Polen Capital

Polen Capital is a growth public equity investment firm founded in New York in 1979 by David Polen. Its marquee product, the Focused Growth Fund, which manages $80 billion at peak and is the topic of discussion in this article, was launched in 1989.

In 2002, the firm moved its headquarters to Boca Raton, Florida, for cost-of-living reasons.

The firm has expanded its offerings over the years to include:

• Focused Growth: Large-cap growth, based in Boca Raton, FL.

• Small Company: Small-cap growth, based in Boston, MA.

• Emerging Market: Emerging market growth, based in London and Hong Kong.

• Credit: Through the acquisition of DDJ Capital Management in 2021., a high-yield credit investment firm, based in Waltham, MA.

Investment Style

The Polen Focused Growth Strategy (“the fund”), with an AUM of $80 billion at the peak and about $60 billion now, focuses on investing in businesses that fit the following five guardrails:

1. Above-average (mid-single-digit) organic revenue growth

2. Stable or improving margins

3. Sustainable >20% ROIC (return on invested capital)

4. Consistent excess free cash flow (FCF) every year, not just during good times.

5. Low debt and a cash-rich balance sheet (leverage below 3x current FCF).

Since its inception in 1989, the Focused Growth Fund has invested in only ~130 names that meet all their guardrails at the right valuation.

From a global pool of 300-350 companies meeting their guardrails, they filter down to 160-170 understandable companies, ultimately selecting ~20 names for sizeable positions at any point in time.

As a growth investor, Polen is not searching for the “50 cent dollars” under the styles of traditional value investing (eg. Baupost, GAMCO, Greenlight.) Instead, they are looking for “dollar dollars” that grow to be worth more than a dollar over time.

The team spends time ascertaining the sustainability of their target’s moat and the durability of growth, the latter of which is often undervalued by the market: e.g., A company that trades at 30x NTM earnings is valued at 11x earnings five years out if earnings can compound at 30% annually.

The fund favors companies with multiple moats that don’t require heavy reinvestment and ideally the moats reinforce each other (e.g., network effects with switching costs).

In terms of growth runway, they seek companies within secular themes that are still early in their penetration phase (e.g., cloud computing around 2010s, AI in 2020)

Their goal of value creation is to own a portfolio of companies that compound earnings per share at mid-teen rates, allowing the portfolio's value to grow steadily without relying on changes in market perception, also known as value multiples.

Investment process

At Polen, everyone is an analyst with coverage responsibilities, including the portfolio managers (PMs). Analysts cover an average of 10-20 names, though PMs cover fewer due to additional responsibilities.

While there's no mandate to pitch names annually, analysts update the team on major events related to their coverage quarterly. Macro factors such as foreign exchange risks and tariffs are considered alongside company-specific analysis.

Weekly Wednesday morning meetings serve as a platform for new write-ups and updates, typically lasting 2-3 hours and focusing on 2-3 names for initial research on a new position or annual updates on existing holdings. When introducing a new name, the primary analyst presents to the entire team, anticipating thorough questioning by the rest of the team during the discussion.

In the Wednesday afternoon meeting (called “universe discussion), the team decides which new ideas to add to the coverage universe using their proprietary ValueLine-like dashboard that fits the five guardrails. The idea filter excludes companies with high-leverage, undifferentiated products, regulated, high-capex, and cyclical.

They employ an expected return framework for valuation: the key is to focus on their company’s earnings power five years out and apply a multiple based on a normalized interest rate environment (eg. in the decade before the 2008 financial crisis, the yield on the 10-year US Treasury note averaged 4.9%, so let’s assume it’s 5%, which implies a normalized multiple of 20x).

The firm expects multiple compression over time and will never assume expansion to be conservative, but by then the earnings have compounded 20%+ that they are getting paid.

Risk management prioritizes adherence to guardrails and avoidance of capital impairment. Polen’s “Heat Map” follows a similar philosophy to reverse DCF to assess how multiple contraction impacts IRR. They also use DCF to understand the levers of multiple changes for the business (i.e., revenue growth, margin, capital intensity, and working capital intensity).

Portfolio management

PMs make buy/sell decisions and decide position sizing. There's no formal research committee or voting process.

Sizing decisions prioritize allocating more capital to companies with faster earnings growth, more reasonable valuation, accelerating EPS/revenue stories, and larger moats (preferably in the form of multiple moats.)

