Talk Your Book: Quality Growth Investing

0:00Today's Animal Spirits Talk Your Book is brought to you by Jensen Investment Management Management Go to JensenInvestment.com slash ETF to learn more about the Jensen Quality Growth ETF, ticker JGRW. That's JensenInvestment.com slash ETF. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnick and Ben Carlson as they talk about what they're reading, writing, and watching. All opinions expressed by Michael and Ben are solely their own opinion and do not reflect the opinion of Ritholtz Wealth Management. This podcast is for informational purposes only and should not be relied upon for any investment decisions.

0:38Clients of Ritholtz Wealth Management may maintain positions in the securities discussed in this podcast.

0:46We're joined today by Kevin Walcush. Kevin is a portfolio manager for Jensen Investments. Ben, when thinking about different sort of factors, I think that probably the two that come to mind right away is value and growth. Then maybe momentum, maybe small or size. Is quality the forgotten factor or the one that's least discussed? Well, quality is the new one, right? We had the original Fama French three-factor model, right? Was this the fourth or maybe the fifth? Profitability was in there somewhere. Yeah, I guess profitability and quality are kind of similar. But yes, it's probably the newest one.

1:21And I think if you deconstructed Buffett's returns going far enough back, quality is probably a bigger piece than most people realize. I think if you were to look at just one business metric, I think quality would keep you out of trouble. Yeah, I can see that. Right? Like over a full cycle, whatever that means? Yes. Not saying that quality businesses can't get dinged if they miss or something goes wrong, but that it keeps you out of the really big, big losers. You know what? I don't know. It just came to my mind. I was listening to the conference called Disney. Great company, not a quality business.

1:55That's true. Which means quality businesses can change, right? They don't stay that way forever. Yeah. Yeah. So we've talked to Jensen Investments before. We talked to Kevin Walkish today, and we talked about their quality growth ETF. And what I like about Kevin is he said, listen, we're in the large cap growth space, which is doing great, but we're underperforming. And I love when active managers admit that, saying, this is just not the environment for our strategy right now to keep up when you have this AI boom going on and recognizing that factor as well. So here's our talk with Kevin Walkish from Jensen Investment Management.

2:41We're joined today by Kevin Walkish. Kevin is from Jensen Investment Management. Kevin, welcome back to the show. Great, thanks. Great to be back. I have a question for you that is kind of hard to answer. Maybe I tried to explain to my kids the other day what rhetorical means, which is harder than it sounds. But I'm curious, investing in a place like large cap growth stocks, where everything is seemingly going well, how do you figure out the difference between skill and luck when you are investing in a segment of the market that is doing really well and seemingly outperforming all comers? How do you think about this question of I'm riding the wave, but also we're picking the stocks and how do you try to decipher for this?

3:19You know, I think time is a great differentiator. You know, in that case, you know, we think of ourselves as a long-term manager in a market that's very short-term focused and increasingly short-term focused. And in that regard, you know, you know, we think about efficient market theory, all the information's priced in, but the reaction can be very disproportionate in terms of a risk perception and a value perception in the short term. We think that plays out over the long run. And so, and we think that our ability is sort of long-term managers to look at current market conditions through a different lens sort of enables us to sort of help distinguish what we think is first and foremost, our companies, our quality companies that can really generate what we think is very strong value over time.

4:01And we think that that value our shareholders can participate in. And so what I'm saying is maybe long form, but really what I mean is that ultimately the long-term sort of sorts out the luck from the skill. But I would also say that luck is still a part of the business. Yeah. And I'm just curious, how do you prepare for the inevitable other side of this mountain if there is a period of underperformance for this specific type of investing for large cap growth? How do you think about that period when maybe it's not just not going to cover off the ball all the time? Well, again, sort of as a long-term manager, we want to look through the cycle.

