The Jensen Quality Growth fund manager on whether competitive advantages are as durable as before, how to evaluate capital allocation, and more.
Our guest today is Eric Schoenstein. Eric is a managing director at Jensen Investment Management, where he serves as the firm’s chief investment officer and is a portfolio manager of several Jensen strategies, including its flagship Quality Growth strategy. That strategy is a concentrated portfolio of 25-30 stocks of growing businesses that Jensen’s team believes boast durable competitive advantages. Prior to joining Jensen in 2002, Eric was a senior manager at Arthur Andersen. He earned his bachelor’s in business administration from Oregon State University. He is also a trustee and the board chair for the Oregon State University Foundation Board of Trustees.
Jensen Quality Growth
Quality and Growth
"15 Cheap Growth Stocks Amid the Volatility," by Dave Sekera, Morningstar.com, Feb. 28, 2022.
"The Best Way To Capture Quality Growth," by Helen Fowler, ETF.com, Dec. 4, 2013.
"The What, Why, and How of Quality," by Ben Johnson, Morningstar.com, March 30, 2016.
“A Closer Look at Quality: The Fuzziest of Factors,” by Ben Johnson, Morningstar.com, Feb. 13, 2019.
“Risk Management--U.S. Equity Investing,” by Eric H. Schoenstein.
“Interview With Eric Schoenstein of Jensen Investment Management,” Motley Fool, June 3, 2016.
“Jensen Quality Growth Invests Patiently--and Very Successfully,” by Reshma Kapadia, Barron’s, Jan. 21, 2017.
“Q&A: Jensen Investment on Bracing for Volatility,” by Coryanne Hicks, U.S. News & World Report, Jan. 13, 2021.
“Jensen Quality Growth Fund: Stock Investing With a High Hurdle for Entry,” by Steve Schaefer, Forbes, July 23, 2013
“Jensen Fund Managers Asks One Really Important Question When Deciding to Invest,” by John Sullivan, ThinkAdvisor.com, June 24, 2012.
“How Microsoft, PepsiCo and Other Solid Plays Helped This Fund Manager Ride Out a Bumpy Decade,” Barbara Kollmeyer, MarketWatch, Jan. 29, 2020.
“Microsoft Results Point to New Growth Chapter,” by Daisuke Wakabayashi, Reuters, Oct. 29, 2007.
“Apple Services to Drive Next Leg of Growth, Says Schoenstein,” Bloomberg Technology, March 27, 2018.
“Why One Of 2016's Best Large-Cap Funds Finally Bought Apple Shares,” Steve Schaefer, Forbes, April 11, 2016.
Jeff Ptak: Hi, and welcome to The Long View. I'm Jeff Ptak, chief ratings officer for Morningstar Research Services.
Christine Benz: And I'm Christine Benz, director of personal finance and retirement planning for Morningstar.
Ptak: Our guest today is Eric Schoenstein. Eric is a managing director at Jensen Investment Management, where he serves as the firm's chief investment officer and is a Portfolio Manager of several Jensen strategies, including its flagship Quality Growth strategy. That strategy is a concentrated portfolio of 25 to 30 stocks of growing businesses that Jensen's team believes boasts durable competitive advantages. Prior to joining Jensen in 2002, Eric was a senior manager at Arthur Andersen. He earned his bachelor's degree in business administration from Oregon State University. He is also a trustee and the board chair for the Oregon State University Foundation Board of Trustees.
Eric, welcome to The Long View.
Eric Schoenstein: Thank you for having me. I'm happy to be here.
Ptak: We're happy to have you. Thanks so much for doing this. I wanted to start macro. Many are comparing the current growth-led market, I guess until recently we could say growth-led market, to the tech and internet frenzy of the late 1990s. As a very experienced growth investor, albeit one with a focus on quality, do you see the same parallels?
Schoenstein: You know, Jeff, I don't know that we would see necessarily the same parallels. I think there could be some pieces that feel similar, certainly, in terms of some of the data charts that you might look at and things like that that would show some of the same vulnerabilities. I think what I would say, though, is that the previous period that you referenced in the late ‘90s, I mean, you really were dealing with a different environment from the standpoint that many of the business models and, frankly, just the idea of what was disrupting things at that point in time from a company perspective, the internet was the big thing and dot-coms were the big thing, and frankly, most of those businesses didn't really last for fundamental reasons. They didn't produce cash flow; they didn't produce strong earnings and revenue growth, which would allow them to reinvest and sustain for the long term.
I think what we're seeing in terms of the current growth-led market: There are some similarities, no question. I think, actually, at the end of last year, if you looked at the Russell 2000, for instance, the number of unprofitable companies was nearly 50%. Clearly, that's not something we invest in. We're looking at strong, high-quality, fundamental businesses with high degrees of free cash flow. And so, that's not an area we're in. But it certainly is an area that has received a lot of investment. And so, from that perspective, it may feel a little bit similar. But I think there's a number of other factors and other parts of the market that, frankly, are not seeing that kind of similarity. And the real challenge that we're seeing right now, and the real sort of issue is: How do you as an investor pivot from what has been a high-return environment, maybe not necessarily high-growth in terms of business performance, but a high-return environment to one that inevitably needs to be thought of as a much lower-return environment?
