Jensen Investment Management’s market outlook for 2015.
Jensen Investment Management – Looking Forward
The year 2015 has been mixed for the U.S. economy, as strong markets for labor and housing were offset by weak advances in consumer spending. Lackluster returns from the U.S. stock market reflected this environment as the combination of an uneven domestic economy, overhangs from lower commodity prices, and weak economies abroad weighed on market sentiment. Consequently, the view into next year seems a bit cloudier than previous years. The big question entering 2016 is whether the U.S. stock market will shrug off current challenges, or if 2015’s muted returns signal the end of the recent bull market and slowing economic growth. With this backdrop in mind, here are a few of the key themes we’re watching for 2016.
Jensen Investment Management – Energy and Commodities Prices
Commodity-dependent economies, such as the oil-and-gas-propelled economies of Russia, South America, and the Middle East, will face very hard times if commodity prices remain low. We don’t believe that this state will last forever, but it may take some time for supply to come down to meet demand. Historically, boom and bust commodities cycles take several years to sort out, often with dramatic events along the way – high-profile bankruptcies, resignations, and volatile prices. Consequently, we believe that the most likely scenario is that soft commodity prices will continue in 2016.
Historically, very few energy and commodity companies have met our strict profitability requirements – Return on Equity (ROE) of 15% or greater for at least the last ten consecutive years. From our viewpoint, the current glut in the energy market is a prime example of why we have held a dim view of many of these companies: their fates are often determined primarily, even exclusively, by factors outside of their control.
That said, we still believe that there are good companies out there with exposure to energy markets, but have the ability to weather the volatility. For example, the Jensen Quality Growth Fund’s portfolio holdings Ecolab (ECL) and Praxair (PX) both have revenue exposure to energy end markets, but this has been partially offset by the lower costs they have enjoyed as they use energy products as inputs in their manufacturing processes. Additionally, both companies have relatively low exposure to the oil and gas exploration component of the energy market, which is arguably the most cyclical.
In the U.S. we expect low commodity prices to be a net positive for the consumer in 2016, with lower gasoline, heating oil, and natural gas prices driving consumer spending in other areas. Consumer confidence remains reasonably strong despite some volatility this year, and unemployment and inflation remain low. Rising interest rates may result in weaker housing market activity, but overall we believe the U.S. economy will continue to post steady growth in 2016, with the U.S. consumer remaining a driving force of that growth.
In our portfolio, we believe that consumer discretionary companies TJX Companies (TJX) and Nike (NKE), as well as consumer staples companies Proctor & Gamble (PG) and Colgate (CL), all stand to benefit from strong consumer spending and lower input costs.
Jensen Investment Management – Currency and Interest Rates
Over the very long term, we believe that currency effects for geographically-diversified companies tend to wash out: what goes up must come down, and vice versa. However, like energy and commodity prices, currency cycles can be long-term in nature. Following the 2008 recession, the U.S. Federal Reserve drove down the value of U.S. dollar via a drop in interest rates and substantial quantitative easing over several years. In mid-2014, the U.S. dollar began to rise against global currencies, due to both the expectation of rising interest rates in the U.S. and weakening in large economies abroad.
We believe that the strong dollar will continue. While 2016 may not see the same rapid appreciation in the U.S. dollar as in 2015, we believe that the exchange rate is likely to remain strong on a relative basis due to increased interest rates in the U.S. and expansionary monetary policies in large economies overseas.
Since 2008, the U.S. Federal Funds rate has remained near zero, and the first rate increase by the Federal Reserve was pushed back several times, with only a modest 0.25% hike in December 2015. Barring any major economic weakness in the U.S., we expect increases in 2016 to be equally modest. Even if the Fed raises rates at the same speed as the last cycle (2004-2006), it will take over two years for rates to rise to the 2006-2007 peak of 5.25%. Consequently, we believe that at least through 2016, effective interest rates will likely remain historically low.
At Jensen, we value companies which make prudent use of debt and maintain high credit ratings. High interest coverage and relatively low indebtedness allow companies to access credit at favorable rates, and under favorable terms. For, example, as of November 30, 2015, our portfolio companies boasted ratios of earnings before interest and taxes to interest expense (a measure used to assess credit quality) of 14x, versus 8x for the S&P 500 Index.
Our concern in a rising rate environment is more for companies outside of our portfolio – we prefer avoiding highly-leveraged companies with low credit ratings and risky business models in the next few years, as we believe their strategies can be constrained by high indebtedness.
Jensen Investment Management – China
The big question mark for 2016 remains the economy of China, the largest contributor to global economic growth in recent years. Although there has been some question as to the veracity of China’s self-reported growth figures, it remains clear that the country is pulling out all the stops to stimulate economic growth – devaluing its currency, ending the one-child policy, enacting strict stock market controls, and providing capital infusions into the private sector. Here, as elsewhere, actions speak louder than words.
While there is no question the Chinese economy is slowing, the question is how much, and where will it bottom? Consumer spending in China was a bright spot in 2015, with many premium brands bucking the trends in the broader Chinese economy, but a serious economic downturn could spur an increase in the savings rate of the Chinese consumer – belt-tightening that could hurt consumer spending.
Overall, we believe that the Chinese government has enough levers to pull to avoid a major near-term economic collapse, but we are closely watching Chinese consumer sentiment, the Chinese real estate market, and the government’s fiscal and monetary policy actions. In our portfolio, we like companies with a diversified, rational approach to China. While others are focused on growth alone, we like to see sensible growth plans focused on return on equity, like those from 3M (MMM), PepsiCo (PEP) and Proctor & Gamble (PG).
Jensen Investment Management – Legislation
The upcoming U.S. presidential election means that 2016 will likely be a good year for media spending. We believe that advertising and media companies, such as portfolio holding Omnicom Group (OMC), should benefit from increased advertising spending during the cycle. While it is possible to take marginal bets on smaller companies, we prefer the diversification and large portfolio of services that an agency holding company offers.
Due to the distraction of elections, we don’t expect any major policy disruptions for the U.S. economy coming out of Washington in 2016. We view this expected pause favorably given recent events, including the 2012 “fiscal cliff”, the 2013 government shut-down debates, and the large-scale disruption to the health care industry from the 2010 passage of the Affordable Care Act (ACA).
Speaking of health care companies, the ACA has thus far been a mixed blessing – more revenues, but often at a lower margin. We believe 2016 will follow 2015, with companies working hard to develop products that deliver increased safety and efficacy.
In the portfolio, we like Becton Dickenson’s (BDX) approach to the market, delivering must-have basic medical technologies in syringes, catheters, and diagnostics that can benefit from increased healthcare utilization. For pharmaceuticals, we believe portfolio holding Johnson and Johnson (JNJ) has some promising drugs in the pipeline, and we like the company’s stable business model and high-quality credit profile.
Jensen Investment Management – Company Results
At the end of the day, all of these factors, and others, will influence the financial performance of our portfolio companies. At Jensen, we prefer to focus on those which we believe can produce strong underlying business results in 2016. We believe that companies with strong fundamentals, durable competitive advantages, and a history of growing free cash flow will have a greater ability to chart their own paths, and that these companies should outperform lower-quality businesses over time.
Whatever happens in 2016, we believe that paying attention to these important company fundamentals helps Jensen manage risk, provide a measure of capital protection in volatile markets, and provide long-term capital appreciation for our clients.