Animal Spirits Podcast - Talk Your Book: Investing in Quality Growth

Episode Date: February 20, 2023

On today's show, we are joined by Kevin Walkush, Portfolio Manager at Jensen Investment Management to discuss how return on equity works, dealing with changing moats, setting expectations for returns, and much more!   Find complete shownotes on our blogs...  Ben Carlson’s A Wealth of Common Sense  Michael Batnick’s The Irrelevant Investor  Like us on Facebook  And feel free to shoot us an email at [e-mail] with any feedback, questions, recommendations, or ideas for future topics of conversation.      (Wealthcast Media, an affiliate of Ritholtz Wealth Management, received compensation from the sponsor of this advertisement. Inclusion of such advertisements does not constitute or imply endorsement, sponsorship or recommendation thereof, or any affiliation therewith, by the Content Creator or by Ritholtz Wealth Management or any of its employees. Investments in securities involve the risk of loss. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. The information provided on this website (including any information that may be accessed through this website) is not directed at any investor or category of investors and is provided solely as general information.)  Learn more about your ad choices. Visit megaphone.fm/adchoices

Today's Animal Spirits Talk Your Book is brought to you by Jensen Investment Management. Go to Jenseninvestment.com to learn more about their high-quality growth equity strategies. Welcome to Animal Spirits, a show about markets, life, and investing. Join Michael Batnik and Ben Carlson as they talk about what they're reading, writing, and watching. Michael Battenick and Ben Carlson work for Ritt Holtz Wealth Management. All opinions expressed by Michael and Ben or any podcast guests are solely their own opinions and do not reflect the opinion. of Ritthold's wealth management. This podcast is for informational purposes only and should not be relied upon for investment decisions. Clients of Ritthold's wealth management may maintain

positions in the securities discussed in this podcast. Welcome to Animal Spirits. Talk your book with Michael and Ben. Michael, on today's show, we had Kevin Walcush, who is a portfolio manager with Jensen and Investment Management. We've talked to people from Jensen before. This is the first time talking with Kevin. He brought up a very interesting point because you asked him, what is the difference between a concentrated portfolio of 25 to 30 stocks where you're doing bottom-up investment research and talking to company management and doing your own financial statement analysis versus just an ETF of high-quality names that is 2 to 300 stocks that's picked by an algorithm centrally. And his point was, well, that ETF is going to be backward

looking as an active manager in concentrated positions. You're going to have to be forward-looking. And I think that is the right answer. If you're going to be relying on someone who's making stock selections on your behalf in any sort of active framework, they have to be forward-looking to think about what's coming next or what the pivot points are. Obviously, not everyone's right, but that's the line of thinking, right? And it kind of has to be concentrated as well, I think. Yeah, I made the point in talking with Kevin that if you're going to pay for an active manager, you want something that in really no way shape or form resembles an index. So I think that's what you're getting with this strategy. And I like the fact that they use a stable metric as their base, but it's not the be all end-all.

Because obviously, nothing can be reduced to single variable analysis. So I thought the way that they incorporate other metrics and other qualitative inputs was interesting. Let me ask you a question. Since both of us went through the CFA, not having to look at this paper on ROE, could you have written out the equation for return on equity from your memory without looking? Yes. You could have done it? Like, even the broken out part? Oh, God, I want to embarrass myself.

But isn't it just net income? Yes. Divided by assets minus liabilities? Right. Yes. Okay. Yeah, come on. I'm just asking.

Still, I got it. Yeah, but you can break it up into different. The form is that sucked were free cash flow, because it was free cash flow to the firm and then free cash flow to equity. What is that all about? Oof. PTSD. Yes.

There was a lot of formulas for that. But anyway, reading this gave me some flashbacks that. Anyway, I thought this was a really interesting conversation to hear how they think about quality and how they have that. He called it a bright line of ROE. And under that, then you do your analysis. So it's kind of melding some quantitative with some qualitative. So here is our talk with Kevin Walcush, a portfolio manager from Jensen Investment Management on their high quality growth equity strategies. All right, we are joined today by Kevin Walcush.

