Jensen Investment Management’s View On Valuations: Perspective Is Key by Allen Bond, Portfolio Manager
H/T Dataroma
[timeless]
In recent conversations with both clients and the media, the topic of valuation has been a common theme. We believe perspective is vital.
One particularly pointed question of this variety was presented during a recent appearance on CNBC. The hosts cited the seemingly irrational divergence between movements in the bond and stock markets and inquired about the valuation implications for both. They highlighted that the S&P 500 Index continues to flirt with all-time highs, while the 10-year Treasury yield is approaching 50-year lows. And, they are not the only market observers interested in this trend. Jeffrey Gundlach, the often outspoken founder and manager of DoubleLine Capital, recently referred to this phenomenon as “market mass psychosis.”[1]
Are Markets Behaving Irrationally?
We view the crux of this argument as follows. On the surface, a stock market trading near all-time highs indicates, at a minimum, benign fundamentals. Currently, we see evidence of this in steady (if plodding by historical standards) domestic economic growth and an improving jobs market. On the other hand, the sharp rally in the Treasury market could indicate a ‘flight-to-quality’ foreshadowing an impending uptick in market volatility. So, back to Mr. Gundlach’s characterization, is the market crazy or is there a rational explanation?
We believe perspective is critical here. Jensen’s perspective is that of a long-term investor, and we view the ebb and flow of these relationships over the period of multiple market cycles. And through that lens, the current relationship between stock and bond prices may ultimately prove to be unsustainable. However, we do not believe it to be irrational (or even psychotic, as Gundlach suggests) given the current investment climate.
Investors of all stripes continue to search for income. In our view, this desire, in combination with a supportive fundamental backdrop and low absolute Treasury yields, has rationally led to a simultaneous rally in both stock and bond prices. Case in point: high-dividend paying stocks have led the equity market in 2016, while the decline in bond yields has come primarily from a ‘flattening’ at the longer end of the Treasury yield curve.
Implications for Jensen’s Investment Philosophy
Our CNBC appearance was a good reminder that not all market participants share our perspective. Specifically, the show hosts wanted us to identify a near-term catalyst that would end this so-called imbalance. Perhaps the catalyst will be an uptick in inflation, or signs of a sustainable increase in corporate earnings growth. However, these are at best educated guesses, and we do not believe in investing based on such speculation.
At Jensen, we continue to build the portfolio one stock at a time based on company-specific fundamentals and valuations. We realize, however, that this endeavor does not take place in a vacuum and that price discipline becomes paramount in the current investing environment. We have executed more sales of portfolio companies based solely on valuation in the past two years than at any period in recent history. At the same time, our ‘bench’ of potential portfolio candidates remains robust and we continue to see valuation opportunities. This is evidenced in our addition of two new companies to the Jensen Quality Growth Fund portfolio thus far in 2016.
The bottom line is that we remain steadfast in our philosophy of diligent, bottom-up portfolio construction. Within this construct, we maintain that the right balance of patient and nimble investing is critical and, consequently, do not see long-term discipline and short-term flexibility as mutually exclusive.
[1] Gundlach says Wall Street’s suffering ‘mass psychosis’ – Marketwatch.com, 7/13/16
Opinions expressed are subject to change at any time, are not guaranteed and should not be considered investment advice.