Benz: How are you thinking about making that pivot?
Schoenstein: For us, I wouldn't call it so much of a pivot for us because our strategy and our investment philosophy has always been long term in nature, investing through the cycle. And when you approach investing from a longer-term perspective, you're “OK, last year or the last three years, I had great returns; where do I go to get those great returns again?” I mean, our clients certainly understand markets will go through downturns. Markets will inevitably go through corrections. Our clients certainly also understand that really long-term investing and successful long-term investing is more about time in the market rather than timing the market. And that distinction, while it may not appear to be a large one, I think it's an important one. And that's really where, from the standpoint of what we're facing now and what we're thinking about, we're always trying to take information regarding our businesses and regarding the overall business environment and determining what that means from the long-term opportunities for future growth and then, ultimately, future stock price appreciation, and that doesn't change. The impacts and factors will change. And obviously, our discounted cash flow modeling that we do for our businesses that helps us determine whether a stock looks attractive will change. But the underlying philosophy remains very much the same.
Ptak: I wanted to shift and talk a little bit about risk management. I think I heard you or one of your colleagues describe your approach as “risk first.” And so that seems like a logical place to go earlier in our conversation. The holdings in your flagship strategy, Jensen Quality Growth, were recently trading for around--and this is an estimate--25 times forward earnings in aggregate. Can you talk about how you manage valuation risk? And what gives you comfort that the portfolio you've built, notwithstanding its quality, that it isn't too rich?
Schoenstein: Sure. I think that's a good question. Although I do think there's some things to think about within what you talked about, and this is maybe a distinction that we can look to or talk about further. A price/earnings multiple, you mentioned 25 times forward earnings, generally speaking, that 25 times measure, usually, that's a forward 12 months notion. Our investment horizon for our businesses is, frankly, considerably longer than that. When we model our businesses, we're looking at a 10-year growth phase and a drawdown phase where incremental return on equity begins to decline and ultimately a terminal phase. That's a very different proposition than trying to look at something that in effect would be somewhat of a snapshot in time.
Now, from the standpoint of managing the risk of that, really for us, risk is broadly, I would say, three areas that we look to. One is to mitigate and manage fundamental risk in the business. So, in other words, what's going on in the business and what risks are there to that, that would create maybe perhaps even failure risk as a final nail in the coffin. We're also looking to mitigate pricing risk. In other words, these are high-quality businesses. Our strategy has always been focused on companies that, frankly, will probably trade at premiums to the broader market because people are willing to pay for quality, whether that's in companies or consumer goods or anything else. And so, we need to be cognizant of the pricing dynamic to make sure we don't overpay. And the last one would be what I'll call “stock-specific risk” or “security-specific risk,” where now we're looking at, “OK, what are the relative position sizes that we want for individual companies?” Not every company will be our number-one position and not every company will be our number-29 position. And so, from that perspective, that I think is where we will fold in maybe some cross-checks related to relative valuation to each other where some of the multiple issues like you talked about could come into play.
But I would say, frankly, that right now, and frankly, especially, over the last couple of months, the valuation construct for our portfolio and the markets more generally has certainly come down. And yet, relative to the benchmarks, we do not see a high premium over the benchmark P/E for our strategy. And frankly, that correlates to our own DCF measures where we see, frankly, a lot of attractive opportunities, even within what we're considering a compressed growth environment. And I think it's the attractiveness of the opportunity, the strength of the fundamentals of these individual businesses, and then our stock-specific or security-specific work that gives us comfort that the portfolio right now, one, isn't too rich, and two, will, from a long-term perspective, do a good job of mitigating risk on behalf of our investors.
Benz: Lately, the Quality Growth strategy does seem to be capturing more the downside than has been typical for it over time. What's the risk/reward profile that you seek to attain, and what about how you pick stocks and structure the portfolio confers that?
Schoenstein: I think it's important to stress that we invest for the full cycle. And within a cycle, there will be periods that will certainly be negative and certainly be positive. What we've seen over the last couple of months is a number of factors all hitting virtually at the same time, everything from more-realistic recognition of interest rates that are rising or likely to rise, you've got inflation concerns that are certainly deep and everyone is well aware of and all of the logic and reasoning behind that, and then on top of that is clearly the humanitarian crisis with the invasion of Ukraine, and that's obviously added to the nature of all of this.
What I would say though, and I think this is where the cycle really comes into play, if you go back to the last what we'll call full market cycle, frankly from October of 2007 to roughly right before the bear market at the beginning of the pandemic, in February of 2020, that generally was about a 12.5-year cycle. That's obviously a long cycle for many investors to think about. But I think it's illustrative of what we look for from our strategy. If we look at that entire period of time, major downturn, major upturns, and lots of growth in between, the strategy captured about a little bit over 90% of all of the up market, captured the upmarket opportunity, while at the same time, participated at about an 80%, a little bit over 80%, level in the down markets that took place in that same time frame. And so, the overall picture was that if you were invested in our Quality Growth strategy over that course of time, versus the S&P 500, there was an annualized outperformance of about 125 basis points for that period of time. Now, that wasn't linear. That wasn't something that happens each and every year. But it speaks to what we think the risk/reward profile should be--is that if you look at investing as a full cycle opportunity, then you should be looking for strategies that can outperform over that full cycle. And we think our strategy certainly has shown that over time.