4:41We want to manage to the full cycle. We know the downturn is going to come at some point. As a quality manager, you know, we're looking for those businesses that are durable, battleship ready, all weather in nature in terms of being able to weather sort of the volatility that, you know, markets can experience over a full market cycle. So, and then as a long-term manager, you know, long-term holding, average holding for our period, for our strategy is seven to eight years. And the thinking is, is that our businesses can sort of navigate the volatility that we would experience or expect to experience.

5:15So right now, what we've seen is high market concentration, really focused really on an AI trade, in our opinion, that we just don't believe is sustainable. Having managed this strategy since even before the dot-com implosion, you know, really dealing with that sort of bubble, also dealing with 07, 08, where we saw financials, energy and home builders build, we didn't really participate in those. And that's sort of the nature of our strategy, being focused on quality businesses that are very consistent. And so when those bubbles have popped, the value is, in our opinion, recognized of the businesses that we own.

5:54And that is sort of enables a strong recovery in that case from a downside protection standpoint. So in that sense, we want to manage for the full market cycle. We want to acknowledge the current challenges. Right now, AI is a little bit of a headwind for us. We would expect as the market sort of broadens out away from this concentrated trade that we'll see the value in the rest of our portfolio be recognized and then thus benefit our shareholders. Within the quality segment that you all play, and I'm sure there's a heavy quantitative element to this in terms of ROIC or ROE or whatever you guys are looking at, which we can get into.

6:33But is there a qualitative element as well to the story? Well, so the way we sort of build up our portfolio or concentrate portfolio of 25 to 30 names, we want to look for first and foremost companies that have high returns on capital. And so in that regard, we do look for return on equity. Companies have to return in excess of 15 % return on equity for 10 years. To us, that sort of represents the ability of a business to generate high returns over full market cycles. And so from a quant perspective, then we use that screen across all publicly traded companies. And that sort of narrows down our universe to about 350 stocks.

7:10In that case, so it's a pretty high bar in that regard. And then after that, from a quantitative standpoint, we kind of what we do then is we do a deep dive and analysis into our businesses to really sort of build out that thesis. And that tends to go down the qualitative path. And so when we think about then portfolio construction, the other sort of quantitative aspect would be valuation. You know, we're really focused on discounted cash flow. You know, we think we've done the deep dive and understand our businesses from a fundamental standpoint. So in that case, you know, through our DCF, we want to determine full value.

7:44And so that would be sort of the other sort of quantitative contributor to portfolio construction, which in our mind really sort of marries up sort of the quantitative, but really the art and the qualitative to help us build our portfolio. So within your top 10 holdings, which you mentioned they're concentrated. So the top three, which I'm going to mention are 22%, give or take, it's Microsoft, Alphabet, and Apple. Of the Mag 7, those are the only three that are in your top 10. So it's not here. And I wouldn't expect Tesla to be in here. I would not expect Nvidia to be in here just given that its rise has been meteoric and very quick and just wouldn't filter through the screens that you have in place.

8:24But maybe we could use like Meta and Amazon that aren't in here as a jumping off point to talk further about what quality means to you. So what is it about those two businesses that might have them not in the top 10? I don't know if you own them or not. We don't own them. Amazon's easy. They have not generated that consistent return on equity that we're seeking. So they've not generated a minimum of 15 % return on equity for 10 consecutive years. You know, they basically were on track years ago when the business was really focused on just sort of the core sort of retail. But pretty much they went off track when they went into consumer electronics.

9:03And consumer electronics typically commoditize relatively quickly. And that sort of investment in that direction really sort of, in our minds, really compromised the return on equity. And so in that case, they don't qualify. Meta actually does qualify. We've done the fundamental work on the business. And this would be an example where we think about portfolio construction is you certainly have the fundamentals, the valuation and security specific risk. In this case, governance is incredibly important to us and also consistency in the business. So when we looked at Meta, it's a good business. It's done really well from a stock perspective.

