YETI - Polen U.S. Small Company Growth Q3 2023 Commentary
2023-11-09 10:05:00 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.
- The U.S. Small Company Growth Composite Portfolio returned -3.97% in Q3, outperforming the -7.32% return of the Russell 2000 Growth Index.
- The portfolio emphasizes long-term thinking and a disciplined investment process to navigate macroeconomic uncertainty.
- The portfolio experienced both positive and negative contributors to performance, with companies like Goosehead Insurance and CCC Intelligent Solutions performing well, while Euronet Worldwide and Doximity detracted from performance.
Commentary
The U.S. Small Company Growth Composite Portfolio returned -3.97% ((Net)) in the third quarter compared to a -7.32% return in the Russell 2000 Growth. Year to date (YTD), the Portfolio returned 10.43%(net) compared to 5.24% for the Index. In the quarter, we believe negative absolute returns for the Portfolio and Index were driven by continued macroeconomic uncertainty related to interest rates, credit tightening, and an uneven economy from a growth perspective. We continue to navigate this environment by emphasizing long-term thinking, our disciplined Flywheel-driven investment process, and patience, buying growth companies we believe are significantly discounted to their long-term intrinsic value.
This year continues to be a reminder of how rapid market sentiment can shift. This, combined with a short-term focus and a false urgency to react, can lead investors to make poor decisions. We believe the answer to this dilemma is a time-tested and disciplined investment process and a portfolio built for resilience.
Our goal is to deliver great long-term performance driven by best-in-class companies with durable long-term growth and high returns on capital.
We use our Flywheel framework to determine whether long-term compounding conditions are in place. The flywheel conditions include a well-positioned product or service, a repeatable sales process, a robust business model and financial stability, effective management, and the ability to reinvest at high rates of return.
With a long-term view, this is an opportunistic time to invest in small cap companies. We are finding opportunities across the investible universe above our historical internal rate of return ((IRR)) expectations, planting the seeds for solid performance in future years. Our goal is not to time the market but to build a concentrated portfolio of truly unique flywheel companies with diverse growth opportunities and business models to deliver compelling fundamental performance in any environment.
Portfolio Performance & Attribution
During the third quarter, the U.S. Small Company Growth Composite Portfolio (the “Portfolio”) returned -3.66% gross and -3.97% net of fees, respectively, compared to the -7.32% return of the Russell 2000 Growth Index (the “Index”).
The top contributors to the Portfolio’s relative performance in the third quarter were Goosehead Insurance ( GSHD ), CCC Intelligent Solutions ( CCCS ), and ( YETI ).
Goosehead Insurance operates as a personal line insurance brokerage, pioneering a disruptive business model swiftly seizing market share from conventional independent and captive broker models. The company continues to deliver results ahead of expectations, underpinned by compelling pricing, enhanced agent productivity, and improved margins. We are particularly impressed by the company's adept execution and its capacity to achieve substantial cost efficiencies, which we believe are sustainable in the long term.
CCC Intelligent Solutions provides software and tools to the automotive insurance ecosystem. Their customers include insurance companies, repair shops, parts suppliers, medical insurance carriers, and auto manufacturers. Company fundamentals have surpassed our expectations this year, demonstrating the durability of the business and its critical role in the auto claims ecosystem. Acquisition speculation also drove the stock higher at the end of the quarter. We believe CCC remains an attractive long-term investment from a quality, free cash flow growth, and valuation perspective.
Yeti, an outdoor and lifestyle brand known for its coolers and drinkware, was also a significant contributor. Yeti delivered better-than-expected quarterly results after navigating a voluntary product recall that negatively impacted earnings. The company continues to navigate a challenging period, but we believe this is temporary. Our long-term outlook for the business is unchanged.
The most significant detractors from the Portfolio’s relative performance in the quarter were Euronet Worldwide ( EEFT ), Doximity ( DOCS ), and Alight ( ALIT ).