The thing I would say about the current market and the current environment is we're very early in what I would call a new cycle. Arguably, if you want to talk about and having started in 2020, we've barely gotten into it. And you certainly have some very interesting dynamics impacting how things should be looked at at this point in time. And I think it's too short of a period of time to try to draw too much in the way of major conclusions, particularly given the fact that we've got what I'll call some exogenous impacts from the war in Ukraine, certainly the unprecedent stimulus that took place during the pandemic, $5 trillion and growing. Those are some things that have yet to fully play out in terms of the full cycle. So, we're disappointed to not see slightly better performance in this down period. But we've certainly always known that investing is a marathon, it's certainly not a sprint and to evaluate it in a two-month period feels like you're looking for it as a sprint.
Ptak: Speaking of marathons, I would say, just when I look at your typical holding period versus the average mutual fund’s, it's pretty clear that you view it that way because you trade very infrequently. I think the turnover has typically been below 20% per year in your flagship strategy, which means you're holding stocks for five-plus years on average. Can you talk about the margin of safety you demand before you enter a name, and how you might modify or relax that margin of safety requirement while you hold a stock along the way?
Schoenstein: Yeah, I think one of the things that's important here is we don't have a specified margin of safety at which point we would enter a name. Our discounted cash flow analysis work that we do is predicated on trying to really build up an entire valuation look at all of the businesses we invest in. We typically only invest in 25 to 30 companies. So, the good news is that our team of six that manages this investment strategy, we have the capacity to be able to go through those 25 to 30 business models. We want to really make sure we're encompassing or capturing all of the various elements of the fundamental profile of business. And frankly, the margin of safety will be different depending upon the company, depending upon the industry. Even the discount rate that we use will be different for every company. So, we have a risk-free rate that's in place. We have an equity risk premium that we have long determined using fundamental discount rate information from Duff & Phelps. And that information then comprises that discount rate and ultimately then helps us to get to what we believe the full value of the business to be.
The margin of safety, frankly, will be, as I said, different for every company. It will also, frankly, be different depending upon the period that we're in. So, to your point, modifying or relaxing the margin of safety requirement, certainly in an environment of rising prices and perhaps even multiple expansion, as we've seen over the last three years, would have caused some compression in that margin of safety. Ultimately, though, it is a discipline, and the discipline does require us to have some margin of safety. And I think the idea of having something that's overly prescriptive or specific perhaps can actually create some unintended consequences. Active investing, frankly, is as much art as it is science. And I think the margin-of-safety issue is one where we believe we've got a disciplined process to help us manage that margin-of-safety risk and also be flexible within it to ensure that we're not overreacting to movements in market prices that could cause us to sell businesses at just the wrong time.
Benz: Jeff mentioned your long holding period, and you've held some of the fund's best-performing stocks for more than a decade. You were probably tempted to sell along the way, at least for some of those names. Can you give an example of a decision where you let a name run beyond your estimate of its intrinsic value that paid off? And perhaps another example where you gave too much rope and it cost you performance?
Schoenstein: I think one of the things that's important here is the idea that intrinsic values has a stopping point. For us, that's just simply not the case. Intrinsic value, or full value, we use those terms somewhat interchangeably, really, it rises over time. Another way to think about your question would be, we've never really ever had price targets for our businesses because those price targets will move as the business continues to create value. And ultimately, that value creation is what we think will be reflected in the stock price. But that ongoing value creation, that ongoing cash flow generation allows the measure of full value to continue to go up over time. And it's really more of the relationship between what the stock price is trading at and that full or intrinsic value measurement that we're trying to manage.
And so, the idea that a company might run beyond our estimate of intrinsic value, I think the way we would look at that, and this is something we've done for a number of years, is we have a base case of what we think the valuation is worth. And we also have a best case for what we believe the valuation could be. And really, it becomes a scenario where if it exceeds the best case, clearly, we've got something that is in need of certainly trimming at the outset, reevaluation of the entire valuation model, the discounted cash flow model, and then potentially a complete sell if it's trading beyond that best-case scenario. And part of our balance is to try to make sure that we're reassessing these businesses on an ongoing basis. And I think that's also an element that hopefully puts us in a position where we're not holding on to companies too long. We will take profits along the way. And certainly, that's been something that we've hopefully been able to do.
I'd say, to give to your examples, specifically, I'd say, one that we've allowed--or a company we've allowed to run a little bit--again, this gets back to the art and the science. We've had Intuit in our portfolio for a while, and it's a company that can run pretty well sometimes. It's certainly had a lot of growth, and we've allowed it to run and that's paid off in those periods where we did allow it to run. Obviously, it's down this year, but I think that's a good example of one that paid off in our favor.
