Risk Management U.S. Equity Investing. Eric H. Schoenstein, Managing Director - Portfolio Manager

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1 Risk Management U.S. Equity Investing Eric H. Schoenstein, Managing Director - Portfolio Manager

2 Primary Investment Risks 2 In our opinion, all investment risks fall under the umbrella of two primary risks.

3 3 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.

4 Secondary Investment Risks 4 + Operational Risk + Adherence to investment guidelines + Trading errors and violations of restrictions + Disaster recovery and operating ability if systems compromised + Portfolio Risk + Depth of fundamental research + Quality of earnings and free cash flow + Valuation metrics + Sell discipline + Organization Risk + Key person risk with portfolio management teams + Depth of staff in investment and client services + Alignment of interests between investment team and clients

5 Price Risk 5 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: 1. Systematic risk measures how sensitive a given stock price is to movements in the overall market. 2. Non-systematic or company specific risk is the risk that a security drops in price or generates inadequate returns due to company specific factors. Mitigation tools include: 1. Purchase price discipline 2. Weekly dashboard monitoring

6 Fundamental Business Risk 6 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.

7 Risk Management Starts With Quality 7 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. + Jensen Quality Universe + Team-managed strategy + In-depth due diligence on portfolio candidates + Extensive monitoring of current portfolio holdings

8 Risk Management Fundamentals 8 At Jensen, stock valuation follows fundamental company research. Significant time is spent on studying and researching the following: + Business strategy + Competitive advantages + Management Team + Financial Statements + Barriers to entry and competitive dynamic of the markets they compete in

9 Risk Management Fundamentals 9 + Companies create value when their returns on capital exceed their capital costs + Companies producing high returns on capital can attract competitors and increasing competition could eventually drive returns down to the cost of capital + Our own proprietary research indicates that there is a high probability that companies with an ROE of 15% or greater for ten consecutive years will generate an ROE of 15% or more in subsequent years* + In our minds, durable competitive advantages and solid entry barriers can delay the inevitable entrance of new competitors + Strong brand names, differentiated products, unique manufacturing processes, technical know-how, patent protection and economies of scale can represent economic moats** *Jensen Investment Management Understanding the Investment Process at Jensen Investment Management, Step One: Return on Equity. White Paper, p.12. Jensen Investment Management. **Economic moats: The competitive advantage that one company has over other companies in the same industry. A company with a wide moat possesses characteristics that act as barriers against other companies wanting to enter into the industry.

10 Risk Management Valuation 10 + Factors impacting business value and, ultimately, stock valuation include: + Discount rate + Return on capital + Reinvestment rate + Competitive advantages + Earnings growth + Share repurchases + Risk naturally exists in connection with the assessment of these items

11 11 If good investors buy businesses, rather than stocks (the Warren Buffet adage), discounted cash flow valuation is the right way to think about what you are getting when you buy an asset. -Aswath Damodaran For Institutional Investor Use Only

12 Risk Management Valuation Methods 12 MULTIPLES Advantages + Simplicity is a virtue of this valuation method + Applied to Projections + No Forecasting of distant revenues, EPS or EBITDA Disadvantages + Highly Subjective - Determining the appropriate multiple to use for a given company can be highly subjective because truly comparable companies rarely exist. + Assumes Value Multiples assume the market is correctly valuing the peer group. + Reasonability is Not Considered - This method does not consider whether the fundamental drivers of the business value embedded in the multiple are reasonable.

13 Risk Management Valuation Methods 13 DCF METHOD Advantages + DCF Requires Consideration of Fundamental Drivers for Business Value Creation: + Cost of Equity Capital, or (Discount Rate) + Return on Capital + Competitive Advantages & Barriers to Entry + Reinvestment Rates Disadvantages + More complex than multiples, (However PhD not required) + Difficulty with estimating the fundamental drivers + Forecasting uncertain future business results + Terminal Value can comprise too much of a company s value + Growth Rates + DCF allows investors to incorporate business strategy changes into the valuation.

14 Risk Management Additional Mechanisms 14 + Maximum position size weightings: Jensen limits the size of individual security weightings to 7.5% of portfolio assets. Setting a maximum weighting limits the negative impact that a price decline in an individual security can have on portfolio performance. + Industry weighting limits: We will not allow an industry to account for more than 30% of a portfolio s assets. This limit can help protect investors from weak performance in any individual industry. + Liquidity risk: Jensen generally sells no more than 15-20% of a security s average daily trading volume on any given day. Assessing this risk is important as security price declines can be exacerbated if a large portion of the holders of a relatively illiquid security attempt to exit the position at the same time.

15 Sell Discipline 15 Jensen s disciplined process for selling securities is another critical component of risk management. Well-defined mechanisms for removing securities from a portfolio enable portfolio managers to better manage both fundamental business risk and price risk. At Jensen, we liquidate positions under the following circumstances: When the price of a stock reaches our estimate of full value, we sell the position and deploy the proceeds in what we think are more attractively priced securities. Selling fully-valued securities can reduce the price risk inherent in a portfolio. If a portfolio holding s ROE falls below 15%, the company is removed from client portfolios. In our view, a decline in a company s ROE below the 15% minimum indicates that the company s competitive advantages are under pressure. This can lead to a decline in the rate of business value creation or outright value destruction if the company s ROE falls below its cost of equity. We believe that removing companies that violate our minimum ROE requirement of 15% lowers the fundamental business risk embedded in the portfolio. We may liquidate positions from our portfolios if more compelling investment opportunities arise. This can reduce business risk and price risk if the new security has stronger fundamentals and is more attractively priced than the security it replaced.

16 Risks to Our Approach 16 + Business and market disconnects for either short- or long-term periods + Client education on long-term portfolio behavior and focus on absolute returns + Poor execution of bottom-up company analysis + Improper execution of sell discipline

17 Conclusion Risk cannot be avoided when it comes to investing. It is imperative for investors to select managers with the ability to identify the various risks embedded in investment portfolios. More importantly, investors should choose managers that utilize effective tools to manage those risks in order to meet investment objectives and avoid permanent losses. We use a variety of techniques to manage both business and price risk in client portfolios. We believe the risk management tools incorporated in our investment process can enable our clients to generate attractive risk adjusted returns over time.

18 Disclosures 18 Jensen is an Investment Adviser registered under the Investment Advisers Act of Although taken from what are believed to be reliable sources, Jensen cannot guarantee the accuracy of information received from third parties. Graphs, charts and/or diagrams cannot, by themselves, be used to make investment decisions and are solely for illustrative purposes. The views and opinions expressed herein are subject to change and are not designed or intended to serve as a basis or determination for making any investment decision.

19 Thank You 19 Contact Information: Jensen Investment Management 5300 Meadows Road, Ste. 250 Lake Oswego, OR or