Euronet Worldwide is an industry leader in providing secure electronic financial transaction solutions. They operate one of the largest independent ATM networks in Europe, are the world's largest payment network for prepaid mobile top-ups, and the second-largest global money transfer company. The stock’s recent weakness was in response to a lowered outlook in the EFT segment, which accounts for ~50% of profits. This segment was impacted by economic pressures on consumer spending in Europe. While we believe this will be a headwind, Euronet Worldwide’s overall revenue and profit growth is still impressive relative to the broader universe. The stock's decline appears to be an overreaction. We believe the company has a robust business model and long-term growth drivers. Euronet Worldwide also benefits from a long-tenured management team with a proven track record of navigating challenging periods.
Doximity is a productivity and professional network app for doctors that generates revenue primarily from biopharmaceutical advertising. The stock was negatively impacted by a weaker growth outlook and the acknowledgment that the company needs to invest to shift towards a self-service model to meet customers’ needs better. We believe the advertising return on investment remains best-in-class and physician engagement remains convincing, but we are closely monitoring the position.
Alight is a leading cloud-based provider of employee engagement tools and solutions for workplace benefits, payroll, administration, and wealth services. The stock negatively reacted to lower-than-expected bookings guidance for its small but growing business-process-as-a-Service (“BPaaS”) segment. Due to the nature of Alight’s business model, the market is putting too much emphasis on BPaaS bookings, in our opinion, which is a flawed metric. We believe business remains healthy, and our long-term expectations for high-single-digit revenue growth with expanding margins remain unchanged.
Portfolio Activity
We started positions in three new investments during the quarter: Clearwater Analytics ( CWAN ), XPEL , and EXL Services.
Clearwater Analytics is a leading provider of investment portfolio reporting and analytics solutions. It uses advanced data and analytics to serve as the book of record across many asset classes for investment managers, corporations, insurers, and pension funds. The company analyzes and reports over $6.4 trillion in daily assets across numerous accounts. Their software simplifies operations and ensures accuracy, speed, and scalability—adding significant value for customers while reducing complexity. We believe that the company is poised to sustain its robust growth trajectory, achieving annual top-line growth of 20% with meaningful margin expansion over our five-year investment horizon.
Clearwater Analytics is a great example of a Flywheel company with a unique and sticky product, high net recurring revenue, a significant runway for growth, and a business model and competitive advantage that strengthens with scale.
XPEL is a leader in the automotive paint protection film (“PPF”) market. PPF is popular for high-end vehicles and gaining broader traction due to the solid value proposition and XPEL, which drive market growth. XPEL is a notable name brand that has become synonymous with paint protection. It has the most extensive distribution network and exceptional software to aid installation centers. We believe it’s still early for paint protection as the product gains traction with dealers, OEMs (original equipment manufacturers), and a broader set of consumers. While the product may seem simple, the infrastructure cannot be easily replicated. Regarding value creating reinvestment, XPEL is planting the seeds for many years of growth with early investments in Europe and opening up PPF to new markets such as architectural and Marine. The financial model is also robust, with 20% operating margins, compelling free cash flow conversion, a solid balance sheet, and high returns on capital.
EXL Services is an outsourced businesses services and analytics company with a long track record for driving digital transformation. EXL’s specialization and reputation in the insurance industry has also been a point of differentiation and served as a springboard to grow the business. We previously owned EXL but sold the position when the company navigated a difficult transition. Encouragingly, the company managed very well through that difficult period and upgraded the management team, which has brought more discipline to their capital allocation, as evidenced by increasing returns on invested capital. Looking ahead, we anticipate mid-teens free cash flow growth and capital to be deployed towards share buybacks and small acquisitions.
During the quarter, we exited five positions: Altair Engineering ( ALTR ), Farfetch ( FTCH ), Leslie’s ( LESL ), OLO , and DocGo ( DCGO ).
Altair Engineering is a simulation software company and a solid flywheel company. We decided to completely exit the position after trimming it last quarter due to valuation. The stock was up 66% YTD at the time of sale in mid-July, and we decided to redeploy capital towards high-quality flywheel companies with more attractive expected IRRs in the form of new ideas and additions to existing holdings.
