Jensen Quality Growth Fund Year End CommentaryVW Staff
Jensen Quality Growth Fund commentary for the period of December 2015.
Jensen Quality Growth Fund – Year in Review: 2015
U.S. equity markets are poised to turn in a relatively lackluster year in 2015. On a year-to-date basis through November 30th, the total return from the S&P 500 index was 3.01%. This result compares to annualized returns of 14.40% and 7.48% over the past five and ten years, respectively. Further, 2015 featured a notable spike in volatility in mid-to-late August which coincided with the first 10%+ correction in the S&P 500 index in approximately four years.
We believe U.S. equity markets were shaped by the following trends in 2015:
- U.S. Earnings ‘Recession’.
Operating earnings for companies in the S&P 500 index are expected to decline 5.6% in 2015. We attribute the decline to weakness in the Energy sector due to the year-over-year collapse in oil prices, as well as to currency headwinds for those index constituents with exposure to the strengthening U.S. dollar. A 2015 decline in S&P 500 index earnings per share would represent the first since 2008.
- ‘Muddle Along’ Developed Global Economies.
All the G-7 economies2 are expected to post modest real GDP gains in 2015, marking the first synchronized increase in five years. Domestically, despite another first quarter ‘hiccup’, 2015 real GDP is expected to increase 2.57%. This would be the sixth consecutive annual increase, all within a range of 1.60% to 2.60%.
- Growth Slowdown in Large Emerging Economies.
Real GDP growth in three of the top four emerging economies is expected to decelerate for the second consecutive year in 2015. Further, real GDP is expected to decline in Russia and Brazil in 2015 and 2016. Despite this weakness, emerging market economic activity still has important global investment implications as China, per official data, is the largest individual-country contributor to worldwide GDP growth.
- Expected U.S. Monetary Tightening.
After several ‘false-starts’ throughout the year, the U.S. Federal Reserve is expected to raise the Fed Funds rate in December for the first time since 2006. In our view, this rate increase would be important from a symbolic standpoint, but we do not expect the move to be a precursor to aggressive near-term monetary policy. Rather, we anticipate a ‘data-driven’ U.S. Fed to slowly remove accommodation as a function of economic conditions.
- Narrow Leadership Among U.S. Stocks
Through November 30th, the S&P 500 index increased by 21.6 basis points. The ten largest stocks in the index6 accounted for 37.8 basis points (or 175.2%) of the gain, suggesting strength among large companies and limited participation by other index constituents.
Last year in this piece, we struck a cautious tone with our outlook due to the strong run of market performance preceding 2015. Assuming a year-end market close near current levels, we believe the debate going into next year will be whether 2015’s muted returns prove to be a ‘pause that refreshes’ or a harbinger of poor economic and business results on the horizon. We lean towards the former as (1) continued steady global economic growth supports further equity market advances, (2) we perceive earnings headwinds from U.S. dollar strengthening and weak oil prices as short-term in nature and believe easier year-over-year comparisons should mitigate further negative impact in 2016, and (3) we expect hawkish U.S. Fed policy actions to occur at a slow and manageable pace.
Jensen Quality Growth Fund Performance Discussion
Overall, we remain pleased with the business performance from individual companies held in the Jensen Quality Growth Fund. Notably, we estimate that over the past fi ve years, earnings-per-share growth for companies held in the Fund have increased at a faster rate and with lower volatility when compared to S&P 500 index companies. We attribute this consistency to our focus on steady, all-weather businesses.
On a year-to-date basis through November 30th, the Fund produced a total net return of 2.76%, underperforming the S&P 500 index by 25 basis points. Our analysis of relative performance attribution for this period highlights the following:
Jensen Quality Growth Fund – Top Individual Stock Contributors: Accenture and Nike:
- Accenture (ACN) is a leading global management and technology consulting company. The entrenched nature of Accenture’s technology and outsourcing solutions results in high customer switching costs. In our view, the stock outperformed in 2015 as the company’s results consistently exceeded expectations. We trimmed the position slightly late in the year to take some profi ts but the stock remains among the largest Fund holdings.
- Nike (NKE) is the world’s leading supplier of footwear, sportswear, and sports equipment. Competitive advantages for Nike consist of powerful brand equity, manufacturing scale, and strong research and development infrastructure. We believe the stock price performed well in 2015 due to strong gains in organic sales and earnings-per-share. The position was trimmed slightly during the year to capture profi ts, but we continue to expect it to be a long-term holding.
Jensen Quality Growth Fund – Top Individual Stock Detractors: United Technologies and Praxair
- United Technologies (UTX) is a global industrial conglomerate with leading market positions across its businesses. Technology leadership, the cost of replicating its global manufacturing footprint, and entrenched market positions represent the company’s most significant competitive advantages. United Technologies is among the fund companies most exposed to infrastructure building in China and other emerging markets. Economic slowdowns in these markets resulted in disappointing business results and share price weakness during the year. After adding to the position late in 2014, we did not change it in 2015. While we are closely monitoring short-term headwinds, we remain confi dent in our long-term investment thesis for United Technologies and, as such, it remains one of our highest conviction Fund positions.
- Praxair (PX) is the largest industrial gas producer in North and South America and third-largest in the world. Our analysis indicates that contracted revenue streams, the low-cost nature of the company’s products to its customers, and high contract renewal rates result in durable competitive advantages. Much like United Technologies, economic weakness in several developing markets negatively impacted Praxair’s results and share price during 2015. We added to the Fund’s position in Praxair during 2014 but made no changes in 2015. Praxair remains one of the Fund’s top holdings due to our confi dence in the strength of its competitive advantages.