I don't know that we really have an example of one where it cost us from the standpoint of our interaction on companies because we do trim. There is a discipline. It's not simply let it run and not really go back and focus and think about it. We are keeping a close eye on these companies. One of the hallmarks of our process is that our entire investment team meets every single morning. And the purpose of that meeting is to talk about anything going on inside our businesses, both fundamentally and from a valuation perspective. So, the likelihood that something that would really go beyond what we believe it's worth and we would continue to give it too much rope, is something I would say is really not very likely to occur. It's more likely to take place more on the fundamental side, where we've maybe perhaps missed something on the fundamental structure and we should have gotten out of the company a little bit further. That's one of the hallmark challenges for high-conviction active managers is to make sure you don't fall in love with your companies. We've probably had a couple of examples like that in the past, but we work hard to make those very few and far between.
Ptak: I wanted to shift and talk about quality, which is another, I would say, telltale aspect of your investment process. I'd be remiss if I didn't ask about one of the things that's changed about quality investing, which is the availability of low-cost mechanized options for getting "quality." There are quality screen ETFs; they charge a fraction of what you do at a Jensen Quality Growth, and mechanized stock selection, as I mentioned before. What do you think those who might be tempted to choose one of these ETFs might want to bear in mind before they take the plunge, speaking as somebody that's spent years and years actively investing in stocks through a quality lens?
Schoenstein: This is a question that we've certainly heard over time, and I think it's increased in time more recently. I think the challenge with factor-based or, I guess, mechanized, to use your term, strategies, where they're trying to load, for instance, on a quality factor, the challenge is, what we've seen over our research and some of those strategies is: One, the quality factors, frankly, have seemingly changed over time. In other words, they haven't remained consistent. Partially because, I think, those strategies are being managed, and as return profiles don't measure up, they look for different ways to manage the quality factor and how it's loaded. I think another distinction would be that if you're investing in those kinds of strategies, inevitably, they begin to look a bit more like indexes--far more holdings, certainly, than what we have. We generally will only hold 25 to 30 companies in our high value creation, actively managed, high-conviction strategy. And I don't think that would be the case with some of those factor-based strategies. And the issue becomes, then, in an effort to load those strategies where they capture similar performance in terms of downside participation, you end up exposing the strategy perhaps to a lower amount of participation when markets go up. And that's almost exactly the opposite of what you want to be doing.
So, it’s very different. They have not necessarily proven themselves. And I think the other issue here, and this is perhaps maybe the more important one I should have led with, is the factor basis for those kinds of investment products is backward-looking. I'll be the first one to tell you: Our return on equity requirement of 15% a year for 10 consecutive years is backward-looking, but our research doesn't stop there. If you were to go back to 2008, the financial crisis, you probably would have had a quality factor that would have ranked banks and homebuilders quite highly. And yet, in 2008, the banks and the homebuilders that would have been present in our universe at the time, those all fell out, and it became something that was a real distinction between legacy moats and true durable competitive advantages. And I think that's one of the distinctions that quality factor-based ETFs have a harder time trying to capture in looking forward.
Benz: High-quality firms possess traits that most investors covet. So, can you explain the mechanics of earning excess returns in names that generally tend to trade at higher multiples than the broad market? Does it come down to expecting the firm to outgrow the expectations you believe that market has priced in?
Schoenstein: I don't know that I would say it's about outgrowing the expectations of the market. Although, certainly, that could be a component of it. Our thesis in valuation has always been around discounted cash flow, as I said. These are mature companies. Because they've had that minimum 10-year track record, they're generally mature companies. And in many cases, they've had track records longer than that. From our perspective, the effort here is to participate in the value creation of the business models. Our research has shown to us over three decades that competitive advantages matter and competitive advantages are correlated with the ability to create value. And ultimately, consistent value creation can be correlated to stock price appreciation from a long-term perspective.
For us, it's really not about trying to capture expanding multiples. Multiple expansion for us has generally been more of a bonus to our returns, rather than a foundation of our returns. The foundations of the return profile have largely been based upon the value creation in the business. And then, you've got, in a lot of cases, a dividend payment that acts as a supplement to that value creation and, frankly, can also act as a compensation to shareholders during those periods where they may need to be patient with the investment. And then, multiple expansion, as I mentioned, becomes sort of the bonus. So, in a high-multiple environment, in a low-multiple environment, ultimately, we're still trying to look at: Do we have reason and justification for strong growth expectations in the future, or sound--really said better--sound value creation opportunities in the future, and are those opportunities priced appropriately at today's market price? And if we can find those kinds of businesses, and for 30 years, we think we've done that, then that will generally overcome the vagaries of what multiples might do and also allow us to focus on what our expectation for the business is, rather than trying to overly concern ourselves about what might or might not be priced in from a market expectation.
Ptak: I was actually going ask about multiple expansion, in what role that assumption might play in your process. But you kind of answered it. But I guess my next question is, When you've done performance attribution analysis, looking at the strategy's performance, and has that borne itself out where the bulk of your performance has come from dividends and fundamental improvement rather than multiple expansion over time?
