Kent Gasaway Buffalo Small Cap fund

Age: 62

Credentials: BBA in finance, University of Iowa; TK, Stonier School of Banking (Rutgers)

Experience: Portfolio manager, Jensen fund (2000-present); chairman, Jensen Investment Management (2000-present); vice president, Principal Financial Group (1997-2000); financial group vice president, Wellmark Inc. (1990-1997); chairman, president and CEO, First Interstate Bank NA (1981-1990); vice president, Iowa Des Moines National Bank (1975-1981); financial analyst, Ford Motor Co. (1969-1975)

Ticker: JENSX

Inception of Fund: August 1992

Style: Large growth

Assets Under Management: $1.66 Billion

Three-and-five year performance as of June 1, 2009: -4.2% and -1.7%, respectively

Expense ratio: 0.85%

Front load: None

Minimum investment: $2,500

Alpha: 1.47% vs. Standard & Poor’s 500

Because of the erosion of the businessclimate over the past two years, you would think that the managers of the Jensen Portfolio might be tempted to cut the investments in their fund some slack. Rather than insisting on a company having at least 10 consecutive years of returns on equity of 15% or higher-a cornerstone of the fund's strategy-perhaps they might let one or two slide with, say, 12% or 13%.

Hardly, explains Robert Millen, one of the five managers. "There is no reason for us to break that rule," Millen says. "We find that when a company stops reaching that 15% return on equity, they have somehow lost their competitive advantage, and they will have a hard time getting it back."

Millen points out that a 15% return is the minimum required to gain entry into the fund. The typical holding actually sports a 25% return on equity, giving the stocks some cushion for worse results without deviating entirely from their growth trajectories.

This investment discipline has helped Lake Oswego, Ore.-based Jensen to hold up exceedingly well throughout the downturn. For the past year through June 1, the fund is down 21.7%, beating 95% of its large-cap growth peers, according to Morningstar; over the last three years the fund is off an annualized 4.2%, putting it in the category's top 16% through June 1.

On the other hand, the portfolio tends to lag in hot markets, an unusual trait in a growth fund. "It's usually the companies that led the market down that tend to rebound faster in the early stage of a recovery, but the companies we invest in don't do as poorly in a downturn," Millen explains. The Jensen fund spent three of the four years between 2003 and 2007, when the market was roaring, in the category's bottom 10%.

PUTTING IT TOGETHER

To construct the portfolio, the Jensen managers look for stocks with 10 straight years of 15% or more return on equity, a measure that shows how well a company uses reinvested earnings to generate future profits. They believe that ROE is a much better predictor of ongoing growth than earnings, which is more of a rearview calculation.

Firm founder Val Jensen began using the ROE measure when he started Jensen Investment Management in 1988. (Jensen retired in 2004.) He got the idea from William Fruhan, a Harvard Business School professor whose book, Financial Strategy: Studies in Creation, Transfer and Destruction of Shareholder Value, studied 1,500 companies from 1965 to 1975 and found that those that met the 15% ROE hurdle for sustained periods of time tended to generate mountains of free cash flow. Not only that, but the 72 standouts in Fruhan's study also had focused businesses and strong competitive advantages.

To find these winners, the managers screen 10,000 publicly traded companies looking for those with high ROE. Only about 150 names emerge. The list is then winnowed down to around 50 stocks. The others are eliminated owing to fundamental problems: The managers aren't able to identify a competitive advantage for the firm or it has a specific operational problem. "We want to find quality businesses that will generate these kinds of returns for the next 10 years," Millen says. With the 50 that remain, the managers begin their research. Once they determine a stock is worthy of inclusion, they apply their value metrics.

THE PRICE IS RIGHT

The problem with focusing on great companies is that they don't come cheap. After all, well-run businesses should command a premium to the market. The managers, however, refuse to overpay. In fact, they will only buy stocks when they are selling at a substantial discount to what they deem to be the stocks' intrinsic value, usually in the 20% to 40% range, arrived at using a discounted cash flow model. This pricing discipline gives the portfolio downside protection, Millen says. "When you're buying cheap companies, their prices don't fall as much in a downturn," he adds.