9:40but we feel like for our type of investors who are really looking for stability and a degree of predictability, a couple of things really sort of stood out to us. One was just sort of the decision by Mark Zuckerberg to go into the meta universe and to kind of almost at that point, sort of on his own decision, really pivot the business in a massive way. And in that regard, that was a real concern for us from a decision-making standpoint and a governance standpoint. Worst name change in the last 20 years, right? Got to be up there? It's got to be up there. I mean, I think that's where branding definitely makes a difference.

10:15I think that one definitely took them off track from a name perspective. So NVIDIA not being on here is another one. And I want to touch on some of the things you said earlier about the AI potentially being in a bubble. And I tend to agree. I don't see how, even if AI is everything that it's promised to be, I don't think we've ever had a handoff technologically where you get this huge cycle of investment from firms that's immediately handed off to usage for clients and businesses. And that it just, it's never a smooth transition or handoff. So even if AI is everything people say it's going to be, I just don't see how we get from here to there without a bubble deflating at some point.

10:55Is that the way you're thinking about this? Yeah, definitely. I mean, when we look at, you know, what right now is where's the constraint? It's around compute. And so the value is sort of accruing in that direction. We know, you know, historically, semiconductors have been relatively volatile, very cyclical. You know, we think as soon as the constraint moves away from chips, we think that will be that time where that bubble sort of pops. But then we sort of expect, you know, we think about AI long term, we're excited about it. We think the opportunity for value creation is amazing. In our mind, then, after that sort of shift and that realization that all the value is accruing to a handful of chip companies, but it's really sort of broadening out, we think at that point, that certainly will be sort of that catalyst where this market bubble will pop.

11:45I want to ask you about that specifically because it's a weird thing where if you think back to the internet bubble, dot-com bubble, there were so many companies. IPO is going up a couple hundred percent on the day it came public. This is a different sort of bubble, if we're going to call it that, where it's really focused in the mega, mega, mega, mega cap tech. I don't know if that's better or worse, but it's a weird dynamic where you're not just seeing all of the – like, oh, we're also an AI company. You're not seeing like a dozen of these companies pop up and just go vertical. That's just not happening.

12:18It's really accruing to the NVIDIAs of the world. And I guess it's a short list beyond that. You know, AMD, Micron, et cetera. Right. I mean, well, it's interesting to those, you know, kind of compared to the dot com time. You know, there was a lot of companies that would, you know, basically put a lot of investment into hope, so to speak, and the idea around it. Meaning, you know, you sort of see like a web van. A web van would do a massive sort of investment in supply chain and try and sort of do a build it if they will come sort of faith based type opportunity. And that really compounded. And I think that, you know, the the value of the people didn't really drive towards that business quick enough.

13:01In this case, it's interesting. In our mind, these businesses, the semiconductors, the semiconductor equipment, they are creating a lot of value pretty relatively early, in our opinion. And we also see that value on sort of the platform businesses like a Microsoft and an Alphabet. And so I think that's what makes this one probably a little bit trickier, is that there is some value creation going on. The runway looks interesting. But then I think the challenge is, we're not exactly sure where this is going to sort of the cadence of how this is going to play out in terms of what are the services that we're really all going to benefit from.

13:38And so I think that degree of hope is still relatively high, but there is some value creation going on. But I think at that point where hope realizes the value is not coming as quick as was hoped for is when we'll see sort of that bubble pop. And I think that's just that uncertainty this time. And, you know, it's sort of like Mark Twain said, you know, history doesn't repeat itself. It just often rhymes. And I think that's sort of the rhyme from this experience that I think, you know, relative to the internet bubble, but then also different bubbles that have sort of we've experienced over, you know, many markets.

14:13Do you find that the quantitative aspect of your strategy makes it easier or more difficult to invest in this kind of market? Like, because I guess if you have these hard and fast rules, it just, it keeps those companies out regardless, right? You have your rules, you stick to them. On the other hand, it's like, you see some of these companies maybe going ballistic and you think, geez, I wish we could invest. So how do you, how do you think about that? Yeah, I think that's just sort of the discipline of what we want to employ with our strategy and that sort of long-term focus. So typically our strategy, so we, we are underperforming, um, in this kind of market.

