QUALITY GROWTH INVESTING

A Series of Reports From Jensen Investment Management

October 2011

Voracious Volatility: A Time to React or Stay the Course?

Introduction During the summer of 2011, equity markets endured high volatility as measured by indexes such as the CBOE Market Volatility Index 1 (VIX). In general, market participants have reacted strongly to the uncertain economic outlook for both the United States and abroad, especially in the Eurozone. While volatility has spiked within the past few months, it has not been nearly to the very high level degree that was experienced at the end of 2008. Still, this heightened uncertainty has brought market volatility to the forefront in the minds of many investors and our clients. Figure 1: Daily CBOE Market Volatility Index (VIX), Measured Daily for the Three Years Ended 9/30/11

90 80 70 60 50 40 30 20 10 0

Throughout these and other troubling volatile periods, we at Jensen Investment Management have stuck
1 The Chicago Board Options Exchange Market Volatility Index (VIX) is a popular measure of the implied volatility of S&P 500 Index options. A high VIX implies a high expected movement in the S&P 500 in the next 30-day period. The VIX is not indicative of future returns; rather, it is used as a proxy for market sentiment.

to what we know. We rigorously apply our investment philosophy of investing in what we believe are high-quality companies with strong competitive advantages, growing free cash flow and consistent earnings. Some may ask if we changed our long-held investment strategy during the recent market turmoil. By every measure, the answer is no. Although market volatility can present opportunities for Jensen to trim some holdings and/or add to positions at what we feel are good price levels, we consider volatility to be more of a nuisance a temporary market reaction and more noise than anything else. While there may be higher volatility in the market, our investment philosophy and process remains consistent. To this point, we will address some common measures of market and portfolio volatility, how they apply to our portfolio and how one can determine whether an investment manager or the broader market is responsible for changes in the behavior of a portfolio. Measuring Volatility - Beta One popular way to analyze changes in a portfolios volatility relative to a broader market is a measurement called Beta. This calculation measures both the magnitude and directionality of changes in a portfolios value, relative to some type of larger market index. If a portfolio has a Beta of 1.0, this would indicate that the portfolios value moves in the same direction and to the same degree as a movement in the relevant stock market index.2 If an investment managers Beta changes substantially over time (such as from 1.0 to 3.0), it could indicate a large shift in the managers strategy. In Figure 2, we present our portfolios weighted-average Beta versus the S&P 500 Index, measured at monthly intervals for the past 15 years. 3 The Beta vs. the S&P 500 Index as of 9/30/2011 was 0.90. Figure 2: Trailing 5-Year Jensen Beta, Weighted Average of Fund Holdings vs. S&P 500 Index, Measured Monthly for 15 Years Ended 9/30/11

1.20 1.00 0.80 Beta 0.60 0.40 0.20 9/1996 9/1997 9/1998 9/1999 9/2000 9/2001 9/2002 9/2003 9/2004 9/2005 9/2006 9/2007 9/2008 9/2009 9/2010 9/2011 Jensen Beta vs. S&P 500

Source: Thomson-Reuters

Further examples: a portfolio Beta of 0.0 indicates that changes in a portfolios value are not correlated with movements of a particular index, while a Beta of -1.0 would mean that the portfolios value moves to the same degree, but in the opposite direction as compared to that index. A Beta of 2.0 would mean that if the value of the index increases 5%, the value of the portfolio typically increases 10%. A Beta of -0.5 would mean that if the value of the index increases 5%, the value of the portfolio typically decreases 2.5%. It is important to note that these are weighted averages calculated from individual stocks held by the Jensen Quality Growth Fund, and that this calculation is not the same as the Beta of the Funds returns (although we believe it should be an acceptable proxy.)

