2016 Trend – Focus Returns To Fundamentals by Jensen Investment Management
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At Jensen Investment Management, our focus remains on long-term results. We invest through the lens of business owners with a long-term mindset. As such, we hesitate to highlight short-term performance or market trends. However, we also recognize that capital preservation, one of the key attributes of our strategy, often manifests itself in relatively short time periods. We believe we are currently in one of these periods.
Through February 5th, the S&P 500 index produced a total return of -7.85% on a year-to-date basis and a price decline of 10.9% since its most recent peak in early November of last year. The decline since November marks the second 10%+ market correction in the past six months. Notably, we have observed a marked change in some long-term market trends during these periods that have benefited the Quality Growth Strategy returns relative to those of the broader market.
On a year-to-date basis through February 5th, the Quality Growth Fund I-shares produced a total net return of -4.13%, capturing 53.4% of the S&P 500 index’s downside. While we are never happy with negative returns, we are pleased that our strategy has performed in-line with our expectation of a measure of downside protection in choppy markets.
To view the standardized performance for the Jensen Quality Growth Fund and the S&P 500 Index, please click here.
Performance data quoted represents past performance; past performance does not guarantee future results. The investment return and the value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance of the Fund may be lower or higher than the performance quoted.
What are the aforementioned changes in underlying market trends? And, how do they explain the relative outperformance of the Quality Growth Strategy?
Jensen Investment Management – The leadership of low-quality stocks
Over the past several years, we have noted the leadership of low-quality stocks since the market bottomed in 2009. That trend reversed modestly in 2015 and that reversal has accelerated thus far in 2016. We use the S&P Quality Rankings[1] as a proxy for quality. On a year-to-date basis, we estimate that low quality stocks produced a total return of -9.56%, underperforming high quality stocks by 464 basis points.
During this period, the Quality Growth Strategy held an 80%+ average weighting in stocks considered high quality in the S&P Quality Rankings System. We estimate that our bias towards quality, inclusive of both the portfolio’s high exposure to high quality stocks and its minimal exposure to low quality stocks, bolstered our returns by more than 300 basis points when compared with S&P 500 index.
Jensen Investment Management – Momentum growth stocks posted strong returns in 2015
Another S&P 500 Index trend we noted in 2015 was the strong returns from ‘momentum growth’ stocks. Specifically, stocks in the highest earnings per share growth quintile and those in the highest price to earnings (P/E) quintile (including negative P/E stocks) significantly outperformed the overall index. This suggests that investors in 2015 favored the fastest growing companies with little concern for valuation. This bias also sharply reversed in early 2016 – in the year-to-date period, these same ‘momentum growth’ stocks are the worst performers in the index.
We believe this trend also benefited the Quality Growth Strategy on a relative basis, as it held less than 5% position in the highest growth quintile and a 0% weighting in the highest P/E quintile and negative P/E stocks in the index.
At a high level, we believe recent market volatility is another datapoint backing our view of a ‘changing of the guard’ in terms of secular market drivers. Investors can no longer rely on a Bernanke/Yellen ‘put’[2] to justify ‘risk on’ strategies[3]. Rather, we believe the trends we noted are evidence that investors are increasingly using fundamentals and valuation to discern between stocks instead of simply seeking broad risk exposures.
As Warren Buffet has famously said, “Be fearful when others are greedy and greedy when others are fearful.”
We agree. There are silver linings to the recent market decline: both investor expectations AND stock valuations have been reset. What we see is a market not moving in lockstep; rather, individual stocks seem to be rising or falling relative to their equity benchmarks on their own merit. We view this type of market favorably and are hopeful it can create a target-rich environment for stock-picking.
Earnings growth is not representative of the fund’s future performance.
[1] S&P Quality Rankings System ranks stocks into nine buckets based on historical growth and stability of earnings and dividends. We consider stocks ranked A- and above as high quality and those ranked B+ and below as low quality.
[2] Bernanke/Yellen ‘Put’: In 2007 and early 2008, the financial press had begun discussing the Bernanke Put, as new Federal Reserve Board chairman, Ben Bernanke continued the practice of reducing interest rates to fight market falls.
[3] ‘Risk on’ Strategies: An investment setting in which price behavior responds to, and is driven by, changes in investor risk tolerance. Risk-on/risk-off refers to changes in investment activity in response to global economic patterns. During periods when risk is perceived as low, risk-on/risk-off theory states that investors tend to engage in higher-risk investments. When risk is perceived as high, investors have the tendency to gravitate toward lower-risk investments.
