts.

In constructing the portfolio, Jensen does not pay a lot of attention to a company’s or a sector’s weight in the S&P 500 (the index against which it measures itself) but is certainly aware how it compares to the index. Decisions are made by 8 member investment committee. And turnover has averaged 15-20% (implying a holding period of 5 years).

Some recent buys in the fund include:
• C.R. Bard – manufactures catheters and is ranked #1 or 2 in 80% of its sales. The company has strong R&D and its products are relatively low cost and often part of a procedure so they fly under the reimbursement/cost containment radar.
• Oracle – management team has depth. Millen also believes that M&A has become a core competence, so now Oracle can offer the whole “stack” of products from database to middleware to applications unlike IBM or SAP.

They believe the portfolio is well positioned with an historically low price to value ratio, though not as low as in 2008. Typically, the Jensen portfolio has traded at a 25% premium to the S&P 500 price/earnings ratio, but now it is on a par with the index. This made Millen quite optimistic about the prospects for the portfolio.

Jensen has become a bit more active in its portfolio management, for example they will “tweak” portfolio weightings based on business performance and price/value so own more of its highest conviction names.

Jensen has three elements to its sell discipline:
• Company breaches the 15% ROE threshold – indicates a fundamental change in business prospects. This results in an immediate sale.
• Price exceeds intrinsic value – Jensen will sell the remainder of its position.
• lf they can replace a stock with one that represents better value

Some examples of recent stocks they have sold include:
• Wells Fargo – it breached the 15% ROE
• GE – they lost confidence in its ability to be a growth company

At this point the Jensen Fund is the firm’s the only mutual fund but in the near future Jensen will be offering a new fund based on some research they did into their universe. The new fund may place more emphasis on valuation than the current Jensen Fund. Currently they are in a quiet period so they could not discuss the new offering.

Overall, while their approach modestly differs from ours (for example Jensen does not require stocks they own to pay a dividend), Jensen has a number of high quality names in common with our portfolios. We like the disciplined approach that the company uses to construct its portfolio, but also are pleased to see that they are constantly looking for ways to improve their process. We continue to believe the Jensen Portfolio is a very worthwhile holding for investors.

(Harvest Financial Partner holds this fund in some of it client portfolios. Holdings may change over time)

Monday, February 1, 2010

4th Quarter 2009 Quarterly Letter to Clients

2009 was quite a year. We had one of the best years for the stock market in the last decade, but who would have guessed that last March? Back then, we wrote that stocks were due for a bounce, and boy what a bounce we got. We never expected a move of the magnitude we experienced, so we will chalk that up as a pleasant surprise—our favorite kind!

But as we look back over the year, we were generally cautious (and we still are). While we never moved out of the market, we also were not aggressive enough buyers last winter and spring. In retrospect, we held onto too much cash. Our goal is to protect our clients’ capital, and as stocks rapidly rose last year, we expected a pullback that never came. Our caution left us holding cash waiting for cheaper prices. We still are!

What has been interesting is that we are finding more intriguing ideas today than we have in several months. It is not because we have lowered our standards, but because there are quite a few companies that missed out on most of the market run up or who have seen a large improvement in operating performance. Our caution on the market and economy has not diminished, but we build stock portfolios one company at a time and there are still opportunities out there.

In the case of the mutual funds we use, we have faith that the managers will also remain disciplined. And we have to point out that a number of the mutual fund managers we invest with had stellar 2009 performance.

In addition, two of our managers – David Herro at Oakmark International Small Cap and Bruce Berkowitz at Fairholme won Morningstar’s Manager of the Decade awards for Foreign and Domestic equities, respectively. Mr. Berkowitz also was named the Domestic Equity manager of the year. We would also point out that over ten years ending 12/31/2009 the S&P 500 index returned negative 1% per year--the lost decade that so much has been written about. However, every one of the funds we use generated a positive ten year return (if they had been around for the entire decade).

As impressive as this past performance has been, we know it guarantees nothing. It does, however, reinforce a portion of our mutual fund selection process: we look for managers that utilize an understandable process which has successfully grown their investors’ capital over time. We plan to keep selecting mutual fund managers the same way and sincerely hope it continues to produce similar results.

The bottom line is that there are good investments available, but you just need to be careful and disciplined. We think that is true in any market environment. Our cash holdings have us ready for opportunities presented by the market. To quote Bruce Berkowitz: "cash becomes quite valuable under adverse conditions.”

We wish all of you a happy and healthy 2010. We intend to work hard on your behalf and remain available to help you with any financial matters. Please feel to contact us anytime with questions or concerns.