Schoenstein: Yes, generally speaking, that's been the case, Jeff. It's shown itself, and it's not-- again, these are not things that will be absolutes. Look, I will be the first person to say: I have no problem enjoying and accepting multiple expansion as an opportunity to create value, but to use that as the primary in terms of how we would view our strategy or if that were to be the primary logic behind what our return profile is, I think all of us would have a very, very difficult time with that as a statement. And the research would definitely show from our perspective and from our research that multiple expansion, again, it acts as a kicker. We will absolutely take it when it comes. But it's also something we need to recognize isn't going to be there over time, and what will be there in our minds over time are durable competitive advantages, consistent cash flow generation that's used to reinvest into those competitive advantages, supplement them, or perhaps even add to them, and then ultimately, through those competitive advantages you get execution in a business model that allows for real value creation that isn't reliant, frankly, on multiple expansion. And our research has shown that that's very much been the case.
Benz: We've spoken to other guests about the durability of competitive advantages. It seems like economic moats aren't lasting as long as before, given the speed of innovation and other factors. Have you seen that in the research that you do? For example, has your eligible stocks list shrunk?
Schoenstein: Actually, if anything, our ultimate list of companies that we can invest in has grown. I've been here nearly 20 years. And certainly, some of it is better data, better tool sets that we have at our disposal to dig into the fundamental data information that we have. But anecdotally, I can tell you that in September of 2002, when Val Jensen, our founder, sat down with me on my first day and handed me the Jensen universe. At that point in time, it was 119 names. Today, it's over 320. So, I think it's pretty clear the universe has grown over time.
To your question, or to your point around competitive advantages, competitive advantages, yes, I think it's possible that, certainly, disruption is clearly something that happens. New entrants come in. That's the whole point of business competition is, you start with something that you identify the market doesn't have but needs and that you can provide, and you ultimately hope you get paid for what you create. And eventually, somebody may try to do it better than you. And that can change the competitive advantages. I would say, though, that the durability of those, I think that still remains a very strong statement. And the strongest firms, the ones that really understand the long-term nature of what they're trying to do constantly are reinvesting to shore up those advantages. And while there will be disruption, I think those competitive advantages can remain somewhat elongated more than people might be willing to appreciate.
And then, the other component of this is that, as I said, that reinvestment. These are hallmark businesses that have consistently seen the threats on the horizon and have constantly tried to invest in new opportunities to stave off that competition. I think the importance here is making sure that we are critically assessing that durability, and in some cases, the very disruption that could take place becomes a new opportunity for expansion. I think about technology firms today, and frankly, I look at something where cloud has become a huge driver of growth for companies like Microsoft, and Google, and Amazon, and others. And in some respects, cloud and the investments in cloud have actually become an extension of competitive advantage rather than some disruptive threat. Because you end up driving economic scale and economic scope by selling incremental customers into your cloud-based environment. And I think that's something that almost extends the competitive advantage rather than shortening it. I'd say another example might be MasterCard. MasterCard, most people think, “Oh, it’s your credit card.” But the reality is MasterCard sees and recognizes that there are constant regulatory threats and constant new entrants trying to infringe upon their business. And they are themselves reinvesting the large cash flows that they produce into new ways to participate in all kinds of non-cash-based transactions in a way to expand their footprint and profile and advantages rather than having them shrink.
Ptak: And maybe building on that last answer, I'm curious, do you think that there's a possibility that the market with rates rising will become less forgiving to management teams that to this point have boldly experimented trying to stand up businesses and maybe areas that weren't adjacent to what the firm had focused on to this point? Or do you think that's not the case? Because many of these management teams have proven that they can make these sorts of hard pivots successfully. And then, my related question is, how has your evaluation of management teams as capital allocators, how has that evolved over time, as you've had some of these businesses that come along that are so dominant and throw off so much cash flow that they have the ability to go to range into these areas and experiment in ways that would have been unthinkable previously?
Schoenstein: Let me get to the second part of your question on the management teams. Management assessment or understanding what is making those management teams successful is a key component to understanding and really, in our minds, knowing what you own. I think that's one of the key considerations as we think about a rising interest-rate environment or the potential for lower cash flow generation from a lot of businesses. It's really knowing what you own and what the prospects are is an important element, and management is certainly part of that. We've long visited with the management teams of our businesses. We've obviously had to change how we do that with the pandemic and the lack of travel for business purposes and doing a lot more through virtual and other settings. But frankly, not much has changed from that perspective. I think good management is ultimately good management. And it becomes something that's more about really understanding and looking at how are they being incentivized, how is their board, in this case, for public companies, how is the board holding their feet to the fire, and if they're doing a good job of that, then the likelihood is that the investors don't also have to do that, because they can look to the management team to do what's in their best interest.