As the graph in Figure 2 shows, the Jensen Quality Growth Funds Beta vs. the S&P 500 Index has moved around over the long term, but has, for the most part, been less than 1.0. This generally indicates relative portfolio volatility somewhat below that of the S&P 500 Index. However, the low point in the middle of the graph highlights one of the problems with the Beta calculation. During a period where a portfolios returns substantially diverge from those of an index (that is, the correlation declines), a portfolios Beta can trend away from 1.0, despite no change in the actual volatility of the underlying securities. Further, looking at a rolling five-year number, as in Figure 2, we can see that it takes time for the effect of such a period to wear off. In other words, it is important to know that the calculation for Beta includes the Standard Deviation of portfolio and market returns, as well as the Correlation between them. 4 Therefore, Beta can change substantially if only one of these inputs changes, effectively masking the specific reason for the change. While Beta is a popular metric and seems easy to interpret, it is important to understand its strengths and weaknesses and how Standard Deviation and Correlation can play a role. Measuring Volatility Standard Deviation Another way to measure volatility is by looking at a portfolios Standard Deviation of returns over some time period. Unlike Beta, which measures volatility in market-relative terms, Standard Deviation is a statistical measurement that indicates how much variation, or dispersion, there is from an average measurement. Instead of selecting an index as with a Beta calculation, one must select an appropriate average measurement against which to calculate the Standard Deviation of those data points. In Figure 3, we examine Standard Deviation of daily returns. At the end of each month, the average daily return is calculated and then Standard Deviation is calculated from that set of daily returns. This calculation was then made on a monthly basis for the last fifteen years. 5 As the graph indicates, current levels of daily volatility (as of 9/30/11) pale in comparison to those experienced at the end of 2008 and in early 2009, and are also lower than those during the dot-com boom. Figure 3: Trailing 1-Month Standard Deviation of Daily Returns of Fund Holdings, Measured Monthly for 15 Years Ended 9/30/11
7 Percentage Standard Deviation 6 5 4 3 2 1 0 9/1996 9/1997 9/1998 9/1999 9/2000 9/2001 9/2002 9/2003 9/2004 9/2005 9/2006 9/2007 9/2008 9/2009 9/2010 9/2011 Jensen S&P 500

Source: Thomson-Reuters
4Specifically, Beta = (Standard Deviation of a financial instrument / Standard Deviation of a market) * (Correlation of returns between the instrument and the market) 5It is important to note that these are weighted averages calculated from individual stocks held by the Jensen Quality Growth Fund, and that this calculation is not the same as the Standard Deviation of total Fund returns (although we believe it should be an acceptable proxy.)

What we can see in Figure 3 is that there have been periods of high volatility and that Jensens companies stock prices are not immune to these price fluctuations. Since we typically invest in large-capitalization companies, the stocks of these companies are typically liquid and trade in high volumes. Unfortunately, this also means that these stocks can be used as a source of cash for panicked investors, or as a pool of liquid assets for short-term traders to take speculative positions. Standard Deviation, of course, depends on the data set used for the calculation of the average. Looking at the longer term, through the lens of monthly returns (instead of daily returns in Figure 3), we can see a more consistent pattern due to the smoothing effect of rolling time periods. Figure 4: Trailing 5-Year Standard Deviation of Monthly Returns of Fund Holdings, Measured Monthly for 15 Years Ended 9/30/11

14 Percentage Standard Deviation 12 10 8 6 4 2 0 9/1996 9/1997 9/1998 9/1999 9/2000 9/2001 9/2002 9/2003 9/2004 9/2005 9/2006 9/2007 9/2008 9/2009 9/2010 9/2011 Jensen S&P 500

Source: Thomson-Reuters

Based on this longer term view, which covers the last 15 years, there have been trends in volatility that are quite interesting when viewed with consideration of the economic environment at the time. Relating this back to Figure 2 and our discussion of portfolio Beta, it is clear that there is a relationship here. Holding Correlation of returns constant, a portfolio with a Beta greater than zero but less than one should also have a Standard Deviation of returns that is generally lower than that of the index used to calculate that Beta. But what happens when Correlations change? Correlation with Indexes In general, changes in a portfolios construction are often responsible for observed changes in Beta, Standard Deviation and many other portfolio characteristics. For Jensen, portfolio construction refers to our decisions as to which companies are contained in the portfolio and each companys relative weighting. 6 However, there are other market-related factors that can cause changes in a portfolios characteristics or volatility behavior which are beyond the control of an investment manager. Such factors can cause significant price spikes or declines. As an example, lets say that you own a portfolio of 10 stocks valued at $1,000 in total. All 10 companies are included in the S&P 500 Index. A large bank has $10 billion invested in a portfolio that roughly approximates the holdings of the S&P 500 Index. One day, for whatever the reason, that bank has an emer6 For other asset classes and multi-asset portfolios, portfolio construction can include a multitude of other factors.

