Swedroe: Active Manager Lags Despite Research

May 12, 2017

I recently received an email asking me to comment on a white paper, “Return on Equity: A Compelling Case for Investors,” published by Jensen Investment Management.

The paper explains Jensen’s investment strategy: “At Jensen Investment Management, we believe that Return on Equity (ROE) is a very useful criterion for identifying companies that have the potential to provide attractive returns over long periods of time. Our experience and research suggest that our requirement of consistently high Return on Equity results in a universe of high-quality, profitable companies that are able to generate returns above their costs of capital in a variety of circumstances and economic environments. Further, we believe that this universe produces companies with sustainable competitive advantages, strong growth potential and stocks with a lower beta relative to broad market indices.”

In other words, ROE is a key element of the “secret sauce” that will allow Jensen to deliver alpha to investors, justifying the higher fees that coincide with active management.

The paper explains: “We start by annually selecting only those U.S. companies that have earned a Return on Equity of 15% or greater for the last ten consecutive years, as determined by Jensen’s Investment Committee. From there, we narrow down this universe of high Return on Equity companies through fundamental research based on their growth potential, financial strength, competitive advantages and their lines of business. Finally, we seek to identify the undervalued securities – those that are the ‘best deals’ of the companies that we follow.”

They conclude: “We seek to invest only in quality growth businesses that we can reasonably understand, whose outlooks are favorable and that can be acquired at sensible prices. Our investments remain unless business fundamentals deteriorate below our strict standards, we identify a more compelling opportunity or the stocks become overpriced based on our metrics.”

Supporting Research
It’s important to note that Jensen’s focus on profitability is supported by the academic research. For example, in July 2004, the paper “Profitability, Investment and Average Returns,” by Eugene Fama and Kenneth French, found that more profitable firms have higher expected returns, as do firms with higher book-to-market ratios (value stocks).

The paper was published in the November 2006 issue of the Journal of Financial Economics. Their paper confirmed the findings of the 1996 paper by Robert A. Haugen and Nardin L. Baker, “Commonality in the Determinants of Expected Stock Returns,” as well as those of the 2002 paper by Randolph Cohen, Paul Gompers and Tuomo Vuolteenaho, “Who Underreacts to Cash-Flow News? Evidence from Trading Between Individuals and Institutions.” Both papers found that, controlling for book-to-market equity, average returns are positively related to profitability.

Robert Novy-Marx made an important contribution to the literature with his 2012 paper, “The Other Side of Value: The Gross Profitability Premium.” Defining profitability as revenues minus cost of goods sold divided by assets, Novy-Marx found that profitable firms generate significantly higher returns than unprofitable ones despite having significantly higher valuation ratios, particularly when value is defined by book-to-market.

 

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