Kevin is a portfolio manager for Jensen Investment Manager. Kevin, we had a couple of your other colleagues on before, but welcome to the show. Great. Thanks for having me. Before we hop down today, got some material sent over by you and your team today, and there was a white paper that your team produced in December called Return on Equity, a compelling case for investors. I did get some CFA flashbacks in this, looking at the different equations and stuff in there, maybe one of the first few Warren Buffett books I've read. I'm just curious how your firm decided to have this return on equity focus as a starting point

for investment management, and how was that one of the building blocks? Maybe you just go from that. The foundation of the firm was really around high net worth, and the ethos of our founder and namesake Val Jensen was focused on the best way he thought to serve his clients was focused on building portfolios that is a concentration of businesses that he knew very well, that emulated or reflected high quality components, high profitability, high returns on capital that would ultimately lead to stable returns. and let's say market outperformance, that was sort of the intent.

His thinking then was sort of confirmed by academic research out of Harvard by a professor named Fruin. And he was on a similar quest, and he did academic study of looking for quality businesses. And so he started with a hurdle looking for companies that return in excess of 15% return in equity for 10 years as a reflection of sustainable quality businesses. And what he found was a collection of names that generated very consistent returns and was really reflected by sort of the fundamentals of the business, which ultimately drove those returns. And so that academic background really reinforced what our founder

was looking for. And so when we decided to sort of move forward, he decided to sort of adopt that as sort of that initial indicator of quality to help us really pare down the thousands of stocks that are publicly traded to really help hone in on those key businesses that are demonstrating quality attributes. But what we found over time then is pretty quickly, that's just one indicator. We think it's a strong signal, but we're bottoms up managers. For us, it's about then taking that indicator, but understanding what drove that reflection in the business performance. Would it be reproducible? Is it something that we can count on going forward as an investment manager for the business to deliver fundamental results from the business,

but then see that get reflected in total returns through stock price performance and dividends. So it's also been a while since my CFA days. Just remind the audience, definitely not from my benefit. R.O.E is the stock price divided by its 200 moving average. Did I get that right? No. No. So it's profitability. So it's net income divided by average shareholder equity. It sounds very simple, yet obviously a very deterministic metric. So is there anything that you all have to do as bottom up stock investors to normal? formalize anything? Are you just taking Bloomberg's word for it or whoever your data provider is? Talk about reconstructing the data to make sure that you're actually looking at what you're looking at.

And what are you trying to ascertain from that number? So the number is really a reflection of shareholder value creation. And as we want to understand, it's really reflecting the value that's created by the business. And so when we sort of build that, we want to look at how the business is performing fundamentally. We want to evaluate one-time impacts to the business and understand how that's driving those returns on capital. We do tend to evaluate those. We tend to maybe exclude those from an ROE perspective to generate that sort of run rate that we're looking for in the business. Now, in terms of excluding, let's say, one-time items, it doesn't mean that we forget them. We want to evaluate them within context in terms of how did that impact the business and the profitability. What's the likelihood of that happening again as such that it's not one-time in nature? And from there, then we make a determination on that return on equity. In that white paper, you have this cool chart that shows just a 15% ROE screen that you talked about, and it shows it at the end of 2006, the end of 2011,

and it shows kind of the different changes by sector. And I think if we fast forward today, are most of the companies in this that would pass that first level for you? Are most of them tech now? Is it a lot more diversified than I would be thinking? It's, I would say definitely more diverse. It does tend to gravitate towards certain sectors. So if you look at our universe,

a universe tends to gravitate around consumer, on staples and consumer discretionary, It also is health care oriented, tends to be focused on tech, like you've already pointed out. Areas where typically we don't see that sustainable returns on capital we're seeking would be around energy. Those types of companies beholden the price of oil, don't have pricing power, hard to sustainably sort of deliver those returns that we're looking for. We don't see utilities in the United States, regulated returns cap. They're upside from a profitability standpoint. We don't really see traditional financials.

We tend to see a handful of asset managers. We did, if you go back to the 0708 downturn, where we saw really sort of regulated impacts on traditional financials and banks in terms of balance sheet constraints. We saw a number of those businesses fall out of our universe. So typically, we don't see a lot of financials would be how to think about it. And it kind of makes sense. You know, if you kind of step back from a quality growth business, what we're looking for, first and foremost, is companies that have a strong foundation of competitive advantages.

