Deep Dive: This ‘all-weather’ approach to quality stocks can help you sail through rough waters while staying ahead of inflation

Before taking a look at the fund’s methodology and holdings, here are two items to remind you of why a broad investment in U.S. stocks may be your best way to build wealth and stay ahead of inflation over the long term.

First, over the 30 years through March 7, the benchmark S&P 500 Index’s
SPX,
-0.19%
average annual total return (with dividends reinvested) has been 10.3%. There have been good years and bad years, and significant pullbacks more often than investors would like, but that figure measures up well against the 7.5% annual inflation rate in January, based on the consumer price index.

And for investors worried about current uncertainties, including the tragic events in Ukraine, the pop in oil prices and supply disruptions to come, here’s a chart showing price movement for the S&P 500
SPX,
-0.19%
from the end of 2019 through March 7:

From its then-all-time closing high on Feb. 19, 2020, through the pandemic bottom on March 23, 2020, the S&P 500 fell 34%, excluding dividends.

After that, it took only until Aug. 11, 2020, for the index to recover and close at a new record high. For all of 2020, excluding dividends, the S&P 500 gained 16%, followed by a 28% gain during 2021. An investor who sold into the declining market early in 2020 to avoid the worst of the decline, with the idea of jumping back in during the recovery, was likely to be too late in returning, thus hurting long-term returns.

The S&P 500 has fallen 11.9% so far this year, excluding dividends. A decline of this magnitude is no fun to wait through, but it is worth pointing out that it follows a 48% increase for the index from the end of 2019 through the end of 2021.

During an interview, McIver said that “one of the lesser appreciated secrets of long-term investing success is time in the market, not timing the market.”

A stringent test for growth stocks

In order to maintain a stable portfolio of companies with “all-weather business models,” McIver and his colleagues continually look at the entire universe of U.S. stocks to narrow the list to companies that have achieved returns on equity (ROE) of at least 15% over the previous 10 years. That broad culling reduces the investable universe for the Jensen Quality Growth Fund to about 280 companies.

The fund managers then look at other factors, such as profit margins, sales growth and earnings growth, to narrow the list further.

“Frankly, since we have been doing this so long, we know most of those companies quite well. There is a large set of institutional knowledge we rely on,” McIver said. He joined Jensen in 2004. The Jensen Quality Growth Fund was established in 1992.

No one screening factor is perfect. For example, Home Depot Inc.
HD,
+0.33%,
which is held by the fund, had negative equity as of Dec. 31, making an ROE figure for 2021 meaningless.

McIver said a company can have negative equity if it has been losing money. But a negative figure for equity “may be the result of a company electing to exclude exceptional restructuring costs from net income but not equity, or by structuring a large debt-financed share buyback that may enhance shareholder value,” he added.

So McIver and his team look beyond ROE, “to holistically analyze the financial statements to determine whether a business represents an investment opportunity that is worthy of further consideration,” he said.

Other metrics Jensen analyzes include return on invested capital as well as free cash flow, debt-to-capital and debit-to-EBITDA ratios.

A change in market perception

McIver quoted a Jensen client who recently said: “At times of stress, I believe in getting rich slowly.” He agrees with this philosophy and said it ties into Jensen’s philosophy of “knowing what you own.”

He said investors seem to be in a risk-off mode now, reflecting inflation, geopolitical concerns and the ending of pandemic-related government stimulus, following a risk-on attitude that seemed to be lifting all boats through the end of last year.

Brand loyalty and pricing power are especially important during a period of broad inflation, and the fund’s selection approach tends to favor companies that have both, he said.

Examples of companies held by the fund

According to Morningstar, portfolio turnover for the Jensen Quality Growth Fund has been 12% over the past 12 months — that’s a very low figure. McIver said his team will sell a stock of a quality company if it gets too expensive, and has often bought back in after a combination of price pullback and increasing sales and earnings make it attractive again. One example he named of a stock that was sold and then bought back was Amphenol Corp.
APH,
-0.43%,
which Jensen purchased in September after having sold it in 2020.

MMC

One relatively new holding, which hit the 10-year 15% ROE benchmark within the last few years is Marsh & McLennan Cos.
MMC,
-1.71%.
, which is based in New York and provides insurance brokerage and consulting services to commercial clients worldwide. This is a complex business that McIver described as recession-resistant and inflation-resistant.

People and businesses always need insurance, regardless of the economic environment, and MMC has the advantage of earning fees as it facilitates insurance relationships without incurring the underwriting risk.

According to FactSet, MMC’s ROE for 2021 was 31.3%, which compares to a weighted ROE of 19% for the S&P 500. For 10 years, MMC’s average ROE through 2021 was 23%, compared with 15.6% for the index.

To be sure, it is customary for some industries to have relatively low ROE, which will lower this measure for the index. Then again, favoring more rapidly growing companies is part of the fund’s mandate.

McIver called MMC “undervalued relative to the business they are doing.”

PepsiCo

For 10 years through 2021, PepsiCo Inc.
PEP,
-2.07%
achieved an average ROE of 47.6%, according to FactSet. McIver called it a “battleship company.” Obviously PepsiCo competes with Coca-Cola Co.
KO,
-2.79%
in the soft drink business, but it has an incredible moat in its snack business, which McIver said “on the global level is 40 times larger than its closest competitor.”

A quick look at annual numbers for PepsiCo’s fiscal 2021 ended Dec. 25 backs the importance of PepsiCo’s snacks business to its bottom line. Numbers are in millions.

First, annual revenue:

And now operating profit:

The Frito-Lay North America unit contributed 24.7% of PepsiCo’s 2021 sales but 50.5% of company’s operating profit.

McIver touted PepsiCo’s efficiency and said it had increased its dividend for 50 consecutive years.

Performance

During the long bull market though 2021, the performance of the S&P 500 was driven by technology companies that were growing very rapidly. Some of these didn’t meet Jensen’s ROE criteria.

Here’s how the Jensen Quality Growth Fund’s average annual returns have measured up against those of its Morningstar category and the SPDR S&P 500 ETF Trust
SPY,
-0.14%
over various periods:

The Jensen Quality Growth Fund’s average returns exceeded those for its Morningstar category for all periods. The Morningstar category underperformed SPY for all periods, showing how difficult it is for any active manager to outperform a broad index.

The Jensen Quality Growth Fund’s average returns were higher than those of SPY for 5, 10 and 15 years. The 15-year period encompasses the 2008 credit crisis, and the Jensen fund’s 1% higher average performance, when compared to SPY, translates to a total return for 15 years of 290%, against 275% for SPY.

Fund holdings

The Jensen Quality Growth Fund held 29 stocks as of Dec. 31, with about 1% of the portfolio in cash. Here are all the stocks held by the fund at the end of 2021:

You can click on the tickers for more about each company.

Click here Tomi Kilgore’s detailed guide to the wealth of information available for free on the MarketWatch quote page.

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