DocGo, a healthcare company known for its distinctive mobile healthcare delivery model, was a new portfolio holding as of the first quarter of 2023. While we believe that the business is on track, we have been diligently monitoring a potential risk related to their immigrant services contract with New York City, which widens the range of outcomes for the business to a level we are uncomfortable with and calls into question management’s focus and decision-making. We also learned that the company’s CEO had provided false information about his background and qualifications. This is unethical behavior and is a clear violation of the effective management condition in our flywheel.
Farfetch is a leading digital software and services provider and online marketplace for global luxury brands. While we believe in the company’s long-term potential, profitability has trended in the wrong direction, and a turnaround is taking longer than expected. While Farfetch may still prove successful over time, and the stock is arguably inexpensive, we can no longer count on management’s execution, and we believe there are better risk-adjusted return opportunities in higher quality businesses.
Leslie’s is the largest pool maintenance retailer in the US, with a long history of durable revenue and earnings growth. After following the company for months, we initiated a new position in Leslie’s, recognizing that there were near-term risks related to an unprecedented several years in the industry. While we believed we had waited patiently for an attractive entry price for long-term investment, the risks we had identified were far worse in magnitude than expected. Cold weather and excess inventory negatively impacted the critical summer pool season. These factors would have been surmountable if not for poor management decision-making that amplified the impact on Leslie's financials and increased the balance sheet risk. While we believe the business will recover, we believe management has put the company in a position that restricts reinvestment and limits growth.
Olo is an innovative software as a solution (SaaS) company focused on the restaurant industry. It has a particularly keen position in enterprise digital ordering and has expanded into payments and other critical functions. When we first invested, we noted that point-of-sale incumbents had historically been mismanaged and underinvested in digital, positioning Olo to disrupt the industry. More recently, credible competitors have entered the market, and we have been disappointed with management’s response to these emerging threats. With a broader range of outcomes and an eroding competitive position, we’ve decided to redeploy capital into compelling alternatives.
Outlook
Our outlook is unchanged from the last two quarters as we continue to navigate a highly uncertain environment. Small cap companies as an asset class are heavily discounted relative to history. Still, risks are also significant, whether it be inflation and the path of interest rates, credit availability, or the economy. Despite the uncertainty, we operate with clarity and conviction. We believe that owning great businesses with durable growth and high returns on capital with a significant runway for reinvestment at high returns and further buying those businesses at a considerable discount to their long-term potential, will drive great returns for our clients.
This underscores why we stay focused on the long-term and why we stay focused on competitively advantaged, financially flexible businesses. We believe that always owning businesses with robust balance sheets and the ability to reinvest in any environment trumps short-term temptations to own lower quality businesses driven by interest rates, commodity prices, or leverage.
While the short-term view is heavily influenced by fear and uncertainty, the long-term picture is far clearer than the market would suggest (even at higher interest rates), and by and large, our long-term view and conviction in our Portfolio companies is unchanged. This allows us to confidently sift through the noise and take advantage of price dislocations.
Despite all the challenges, the opportunity set in small caps is attractive regarding valuation and the prospect of persistent growth. In our opinion, high quality small cap companies have greater latent potential for growth relative to more mature businesses. We believe, the best small cap growth companies can quickly reduce spending and increase profitability if needed, given their high starting levels of investment.
In our opinion, the best-of-the-best small cap companies will take advantage of adjacencies and have a better potential opportunity for value-added acquisitions.
Of course, many companies do not meet this high hurdle, which is why we hold a concentrated portfolio of companies that do not just offer growth and high returns but also durability, robust financial models, the ability to self-fund growth, and what we believe to be superior management teams.
We believe great investing requires a clear and proven philosophy, a disciplined process, and conviction. It also requires great humility and a willingness to change your view when the evidence requires it. We look forward to keeping you updated on our views in future commentary.
Thank you for your interest in Polen Capital and the U.S. Small Company Growth Portfolio. Please contact us with any questions.
Sincerely,
Rayna Lesser Hannaway, CFA | Whitney Young Crawford
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.
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Polen U.S. Small Company Growth Q3 2023 Commentary