20 years ago, as we were looking at the internet crisis, I mean, once upon a time, we were looking at management teams and probably, generally, I think investors were saying, “Wow, if they're not investing in the internet, the internet is going to take over the world, and if they're not doing that, then clearly, they're mismanaging, and they're not utilizing their cash flow appropriately.” Then all of those companies or a lot of those businesses went belly-up, and we've reinvented ourselves. And ultimately, I certainly think that it's feasible that investors might show lower patience. But I think the lower patience is because the return patterns and profiles are coming down.
I think what we would suggest is really looking at how those businesses are reinvesting: What are they doing with their free cash flow, and what kinds of opportunities are they investing in? And if they're doing those things appropriately, it's OK to have a lower-return profile, it's OK to actually take a little bit of a pause given the strong returns we've had for the last three years. Arguably, if you were invested in the index, the S&P 500, for instance, you essentially doubled your money in three years. That's an unheard-of pace. So, to have some patience before you expect that to happen, again, it's certainly, I think, something that might be worth considering. And from an investment in the businesses themselves, again, this gets back to: What are they doing with the free cash flow, and importantly, do they have the free cash flow to continue to reinvest? And that to me is maybe a different distinction--kind of back to what I said earlier about half the Russell 2000 not even being profitable. Those businesses simply don't have that cash flow. And I think in environments where we are right now, current cash and current cash flow is a strong mitigator to perhaps some of those short-term concerns. And ultimately, that cash and cash flow that's being generated will pay off once we get back to being beyond some of these more difficult challenges.
Benz: What's one stock you wish you could own in quality growth but that hasn't cleared your return-on-equity hurdle?
Schoenstein: Actually, I hate to say this this way. But the way I would actually answer that is, we've got a wonderful opportunity set of 300-plus names. And I think there are always going to be opportunities within that set where we wish we could continue to own a business or maybe own a business because it gets too expensive or something like that. But I don't know that we've ever really looked at it and said, like, for instance, something that doesn't qualify for our universe, is there something that we would say, “Oh, I wish we could own that.” I think this is maybe one of the benefits of three decades of learning is: For every company that would have been like, “Oh, that would have been the lights-out investment that we couldn't take advantage of because of our universe requirements” or something like that, for as many opportunities that might be there that are like that, there are a lot more opportunities where you--yes, maybe you missed the upside, but then when that doesn't pan out, you miss all of the downside. And this, again, would go back to like the internet age or the internet bust or the financial crisis--these companies, there can be businesses that can reverse in very, very quick fashion. And I think the beauty of a long-term investment strategy is that you're really looking at it as a long-term proposition.
And in our case, we feel very good about the fact that we've got a very robust universe within which to work. I said 320-plus names. We're only invested in just under 10% of that entire universe. So, I think we've got plenty of opportunities to consistently look at new businesses for inclusion and yet not really have had too many that we've said, “Oh, gosh, I wish we could have been invested in X.” I think we are constantly looking, frankly, more forward than we are looking backward and wistful at something we might not have had the opportunity to take advantage of.
Ptak: I wanted to shift and talk stocks. We've talked about some of the important undergirding concepts when it comes to stock selection and portfolio construction, but I thought we could talk about some of your holdings specifically. You've owned Microsoft, which I think you've alluded to at least once during the course of this conversation, in the Quality Growth strategy. I think it's the second-largest holding. You've held it for a long time. Around the time you bought it, I think the firm was more reliant on things like Windows operating system, hardware sales cycle. I think the Bing search engine was thought to be a potential value driver for the firm at that time. Times have obviously changed. Can you talk about your original thesis for owning Microsoft, compare that to now, and maybe what lessons do those differences impart?
Schoenstein: Yeah, I think Microsoft is an interesting case study. I think we first purchased it, I believe, it was in 2005. And you're right, at the time, it was all about the Windows operating system frankly and all about the PC. As the former CEO used to say--it was all things PC. And at the time, our thesis was this is a really good business. There's a lot to like, but perhaps they were a little bit indiscriminate in how they spent the vast cash flow that they were generating, and we wanted to see some more discipline. And we did begin to see what we thought was a bit more of a disciplined approach to cash flow deployment.
Now, obviously, in hindsight, I think a lot of people in the late 2000s, even into the early 2010s, the reality was Microsoft was considered to be dead money, if you will. But I think the underlying parts of the thesis that we had at the time, some of those pieces are still very much in place. The Windows operating system, the idea that the company was providing something that was ubiquitous within the enterprise and that would have huge market share that we believe would not erode over time from the standpoint of Windows and the operating system itself and the Office suite of products also, Word and Excel, et cetera, that's very much remained the same. I mean, their market share in those areas hasn't really changed. I think what's changed and the pivot point here--I think one of the things that historically Microsoft struggled with is they weren't necessarily a company that exhibited some of the first-mover advantages that you might expect a company like that to have. But I think with the new CEO, when Nadella took over, there was a shift. And what we saw and what I think one of the things that was really, maybe not an aha moment, but a real pivot point for the business was when it started talking about three screens and a cloud. In other words, we're not going to just be for what you do in your office, we're going to be for all of your devices, we're going to be interconnected, and we're not going to be just about the PC, we're going to be more across different platforms. And I think if there was a lesson learned from that--look, I still think there was value creation in the business during that period where the market looked at it as dead money, and I think our patience has been rewarded.