gency need to raise cash and liquidates its $10 billion portfolio as quickly as possible. On that day, virtually all of the stocks in the S&P 500 Index could be trading at lower prices, as the bank has flooded the market with orders to sell those stocks. All of the companies in your portfolio -- and in the index -- may be down on the same day, despite no specific new information about these companies. This is an example of when Correlations between stocks increase due to the actions of market participants. In fact, this Correlation between stocks in an index (or in a portfolio) can change substantially over time. Correlation is similar to Beta in that a measurement of 1.0 means that two data sets move in the same direction at the same time, while a measurement of -1.0 means that the two data sets move in the opposite direction at the same time. Unlike Beta, however, 1.0 and -1.0 are the boundaries and correlation only indicates the relationship between directionality and not the magnitude of these movements. As shown in Figure 5, Correlations between all of the stocks in the S&P 500 Index can vary substantially and Jensens companies, like most large-capitalization companies, are not immune to these swings. Figure 5: Trailing 50-Day Median Correlation of Stock Prices of Fund Holdings vs. the Same Calculation for the S&P 500 Index, Measured Daily for Three Years Ended 9/30/11 against the S&P 500 Index*

1.00 0.90 0.80 0.70 Correlation 0.60 0.50 0.40 0.30 0.20 0.10 0.00 9/2008 9/2009 9/2010 9/2011
Source: Thomson-Reuters * On each day, the price for each stock in the portfolio was calculated for the past 50 days. The correlation between this 50-day set of prices and the same 50 days of prices for the S&P 500 Index was then measured, after which the median of these correlation values was measured. This median number then represents how correlated the price movements of the contents of a portfolio are with the price movements of the S&P 500 Index. This median data is graphed in Figure 5 as the line labeled Jensen. The same calculation process was repeated for each stock in the S&P 500 Index and measured against the price movements of the Index as a whole. The median of these correlation values was then measured and graphed in Figure 5 as the line labeled S&P 500. Interpreting this data graphically, during periods of low correlation (for example, a value of 0.40 0.50) stocks tend not to move in the same direction as the S&P 500 Index at the same time. During periods of high correlation (for example, a value of 0.90 or higher), stocks tend to move in the same direction as the S&P 500 index at the same time.

Jensen S&P 500

As shown in Figure 5, during some time periods, including the past month, Correlations between stocks can approach 1.00 a scenario in which everything essentially moves together. We think thats a strong departure from valuing a company based on its business fundamentals. But what does this all mean? Are investors at the mercy of large speculators who can substantially change the behavior of the markets simply by throwing their weight around? Unfortunately, in the short term, this is true to a certain degree. However, we believe that it is more important to focus on long-term, time-test-

ed strategies that make sense rather than focusing on short-term worries and daily stock price fluctuations. Ben Graham, the famed Columbia University professor and financial analyst, once opined that in the short term, the market is like a voting machine, but in the long term its more like a weighing machine. That is to say, daily swings in market sentiment are just that, and we believe its more important to have sound decision making and a consistent long-term view. Focusing on the Companies At Jensen, we believe that the long-term returns generated by the stock and dividends of a quality business reflect its long-term growth in earnings and free cash flow. In our investment process, we seek companies with sustainable competitive advantages and persistent, strong business performance. Often these companies are termed high quality due to their stable business models, consistent earnings and dividends and long track records of steady growth. We are often asked how we measure a subjective characteristic like quality. One thing we look for is consistency of a companys earnings. Presenting this graphically, we can look at a measurement called Earnings per Share Variability, which is calculated as the average absolute percentage-deviation of a companys past 20 quarters earnings from a longer term trend line.7 A high quality company should have low deviation from a linear pattern as its business and cash flows should be stable and regular. A lower quality company, by comparison, should have a higher deviation from a steady earnings trend. Over the past ten years, a period of substantial market volatility, the Earnings per Share Variability of Jensens portfolio companies has been consistently lower than that of the companies in the S&P 500 Index. This data is graphically depicted in Figure 6. Figure 6: Earnings per Share Variability of Fund Holdings vs. Those in the S&P 500 Index, Measured Monthly for 10 Years Ended 9/30/2011

35 30 EPS Variability (%) 25 20 15 10 5 9/2001 9/2002 9/2003 9/2004 9/2005 9/2006 9/2007 9/2008 9/2009 9/2010 9/2011 Jensen S&P 500

Source: Thomson-Reuters
7 Specifically, this trend line is calculated with a linear regression analysis, a mathematical calculation where the relationship between two variables is estimated by attempting to find a line of best fit. This line is typically determined using a least squares approach, where the overall trend line minimizes the sum of the squared errors and therefore best fits the observed data from the two variables.
8

S&P analyzes about 4,000 stocks traded on the NYSE, AMEX and Nasdaq exchange based upon each firms per-share earnings and dividend records, then recalculates core earnings by backing out certain items (extraordinary items, discontinued operations, impairment charges, etc.) Figures are also adjusted for changes in rates of earnings/dividend growth, stability over a long-term trend and cyclicality. S&P then divides stocks into a quality category matrix, rating each stock from A+ to D, basing ratings upon each individual companys growth and stability of earnings and dividends.

