Commentary
International Fund Second Quarter 2021 Commentary
The International Fund is significantly overweight to Europe and we think poised to benefit as the ongoing vaccination rollout allows European economies to reopen more. MORE
Summary
Our interactions with Polen go back several years, when we were first introduced to their domestic strategy. We initiated formal review of their international growth strategy in the fall of 2019 and conducted and completed in-depth due diligence on them in 2021. We think Polen’s culture and quality of the team are unique and among the best we have seen. Their long-term, focused, quality growth investment philosophy is time-tested and deeply ingrained in the team. The investment process and decision making are designed to execute this philosophy in a consistent, disciplined manner and with a high level of skill. As such, we believe Polen will outperform the international benchmark index over time and is an excellent addition to iMGP International.
Firm history
Polen capital is an independently owned, employee-controlled global investment management firm. Employees own 71%, and the remainder comprises passive ownerships in 20% iM Global Partner and 9% Polen Family Trust. The firm was founded by David Polen in 1979.
As a broker, David Polen was investing in the 1960s and 1970s and over two decades developed a philosophy of investing in only the highest quality companies, and compounding wealth by holding these businesses for the long term. This approach has been adopted by the Polen Large Company Growth team, several of whom had the opportunity to work closely with David Polen before his passing in 2012.
Polen Capital launched its first strategy, US Focused Growth, in 1989. In 2015 and 2017 the firm launched Global Growth and International Growth strategies, respectively. These three strategies are managed by the Large Company Growth team based out of Boca Raton, Florida.
The firm’s stated mission is to “preserve and grow clients’ assets to protect their present and enable their future.” Polen’s Large Company Growth team’s mindset is about managing risk and they think in terms of margin of safety. This risk-averse thinking permeates their investment philosophy and approach.
Investment Philosophy
The Polen team believes that a company’s earnings growth ultimately should drive its stock’s performance over the long term. Focusing on earnings or cash flow growth allows them to cut through the noise in the market. As long as they pay a reasonable or a fair price, the stock price should follow earnings or cash flow growth over the longer term. They hope to achieve around mid-teens earnings growth at the portfolio level, with some companies generating higher growth and some less. They believe that if they are able to achieve this level of earnings growth, they should outperform the market where the average company may generate roughly mid-single-digit earnings growth. The level of attractive earnings growth they seek is typically found in what they like to say are among the most competitively advantaged businesses. Because there aren’t many businesses who can consistently generate this high level of earnings growth, Polen believes in concentration. This concentration in high-quality growing companies with durable competitive advantages is what Polen believes gives them a margin of safety.
An important element of Polen’s investment approach is about mitigating downside risk. They see risk in investing in cyclical companies, where earnings are not consistent. They see risk in industries where competitive intensity is increasing, where the business’ competitive advantage (their “moat” as Warren Buffett would say)may no longer be secure and durable. They see risk in overpaying for a great business.
To assist in their search for these competitively advantaged companies, all companies have to meet what Polen calls five “guardrails.” These are:
- Strong balance sheets with little debt, and preferably a net cash position
- Strong free cash flow that can be reinvested at high rates of return or returned to shareholders
- At least 20% return on investment that is sustainable
- Stable to increasing profit margins
- Organic revenue growth
The guardrails help narrow the universe down to a subset of companies that are “defying normalcy” and where there is something “special” going on. These companies are bucking the mean-reversion trend and maintaining economics “a couple of standard deviations above normal.” Those are the businesses the Polen team wants to understand better.
The key question with respect to assessing the competitive advantage of a business is to understand what’s special about this business and why it can’t be replicated. They want to identify and own business models where it takes a long time and/or a lot of money and/or a lot of effort to replicate.
Firm Culture
There are many elements behind Polen’s culture. It is firstly client centric, which relates to their investment philosophy. They believe they are responsible for preserving clients’ present (mitigating downside) and securing their future (which involves capital appreciation). They deeply believe both objectives can be met by focusing on long-term earnings growth and concentrating in only the highest-quality businesses, as long as they don’t overpay for their attributes. They have executed on this philosophy in the US market for over 30 years with considerable success. This has deepened their belief, and it has become the team’s singular focus over time, and a source of their strength and advantage in our view.
This belief gives them direction on the type of people they want to hire and how to motivate and retain them. Polen values diversity in thought and experiences. They expect objectivity and constant improvement from each other. Incentives are well-aligned with investment philosophy and driven by overall team success.