We've seen a lot more change in the last 10 years certainly than what we saw in--maybe the last seven or eight years--than what we saw in the first seven or eight years of our investment. But I think this is one where the value creation was continuing. The market arguably was penalizing the business more, and I think it's certainly been referred to from if you go back in history, the (bomber overhang) effect and things like that, which that wasn't about what was happening in the business. They just needed something to help unlock the value. And once that was unlocked, we've seen tremendous growth. And I think, even now, as much growth as the company has had, I think one of the things that stock prices can sometimes do is underappreciate cash generation. And in Microsoft's case, I think that's been certainly one of the cases that's happened. And now, we've really got a business that's very much still the same kind of business. It's serving small and midsize customers, servers, and software. It's just that the whole approach to how companies access the servers and software has changed and become something that's actually become even a stronger competitive advantage than what it was when we first owned the business. Our lesson is: This is one where I would say patience was a virtue. And the patience really was only achieved because we could see the value being created year-in and year-out and the cash flow being generated year-in and year-out. If that hadn't been taken place, we may not have stuck with the investment and that ultimately would have been to the detriment of our investors.
Benz: I'm sure you never tire of answering questions about Amazon, which the Quality Growth strategy has never owned. Can you talk about which of your names is most vulnerable to an incursion by Amazon and also, how you've been able to satisfy yourself that you'll still get paid for courting that risk? Seems like healthcare and pharma might be one such area?
Schoenstein: Yeah, Amazon, obviously, it's a business model that is disruptive. There's no question about that. The reality of the business, however, is that it does not … let's go back to the beginning. 15% return on equity each and every year for 10 consecutive years. Amazon doesn't have that track record yet. And let me state that, right? Yet. It is generating it, and it is building it. But it isn't there yet. And frankly before it started on that path, Amazon, let's not forget, within the last decade, had years where they lost money. It was more about revenue growth rather than profits and cash flow growth. And that's totally fine. If the business wants to run itself that way, we don't have any issue with that. It just doesn't meet our standards.
I'd say we certainly have seen the opportunity for disruption from Amazon in all kinds of different places. However, I think, in each and every case where we've seen--like, they're absolutely competitors with Microsoft and Google, both in our strategy from the cloud perspective and providing infrastructure, cloud infrastructure. Companies on the consumer space, like Nike and TJX, have certainly had to deal with the potential for disruption. Although I would say, in both of their cases, I think they've done a really nice job of reaching in to their consumers on a more direct basis to help offset the impact of a wide distribution network like Amazon. Quite frankly, I'm not sure that we've seen on the healthcare side and the pharma side as much disruption as we have on more of the, what I would say, more distribution. I think there's still more to play at that.
I'd say probably the easiest thing to think about from a disruption perspective, or an Amazon effect, if you will, would be delivery, which would be UPS, and UPS is a holding of ours, where there's no question that we've owned that for a little bit. How we manage that? How we think about that is more--this is, again, I mentioned earlier, stock-specific or security-specific risk when constructing our portfolio. Not every company is going to deserve a place at the top of the portfolio. And I think UPS as a result of some of the challenges that they face as Amazon competes with them is one of those businesses that generally ought to be more towards the bottom third of our portfolio, has great competitive advantages, lots of free cash flow, but also has very dynamic competition that we need to keep an eye on, and as a result of that assessment, it's in the bottom third of our portfolio intentionally. I think for many other businesses, one of the potential benefits of the pandemic--and I would never want to actually say there were real benefits--but one of the outcomes I guess maybe said better is a lot of businesses were forced to confront very different distribution, more broad-based distribution if you think about how we all decided to order online and pick up at the store, parking-lot delivery from Home Depot and Target and all these other companies. And that has re-created a consumer experience for those companies that Amazon actually has a harder time meeting, at least for the time being. Yes, they do some same-day delivery. But the idea of Prime was to disrupt all of that, and yet, many businesses have fought back.
I think this is actually one of those things where there's some give and take in this. And it's certainly one that bears constant monitoring because they're always looking for new areas to disrupt and new ways to think about things. But I think the really resilient businesses that do actually have stronger competitive advantages that are durable and that they continue to reinvest in, they will have success in fighting off some of that competition. And I think by and large, we've seen that, for now, these companies are holding that Amazon disruption mostly at bay.
Ptak: I wanted to talk about another category of risk, which is ESG risk. I know that ESG is a dimension of your process. I wanted to talk about it in the context of Stryker, the medical-devices firm. It's another name you've owned for a long time, and it boasts a number of attractive attributes as a business. But I know it's also been flagged before for some of the issues with product safety, especially as it relates to hip implants. Is it fair to say that your goal in a case like Stryker isn't to minimize ESG risks like these but rather to ensure you're being paid adequately for them?
