Jensen Quality Growth Fund commentary for the third quarter ended September 30, 2016.
Jensen Quality Growth Fund – U.S. Performance Summary
The U.S. equity market, as measured by the S&P 500 Index, produced a return of 3.85% during Q3. In the first two months of the quarter, the market continued the pattern of complacency that defined the summer. In September, however, volatility increased in response to renewed scrutiny on a potential U.S. interest rate hike and the impending presidential election. Despite strong consumer spending and employment, Q2 U.S. gross domestic product (GDP) grew just 1.2%, and the Federal Reserve’s decision not to raise interest rates continued the trend of a lack of clear growth signals.
On a relative basis, the Jensen Quality Growth Fund underperformed the S&P 500 Index. On a sector basis, positive stock selection in Consumer Staples and an overweight to Information Technology boosted relative performance. The Fund’s stock selection in Information Technology was the primary detractor from relative performance, with stock selection in Industrials also detracting. On a quality basis (as measured by the S&P Quality & Dividend Rankings) our overweight to the highest quality stocks in the A+ and A categories detracted from relative performance, however we delivered positive stock selection within those high quality categories.
At the company level, the Fund’s top performer this quarter was Microsoft (MSFT). The company beat the street’s revenue and earnings expectations, which we believe was largely driven by its success in the enterprise cloud market. A key to their success, in our opinion, has been their hybrid cloud offering. This enables customers to migrate from their existing on-site systems to the cloud at the customer’s discretion, and has been well received in the market.
The largest detractor to performance was Cognizant Technology (CTSH). On September 30th, the last day of the quarter, Cognizant issued a press release announcing the company had initiated an internal investigation into potential violations of the U.S. Foreign Corrupt Practices Act related to facilities payments made in India. Additionally, the company’s president, Gordon Coburn, announced his resignation. Cognizant named a long-standing insider to the vacated president role and self-reported the investigation to the Security Exchange Commission and the U.S. Department of Justice. As a result, we reduced the position in the Fund due to the uncertainty created by this event, and we will continue to monitor the situation and manage the position as new information becomes available.
The Jensen Investment Committee added Alphabet Inc. (GOOGL) to the Jensen Quality Growth Fund in September. Alphabet is a global technology company that delivers internet services such as Google and YouTube, operating systems such as Android and Chrome, hardware such as Nexus smart phones and tablets, and enterprise cloud infrastructure.
Fundamentally, we believe the company’s competitive advantages –such as its iconic brands, innovation, and economies of scale –are sound. We also believe the company’s growth drivers are compelling. For example, its core search and advertising model has continued to dominate its markets and evolve as the advertising market shifts from online to mobile. While the company has historically generated high double-digit top-line and bottom-line results, we expect such results will likely slow but stabilize into what we believe is an attractive quality growth profile.
One of the key reasons we believe now should be a good time to invest in Alphabet, is because the company’s senior leadership has matured into what we consider to be a quality growth management team. Alphabet hired Ruth Poratas CFO in the spring of 2015, and she was instrumental in restructuring Google into the Alphabet holding company last fall which broke out the “Other Bets” segment. “Other Bets” are considered long term, exploratory investments that have very little immediate payoff, such as self-driving cars and Google Fiber. By breaking out this segment, investors now have better visibility into how much these projects cost and what impact they have on the overall business.
Uncertainty around November elections, concern about rising U.S. interest rates, and continued slow growth may lead to an increase in volatility amongst investors during Q4. U.S. economic growth is not robust, however it is not deteriorating. On this basis, any surprise results in the Presidential election, holiday U.S. sales or company earnings could contribute to spikes in market volatility.
In this uncertain and slow growth environment, we expect the quality businesses in the Fund can continue to grow organic revenue and net income above the S&P 500 average. While much of the focus in the U.S. large cap growth space has been on a reach for yield that can lead to high valuations, the Fund’s businesses focus on consistently growing their earnings and cash flows, as well as dividend yields, that may result in more reasonable valuations based on their growth expectations. At Jensen, we prefer to focus on those companies which we believe can produce strong underlying business results for the remainder of 2016 and beyond and use short-term volatility to try to take advantage of pricing disconnects in the stocks of these businesses.
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