That enables these companies to have sort of that sustainable price. price or cost advantage, then that ultimately underpins the strength of the business to deliver those high returns on capital well in excess of their cost of capital. And we typically, it's really hard to see sort of that pricing power from businesses in those sectors that I talked about that don't typically qualify. Do you sector normalize because I would imagine that what is normal for the return equity of one sector might look wildly different from materials versus communications or whatever. Or is it like, no, no, no. Our rule is we have a number, 15% whatever the number is, and we don't deviate really for any reason. Talk about the difference

in sector composition and how that might impact your portfolio construction. For us, first and foremost, the return on equity screen that we're looking for is an absolute. So it's not relative and it's not normalized on a per sector basis. So for those sectors that typically don't have companies that qualify, then that's sort of a reflection of what we, would say is relatively lower returns on capital such that they're not high enough relative to their cost of capital to sort of develop those returns, the sustainable returns that we're looking for. You mentioned cost of capital. I know you're not macro people, your bottoms up. Nevertheless, it's impossible to ignore what's happening in macro now. It actually matters quite a fair

bit, especially if you're talking about this kind of cash flows. Talk to us about how the roles of interest rates impact your thinking, your stock selection, that sort of stuff. An important element of our understanding of our businesses and our portfolio construction is rooted in valuation. So when we think about what are the fundamentals driving the business, but equal to that is really the valuation. A, we don't want to overpay. We certainly want to identify value in those pockets of value where we can sort of really invest and sort of apply more money to those opportunities. When we think about valuation, we're a DCF shop. And we think about discounted cash flow. An important element is sort of that cost of equity overall. And we do discounting.

cash flow to equity analysis. So our discount rate is based on a risk-frey rate and an equity risk premium. And so when we think about interest rates, very simply when we think about impact evaluation, rising interest rates that we've been experiencing increase that sort of cost of equity overall. And what we're seeing then is valuations coming down as a result. With that is not really forcing us, but it's enabling us to sort of tune our models and our understanding from evaluation perspective, what our businesses are doing from evaluation perspective, and ensuring to us at least from evaluation perspective, we're not owning names that might be overpriced such that we can sell those or trim those names down and

then reinvest in names that from evaluation standpoint, including a consideration of fundamentals, could be better long-term opportunities at any given time. I'm curious as a portfolio manager of long-term stock holdings, high-quality, how you deal with the fast-moving nature of the markets. Even, I guess if you look at the past three to four years, as an example, we had this 35% bear market in a month. Then we had 18 to 20 months of this rip-roaring bull market. Then last year was just down again.

This year, for the first month of the year, things shut back up. Then we have rates going from zero to four percent, basically, and what kind of felt like overnight, if you look at the long trajectory of interest rates. Does that make things more challenging for you as a portfolio manager, more exciting, harder, all of the above? How do you think about that as a long-term? shareholder when things seem to be moving so much faster than they ever have? The way we think about it, I kind of feel a little bit from a team perspective and how we

approach it as a long-term investor, maybe a little bit different than what we think is increasingly short-term focus market. And what I mean by that then is, for us, we certainly acknowledge we're on the same ride as everyone else. And so as we're kind of on that path, but when we look at what's going on through a long-term lens, we think we see different opportunities and risks in that regard. And so while we will see certain volatility where higher volatility tends to create more opportunities for us, that quality names typically are priced at a premium, that we see during large downturns and opportunities sort of high-grade the portfolio. And so in that regard for market downturns, it's kind of interesting from that

perspective where, look, how do we sort of tune the portfolio from the long term from this new sort of set point, where maybe the market is sort of oversold in our opinion. and has given us great value entry points. Conversely, when the market's running, we have the discipline around valuation. And so, in our opinion, we're able to sort of tune the portfolio based on names that can run a bit and that we can take advantage of that. We can trim, we can sell, and we can redeploy into names from a long-term perspective that we believe can drive sort of the long-term returns that we're seeking.