Schoenstein: I think it's worth recognizing ESG--we see a lot of correlation between ESG and quality. The good business practices and good ESG practices, for lack of a better way to put that, frankly, there's a lot of similarity there, a lot of correlation there. If you're being good stewards in the environment and being good stewards of your stakeholders, more broadly, you do a lot of good things for the E and the S, and at the same time, also, frankly, do a lot of good things for the business itself: lowering costs, increasing efficiency, treating your employees, treating your communities appropriately. We think there's certainly a strong alignment with that. We're not an ESG product. The Quality Growth strategy is not an ESG product. But I think it certainly is one where we see, call it a “dual mandate” that exists between those two, where we can produce what we believe to be very strong financial returns and investment returns and at the same time have good value alignment with our clients.
Now, in the case of the one you mentioned, the company you mentioned, Stryker, I think it's worth noting it's a risky endeavor. If you think about their orthopedic business, you're trying to solve issues related to essentially replacing human anatomy. That is not an endeavor that should be thought of as a zero-defect sum game. They do have certainly robust regulatory review. And occasionally, you will have recalls, product issues, things like that. I think that, here's one thing we would certainly look at is, there's certainly a part of doing business, especially in the healthcare space, is that there are risks. Yes, we want to be compensated for them, but I think it's also worth keeping in mind: What is it that they've been dealing with, and how has that turned out in the face of the business more broadly? I think in the last three years or so, we've seen a little over $300 million that the company has paid out for recalls. Now, that sounds like a very substantial sum, and I'm not trying to diminish the impact to individual patients. But that $300 million has been paid out in a time frame where they've generated almost $9 billion in cash flow from operations. It's a very, very small part of what's happened within the business, and that cash flow has been reinvested to shore up those areas where recalls are taking place to try to constantly innovate where there are issues with any of their devices, to the next generation of devices that hopefully won't have those issues.
I don't want to be so, you know, in summary fashion to say, look, it's just a cost of doing business. We do want to see them trying to do the right thing. I would argue and we would certainly look at it as: Are they trying to do the right thing and then occasionally have something that is a bit of a misstep where they have to correct before they can continue to move forward? Or is it something where they're actually doing something that's, frankly, a lot more damaging and, frankly, not taking responsibility? That would be a much more difficult ESG challenge for us and, frankly, just a business challenge that we would probably not want to invest in.
Benz: For our last question, I'd like to ask: What's a hot topic of debate on your investment team right now? Perhaps you can give us one that's sort of macro and another that is more stock- or industry-specific.
Schoenstein: I'd say right now the hot topics are probably exactly what you'd expect. I don't know that we're necessarily debating inflation or how many times the Fed is going to raise interest rates. That's certainly been a hot topic more broadly. I'd say, if there is something we are paying attention to right now, that's a bit of a topic: What impact, if what's happening between Russia and Ukraine--and first and foremost, we absolutely understand this is a humanitarian crisis, first and foremost, and that's the most important focus here--but as we think about it from a longer-term perspective and we hear and see all of what companies are doing, what governments are doing to try to force Russia's hand and get them to pull out and stop this unfortunate invasion. I think that one of the things we're talking about is: What changes is this going to create to the global economy? You're talking about major reconfiguration of supply chains, potential major reconfiguration of raw material sourcing and raw material element delivery. And so, what impacts are those things going to have if this continues, or if we are entering a new phase of a protracted new Cold War between the West and the East in such a way where it makes it much more difficult to do business as we've thought about it over the last 20, 30 years? We don't have any answers to that. I'm not suggesting that we do or that anybody else would at this point because those are hard to predict. But that certainly is something that's causing us to think differently about or try to start thinking differently about how we evaluate our companies. And I think that macro impact will potentially have broad reaching impacts across, frankly, almost every company in our portfolio. So, it won't necessarily be a single stock or a single industry that could be impacted by that topic.
From a more acute macro perspective, I think one of the nice things about the way we invest, one of the positives about how we invest and utilizing pillars like competitive advantage and free cash flow is that these are businesses that are built for environments of higher volatility and environments where there are other cost pressures on their business model. The cash flow they generate and the cash flow reserves they have allow them to continue to invest through the challenging parts of a cycle, so that they can continue to thrive when the cycle turns more positive. And so, from that perspective, we're anxious to see this period go behind us and move to a more positive construct fundamentally. We also have confidence that the business models are built to survive through this type of environment much better than those that don't have the competitive advantages and the cash flows that we've long sought as part of the Jensen Quality Growth strategy.
Ptak: Eric, this has been a very interesting discussion. Thanks so much for sharing your insights with us. We've really enjoyed talking to you.
Schoenstein: Yeah, it's been my pleasure. And thank you so much for your time today as well. I've enjoyed talking to both of you, Jeff and Christine. Thank you so much.
Benz: Thank you so much.
Ptak: Thanks for joining us on The Long View. If you could, please take a minute to subscribe to and rate the podcast on Apple, Spotify, or wherever you get your podcasts.
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Benz: And @Christine_Benz.
Ptak: George Castady is our engineer for the podcast and Kari Greczek produces the show notes each week.
Finally, we'd love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com. Until next time, thanks for joining us.
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