Between high energy prices, soaring inflation, rising interest rates, stalling growth and increased geopolitical tensions, investors were besieged by risk on all sides in 2022. The performance of stocks reflected the mood, with the S&P 500 Index posting a sharp decline of -18.11% for the year — one of its worst years in decades. No wonder investors are still on edge.
At times like this I am reminded of Warren Buffett’s famous advice for investors: “Rule No. 1: Never lose money. Rule No. 2: Never forget rule No. 1.”
At Jensen, we also prioritize managing risk with the goal of capital preservation; we favor high-quality companies (those ranked A+, A, or A-, as measured by the S&P Earnings & Dividend Rankings). Although 2022 was a tough year for most investors, Jensen’s Quality Growth Strategy beat the S&P 500 Index, and our clients benefited from a “flight to quality” that often occurs when investors get an unpleasant surprise and look for lower-risk investments.
Thankfully, some of the economic risks have receded in 2023. The easing of inflationary pressures has been particularly good news for investors. But while inflation feels more tolerable than it did in 2022, it’s still high; and as the storm clouds have not fully dispersed, we counsel investors to remain vigilant — and their advisors even more so.
Fate delivered a reminder of this with the recent failures of Silicon Valley Bank (SVB) and Signature Bank. The banks’ sudden demise illustrates the conundrum that policymakers face in trying to manage inflation after an era of ultra-low interest rates, as well as the impact that companies can face from shifting monetary and fiscal policy priorities.
Most companies are used to dealing with policy changes as part of the electoral and business cycles. But after a decade in which the cost of capital has been close to zero, many businesses are having trouble adjusting to seven interest rate hikes, as evidenced by the increase in corporate debt defaults, which according to the S&P Global Ratings are at their highest since the financial crisis of 2009. Policymakers are trying to exert some much-needed control over inflation without endangering the economy, but the hikes triggered a set of unintended consequences that the stock and bond markets have struggled to digest. Since the rate hikes began, capital market volatility has returned with a vengeance.
The Federal Reserve is under pressure to respond, perhaps by slowing down or even abandoning its rate increases, and avoiding further “breakage.” But if it does, inflation could soon be on the rise again with the risk of the “stop and go” inflationary trend of the 1970s. With the 2024 U.S. presidential race already started, the risk is greater that monetary policy will be politicized. The most recent crisis in the banking sector also could prompt a heightened regulatory environment for the U.S. financial system.
Thankfully, at Jensen our strategies tend to have no direct exposure to banks and minimal indirect exposure to the financial sector. Few companies in the financial sector meet our requirement of consistently high profitability, with a minimum 15% return on equity (ROE) for at least a decade, as determined by our investment team. Instead, our focus is on what we believe are consistently profitable, well-managed businesses with durable competitive advantages, robust balance sheets, and strong cash flows. Recent events reaffirm our investment thesis, as financial sector companies across the board have a difficult time clearing the strict ROE hurdle that companies must overcome to be considered for inclusion in our portfolios.
Keeping up with the policymakers
Business risks are by no means confined to the banking sector. Pharmaceutical companies, for example, face the prospect of new price caps for some medications that could impact profitability. Several of the companies in which Jensen invests have this exposure. That is why we believe it is so important to favor cash-rich companies with demonstrated track records in managing risk.
Pfizer is one pharmaceutical that is well positioned to respond to regulatory changes; it is used to navigating the maze of rules and requirements imposed across its international operations. The pharma industry remains far more regulated in the U.K. and Europe, for example, where the company has substantial operations.
Apart from the successful COVID-19 vaccines and antivirals that Pfizer has used opportunistically to further invest in its business through R&D and acquisitions, the company has been careful not to rely too heavily on the sales of any one medication to drive profits. Its geographical and product diversification helps insulate it from political risks that could prove a significant headache for more concentrated competitors. We think of this business as a “battleship company”: over the years, it has demonstrated an ability to navigate changes in the political climate and to grow despite the challenges of developing and successfully bringing to market new medications that help patients in multiple legal jurisdictions. We believe this will continue and be reflected in its earnings.
Healthcare company UnitedHealth Group, is another example that is positioned to navigate risks. In its role administering Medicare and Medicaid, it has been exposed to policy changes from different administrations. Despite that, UnitedHealth Group has successfully found new revenue streams: Its unique, value-add business solutions have generated consistently strong earnings and free cash flow, allowing it to invest in new initiatives that are designed to provide the foundations for future growth.
Inflation remains the No. 1 risk
Although inflation is declining, it still represents a significant threat to investors’ financial health.
After a year of record-high inflation, it is natural to feel some relief when inflation dips to “only” 4.9%, as the U.S. Bureau of Labor Statistics reported in April 2023. But investors should be under no illusions: an inflation rate of 4.9% halves the real value of capital in about 15 years. In an age when people can reasonably expect to live for decades in retirement, the destructive potential of this wealth erosion should not be underestimated, and it is vital that advisors ensure investors understand and are well prepared.
Periods of high inflation and weak growth are nothing new in historical terms — but they are new for many investors today. The lessons of past cycles and the crisis of 2007–2008 have grown foggy, and cognitive biases are also in play; it is human nature to recall steep market falls and rebounds, and easy to forget the sometimes extended choppy and directionless periods in between. Years of central bank support has conditioned many to expect protracted bull markets, punctuated by occasional but brief bear markets. This may have left some investors ill-prepared for the more prolonged period it might take for a full recovery.
Meanwhile, central banks are running out of ammunition. They will likely have to keep interest rates higher for longer, no matter how unpalatable that may be, to force the inflationary genie back into the bottle. This will take time; many of the factors that caused high inflation have been brewing for years, and hangovers typically last longer than we like. Managing investor expectations will be a significant challenge.
A case for quality
In highly directional markets — both bull and bear — the prices of quality companies become more correlated with their peers. Investors can respond emotionally and spend less time weighing individual companies on their own merits. It is in the in-between markets, where the mood is more uncertain, that the performance differential between higher- and lower-quality companies can be most pronounced. We believe that high-quality companies with consistent earnings predicated on competitive advantages, pricing power and strong cash flows are better placed to manage periods of uncertainty and rising interest rates. Overleveraged companies that do not enjoy the flexibility of holding cash are not as well positioned to manage their own destinies, and they can get left behind.
In our experience, quality growth businesses are more likely to maintain higher levels of earnings despite rising rates. They may even find opportunities to acquire struggling competitors and diversify into new areas of growth. The high-quality companies we favor didn’t just survive the bear market of 2008–2009; many of them exited the downturn in a stronger competitive position than before.
In other words, volatility and uncertainty can be positive for high-quality companies — and for investment strategies that focus on identifying such businesses. We believe it is these companies that are best positioned to capitalize on the opportunities that market disruption creates, and advisers can really add value for their clients during tough times.
Rob McIver is a managing director, president and portfolio manager with Jensen Investment Management, where he is a portfolio manager of the Jensen Quality Growth Strategy. He has 29 years of experience in banking and investing, including 10 years with Schroder Investment Management in London. He joined Jensen in 2004. The companies discussed in this article, from the Jensen Quality Growth Strategy, are solely intended to illustrate the application of our investment approach and are not to be considered a recommendation by Jensen.