Besides Earnings per Share, we look at a multitude of fundamental factors when researching a company revenues, expenses, profit margins, free cash flows, dividends and share repurchases as well as qualitative factors like competitive advantages, strengths and weaknesses, regulatory challenges and future growth opportunities. All of these factors together add to our picture of a company. Another way to look at Jensens consistency in company selection is by examining the Standard & Poors Earnings and Dividend Quality Ratings8, which seek to rate companies based on the growth and stability of their earnings and dividends. Over the long term, Jensen has been remarkably consistent in selecting these highly rated companies, even though these S&P ratings are not a factor in our investment process. Figure 7: Weighted Average S&P Earnings and Dividend Quality Ratings for the Funds Holdings, Measured Monthly for 15 Years Ended 9/30/2011

A+
Weighted Average Rating

A ASource: Thomson-Reuters

B+ B

Jensen S&P 500

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(Calculated as a weighted average based on the actual weight of each company in the portfolio (or S&P 500 Index) as of each date. As of 9/30/11 the highest rated company in our portfolio was A+ and the lowest was B+.)

Conclusion Here at Jensen, we dont change our stripes when market emotions run high. We stick to what we know and what we do best working to find high quality companies with strong cash flows, sustainable competitive advantages and positive outlooks for future growth. Looking at the most recent four quarters available, our companies have grown earnings per share at 15%, revenues at 13% and dividends per share at 19% compared to the same period a year ago. While some investors may be nervous when volatility spikes, we believe that sudden reactions to shortterm fluctuations rarely help anyone, and it is more important to have and maintain a view of the bigger picture and a portfolio of quality companies. Since our firms beginnings more than 20 years ago, we have stayed true to this long-term focus and investment discipline, while continually working to help our clients achieve their investment goals.

9/2011

All factual information contained in this paper is derived from sources which Jensen believes are reliable, but Jensen cannot guarantee complete accuracy. Any charts, graphics, or formulas contained in this piece are only for the purpose of illustration. The views of Jensen Investment Management expressed herein are not intended to be a forecast of future events, a guarantee of future results, nor investment advice. Holdings and sector weightings are subject to change without notice. Past performance does not guarantee future results. The Quality Growth accounts managed by Jensen (including the Fund) are nondiversified, meaning that they may concentrate their assets in fewer individual holdings than a diversified product, and therefore are more exposed to individual stock volatility than a diversified product. Investing involves risks; loss of principal is possible. The S&P 500 is a broad based, market value weighted index consisting of 500 stocks, and is widely recognized as representative of the equity market in general. The index is unmanaged and you cannot invest directly in an index. EPS Growth is not a measure or forecast of an accounts (including the Funds) future performance.

The Jensen Quality Growth Funds investment objectives, risks, charges and expenses must be considered carefully before investing. The prospectus contains this and other important information about the investment company, and it may be obtained by calling 800-992-4144, or visiting www.jenseninvestment.com. Read it carefully before investing.
Definitions: Beta: A measure of the volatility of a securitys total return compared to the general market as represented by a corresponding benchmark index. A beta of more than 1.00 indicates volatility greater than the market, and a beta of less than 1.00 indicates volatility less than the market. Price to Earnings (P/E) Ratio: Is a common tool for comparing the prices of different common stocks and is calculated by dividing the current market price of a stock by the earnings per share. Free Cash Flow: Is equal to the after-tax net income of a company plus depreciation and amortization less capital expenditures. Earnings Per Share (EPS): The net income of a company divided by the total number of shares it has outstanding. Market Capitalization: The total dollar market value of all of a companys outstanding shares. Market capitalization is calculated by multiplying a companys shares outstanding by the current market price of one share.

Jensen Investment Management is the adviser to the Jensen Quality Growth Fund and is distributed by Quasar Distributors, LLC.

5300 Meadows Road, Suite 250 Lake Oswego, OR 97035-8234 503 726 4384 Toll Free 1 800 221 4384 Fax 503 726 4385 www.jenseninvestment.com