So I would say, for the most part, as a quality manager invested in, a concentrated portfolio of names that we know very well, that we apply, sort of a risk-first mindset that overall, during these volatile times, A, I tend to sleep well just as well during the times when things are kind of easy. And I'm excited about these sort of windows of opportunity where we can sort of drive more improved value that we believe we can realize over the long term. Benjamin mentioned something about things shifting quickly or Mark is moving quickly these days. I'd love to get your opinion or your take. Maybe we can use this as an example or an illustration about your thought process. And you

You might even know the name. So let's talk about Google, which has had spectacular financial metrics and everything that you can measure looks wonderful. And then you have a moment in time where we did last week where a moat that once seemed impenetrable was hit very hard and the market reacted very quickly. When things like that happen, and you don't need to necessarily comment on Google and Microsoft and all that sort of stuff, I guess what I'm asking is how do you think about things changing and moats maybe not being as impenetrable as you might thought and sell discipline

all that sort of stuff talk about when the facts change type stuff i think the last couple weeks with chat gpt really manifesting through Microsoft from a value ad because we own Microsoft and we also own alphabet so we get to kind of see that play and that shift and perception in terms of value creation first and foremost it really is a long-term investor we're sort of looking at right now if you look at the headlines you look at the reports and you look at the information there's a very very strong from our impression hype cycle on this. I even read Reporzi's in the word mania. You're seeing valuations with any business right now that has AI within sort of their collective in any ways is running really well. And if you kind of go back, I think from a

euphoric standpoint of opportunity, there's a lot of speculation. But for us, then, it's how do you ultimately execute. So if we look at it through, let's say the alphabet lens and the impact on Google, really high market share, very much an innovative. and a long-term innovator, but there's always going to be a challenge to any sort of innovation incumbent. And in this case, it's a matter of how do they pair back and deal with potential threats to their business over time? Because this isn't the first thing. This is something that's really sort of come really quickly. As we've evaluated over the years, they've had a lot of threats and impacts on the business, whether it's, say, regulatory threats or other competitive

threats. We've seen them make those investments. Right now, from an AI perspective, they have a strong reputation in AI, but right now, chat GPT just sort of did a leap forward. And Microsoft is benefiting from that, from a timing perspective. Long term, how is search going to be in their slice of the ad market? We're seeing ad online ad get a little bit computed away. We're seeing still the strength in the business and the execution and the fundamentals and the financials. As we think about this impact, we think about how do they respond. They have their own AI.

And so when we look at it, we think, yes, can there be a shift in market share? Do we think that Microsoft's Bing can shipped up within the market? Yes. But does Google still have such a large incumbent position that they can generate significant amounts of cash off of? Definitely. But as fundamental managers, we continue to grapple that with everyone. We think the hype is high. We think things will normalize.

We think that Google will have an opportunity to still continue to demonstrate its value. but we also think Microsoft now has an opportunity to realize that value. Our clients then, net for net, can realize that benefit across the board. So we have a diversified AI play here, basically. You're not trying to pick the winner among the subs out there. We think both are winners in so many ways. It's not like we ever sat down and said we can only own one or the other. We see benefits to both business models.

They've been relatively different and differentiated. Microsoft's an interesting opportunity of itself from a competitive standpoint. We know they've competed for years, but we've seen value by both as they've competed relative to each other. And we definitely have seen the reflection of that value creation on high returns on capital, strong profitability, strong growth drivers that are very robust. Last year, the trend accelerated of outflows out of active management and into index funds. Can you talk about how you all have fared?

You don't need to necessarily comment on your flows per se. But what is the value add that you all provide above and beyond, say, a quality ETF or something along those lines? Well, I think relative to, let's say, an ETFs, we've seen them there's a handful out there. They tend to be backwards looking on indicators. And so that's the best they can do, in our opinion. We don't see a forward-looking element, but investing in stocks and businesses is about looking forward and trying to ascertain that sort of value creation going forward. forward. But also, the aspect of value is, how's the business executing, but then what are the

risks to the business? We don't see how an ETF can sort of capture that by being backwards looking. So we believe, as a manager, we think we can look forward and account for risk and continue to sort of invest in that manner. We can also look from evaluation. Sorry to Fred Yop, what do you mean exactly by ETFs are backward looking, your forward looking? Could you just explain that in greater detail? Typically, let's say a quality-based ETF is looking at factors that are based on historical data. If you're looking at, let's say, returns on equity across the board, you're looking at profitability, you're looking at profitability, stability, you're looking at growth.

