CWAN - Polen U.S. SMID Company Growth Q3 2023 Commentary
2023-11-09 09:50:00 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. SMID Company Growth Composite Portfolio returned -5.26% in Q3, outperforming the Russell 2500 Growth index.
- The portfolio focuses on long-term thinking and buying growth companies at a discount to their intrinsic value.
- Opportunities for investment in small-cap companies are currently attractive, with potential for solid performance in the future.
Commentary
The U.S. SMID Company Growth Composite Portfolio returned -5.26% net of fees in the third quarter compared to a -6.84% return in the Russell 2500 Growth. YTD, the Portfolio returned 11.68%(net) compared to 5.63% 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 outstanding 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 exist. 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. SMID Company Growth Composite Portfolio (the “Portfolio”) returned -5.00% gross and -5.26% net of fees, respectively, compared to the -6.84% return of the Russell 2500 Growth Index (the “Index”).
The top contributors to the Portfolio’s relative performance in the third quarter included Goosehead Insurance ( GSHD ), Globant ( GLOB ), and YETI .
Goosehead Insurance operates as a personal line insurance brokerage, pioneering a disruptive business model and 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.
Globant, an IT consulting firm focused on helping companies embrace digital transformation, was a top contributor. The company has reported compelling results this year despite increased pessimism about the IT services space and some competitors reducing their outlook. While we do not believe Globant will be immune to a more significant downturn in IT services spending, we believe the long-term outlook for Globant continues to be very attractive.
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 included Farfetch ( FTCH ), Doximity ( DOCS ), and Paycom ( PAYC ).
Farfetch is a leading back-office services and software provider for luxury brands seeking to globalize their businesses online and an extensive online marketplace for luxury apparel and accessories. During the quarter, the company reported weaker-than-expected revenue and gross merchandise value (“GMV”) while also lowering GMV and operating margin projections for the entire year. The stock traded down more than 40% on this news. We ultimately exited the position during the quarter. Please see the commentary in the “Portfolio Activity” section for more details about the sale decision.
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.
Paycom, a leading provider of cloud-based human capital management software for small and mid-sized businesses, was another detractor in the period. Despite reporting positive results, the investors seemed concerned about the company's performance in the year's second half. As a result, the stock fell by almost 20% on the day of the report. However, the company is committed to investing in its BETI platform to onboard more customers, which may have a short-term negative impact on revenues. But, in the long run, it can benefit the company's margins. Our positive long-term outlook remains unchanged. We still believe the company has an attractive growth potential in a large addressable market.
Portfolio Activity
Portfolio activity this quarter included one new investment— Clearwater Analytics ( CWAN )—along with additions and trims to existing holdings.
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 on over $6.4 trillion in daily assets across numerous accounts. Their software simplifies operations and ensures accuracy, speed, and scalability, adding significant customer value while reducing complexity. We believe the company is poised to sustain its robust growth trajectory, achieving annual top-line growth of 20% with meaningful margin expansion over our 5-year investment horizon. Clearwater 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.
We exited three positions during the quarter, including Copart ( CPRT ), Farfetch, and OLO .
With Copart, we eliminated our position as the relative valuation has become less attractive on the back of strong YTD performance in 2023. With a decline in the expected IRR relative to our current opportunity set, we felt it prudent to move on in favor of superior alternatives.
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.
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 what we view as superior alternatives.
Outlook
Our outlook is unchanged from last quarter. The current environment continues to be highly uncertain. SMID cap companies as an asset class are heavily discounted relative to history. Still, risks are also significant, whether inflation and the path of interest rates, credit availability, or the economy. Despite the uncertainty, we operate with clarity and conviction. In our opinion, 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 discount to their long-term valuation creation potential will drive great returns for our clients.
This underscores why we stay focused on the long-term and competitively advantaged, financially flexible businesses. We believe that always owning businesses with solid 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 what we view as price dislocations.
Despite all the challenges, the opportunity set in SMID caps is attractive regarding valuation and the prospect of persistent growth. High quality SMID cap companies have greater latent potential for growth relative to more mature businesses. The best SMID cap growth companies can quickly reduce spending and inflect profitability if needed, given their high starting levels of investment.
We believe the best-of-the-best SMID cap companies will take advantage of adjacencies and have a better potential opportunity set 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 time-tested 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. SMID 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.
For further details see:
Polen U.S. SMID Company Growth Q3 2023 Commentary