Four value stock picks from a fund manager who avoids the energy sector

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Jensen Investment Management follows a simple rule for initial stock selection: companies must have achieved a return on equity (ROE) of at least 15% per annum, for at least 10 consecutive years.

This is a tall order, and it can reassure investors during a period of market turbulence. Easier strategies focused on bull market growth, driven in part by soaring stocks of companies that had not achieved profitability, no longer work.

Jensen’s primary investment vehicle is the $9.1 billion Jensen Quality Growth Fund JENIX,
+1.40%,
which is rated five stars (highest) by Morningstar. The Jensen Quality Value Fund is smaller, with $183 million in assets, and has a four-star rating. Jensen Investment Management is based in Lake Oswego, Oregon, and has approximately $13 billion in assets under active management.

During an interview, Tyra Pratt, co-manager of the Jensen Quality Value Fund JNVIX,
+1.32%,
discussed four of his holdings, including three in the consumer discretionary sector, which has been hit hard this year.

Rob McIver, managing director of Jensen who co-manages the Quality Growth Fund, was also on the call, explaining why the company is not investing in the energy sector.

This may seem to put the company in a difficult position – after all, the S&P 500 energy sector has returned 50% this year. Again, if we look back 10 years, the sector’s total return was only 76%, compared to 243% for the entire S&P 500 SPX,
-2.66%.
(All returns in this article include reinvested dividends.)

The reason Jensen avoids the energy sector is simple: most companies in the sector cannot pull off the first rally by consistently achieving a 15% ROE. In a year when the price of West Texas CL.1 crude oil,
-2.36%
rose 53% through June 15, based on futures prices, energy companies have “incredibly positive cash flow,” McIver said. But energy producers have an inherent disadvantage for long-term investors.

If a company meets Jensen’s initial screening, with a minimum ROE of 15% for 10 consecutive years, then the company’s portfolio managers will subject it to rigorous qualitative review. McIver said that a few years ago when an energy company passed the initial screen, “what we weren’t comfortable with was that the company made a product which she did not fix herself”.

Soaring profits for energy companies now follow “a long period of destruction of shareholder value,” McIver said. “The forces of supply and demand outweigh the pricing opportunities for these companies. Pricing is commoditized.

Avoiding the energy sector has now dampened the performance of both funds this year, which Pratt called a “short-term hiccup” as part of a long-term investment strategy.

The time of value

Let’s start with a Twitter post from Jeff Weniger, head of equity strategy at Wisdom Tree Investments:

We could be at an early stage in a value cycle – marked by outperforming companies that tend to trade at lower earnings and sales than growth stocks. Value companies also tend to have more stable earnings, which fits well with Jensen’s initial screening methodology.

Here’s a simpler chart showing how the S&P 500 Value Index has outperformed the S&P 500 Growth Index and the full benchmark so far this year:

set of facts


It remains to be seen whether the Federal Reserve’s efforts to reduce inflation will result in a recession, but the reversal of central bank and pandemic-era fiscal stimulus has had a dramatic effect on stocks in 2022, making value strategies shine after years of underperformance during the bull market.

Four value stock picks

Pratt explained that the Jensen Quality Value Fund is mostly concentrated in mid-cap stocks, while the company’s Quality Growth Fund is mostly in large-cap stocks. The fund typically holds shares of 30 to 50 companies.

She cited four examples of stocks held by the fund — one health care name and three in the consumer discretionary sector. So far in 2022, the S&P 500 healthcare sector has fared relatively well, down 13%, while the consumer discretionary sector has fallen 31%.

She described the consumer discretionary rout as “an opportunity” for Jensen to increase his stakes in “more sustainable” companies that have competitive advantages.

Here are the four actions that Pratt talked about:

Company Teleprinter Average ROE – 10 exercises Total return – 2022 until June 15 Change in rolling 12-month EPS estimate since December 31

Includes Health Corp.

EHC,
-3.03%

31.11%

-13.7%

-4%

Pool Corp.

BOWL,
-5.04%

64.36%

-37.2%

17%

Tractor Supply Co.

TSCO,
-2.35%

34.13%

-17.0%

13%

Carter’s Inc.

IRC,
-3.39%

26.78%

-27.9%

15%

Data Source: FactSet

The chart includes increases in rolling 12-month earnings per share estimates, which may be of interest as they may help drive stock prices higher over time. They obviously haven’t done that this year, and Jensen is following a very long-term strategy. So far this year, consensus estimates of rolling 12-month weighted aggregate EPS for both sectors are down 1%.

Here are Pratt’s comments on the four companies:

  • Encompass Health Corp. EHC,
    -3.03%
    provides inpatient rehabilitation services, which Pratt described as an industry with high barriers to entry. She said the company’s main market share is bolstered by its technology, which helps it coordinate with hospitals that refer patients to its facilities. The company has a “favorable long-term outlook” due to an aging baby boomer population, she added.

  • Pool Corp. SWIMMING POOL,
    -5.04%
    was a clear favorite among investors early in the pandemic, as people focused on improving their homes. But investors have balked this year as the economy reopened. The company is the largest distributor of swimming pool supplies through small businesses in the United States. Pratt said the company has a price advantage because the pool construction and maintenance companies it sells have the option of working with a single supplier. As anyone with a pool can tell you, maintenance is hardly “discretionary,” even if the company is in an S&P industry with that name.

  • Next is Tractor Supply Co. TSCO,
    -2.35%,
    which provides agricultural supplies and tools to DIYers and focuses on markets “typically overlooked” by Home Depot Inc. HD,
    -2.17%
    and Lowe’s Cos.
    -3.73%,
    said Pratt. She cited the company’s “unique product line,” which comprises about half of edible/consumable products, including livestock feed and agricultural supplies.

  • The latest is Carter’s Inc. CRI,
    -3.39%,
    which is a children’s clothing retailer with its own well-known brands, including OshKosh. Pratt sees Carter’s as a long-term defensive play, in part because baby and children’s clothing is less cyclical because clothes need to be replaced quickly. “There’s also a fashion element” because of Carter’s marks, she said.

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