Jensen Investment Management white paper on a series of reports on quality growth investing that discusses risk management.
Risk Defined
As illustrated below, Jensen believes that two primary investment risks exist. The first is the permanent loss of capital. If an individual invests $100 in the stock of a risky company and the price declines to zero because the company files bankruptcy, the investor suffers the permanent loss of $100. As it relates to avoiding permanent losses, we agree with Warren Buffett when he famously opined:
“ Rule No.1: Never lose money. Rule No.2: Never forget rule No.1.”
The second primary investment risk in our minds is generating returns that are inconsistent with client objectives. For example, if a retiree selects a conservative equity income fund with the goal of providing consistent retirement income and capital appreciation, those objectives may not be met if the fund performs more like an aggressive equity fund and drops sharply during a market pullback.
In our opinion, all other investment risks fall under the umbrella of the two primary risks discussed above. Fundamental business risk is the risk that a company’s sales, earnings, cash flows, etc. fall short of expectations, leading to a decline in the price of the company’s stock.
A host of factors can cause a company’s results to fall short of expectations. Some of these include price competition, more stringent regulations, raw material cost increases, technology changes, product quality deterioration and a loss of competitive advantages.
Price risk is simply the risk that the price of a security declines or that the security generates a return that falls short of alternatives and/or client objectives. Price risk can be measured in two different ways. Systematic risk measures how sensitive a given stock price is to movements in the overall market. Non-systematic or company specific risk is the risk that a security drops in price or generates inadequate returns due to company specific factors.
Interest rate fluctuations, political turmoil in foreign countries, cyclicality, management changes and natural disasters represent a non-exhaustive list of additional risks faced by investors. We believe these risks are simply components of fundamental business risk and price risk, both of which reside under the two primary investment risks outlined above.
Risk Management
At Jensen, we believe risk management involves using tools and mechanisms to help reduce the negative impact on portfolio returns brought about by both predictable and unforeseen events. Arguably, the most important mechanism employed by Jensen in managing portfolio risk is the discipline with which we execute our strategy. This strategy has not changed since the inception of Jensen Investment Management, back in 1988. We invest only in what we believe are high quality businesses that have generated a return on equity of at least 15% for ten consecutive years, as determined by Jensen’s Investment Committee. Jensen has not strayed from this strategy even when our investment style has been out of favor at times in the past. We believe this strict adherence to our investment strategy reduces the risk that our clients’ portfolios will perform in a manner that is inconsistent with their objectives. Specific tools and mechanisms utilized by Jensen to manage fundamental business risk include the following:
+ High quality universe: Our requirement is that a business have a return on equity (ROE) of 15% or more for ten consecutive years in order to qualify for the Jensen Quality Universe. In our opinion, this requirement results in a pool of high quality companies from which portfolio securities are selected. Most of the companies in our universe possess durable competitive advantages, strong balance sheets and generate significant amounts of free cash flow. In our view, these characteristics result in lower business risk relative to companies not included in our universe.
