The Jensen Fund isn’t exactly a household word. But then again, not long ago, “Amazon” just referred to a river basin in Brazil. The large-cap growth fund has gained notoriety by performing well when its category peers don’t. For example, in 2001, with the S&P 500 and Russell Top 200 Growth down 11.91% and 20.53%, respectively, Jensen Fund held flat, at 0.03%. As for its relative performance within the Morningstar large growth category, the fund ranked in the top 2% for 2001, and in the top 6% for the five-year period ending December 31, 2001. Not bad for a fund not many have heard of, which on February 8, 2002 had net assets of $151 million and expenses below one percentage point.
The fund’s genesis seems directly tied to its success. Jensen Fund sprang forth from Jensen Investment Management, an RIA in Portland, Oregon. While the fund was authorized in 1992 as a public mutual fund, before then (and for some time afterward) it was put to work almost exclusively for the firm’s clients in the Pacific Northwest, where the fund was registered in just five states. An impressive long-term track record and some inquiring phone calls prompted Jensen’s directors in the first half of 2001 to “make some effort to let the world know what we’re doing,” as Jensen’s Gary Hibler puts it. The fund was registered in all 50 states, and joined Schwab’s and Fidelity’s platforms. Word began to get out.
Jensen Investment Management has five principals who also serve as Jensen Fund managers. Most have worked together since the fund went national in 1992. Their investment and business backgrounds play key roles in their ability to analyze prospective companies, which they do by viewing companies not just as common stocks but as performing organizations. The principals are Val Jensen, chairman, Gary Hibler, president, Robert Zagunis, Robert Millen, and David Davies.
“We’ve all been concerned with payrolls, we’ve all had the experience of running a business,” says Jensen, “and I think that helps us when we look at companies.” It helps, too, that Jensen Fund managers are investors in their own endeavor.
The number of holdings in the Jensen Fund is limited by intent, as opposed to being the byproduct of any screening process, though as Jensen notes, “owning the best companies is a limiting factor.” At present, Jensen Fund holdings total 26, though the number generally ranges between 20 and 25. The modest group enables Jensen fund managers to acquire a profound intimacy with each holding.
We spoke recently to three of the fund’s managers–Jensen, Zagunis, and Hibler–to unearth their shared beliefs and the methodologies they employ.
When you go back a few years–2000 comes to mind–it seems that when your fund category was doing well, you were trailing a bit, and when the fund category was performing poorly, you did extraordinarily well. Why? Hibler: We knew why we were trailing; the market was frothy out there and it was overvaluing the companies that were leading the S&P. If you go look at those companies today, they are all trading at 50% of where they were back at that time. Our strategy is to try to understand what a business is worth, and never pay more than what a business is worth to acquire it. At that time, the companies that were leading the S&P were the Intels, the Microsofts, the Suns, and the Ciscos of the world. Their valuations weren’t even close to being supported by their cash flows.
Zagunis: When you analyze the performance of the S&P, you know there’s 500 companies in there, but the driving force of that S&P was not 400 of those companies, it was a very small minority. The upshot–from our point of view–is that the underlying shareholder value creation was not real. Our focus is based on the business performance and persistency of operations and pre-cash flows in creating shareholder value. That doesn’t go away when you wake up in the morning.
Jensen: I’d like to put it even a third way if I could. We think a company has to earn its increase in price. In other words, there’s a definite relationship between a company’s earnings and its price. The market continually over- and undervalues those earnings, but if you take a company earning $1.50 and paying a 50-cent dividend, then in a very simplistic way, the price of the stock should go up $1.00, because that’s the value that was added. We’re really back to that business value. We just looked at a company that we don’t own in any amount, BristolMyersSquibb, and over 35 years it increased earnings at an average rate of 12.5% a year. Do you know what the market did to its price over 35 years? It went up an average of 12.5% a year. If you look at the statistics, this happens over and over and over again: The long-term business performance relates to the long-term stock performance.
You’re not too heavy into technology, and you don’t own energy or retail. A lot of your category peers with those holdings aren’t doing well at the moment. Do you avoid those holdings as a rule? Hibler: We didn’t set out to say we don’t want to own any techs or any retail. We only wanted to own the best businesses out there. Our definition of a good business starts with having to have a 10-year record of absolutely pristine business performance. So that eliminates all cyclicals, eliminates a lot of the techs. That’s what starts to drive our selection process.
In terms of your methodology, I understand that out of all the thousands of stocks, you consider those with 15% ROE over each of the past 10 years, with an eye towards ones that don’t carry much debt. But don’t companies with a big return on equity generally have debt, and you find ones that don’t? Zagunis: That’s a good observation. There are two parts to the answer. What we really look for is the manifestation of a competitive advantage. How does the fact that a company can do something better than others in its industry result in free cash flow? Obviously margins play a role: If you can do something better, you can charge more for it. The upshot is that if you have the competitive advantage–and we select that in part with the ROE ratio you mentioned, along with the culture of the company–if you have that sustained free cash flow, at the end of the day you end up with good earnings plus extra resources that you can go and do something with.
Many companies take that extra cash and reduce their debt. So you get the combination of having high performance and relatively low debt. In addition, with free cash flow, a lot of them do have an aggressive share buyback program, which has a similar effect as to the debt question–you keep reducing your equity.
Then the third big aspect of using cash is that management knows when to employ the resources in making acquisitions, when the time is right. All those uses of that extra cash strengthen [a company's] position relative to its industry peers, so that’s positive. You mentioned the ROE; you’re right. The companies in many ways are penalized by the fact that they don’t have a lot of debt. Which makes the performance even more impressive.
There’s little turnover in the fund. Give me an example of anyone you’ve dropped or added and your reasons for doing so. Jensen: We have dropped Intel.
When did you do that? Jensen: It was between 2000-2001. The reason we dropped it–and we both bought and sold Intel so we can use your illustration–we dropped Intel because it no longer met the 15% return on equity requirement. And we will absolutely drop any company once it breaks that mold, because we believe it no longer has a competitive advantage that it had when we bought it.
We sold it before a split when it was around $140 because we felt that it was significantly over its intrinsic value. So we’ll sell a company if the market price is higher than the intrinsic value, and we will also sell a company when it breaks the 15% rule.
Has the Enron mess affected your due diligence in any way? Your trust of auditors? The way you view fund selection and management? Jensen: We’ve never owned Enron. Part of it, I think, is the fact that when we talk about earnings, we’re really looking for cash earnings. We think cash is king, and if you look at Enron and you examine how much cash it generated since 1994, you’ll see it has generated no cash at all. It was going in the hole regardless of positive earnings per share; it was spending far more money than it was generating. So it didn’t even come close to qualifying for our list.
That means that in order to get these numbers, you have to go into the cash flow statement and the balance sheet and the income statement. It won’t help us see if something illegal and improper is going on in a company, but we feel that one thing that helps us [is that] we follow cash instead of earnings per share, which can be manipulated. The second thing is that if you have a company that has had to qualify for its existence to get on our list for 10 years, and you have evidence of a corporate culture that is consistent year after year, that gives you some faith beyond the accounting numbers. You tend to work with companies that are moral in the first place.
In a nutshell, who’s your fund for and why? Zagunis: We only know one way to invest, and I think that the fund should be a very core holding of a lot of investors. Basically you have high quality, low risk, reasonable expense ratios, tax sensitivity, and good long-term performance. We feel that’s the only way to go.