Those kind of factors, since they're backwards looking, in sort of a cyclical world, in our opinion, doesn't always capture sort of the forward risk and sort of the downside. An important aspect of quality for us, and we think it was a reflection of the investment group as a whole, is about downside protection. It's businesses that execute with very strong fundamentals that we typically see during downmarket events where the market then starts shifting and realizing that value and starts emphasizing that value more and tends to attract more attention, more dollars. And I think you've asked about flows. Flows for us, in my opinion, are very good as a reflection of the value that we have delivered, but also our mix of companies facing the

environment of, let's say, high inflationary environment. We have a portfolio of names that really a key attribute and linkage between really their fundamentals and how they navigate this environment is that they have pricing power. That's a strong reflection of competitive advantages. And so in that regard, we see interest in our type of portfolio that has a portfolio of businesses that can pass price on in a high inflationary environment, preserve value, and sort of continue to execute in a profitable and sustainable way. I like this idea of thinking about your strategy versus a more maybe diversified ETF.

Do you have a company or maybe a handful of companies that consistently passes your first screen, but maybe doesn't pass your next few steps of research where, you go, this company consistently has high ROEs, but the valuations are too high, or there's something about the business that we just don't want to own? Are there companies or sectors that are like that? We'll see, for example, let's say tobacco companies will qualify. from our universe. They do generate really high returns on capital. We've never invested in tobacco businesses. For us, from a risk-first mindset, that sort of that risk of limitless

liabilities. We also really don't see the growth, an important element of what we're looking for, businesses that are growing and creating that shareholder value and growing that sustainably over time. We just really haven't seen that from tobacco companies. So that would be an example. We could see, let's say, lower growth-type businesses. For example, Walmart is one that qualifies from an ROE perspective historically, but we haven't really seen the consistent high levels of growth that we're seeking for that type of business.

And so in that regard, that would be another name, for example, that while it qualifies, it's just not attractive from a growth aspect to us. I imagine that return on equity is a fairly stable metric. Maybe you can correct me from wrong,

but what other metrics do you use to complement return on equity? And this is a two-part question, as you say in the business? And in addition to that, are there any qualitative aspects of a business that you incorporate into your decision making? Again, to recap, how stable is RA, what complements it, and any qualitative inputs? So first off, R.E is a very good indicator of shareholder value. But we also don't think it's the only one. Another one that we look at is return on invested capital, which also includes debt. And so in that regard, we think that's another

important element to sort of true up our return on equity gauge, so to speak, in terms of looking at strong indicators for quality growth business. And so in that regard, that's another area where we want to look and account for. You know, when we think about qualitative drivers of what we're looking for, for us, it's about what are the key drivers that make what we think is a Jensen quality growth business. First, it starts with competitive advantages. And that's really the cornerstone and the basis of our businesses that we deem quality. And so, for example, it could be for a tech company, it could be a network effect. We could see for companies across the board, economies of scale, economies of scope, brand, innovation, something that creates some sort of price or cost advantage.

We typically then want to look for companies that are growing. And I talked about that in terms of a company that can qualify from an ROE, but not grow. Where it's important in elements of growth is very important in that value creation over time. So we want to look for strong and diverse growth drivers. We also are then looking at how does that impact financials? And so we're looking at how does that play out in the top line. We want to look at profitability and what are the drivers and are they improving that profitability to drive those high returns on capital.

We're looking at management team. That would be a qualitative where we want to see them as great stewards of the business in terms of being able to invest in the business and all stakeholders in the success of the business. And so that's not only investing in competitive advantages to ensure they maintain them, but ideally improving or also creating new competitive advantages such that they can drive that sort of long-term value. And then we're also looking at strong boards to hold that management team accountable. And so when we look at fundamentals, certainly we have the indicators, but what we really feel

like is we're really rolling up our sleeves at a bottoms-up manager to evaluate those other elements, what's really driving that financial picture and that success picture. Kevin, you spoke about management companies being stewards of capital. I would imagine that the current environment is music to your ears when you're listening to earnings calls, shout out to quarter, because one of the focuses that I've heard when I'm listening is a return to efficiency. That has been the theme of Q4 earning seasons thus far. Obviously, that's a reflection of interest rates, of tech companies in particular getting killed by the market. Are you hearing that? And are you feeling better about back to brass tax, just business fundamentals improving now that Wall Street is demanding more efficiency from management? In our opinion, as a quality manager, we think it's always the time to focus on efficiency and good execution. We think that right now, and as a quality manager, we typically see that during strong up markets, quality attributes of businesses aren't necessarily as emphasized and valued.

