Accelerating dividend payments are among the fundamental metrics fund manager Robert Zagunis tracks in his stock-selection process. Today, he discusses that in terms of the strengths in some of his picks.

Kate Stalter: Today, our Daily Guru guest is Robert Zagunis of Jensen Investment Management. Robert, perhaps you could start off today telling our listeners a little bit about your investment philosophy, and what you see in the markets at this juncture.

Robert Zagunis: Our investment philosophy is fundamentally a long-term approach based on the premise that enduring wealth is created by owning great companies for a long time.

So then, the question is: How do you define great companies? For us, it really revolves around three main topics. The first is operations that can generate a return on equity, a business return on equity, of at least 15% every year for ten years in a row.

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That may seem like a severe screen, but for us, it represents several things. One is that the company can create shareholder value every year, and then it also imbues into the operations a culture of high level of operating performance, which is what we like.

It also points to a higher quality company in terms of ratings and balance sheets, strength, and so forth.

So the ability to then have free cash flow to self-fund your growth, make acquisitions, making their balance sheets strong, and pay dividends, are all aspects that we like in terms of being able to generate shareholder value. Then the final is a little more subjective, and that is they have to have a really exceptional management team that can make the decisions necessary to keep the high level of growth going into the future.

Kate Stalter: Now obviously in recent months, there’s been a lot of attention to yield. How do you view the balance between yield versus capital appreciation?

Robert Zagunis: Well, not to be too smug about it, but I think if you can get both, you’d want both.

Part of the characteristics of these Jensen Quality Growth Fund (JENSX) companies is that they do have remarkable flexibility on their balance sheet, and they do have a general increasing trend of free cash flow. And this is after they’ve invested into the business.

So what you end up with the profile of the companies is a strong balance sheet. They grow, they fund their growth—because you have to be able to grow in order to keep this high ROE—and they pay dividends for the most part. These dividends have been going up in double digits.

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So the main point is that in very strong companies, you get the growth, i.e. the appreciation, but then you also get the quality, which in many ways is manifested in an increasing dividend.

So we have pretty good yields in these companies, but more importantly than just the yield is the fact that they increase their dividend regularly. We have a number of companies that have been paying dividends and increasing good dividends for decades on end. United Technologies (UTX), 3M (MMM), Abbott (ABT)…companies like that.

Kate Stalter: You mentioned a few of the holdings that you like right now. Can you talk a little bit about some of the sectors that you might be overweighted at this point?

Robert Zagunis: Yes, let me backtrack a little bit. We don’t manage the portfolio by sector. We manage it by individual company opportunities, so that the sector weightings are a consequence of what comes with our analysis.

Right now, we see exceptional opportunities in health care, so we are overweighted in health care. We are overweighted in industrials, and in some cases, we don’t have any exposure right now to banks, but do have T. Rowe Price (TROW) as a financial. That weighting changes as the evolution of these companies and the opportunities sort of morph into different opportunities.

But right now, certainly companies like Abbott Laboratories and Becton Dickinson (BDX), for example, and even Medtronic (MDT) in the medical and the health-care side of things we like.

And on the industrial side, companies like Emerson (EMR), who just recently became a lot more aggressive on the M&A side and they’re going to sort of flex their muscle to grow. And United Technologies, which announced a major acquisition in Goodrich, which we like long term. So they kind of continue the trend of growth and good shareholder value creation.

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