Investment Process
As global generalists, the main activity for analysts and portfolio managers at Polen is to find great businesses and follow how they are evolving. These are companies that have attractive earnings growth, durable competitive advantages, strong balance sheets, high returns on capital, strong secular growth potential, and typically they are producing more free cash flow that they are reinvesting in their competitive moat, which has gotten stronger with time.
Much of the team’s focus is on assessing competitive advantages of a company. They seem laser focused on assessing whether the moat is increasing or decreasing, whether there are other risks that are impacting their confidence in the company being able to sustain margins and earnings growth.
Idea generation and team vetting
Ideas can come from their financial screens (the guardrails), other readings, business models they may come across as part of monitoring existing names, etc. An analyst may take on an idea and do an initial research project. This is then discussed broadly as a team. If a decision is made to continue work on it, the lead analyst will typically work with one of the PMs as secondary. In this phase of due diligence, the team’s focus is on better understanding industry dynamics and growth; company-specific advantages, such as network effects, high switching costs, intellectual property, monopolies etc.; and management’s capital allocation track record. It is an iterative process, and it may take months to work on an idea. The goal is to gain a thorough understanding of each business, its economics and growth prospects and the sustainability of its competitive moat. After an idea has been thoroughly debated by the team the lead analyst would make a formal buy recommendation. The portfolio managers ultimately decide whether or not to purchase a stock.
Included in the iterative deep dive research is a “pre-mortem” risk analysis where the team imagines that an investment has failed and then works backward to determine what potentially led to that failure. This includes environmental, social, and governance (ESG) related risks.
Valuation Discipline
Within the quality growth investment pond in which Polen fishes, their approach is value oriented. Polen assesses valuations and upside systematically. In the end, for a holding to be purchased and held in their portfolios, it needs to meet at least a double-digit expected return hurdle. There are two essential variables behind their calculation—expected earnings growth rate and a five-year price-to-earnings multiple the Polen team believes is fair for the business. If the math gives them less than a 10% expected annualized return, the name is typically sold in favor of ideas that have better upside.
Polen wants to pay a fair multiple for a great business. Generally, they are not expecting multiple expansion for their companies. Most often they are using a lower multiple than current on their estimate of five-year earnings. What multiple they use is largely a qualitative judgment, which is a function of:
- What is the business?
- What is the competitive advantage?
- What is its economics? Why is it improving/Will it improve? How long can these economics be sustained? Polen believes the market has a hard time pricing companies that can grow earnings 15% to 20% for five, ten, or longer periods.
- Does it meet the guardrails?
- What’s the downside?
All these factors become part of the overall equation or judgment on what is a fair price to pay for a given business, the level of earnings growth it generates, the consistency with which it does, the duration over which its competitive advantage might allow it to generate this earnings growth, etc.
Portfolio Construction and Risk Management
The portfolio managers decide on the stock weightings, weighing the potential upside, quality of the business, and risks. Benchmark weightings or tracking error is not a consideration when constructing portfolios.
In terms of risks, Polen’s quality guardrails tend to eliminate businesses based in higher-risk countries with elevated currency risk (so they will be very selective in emerging markets), as well as state-owned enterprises, and many companies in cyclical sectors such as financials, industrials, energy, materials, and utilities.
Sell discipline
Polen’s sell discipline is the mirror image of their buy discipline. Stocks are sold when they no longer meet their financial and quality guardrails, and/or where there is potential or actual impairment in sustainable competitive advantage, and/or where they do not see a high likelihood of at least a double-digit annualized return. Stocks may also be displaced by a better idea.
Conclusion
We have developed a very high conviction in Polen Capital’s Large Company Growth team, including the two international portfolio managers—Todd Morris and Daniel Fields. We believe they are well-suited to running the highly concentrated mandate for iMGP International. It is very aligned with how they think about investing and how they manage their flagship portfolio that is already conviction weighted.
Our confidence in Polen’s international strategy is based on several factors. A time-tested philosophy, developed and honed by David Polen, has been adopted and is executed exceptionally well by the Polen Large Company Growth team. That philosophy is to find great businesses all over the world that have lasting competitive advantages and can generate above-average earnings growth in a sustainable fashion. We believe the key elements behind Polen’s edge are:
- Deep belief in the philosophical underpinnings developed by David Polen and that have been deeply ingrained in the team. We think the clarity of purpose that this philosophical framework provides is relatively hard to replicate.
- Obsessive focus on competitive advantage. It drives their conviction in earnings growth. It drives how they think, what they focus on, the people they hire and how they onboard them, and how the team is compensated and incentivized.
- Their culture: open and collaborative that fosters intellectual flexibility, debate, and objective, critical thinking.
- An exceptionally high-quality group that has been working together for a long time.
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