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Bram de Haas
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Jensen Investment Management Waryof Elevated P/E Argument

Jensen Investment management doesn't buy the market valuation argument as a reason to fade it

May 12, 2018 | About:

Jensen Investment Management Inc, based in Portland, Oregon, is a renowned firm focusing on quality. The firm employs a fundamental analysis strategy by investing in the growth and value stocks of companies less than $1 billion market cap. They primarily invest in the U.S. and just published an interesting note on valuation. I find it especially interesting because it represents the other side of the debate. I've been highlighting mostly bearish commentary. There could be some bias there as I happen to share the idea the U.S. market is very expensive and unlikely to show attractive medium term returns. What are professional value investors that remain bullish thinking? Here's what Jensen sees:

What is our view on market valuations and how does it affect our strategy? This is one of the most frequent questions we have received from clients since the start of the bull market—and for good reason.

Many investors believe that sharp increases in the ratio of a stock’s price to its earnings per share (P/E ratio) can signal an overvalued stock or an upcoming market correction. Since the 2008 recession, P/E ratios have steadily increased. However, compared to the stock bubble in the late 1990s, or historic bubbles in other assets, today’s P/E ratios are not extraordinarily high, and are near long-term averages.

Jensen included data by Thomson Reuters to back up their position:

Even their data shows the market is overvalued by a couple of turns on most of the metrics they picked. There's a good reason investors are watching market valuation as it does have some value in predicting future returns. As per Vanguard research in "what signals matter":

We confirm that valuation metrics such as price/earnings ratios, or P/Es, have had an inverse or mean-reverting relationship with future stock market returns, although it has only been meaningful at long horizons and, even then, P/E ratios have “explained” only about 40% of the time variation in net-of-inflation returns. Our results are similar whether or not trailing earnings are smoothed or cyclically adjusted (as is done in Robert Shiller’s popular P/E10 ratio).

The one I most commonly use alongside the Buffett indicator (GNP to Total Stock Market Value) is the Shiller P/E. Both are extremely elevated. Jensen doesn't like that indicator much:

Included in the graph is the Shiller P/E, sometimes called the Cyclically Adjusted PE (CAPE) ratio. This ratio uses the average of the last ten years of annual earnings, adjusted for inflation, rather than just the last single year. Some market commentators have used this ratio to predict the end of the bull market, even as early as 2013, and the fact that it has reached levels not seen since the end of the “dot-com” boom may seem alarming. However, market P/E’s can be an unreliable indicator for calling the top of the market—high valuations can persist for lengthy periods of time.

While I agree high valuations persist for lengthy periods of time we shouldn't use the indicator in a vacuum. We know many drivers of valuation have been incredibly favorable:

  • Energy costs (remember where oil has been over the past couple of years)
  • Commodity prices (these are an input into the corporate cost base)
  • Cost of capital (credit has been extremely cheap with loose covenants)
  • Limited wage growth (employees have been reallly disciplined since the financial crisis about asking for wage increases, this seems to be changing)

All these factors have contributed to record high gross margins at companies. Add to that a corporate tax cut and it's obvious the market has been surfing on strong tailwinds. I'm not comfortable with the direction these inputs are taking. In my opinion there will be pressure on all these cost inputs with the fed tightening, oil back +$70, wage growth returning.

Jensen isnt blindly optimistic however, they just aren't buying it's a good strategy to move to cash and they try to remain invested(emphasis mine):

Where does that leave us regarding valuation? While valuations may not be as extreme as some pundits have said, they are certainly not deeply discounted, and with expectations of steady interest rate increases, multiples on stocks may compress, based on historical precedent.

Jensen ultimately conludes there may be something to the overvaluation argument but you can't count on it while you can buy select quality companies as they do:

Consequently, we believe it is wise to pay close attention to the valuations of the individual companies in a stock portfolio. In managing the Jensen Quality Growth Fund, we value companies using discounted cash flow analysis.

We examine the fundamentals of the business and make our estimate of the value of the company’s future cash flows, which we believe helps to mitigate business risk and pricing risk. In our view, sensitivity to valuation is important in a growth fund, and combined with our emphasis on durable competitive advantages and persistent returns on capital above capital costs, we are unwilling to sit back and buy any stock at any price. In the last few years, we have sold several companies for valuation reasons, but using our discounted cash flow valuation, we continue to find companies which we believe are trading at discounts to their intrinsic values. We believe this strategy should reward investors over the long term, and whatever the future may bring, we will continue to execute our investment discipline one company at a time.

The table below shows the top 10 holdings in the Jensen 130:

% of portfolio Shares % of portfolio Buying price

Increase/Decrease

BDX - Becton Dickinson 6.42 $216.70  
PEP - PepsiCo Inc. 5.57 $109.15  
MSFT - Microsoft Corp. 5.54 $91.27 Reduce 15.52%
UTX - United Technologies 5.3 $125.82  
SYK - Stryker Corp. 5.21 $160.92  
ECL - Ecolab Inc. 5.16 $137.07 Add 12.02%
UNH - United Health Group Inc. 4.85 $214.00  
PX - Praxair Inc. 4.82 $144.30  
ORCL - Oracle Corp. 4.5 $45.75  

Lots of companies in the medical device space with a few tech companies and PepsiCo (NASDAQ:PEP) to go along. One clear theme is the focus on sustainable competitive advantages or moats. The firm is obviously paying up in order to acquire companies with strong competitive advantages. Becton Dickinson (NYSE:BDX) is the largesst manufacturer of injection needles which are used on a global scale. Because of its market share it can produce a cheap but critical product to an industry that isn't super well known for its cost concious nature. Microsoft (NASDAQ:MSFT) and Oracle(NYSE:ORCL) are (in)famous for their customer captivity. Something else to note is that United Technologies and PesiCo are both targeted by activists.

Ultimately I'm not convinced Jensen is right to disregard market valuation to the extent they do. I guess if you are disregarding it focusing on fundamental analysis to load up on strong durable competitive advantages makes sense. These are more likely to be robut in a downturn.

Disclosures: no positions

About the author:

Bram de Haas
Bram de Haas is the managing editor of The Black Swan Portfolio

Visit Bram de Haas's Website


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