Strict rules make Jensen Fund appealing

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With markets whipsawing and small companies at last falling from favour, the Jensen Fund has some appeal.

Managing the $2.2bn mutual fund, which is based in Oregon, is not too onerous. It has a strict limit of 25 holdings at any one time and in an average year it will buy two stocks. Those stocks, however, have been chosen according to rigid, quantitative screening that predates the current fashion for algorithmic trading. It can only invest in stocks that have increased their earnings per share by at least 15 per cent each year for 10 years. As soon as any company drops below the 15 per cent return on equity criterion, it must be sold and has to spend 10 years re-qualifying.

The fund’s managers avoid small companies and set a minimum market capitalisation of $1bn. This leaves a universe of about 170 stocks at any one time in which it can invest. Managers contend that this allows them to do very detailed research and effectively place a second “value” screen over stocks that have been screened for growth.

It sells when stocks have become clearly overpriced, or when it is necessary to make room for a better idea. The stocks it chooses will tend to have a well-entrenched and strong competitive advantage – it is difficult to grow that much for so long without one. They also tend to create some kind of consistent value for customers, and to be relatively unfashionable.

Its biggest holdings include McGraw-Hill, the Standard & Poor’s to BusinessWeek media conglomerate, General Electric and Procter & Gamble – all well established names that have not excited anyone recently.

Its strict criteria tend to leave it concentrated in a few sectors – healthcare, business services, consumer goods and industrial materials together account for close to 90 per cent of the fund.

In healthcare, a business where the ageing population almost guarantees increasing demand for years to come, they believe they have found a number of strong players, such as Stryker, the dominant provider of beds and surgical tools for orthopaedic surgeons.

One advantage is that managers are “from hope and fear set free”. The increasing interest in applying behavioural science to investing has led to the study of recurring “heuristics” in investing: those tendencies and habits that appear ingrained in so many investors. For example, if people are invested with essentially the same choice but one is presented as crystallising a loss while the other is represented as taking a gain, they will rarely do the former but usually do the latter. There is a deep, and understandable, human objection to admitting that you have made a mistake.

By only investing and divesting according to strict criteria, the Jensen fund smooths the worst effects of both the irrational enthusiasm and needless despondency that are the twin foes of investing success.

A second advantage, as ever, is cost. This fund is not as cheap as an exchange-traded fund – and if actively managed ETFs are ever permitted, then they will probably look a lot like this, with a small, infrequently traded and quantitatively screened portfolio. But at 0.85 per cent, its expenses look very reasonable compared with most actively managed mutual funds.

Robert Millen, the fund´s portfolio manager, argues that high quality stocks – defined as those with consistency of both earnings and dividends – tend to out-perform strongly over the long term. According to a Standard & Poor’s survey, the gap in performance over the last 10 years is equal to 720 basis points of return. As “low quality” stocks, by this definition, have under­performed severely in the last few years, there could be an argument that this fund offers an opportunity to profit from reversion to the mean when high quality stocks return to favour.

“The longer it goes, the bigger the disparity, and you build up some pressure,” he says, suggesting that stocks with resilient earnings tend to outshine others in economic downturns. So if you want to make a bear market call, this fund again might make sense for a portion of an equity portfolio – although investing in cash might do even better.

In spite of these advantages, this is not a low risk fund. The high concentration makes it far less diversified than most funds investing in large-cap stocks. Warren Buffett, famously, logged his great investment returns by having the nerve to bet on a small and concentrated portfolio but it does not work out quite as well as that for everyone.

Second, the commendable discipline mitigates against any sharp timing. For example, the Jensen fund could not have played this year’s boom in ethanol stocks, even if it had wanted to do so. More important, it means cyclical stocks are out, even if they trade on very long cycles. In the last few years, this has meant avoiding energy stocks. With oil above $70 a barrel, it has been close to impossible for a fund to outperform without a substantial weighting in energy companies.

And Jensen’s performance over the last three years does indeed look very mediocre. It has gained 8.38 per cent over that stretch – 7.03 percentage points less than the S&P 500.

But Millen and his team have offered a highly respectable argument that its fortunes are due for a change. While the energy run looks as though it has a little longer to run, which damps its appeal, this still looks like a good home for some exposure to equities.

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