GSHD - Polen Global SMID Company Growth 3Q 2023 Commentary
2023-11-09 09:30:00 ET
Summary
- Polen Capital is a global independently-owned growth equity boutique, led by an experienced team of investment professionals who are committed to preserving and growing the assets of our clients through a prudent and disciplined long-term investment approach.
- Interest rates, inflation, and the uncertain trajectory for global economic growth continued to weigh on sentiment.
- We are still focused on our portfolio companies' long-term value propositions, competitive advantages, growth opportunities, and potential earnings power.
Commentary
Global Small and Mid-Cap equities posted negative total returns over the third quarter. News coverage continued to be dominated by macroeconomic headlines. Specifically, uncertainty surrounding the trajectory for economic growth, the shifting global inflation dynamic, interest rates, and the subsequent impact on financial markets. U.S. Treasury yields rose to 16-year highs as the Federal Reserve signaled a “higher for longer” stance despite core inflation numbers starting to decline.
Economic data has generally shown resilience, especially in the U.S. However, sentiment worsened in China with slowing growth alongside liquidity concerns in the real estate market.
The People’s Bank of China cut interest rates over the period, bucking the trend of many other major economies. Separately, oil rallied to its year-to-date high on coordinated production cuts by OPEC (Organization of the Petroleum Exporting Countries).
At the benchmark level, Energy was the standout sector, with Financials the only other sector posting positive returns. Health Care and Communication Services sectors posted the weakest returns. From a style perspective, Value performed better than Growth, Quality underperformed, and there was minimal return difference between Large and Small Caps.
Portfolio Performance & Attribution
Over the first quarter, the Portfolio returned -6.59% gross and -6.64% net of fees, respectively, versus the -3.55% return for the Index.
Portfolio underperformance was primarily driven by negative security selection. Security selection was strongest in the Financials (Goosehead Insurance, Morningstar) and Real Estate (Altus Group) sectors but was outweighed by weaker selection in Industrials (Alight, Paycom Software) and Health Care (Doximity, Progyny). Sector allocation, an outcome of our bottom-up selection process, negatively affected relative returns. The positive impact of our zero weight to Utilities and underweight to Industrials was outweighed by the negative impact of zero weight in Energy and overweight to Health Care. From a style perspective, an environment where momentum, value, and size outperform quality and growth generally does not support our relative performance.
We remain focused on finding companies with competitive advantages that we believe can compound earnings and cash flows over the long term, independent of commodity swings or economic cycles.
Our most significant individual contributors to performance over the first quarter were Goosehead Insurance ( GSHD ), YETI Holdings, and CCC Intelligent Solutions ( CCCS ).
Goosehead Insurance, a personal line property and casualty insurance brokerage primarily focused on home and auto markets, rose close to 20% over the quarter, bringing its yearto-date return to more than 115%. The company delivered another quarter of robust results, continuing to execute its plan to clean up the corporate organization and return the company to its pre-COVID-19 productivity metrics. Total revenue increased 31% year on year, core revenue grew 27%, and premiums, the leading indicator of future revenue growth, increased 36%. Margins also showed healthy expansion. Broker upgrades and inclusion in the S&P Small Cap Index further boosted the stock.
Yeti, an outdoor and lifestyle brand known for its coolers and outdoor leisure products, delivered solid sales and margins growth, albeit lower than expected for the quarter. However, the market reacted positively to the company raising full-year guidance due to robust demand in the cooler business and lower freight rates, which should positively impact margins.
CCC Intelligent Solutions, a new position over the quarter and leader in automotive insurance data, rose as it was announced that Bain Capital was considering taking the company private. Further details about the company are included in the Portfolio Activity section.
Our most significant detractors from performance included Alight ( ALIT ), Five Below ( FIVE ), and Doximity ( DOCS ).
Alight, a leading cloud-based provider of employee engagement and workplace benefit tools, delivered quarterly financial results. However, it saw share price weakness as management revised expectations for next year’s business process as a service (BPaaS) subscription growth. We added to the position opportunistically as we think the company's fundamentals remain on track, and the long-term opportunity remains promising. At the same time, the margin of safety on the stock is attractive.
Discount retailer Five Below reported a quarter that was in line with expectations but lowered next quarter's outlook, influenced by higher than-normal “shrink” (theft of goods). We discussed the topic of shrink with management, who is implementing measures to mitigate this, and the impact on margins. We believe these issues are manageable, and the company's long-term prospects remain promising.
Doximity is an application that operates like a social media platform for doctors and health care professionals. The company reported quarterly earnings where it reduced revenue guidance for fiscal 2024 and announced that it would cut approximately 10% of its workforce. As it was a new position over the quarter, we discuss the outlook for the company further below.
Portfolio Activity
As expected during periods of share price volatility, we have been refining the Portfolio opportunistically. This includes initiating positions in companies with attractive risk-reward profiles and taking profits by trimming companies that have held up well and those that we believe have lower return expectations in the future.
Over the quarter, we initiated six new positions and sold out of six existing holdings. We also adjusted several portfolio weights, primarily for risk management purposes.
