02 Jul 2010 Jensen - Q2 2010 Commentary
Going forward, we likely face a subdued recovery. Investors have swung from high risk to low risk assets and will likely reconsider their decisions, for better or worse, in a more active fashion. While low interest rates have helped favor lower-quality companies, we believe that leadership should return to quality businesses with strong bal- ance sheets, growing free cash flows and the financial flexibility to prosper. Looking specifically at our portfolio businesses, performance has improved, revenues have increased, and margins appear strong. Earnings have been generally ahead of expectations. Despite the market turmoil we have not seen many of our portfolio companies lowering expectations for the quarter ending June 30. Quality businesses are flush with cash and, in many cases, are making compelling acquisitions to help fuel future growth, buying back shares and returning capital to sharehold- ers in the form of growing dividends.

09 Jan 2010 The Efficient Market Hypothesis, Behavioral Finance, and High ROE Businesses
EMH states that security prices reflect all publicly available information. It does not state, however, that this information must be cor- rect. In fact, because security prices are based in large part on unknown and often volatile future infor- mation (expectations), EMH is probably more consistent with the statement that the market is always wrong! Future reality is likely to always deviate from expectations to some degree.

This caveat is probably the best way to explain periods of heightened market volatility without violating the framework of EMH. It could be argued that in those periods the market was efficiently pricing in future expectations. It just turns out that those expectations were proven to be spectacularly wrong.

Unfortunately for EMH, that defense can only go so far. EMH relies on rational investors. More specifically, it needs marginal investors (those that are driving price movements) to objectively and accurately react to new information.

The modern study of Behavioral Finance got its start in the late 1970s based on the academic work of Amos Tversky and Daniel Kahneman. Their work focused on loss aversion – or what they called prospect theory. They found that individuals experience a greater amount of negative emotion associated with prospective losses than they do positive emotion associated with prospective gains. In other words, losses caused more emotional pain than gains caused positive feelings.

Another bias associated with loss aversion is called the disposition effect, which describes the tendency among investors to hang on to losing securities for too long for fear of realizing a loss, while selling winners far too soon due to eagerness to realize gains.

Another tenet of behavioral finance is recency bias. Recency bias explains the tendency among inves- tors to overweight recent experiences and extrapolate recent trends when making investment decisions. An example of such recency bias is a 1997 study by Yale professor Robert Shiller. He found that at the peak of the Japanese stock market, 14% of Japanese investors expected a crash, but that after the crash a significantly higher 32% of these same investors expected a crash. This bias would seem to be a prime candidate when thinking about root causes for market bubbles.

05 Aug 2009 The Power of Fundamentals
Proponents of EMT believe perfect information exists in the stock market. In other words, whatever information is available about a stock to one investor is available to all investors (except, of course, insider information that is illegal). Therefore, the price of a stock should, they reason, reflect the total knowledge and expectations of all investors. This theory further suggests that investors should not be able to “beat the market” since it would seem improbable to know something about a stock that is not already known to all and reflected in the stock’s price.

Evidence suggests that it may not always work as theorized.

A more recent example was the nearly 57% decline that occurred from the previous S&P 500 Index peak of 1,565 on October 9, 2007 to its most recent low of 677 on March 9, 2009. Investors should wonder — on which one of these days was the market perfectly priced?

While EMT might explain how stocks move on a minute-to-minute or day-to-day basis, we believe that the underlying fundamentals of each business will drive investor returns over longer periods. More specifically, assuming price to earnings (P/E) ratios remain unchanged, a company’s total stock return (TSR) should equal the earnings per share (EPS) growth rate plus the dividend yield.

13 Jul 2009 Is it Time to Invest? Jensen Market Report
During the market rally since March 9, 2009, returns from lower quality companies have significantly outperformed those from higher quality companies. For example, as shown in the following bar chart, from March 9 through May 31, the average return for companies with an S&P quality rating of A or better by Standard and Poor’s was 30.25% compared with a return of 41.49% for those rated less than A. Experience suggests that it is somewhat common for the more speculative, lower quality stocks to outperform during a significant market rally.

During the recovery period following the last recession from late 2002 through late 2007, the returns from lower quality stocks significantly outperformed those from higher quality stocks over an extended period of time. This outperformance, however, occurred during a period of above average economic growth fueled by excessive risk taking and extensive use of leverage by consumers and businesses. A fundamental question may be whether these return patterns will repeat in the next recovery or whether the “new normal” with produce different leadership among stocks.

We believe an argument can be made for new leadership coming from quality growth companies. In a slower growth economy with reduced leverage, higher inflation and interest rates and more government oversight, it is our belief that quality will stand out. Quality companies can generate attractive returns on investment without the need for excessive leverage. Companies with strong balance sheets and superior cash flow generation should be able to absorb the rising cost of debt and take advantage of better returns on their surplus cash holdings. Global franchises can pursue greater growth opportunities outside of the U.S. in economies such as China, India, South America and Eastern Europe. Companies with strong balance sheets and rich cash positions may be able to capitalize on the weaknesses in competitors by gaining market share and making acquisitions to bolster future growth. Their ability to pay dividends and buy back shares represents an added strength. Lastly, well-run businesses with shareholder friendly managers are unlikely to be as affected by new government regulations aimed at reducing risk in businesses with managers whose competence was overstated by the short-term benefits of excess leverage.

03 Mar 2009 Jensen Investment Brief
Sometimes, although a company consistently produces solid results, quarter after quarter, its stock may be ignored by investors for a period of time. But longer term, companies with barriers to entry and returns well above their costs of capital can prove to be excellent generators of wealth, when purchased at the right price. Recent volatility has provided us with outstanding opportunities to buy the stocks of quality businesses at lower valuations. We will only purchase the stock of a company when it is trading at what we believe to be a significant discount to its full value, and the recent turbulence in the market has offered us that opportunity. We believe that buying the stocks of great companies “on sale” can help buffer our clients’ investments in times of market downturn.

With stock prices for many companies hitting multi-year market lows, we have been adjusting portfolio weightings to reflect our convictions and have been further upgrading the portfolio by acquiring the stocks of additional quality businesses.

We do have strict minimum criteria for each company in The Jensen Portfolio, specifically that each company must have a record of 15% or greater Return on Equity for each of 10 consecutive years.

Another strict requirement we will not breach is to only purchase the stocks of companies when they are selling at a significant discount to full value. Full value represents the present value of all future earnings or free cash flows of the business and, we believe, is more predictable for the businesses Jensen owns due to their long histories of consistent performance.

We believe that this market downturn has provided us with the most exciting time in our history to buy quality growth companies at attractive valuations.