14:45Yeah. Who isn't? Get in line. Yeah, exactly. It's kind of binary. Either you own NVIDIA or you don't. Yeah. And in that regard, for us, and we've seen this before, as bubbles inflate, we tend to not keep up. And the more they inflate, the more difficult it is for us to keep up. But typically when they pop is when we really sort of show the value that we can deliver with our type of portfolio of quality businesses. And so in that case, it's a matter of adhering to the discipline, to not style drift, to not get tempted to kind of go after these names, especially when we think valuations can be pretty high for these names.

15:24And to really sort of, in essence, be a little bit on the faith-based side, but also a belief that we don't know when the market will turn, but we have a high confidence that it will turn at some point. You, the 15 % ROE, that's a pretty high threshold, as you mentioned, only 300 some odd companies meet that criteria. What's the valuation overlay? Because naturally, these companies, these wonderful businesses are going to be trading at a higher multiple. They deserve a higher multiple than the market. So how do you think about, okay, this is trading at a premium, but the premium is too high? Well, it's interesting.

15:56So our portfolio, so like right now, you have this concentration in a handful of names. We think the market's undervaluing other large number of companies in the market, especially our quality businesses. So when we look at our valuation and the way we build it up, we still see a lot of opportunity. And so that valuation run, so to speak, isn't as apparent in terms of being really restricting what we're trying to do from a valuation perspective. And I get it. Like you look at the handfuls of NVIDIA and these other names that are just running, but there's a lot of other names that we don't think their value is being recognized at this point.

16:36And so valuations actually, in our opinion, look pretty good. We should mention we're talking here about your Jensen Quality Growth ETF, which is an ETF that's coming out, but a strategy that you guys have employed for a number of years. Is a step into ETFs here for this type of strategy just this is just the way things are going? Because I think people don't realize how really big the mutual fund and separately managed side of the business is, especially for institutional investors and such. Is this just a way to open up the access to more people for this kind of strategy? Absolutely. You know, for us, it's another channel.

17:11You know, our strategy certainly was, you know, initiated on the mutual fund side. We've evolved over time for separately managed accounts, UMAs. And this is just another channel that can offer value to customers who like our strategy, but maybe more tax sensitive, just because ETFs can deal with capital gains in a very different way, in a more favorable way. In that regard, what's interesting is, is our strategy already, because of its low turnover nature, has historically been relatively tax friendly, but not necessarily tax free. And so for our clients who are looking for that incremental edge from a tax advantage standpoint, we think this can help solve their needs in that regard.

17:55So again, we think it's an opportunity to sort of really broaden out the appeal of our strategy. Kevin, I'm not expecting you to have a great answer for this, but I'll throw it out anyhow. These businesses that we're talking about here, because that's what they are, they're not just stocks, they are actually companies. how does the share price converge with the value creation? How does that happen? Sure. Well, I mean, I think it's a matter of recognition in the market. That's the measuring stick, so to speak. And in that regard, our perception of value may be mispriced, in our opinion, in the market.

18:31And so we think time, our belief as fundamental bottoms-up investors is that the return of a business will ultimately get reflected in the share price and combining that with the dividends would create a total shareholder return. We just think that the market can take longer than we identify that. And so in our opinion, our belief as fundamental investors is that the market will ultimately move in that direction and recognize the value creation. So the goal for us is to really, you know, we want to initiate a position. We want to see whether we think the market's maybe missing that value opportunity.

19:07and we want to invest with a discount to that, what we think is the full value. And that gives us a margin of safety, but it also gives us an opportunity for value creation, that recognition. Do you think in terms of catalysts, or do you care about catalysts? Because I think you could say this not just for you picking high quality, large cap stocks. You could say this for people picking small caps or mid caps or international stocks or dividends or low volatility, whatever. Pick any other strategy besides high flying growth stocks that would say the fundamentals are better here. The valuations are better.