We initiated a position in TravelSky ( TSYHY ), a Chinese aviation software company similar to Amadeus ( AMADF ) in Europe. The company has an almost monopolistic position in China and benefits from increased domestic and international travel by Chinese citizens. Per capita consumption of air travel remains low in China and was particularly depressed during COVID-19. The company also benefits from the build-out of airports in the country by providing systems and software. We think valuation is very attractive and is arguably at less than 10x normalized earnings. We expect revenue recovery and corresponding margin expansion as travel resumes and the company monetizes various opportunities.
We bought a new position in Morningstar ( MORN ), a leader in providing investment management and wealth management data, software, and solutions to the financial services industry. Management has spent the last four years investing heavily in several business lines, like private markets data and ESG, that have depressed margins in the near term but should provide durable growth opportunities for many years. As the company reaps the benefits from these investments over the coming years, we expect margins to track towards their prior levels of 20-25% from current low-to-mid teens. Combined with low double-digit revenue growth and management’s long history of opportunistic share buybacks, we think this should translate into healthy EPS growth over our holding period.
We bought a new position in Progyny ( PGNY ), a company owned in our U.S. strategies for some time. They are a leading provider of fertility benefit solutions, and through their differentiated approach, their clients can pursue the most effective treatment and achieve optimal outcomes. We believe the company has only a mid-single digit share of its potential total addressable market and is the most dominant player within the fast-growing managed care category. They are already profitable, earn high returns on incremental capital, and have plenty of runway to grow top-line growth as they continue to win new clients and add new services.
Doximity is an application for doctors and other healthcare professionals and operates like a social media platform for doctors. It primarily makes money on advertising for biopharmaceutical companies. Its offering is unique, given the ability to target physicians accurately by specialty and reach a high percentage of a drug company’s target physician list, making it an attractive alternative to spending on sales representatives. It also has a unique advertising format that meets regulatory requirements, captures physicians while working, and provides drug insight and detail that’s more attuned to medical journal advertising. Doximity is already a very profitable business, and with attractive software-like economics without having to spend much to acquire users or customers, it has an attractive runway for growth.
CCC Intelligent Solutions is a market leader in the automotive insurance market through its CCC One platform. Their vast and growing data set offers a unique position to leverage data analytics and AI to automate the insurance claims process. Their customers – insurance carriers and repair shops – continue to face headwinds from inflation – including labor, parts, and more complex repairs, given greater advances in vehicle technology. The business is a SaaS (“Software as a Service”) business model that generates high returns on capital and has durable growth. The CEO has a track record of investing early in technology (cloud, AI) to keep CCC ahead of the industry and consistently use its vast data set to create additional value for customers.
XPEL is a leader in the automotive paint protection film (“PPF”) market. The company distributes the film along with other automotive products globally. In 2022, 59% of revenue came from the U.S. and 41% from international markets. PPF has seen increasing adoption over the past 5-10 years as car enthusiasts look to the product to protect their vehicles from rock chips, tree sap, hail, UV damage, and salt. XPEL PPF is installed and sold by XPEL-authorized, certified, and trained professionals. The company also provides automotive window film, which protects and tints vehicle windows. In recent years, XPEL has developed products for boats, planes, and architectural windows. We think XPEL is a uniquely competitively advantaged business with a great management team that has evolved and grown the category. The future earnings growth story will be primarily driven by broader adoption, increasing popularity of PPF, and international expansion.
We sold Dechra Pharmaceutical ( DPHAY ) to zero as the company is being taken private, which we’ve discussed in previous letters. We sold CompuGroup Medical ( CMPVF ) due to what we believe are superior alternatives. Fundamentals are largely on track, and valuation remains reasonable. However, we believe there are more attractive opportunities in our universe than the rate of return we expect from the investment. We also sold Koh Young Technology, a Korean leader in 3D automated inspection, for more attractive opportunities.
We are sold out of our position in Keywords Studios ( KYYWF ) due to risk management related to the threat of AI. The company is a leader in the gaming development industry and facilitates outsourcing various functions to 24 of the top 25 gaming companies in the world. Artificial Intelligence is not new to gaming, but the adoption and experimentation are accelerating. We have modeled various scenarios, and the range of outcomes is unacceptably wide.
We sold Musti Group, the Nordics's dominant specialist pet store operator. The stock has recovered modestly year to date. Still, we believe the risks to the business are rising, primarily related to execution risk as the management team explores international expansion outside of the Nordics.
Finally, we sold our small position in Benefit One ( BNTOF ), a Japanese outsourced HR benefits solutions provider. Our thesis that the company would continue to gain new members and cross-sell new products has not manifested. The company benefited from administering COVID-19 shots, which boosted profits materially over the last few years. We had expected that an acquisition, new payment products, and additional partnerships with Netflix and others would enable exciting growth opportunities. There is no evidence of these initiatives succeeding, and several key KPIs are going backward.
Outlook
We continue to stay focused on the long-term value propositions, competitive advantages, ongoing initiatives, growth opportunities, and potential earnings power of our Portfolio companies. As a reminder, our investment time horizon is five years. This allows us to think and act like owners. The markets continue to have a lot of uncertainty and general volatility. In the near term, our turnover has been above what we’d typically expect as we take advantage of opportunities.
Overall, our pipeline of potential new investments remains attractive across a variety of industries and geographies.
Thank you for your interest in Polen Capital and the Global SMID Company Growth strategy. Please feel free to contact us with any questions.
Sincerely,
Rob Forker
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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Polen Global SMID Company Growth 3Q 2023 Commentary