Jensen Quality Growth Fund – Sector Analysis: Energy, Utilities, and Consumer Staples
- Energy and Utilities: For the second consecutive year, the Fund’s lack of exposure to both the Energy and Utilities sectors contributed strongly to performance relative to the S&P 500 index. Few companies in either sector meet our 15% Return on Equity hurdle. We find that commodity price exposure results in volatile earnings and cash flows for Energy companies. And, strict regulation of Utility companies suppresses returns on capital.
- Consumer Staples: Security selection in the Consumer Staples sector detracted from relative Fund performance. Specifically, Fund holdings Colgate (CL) and Procter & Gamble (PG) performed poorly due, in part, to weak economic activity in emerging markets and the strength of the U.S. dollar. We remain confident in our long-term investment theses, however, as both companies benefit from stable end markets, consistent free cash flow generation, and durable competitive advantages.
During 2015, we selectively added to the Fund’s position in Procter & Gamble to take advantage of stock price weakness, and we trimmed the weighting in Colgate early in the year due to valuation.
Jensen Investments – Low Quality Continuing to Outperform:
- We use the S&P Quality Rankings as a proxy for measuring performance differences between high-quality and low-quality stocks. We define high quality stocks as those rated A- or above by S&P. In 2015, the Fund’s average weighting in stocks rated A- or above was 76.96% compared to 38.27% for the S&P 500 index. Similar to 2014, high-quality stocks underperformed low-quality stocks in 2015, although this trend was not as significant this year as high-quality stocks came into relative favor over the past few months.
Jensen Quality Growth Fund – ‘Momentum Growth’ Stocks in Favor:
- Within the S&P 500 index, stocks in the highest EPS growth quintile and those in the highest P/E quintile (including negative P/E stocks) signifi cantly outperformed the overall index. This suggests that investors favored the fastest growing companies with little concern for valuation. Our analysis suggests this trend negatively impacted relative performance given our focus on stable growth, consistent profi tability, and disciplined valuation.
Longer-term, we believe that measuring relative performance over a full market cycle best demonstrates the value of the Strategy (we defi ne a full market cycle as one market peak to the next). The table below shows the Fund’s “through-the-cycle” relative performance. Similar to previous years, the Fund continues to outperform the S&P 500 index by this measure due to capital preservation during the market decline and solid participation on the upside.
Jensen Quality Growth Fund – Portfolio Changes
During 2015, we executed six wholesale portfolio changes. We liquidated positions in Equifax, Varian Medical, and Medtronic PLC and initiated positions in Johnson & Johnson, MasterCard, and Stryker. Additionally, valuation opportunities resulted in a variety of trim/add trades throughout the year.
- Equifax (EFX) supplies credit related information to lenders and individuals. We sold the position solely due to valuation concerns as we retain a positive fundamental outlook on the business. Equifax benefi ts from signifi cant entry barriers and we like the company’s strategy of acquiring unique data assets and combining those assets with sophisticated analytics to improve customer decision making capabilities. Equifax had been a long-time Fund holding, and the decision to exit the position was not taken lightly; however, we firmly believe in the importance of valuation discipline as part of our investment process.
- Varian Medial (VAR) develops radiation-based medical and industrial equipment and dominates the global radiation oncology equipment market. We eliminated the position as a shift in payer mix pressured the company’s traditional end markets. Furthermore, we expect the company’s new growth efforts to result in more volatile margins and free cash flow in future periods.
- Medtronic PLC (MDT) manufactures and markets a broad range of medical devices. We sold the position as its fiscal 2015 financial performance resulted in Return on Equity of less than 15%, a breach of our requirement for Fund inclusion. Medtronic issued equity during the year to fund a portion of a large acquisition, resulting in the decline in Return on Equity. In our view, the acquisition was strategically sound, but our analysis indicates that the company may be burdened with low returns on capital for some time to come.
- Johnson & Johnson (JNJ) is a globally diversified healthcare conglomerate with businesses in pharmaceuticals, medical devices, and consumer healthcare. In our opinion, Johnson & Johnson possesses powerful competitive advantages across its businesses including size/scale, brand equity, intellectual property, and entrenched relationships with global healthcare organizations. We expect opportunities arising from increasing global healthcare demand, new product development, and acquisition activity will result in shareholder value creation over time.
- MasterCard (MA) is global market leader in electronic payment processing, in which it partners with merchants and banks to complete electronic transactions. Our investment thesis is supported by the company’s powerful scale and network effect benefits. MasterCard earns a small percentage of the value of the multitude of transactions it processes resulting in powerful operating leverage. Over time, we believe the continued global shift from cash-based to electronic-based transactions will drive solid revenue and free cash flow growth.
- Stryker (SYK) sells a broad range of orthopedic implants, neurological devices, and surgical tools. The company’s competitive advantages include: leading global market positions, longstanding research collaborations with healthcare organizations, and intellectual property protection. We expect increasing global healthcare demand, new product advances in robotic surgery, and continued acquisition activity to result in steady growth in revenue and earnings.
In closing, the Investment Committee at Jensen Investment Management remains confident in the philosophy and process underpinning our management of the Fund. Our goal remains the construction of a portfolio of companies poised to create business value. To that end, we continue to focus on the long-term ownership of companies with sustainable competitive advantages, resilient financial results, and attractive long-term growth opportunities. Importantly, we believe these attributes allow companies to generate business returns consistently above their cost of capital, ultimately resulting in shareholder value creation.