19:37Do you ever think through, here's the catalyst that could cause these companies to have that price and value come together? Or is it more just, we think this is mispriced and we think eventually the market is going to figure it out? I mean, some of both. I mean, it's really sort of business dependent. And what we find then is that as we build our portfolio one company at a time, 25 to 30 stocks or companies within our portfolio, some may need, in our mind, may have a catalyst that the market hasn't recognized. But others, it's just a matter of good execution, nothing specific, just sort of a market misunderstanding that we think will evolve over time.

20:15You know, as far as catalysts, I'm trying to think of something right now. You know, I think right now, I mean, catalysts right now are moving around our large cap names. Apple, Microsoft, Alphabet, there's a lot going on in that space right now. And so, you know, I think the market's kind of waiting for catalysts in terms of clarity, in terms of value creation, probably also looking for clarity on the regulation side and also on the litigation side. And so in that regard, you know, you could say that we're waiting for that market to kind of recognize that. For other names where we're looking at, you know, we like health care.

20:53Health care is a very strong fit for our type of strategy. specific names like a striker. Striker isn't necessarily, so striker, leading producer of artificial knees and hips. Based in West Michigan. Sorry. Yes. Based in West Michigan, just like me. Barry just got a new hip. I wonder if he's got some striker in his body. But we like, I mean, so that would be a name where, you know, I don't know if we're looking for a catalyst in like a name like striker, but we're looking for really good execution in terms of their dominance within their markets, their robotic surgery technology, that high degree of lock-in, that building out that share, we don't need a catalyst from something like that.

21:30We just need them to continue to execute and get that reflected in the market. One of the big differences between this environment and say the last, I don't know, 15 years are the level of interest rates. You mentioned that you do discounted cashflow. What did higher interest rates do to your models? I mean, it's certainly that risk-free component on figuring out a cost of equity definitely was up. So in that regard, certainly pressured. Were you like, holy cow, we have to sell everything? I mean, it was, yeah, it's interesting. I mean, we certainly, you know, this market period has been a great opportunity for us to kind of make sure, go through all of our assumptions, our processes, and make sure we're still continuing to be on point in terms of that.

22:11And so valuation was no different. Cost of equity is no different. And these high interest rates were no different in that regard. What we found, though, is that when we look at interest rates, we create interest rates on a per company basis. We look at fundamental factors within the business. And in that regard, even with higher interest rates and, let's say, valuations that are a little bit more stretched, we still saw a lot of value opportunity in our businesses through our models. And so in that regard, it helped us sharpen our pencils, but it was very confirming in what we're doing. I'm curious how you stress test some of those models.

22:45I remember my very first job in this industry, I worked for a group of sell-side analysts, and they basically the first day said, here's all of our Excel models. go through these discounted cash flow models and macros that we've created on Excel and figure out the pivot points, like where you can make the biggest change from your biggest assumption. So it's the garbage in, garbage out theory. And going across all those different spreadsheets, it took me weeks to untangle this web of connections here. But how do you think through this? And how do you recognize that these two or three inputs, and interest rates are probably one of them, can really cause a big shift here?

23:22And how do you figure out like how much certainty we have in some of these inputs for making models like that, that kind of try to determine the value? You know, you're hitting the nail right on the head in terms of evaluating what are the sort of the trigger points. You know, we've done this for a long, long time. We've really honed our process. So we've had good opportunities, we think, to sort of test it over time and see where those sensitivities are. Interest rates definitely are a big driver in terms of sensitivity and the valuations. more so than, you know, if you're building a DCF and you're starting from the top line, you're working your way through the profitability, and then you're looking through cash flow.

23:57The biggest sort of sensitivity is around those cost of equities. And interest rates definitely has a big influence on that, more so than volatility on the top line or profitability. So in that regard, for us, then it's a matter of, you know, when we're testing it, we're really sort of evaluating is a, you know, we're certainly updating our assumptions around cost of equity determination. We're also building out confidence intervals on our cost of equities as well. And so we sort of build that out to help us, in our mind, sort of capture what we think is that variability that one would experience in your sort of assumption set.