The fund aims to be fully invested in equities, as their clients typically hold separate allocations to cash. Holding cash can be a 10% drag on returns, assuming correct stock selection (if EPS compounds at 15% and the multiple stays the same, the stock makes 15%, and cash returns 5% in the current market environment as of mid-2024, that’s a 10% opportunity cost of not investing in stocks).

Starter positions have an allocation of 1-3%, with full positions at 4-6% portfolio weight. However, the team seems very bullish on Amazon and Microsoft right now.

Head PM Dan Davidowitz has conceded that the team can improve on position sizing, and the firm plans to consider the four factors (EPS growth, reasonable valuation, accelerating near-term, and larger moats) more thoroughly in future sizing decisions.

PMs will trim positions when businesses go through short-term issues and will exit if there are better ideas, moats are deteriorating, growth profiles are changing, or there is key management turnover.

Team

The Focused Growth investment team consists of 11 individuals, all of whom are generalists in terms of sector and geography. Among them, 7 are portfolio managers responsible for various strategies within the Polen’s large-cap product family.

Dan Davidowitz is the lead PM for the flagship Focused Growth strategy, a role he has held since the days when David Polen ran the firm and the product. Davidowitz's background at ValueLine and a deep value investment shop has influenced his appreciation for business quality.

Ten out of eleven team members hold graduate degrees, with eight possessing MBAs. Three members are graduates of Chicago Booth and Columbia Business School, respectively, likely influenced by the presence of PMs from both institutions. Except for a recently promoted PM, all PMs boast over 10 years of experience at Polen. Jeff Mueller, who recently left the firm, is a Columbia Business School MBA graduate (and in the famed Value Investing Program) as well.

The firm's hiring pattern has occurred in spurts. Three analysts joined between 2016 and 2018, while the most recent two hires joined between 2021 and 2023.

Performance

Through 2020, Focused Growth had a compounded annual return of 15%. However, the fund has underperformed its benchmark, the Russell 1000 Growth Index, in recent years.

Knowing that Focused Growth has not owned Nvidia, Apple, and Tesla, I already understand the cause of underperformance. In their defense, at least Tesla does not fit their investment criteria. Additionally, Netflix and PayPal had been poor picks in hindsight.

In a relatively concentrated strategy, just a few commissions and omissions can easily cause underperformance. In a profession that is all about “what have you done for me lately,” an AUM exodus ensued with underperformance in 2022 and 2023.

According to Dan, in 2022, the team underappreciated the impact of multiple contractions, particularly as interest rates rose swiftly, and earnings growth decelerated.

To counteract the effects of multiple compression, the team focused on companies with faster growth trajectories, such as Amazon and Netflix. However, these selections faced challenges due to tough comparisons coming out of the pandemic period.

Case study on Visa and Mastercard

Even well-known compounders like Visa and Mastercard can be caught up in investor skepticism, such as the perceived threat of blockchain technology.

The revenue growth algorithm for their core payment rail business is simple and predictable: a 4-5% shift from cash and check to card payment, and a 3-5% annual price increase.

When blockchain surfaced, the bear thesis was that Visa and Mastercard would be crushed because their value proposition of charging merchants 3% interchange fees would be diminished. However, it is the banks that charge the interchange fees, not Visa and Mastercard, who make basis points off each transition (not a bad business when you built a large fixed-cost infrastructure with minimal cost to serve each incremental transaction)

One key component of their moat lies in the trust they have established with both merchants and banks, along with their ability to maintain minimal latency in transactions. Their networks function as five-sided networks, connecting cardholders, merchants, banks, processors, and regulators, creating a massive barrier to entry for any attempt to disintermediate via one or two of the five sides.

According to Dan, blockchain technology has several disadvantages in comparison:

1. Transaction Speed: Blockchain transactions typically take minutes to process, significantly slower than the near-instantaneous transactions facilitated by Visa and Mastercard.

2. Unidirectional Transactions: Blockchain transactions can only proceed in one direction, posing challenges in handling fraud or returns.

3. Payment Innovations: While there are payment innovations leveraging blockchain technology to expedite transactions, Visa and Mastercard already provide similar services more efficiently and cost-effectively.

In hindsight, Visa and Mastercard continued business as usual. Those who “bought the dip” got to own two of the best businesses in the world at very reasonable prices.

Let me know your thoughts in the comments. Thanks for reading. I will talk to you next time.