And then what we see during the downtime, that we see that focus shift. And I think we're seeing that now. And so in that case, I think that's where our types of business, can sort of demonstrate that they're not just doing it now, they've been doing it in a sustainable fashion to drive efficiency and execution and success in the business. For these type of environments, we feel really good as a quality manager where our businesses can actually enter them stronger, and in many cases. And these are opportunities for these companies to really build on their strengths and have opportunities to really sort of invest in expanding market share. They have typically very strong balance sheets that they can go after weaker

competitors that were not as weak until you sort of entered these times. And at the end of the day, then, it's about really looking for those management teams that really reflect that long-term nature of the business in terms of running the business for success over the long run. And so we think that's where these moments then shine. When you're setting expectations for your own investors about the type of performance that you would like them to see in their portfolio, is it kind of because these are more stable, high-quality companies, is it the kind of thing where, well, you hope to soften the blow during a bear market, but if there's a raging bull market, you're not going to keep up? Or is it not necessarily like that because you

have more concentrated names and maybe the performance isn't that easy to pigeonhole like that? Typically in our markets, like you said, it can be really tough to keep up. But I think we've done a pretty good job of really keeping up in that regard. We really hold ourselves accountable as a long-term manager to how we perform over our full market cycle. So we're looking for for really how did we do peak-to-peak? Because we have that downside protection element to what we do, and it's just really based on the nature of our businesses,

then we want to basically proportionally capture that when we look at peak to peak, because typically down markets are short and severe. Up markets tend to be long and plotting. And so in that regard, if you're looking at sort of book-ended times, when you look at our strategy, we've been in a really long bull market, stimulated by a very accommodative fed,

a very much rising tide lifting all boats, that if you, as from a management standpoint, looking at, let's say, book-ended times, 15, 7, 10 kind of times, it's hard for that to really sort of capture the peak-to-peak type performance in full cycle that a long-term investor would look for. So it's sort of that downside protection is lack of loss, which can be a very powerful driver for long-term returns, and then very respectable equity-like returns in the upside is sort of the net for net. Kevin, can you talk about portfolio turnover? What sort of holding period is typical amongst your investments? Our flagship strategy, the Jensen Quality Growth Strategy,

it's a large cap, U.S. focused. The portfolio is 25 to 30 names by design. Our turnover is mid-teens. So what that really means is on average, we're holding a name seven to eight years. We're roughly selling two names and buying two names a year on average. That typically changes, though. that cadence. I think you'd asked earlier about highly volatile times within the market can give us opportunities to maybe take advantage of more opportunities than we could have in the past. Can you talk a little bit about the different vehicles that you have available for investors? By the way, I love that you're 25 to 30 names because you do look a lot different than an index fund. You are different and that's exactly what investors are paying for when they hire an

active manager. Unfortunately, sometimes they don't always get. Sometimes they end up getting a closet index, which this is not. But do you mind talking about the different types of vehicles that ways that investors have access to this portfolio? We're on all the platforms. We're available through retail channels. We're available through advisor channels. We're also a large component of our client base as institutional. Our goal is to really make ourselves available as much as possible to anyone that's

interested in our type of investing that sort of fits their goals. From a product standpoint, I mentioned our flagship quality growth strategy. We also have a quality value strategy, which tends to be a little bit downcap and tends to shift a little bit closer to, let's say, core on the value side of core. And then we also have a global version of our quality growth strategy, where we've really expanded our focus on quality towards a global universe of stocks. And we're looking at hitting our three-year number coming up in a couple months in April. Kevin, was there anything that we didn't get to on today's show that you wanted to? No, I mean, I think that's good. We've hit on a lot of our key attributes. Our strategy

your framework is pretty straightforward. We'd love to execute. I think strong emphasis on long term can really sort of help one navigate these environments. Quality of the nature of our businesses tend to be all weather in nature. That durability allows us to handle that volatility that we've been experiencing. I think that captured it. If advises or investors want to learn more, where can we send them? Jenseninvestment.com would be the best. Appreciate it. Kevin, this is great. Thank you so much for your time. We really appreciate you coming on. Thank you so much. Appreciate it. Thank you to Kevin once again. Thank you to Jensen Investment Management.

Remember that's jenseninvestment.com and send us an email Animal Spiritspot at gmail.com.