Sustainable Growth through Quality
Polen Growth Fund
Author: Ticker Magazine
Last Update: Oct 05, 3:06 PM EDT
|Although the market can sometimes be out of sync with fundamentals, it is the underlying earnings growth that drives performance in the long run. Based on this philosophy, Polen Growth Fund invests in its best growth and quality ideas with an investment horizon of at least five years.
ďWe donít try to generate returns through repeating the process of buying low and selling high. Instead, we identify the 20 business that we believe are the best, pay a fair price for them, own them over time and let the underlying earnings growth drive the returns.Ē
Philosophically, we believe that the best way to drive returns over time is to own economically superior businesses that deliver that type of return. Thatís the meaning of the ROE threshold. I am not saying that we wouldnít consider a company that consistently delivers ROE of 19%, so there isnít any magic about the number. But we have to draw a line somewhere.
The average American company has a return on equity of about 12%, so 20% is above the norm is a healthy hurdle. Back in 1989, the guardrails were laid out by the founder and have been the place since the fund was established.
Q: Is the ROE hurdle based on historic averages or on expected returns? Could you give us some examples?
We look for sustained characteristics and for businesses that can sustainably meet our criteria over time. We donít look for companies with no history of making money, which all of a sudden are delivering returns, but we donít exclude that possibility either. Facebook, Inc would be an example of a company, which wasnít earning much five years ago, but now is delivering strong returns and has exceptional economics, despite the current challenges.
Adobe Systems Inc would be another example. It has been a long-term leader in digital media with remarkable returns and solid growth. However, its business model shifted from selling boxed software to a subscription model. Because of the transition, which started in 2011, the company wasnít profitable and didnít have the desired ROE.
As they moved through the transition and the economics started to come back, we made an investment before Adobe fully reached the 20% ROE threshold. We could see that the profit impairment was strictly due to a temporary shift in the business model. Now Adobe has a ROE of above 40% and strong growth over the past several years. It has been one of our largest holdings and leading contributors.
We put a lot of weight in the guardrails in the process, because if a business meets all of them, thatís a good indication that there are competitive advantages, properties and qualities in the business that are worth considering.
Q: What is your view on hardware companies? Do you tend to avoid them?
Because of our focus on free cash flow, we tend to favor businesses that are not capital intensive. We donít lean heavily towards hardware since it tends to be commoditized over time and has more pricing pressure. The commoditization of hardware is a challenge when you own a company for five or 10 years.
However, we have owned companies like Apple Inc for a long time. Apple was our largest holding in the period 2010 to 2012, but we donít own it any more. To some degree, Apple has defied the rule of commoditization, but the industry is historically inclined in that direction.
We have a large position in Alphabet Inc and we owned Qualcomm in 2008 through 2014. The stock did well and we sold it because in 2014 Qualcomm was becoming more dependent upon emerging markets. At the time, the developed world had high cell phone penetration and the market was driven mainly by China, which was moving to 4G standards and had to adopt Qualcommís technology for the first time. There were high-level negotiations by competitive boards and we saw some manufacturers in China not paying royalties. We became concerned that Qualcomm had evolved into a moderate growth company, highly dependent upon China, and we had concerns for this market. For us, that was too much risk to bear, so we moved on.
Thatís a good example of our risk management, which shows that even the best businesses can see new risks. If we see a small chance for a big problem, we are quick to get out. Thatís part of our risk discipline. As a concentrated manager, we take substantial positions in anything that we own. So, if we are not comfortable with the risk, we would rather not own the company.
Q: Would you describe your portfolio construction process and the role of diversification in it?
Our primary benchmark is the Russell 1000 Growth Index, but we are benchmark agnostic in the construction process. With a concentrated portfolio of 20 holdings, we deviate from the benchmark positively or negatively in the short term. However, over a meaningful period of time, the portfolio is set to deliver higher growth than the benchmark.
We invest across the entire growth spectrum. At the lower end, we look for businesses that can at least do better than the market. That means high single-digit returns of 6% nominal growth plus 2% to 3% from dividend yield. So, at the safer end of our portfolio, we would own companies like Oracle, Accenture or even Microsoft, although the latter is recently defying these growth rates.
On the other end of the spectrum, we would invest in companies like Adobe, Align Technology or Facebook, which have been delivering growth of 25%, 30% or more, and companies that we believe would continue to deliver for a period of time. Then we have everything else in between. These different growth companies blend together to deliver mid-teen underlying earnings growth for the portfolio.
We build the portfolio one company at a time and we are extremely careful about the quality in every link of the chain and in the aggregate portfolio that we try to create. Typically, if we want a position, we want a full position. Most of our holdings are between 4% and 5%, which we consider a full weighting. We also have positions with higher weight, because we let the winners run. Today the larger positions in the portfolio are Adobe, Microsoft and Alphabet. There arenít many names that are substantially less than 4%.
Historically weíve been overweight in technology, healthcare and consumer industries. We donít have much exposure to financials, certainly not to traditional banks and insurance companies, but we own companies like Visa or MasterCard, which donít have the balance sheet risk of other financial institutions. Weíve never owned materials, energy, utilities or telecom companies. Our sector and industry exposure is the result of our philosophy to search for the best businesses; we just happen to find the best businesses in certain areas.
Q: What is your sell discipline? Why would you sell a stock?
There are several reasons that would trigger a sell decision and have a strict discipline, which has kept us out of risky situations. We donít own Netflix or Amazon, which have tremendous share price returns, but also have high valuations. So, we are disciplined about what we own.
The first reason for selling a stock would be the emergence of a new risk or a threat to the competitive advantage, as in the case with Qualcomm. Another reason would be the deterioration in fundamentals. If a business stops meeting our guardrails, if profitability declines and economics deteriorate, if there is a product shift or an excessive investment cycle, we would typically prefer not to remain invested in the situation.
We also have a valuation discipline. If the equation between growth and multiples starts to stray, then we will sell. Sometimes the business is doing great, but the valuation reaches a point where we canít remain comfortable and confident that we will get the expected double-digit return. Finally, there are portfolio construction considerations. We always look for better ideas and consider the aggregate portfolio characteristics. We make sure that we are diversified across drivers more than across sectors.
Q: How do you define and manage risk?
Risk is the permanent impairment of capital. We focus on both quality and growth, but we stress quality more than growth. Sometimes we may accept slightly lower growth, but we never compromise on the quality. There are periods with slower growth opportunities at a better price and we embrace them. At other times quality and growth companies become overpriced and we have to stick to our discipline to invest only in quality.
We first need to protect our investors, but we know that we can produce solid double-digit returns over time, and we are happy to do that in a dependable fashion. We donít reach for the extra return that would result in taking more risk.
1 2 More: Mutual Funds Archive