311Polen Focus Growth commentary for the third quarter ended September 30, 2015.
- During the third quarter of 2015, our Focus Growth Composite Portfolio (the “Portfolio”) returned +0.97% gross of fees. Our positive return was in sharp contrast to the significant market decline during the quarter, with the Russell 1000 Growth and S&P 500 indices (the “Indices”) returning ?5.29% and ?6.44%, respectively.
- During the twelve months ended September 30, 2015 the Portfolio returned +18.11% gross of fees, outperforming the Indices by an even wider margin and ranking the Portfolio as the top performer in our peer group*. The Russell 1000 Growth returned +3.17% and the S&P 500 returned ?0.61% over the same period.
- As many factors have conspired to depress already modest underlying market growth during the trailing year, the strong and persistent earnings growth of our Portfolio has been more readily recognized.
- While we have certainly made some good adjustments to the Portfolio during the past year or so and are pleased that several of our highest conviction ideas and largest Portfolio weightings are among our leading contributors, we think the main driver of our significant outperformance during the past year was due to maintaining our investment discipline and focus on the fundamentals, even when the fundamentals did not seem to be driving the market.
- We believe that we have been able to outperform with such consistency over our 27?year history because owning a concentrated portfolio of the highest quality growth businesses drives stronger absolute earnings growth than the broader market can structurally deliver over the long term. Strong absolute earnings growth has driven strong absolute and relative returns for the Portfolio.
Polen Focus Growth – Commentary
During the third quarter of 2015, our Focus Growth Composite Portfolio returned +0.97% gross of fees. Our positive return was in sharp contrast to the significant market decline during the quarter, with the Russell 1000 Growth and S&P 500 indices returning ?5.29% and ?6.44%, respectively. During the twelve months ended September 30, 2015, the Portfolio returned +18.11% gross of fees, outperforming the Indices by an even wider margin and ranking the Portfolio as the top performer in our peer group. The Russell 1000 Growth returned +3.17% and the S&P 500 returned ?0.61% over the same period.
As many factors have conspired to depress already modest underlying market growth during the trailing year the strong and persistent earnings growth of our Portfolio has been more readily recognized. Our firm and our Portfolios are singularly focused on protecting and growing our clients’ assets, and we are proud that we have been able to achieve this once again in a period of high stock market volatility and poor industry returns.
The Indices have not posted negative returns in seven years, so it is worth taking the opportunity to provide some perspective on how the market tends to work during shorter periods, especially ones of exuberance, and to focus on why our investment discipline has worked very well over longer periods of time.
Only a little more than a year ago our trailing 3?year relative performance did not look all that impressive. Today, our 3?year relative performance is in the top quintile of our peer group*. We can say with equal confidence that we were neither significantly less smart a few years ago nor significantly smarter now. The market simply goes through cycles where expectations, or “what is working”, drives stock prices rather than the fundamentals of the underlying businesses themselves. As the legendary investor Ben Graham said, “In the short run, the market is a voting machine but in the long run, it is a weighing machine.” There have been periods ? mostly shorter periods ? when we have trailed the market, and there will be more, but when viewed in longer periods (i.e. 3?year, 5?year, 7?year) our Portfolio has significantly outperformed the Indices. In fact, on a rolling 3?year basis, the Portfolio has outperformed the Indices approximately 75% of the time; on a rolling 5?year basis, approximately 87% of the time; and on a rolling 7?year (or longer) basis the Portfolio has outperformed the Indices 100% of the time. We believe these powerful statistics demonstrate that it is only over longer periods of time that the earnings power of businesses truly compounds, and then over these longer periods the market eventually “weighs” those earnings appropriately, just as Ben Graham said. In the short term, the market remains a mere voting machine. Earnings growth may be influenced by the economy or an industry cycle, but over time it is easier to see which companies have persistent earnings growth driven by some unique competitive advantage. Our expertise is not in predicting short?term movements in stock prices. We have a discipline of identifying and constructing a portfolio of only the most competitively advantaged businesses with wide open opportunities, and nothing less. We also have the patience that is required to let those companies do what they do – compound earnings and returns, usually for a very long time.
We believe that we have been able to outperform with such consistency over our history because owning a concentrated portfolio of the highest quality growth businesses drives stronger absolute earnings growth than the broader market can structurally deliver over the long?term. Strong absolute earnings growth has in turn driven strong absolute and relative returns for the Portfolio.
Over long periods of time the market typically delivers roughly 6?7% nominal earnings per share growth (highly correlated with nominal GDP growth). Dividends paid and reinvested contribute another 2?3 percentage points which, when added to the earnings growth, total to an annualized return of approximately 9?10% over most long?term time horizons. Since the inception of our product on January 1, 1989, the Russell 1000 Growth and S&P 500 indices have compounded annual returns at 9.67% and 9.87%, respectively. Our Portfolio has compounded a 14.40% annual return gross of fees since inception, driven primarily by consistent and sustained double?digit underlying earnings per share growth, and complemented by a roughly 1% dividend yield and a very small benefit from multiple expansion. In essence, our Portfolio has outperformed so consistently over the long?term because it has sustainably delivered stronger earnings growth than the Indices.
While the market swings around (sometimes erratically) during shorter periods, we visualize the market compounding annual returns at that 9?10% rate and our Portfolio compounding on a higher plane. We believe a portfolio that is able to sustainably compound earnings per share 12?15% annually over the long?term will outperform the market because the broader market simply cannot deliver that level of earnings growth. This is because “the market” is made up of both exceptional and poor companies, and everything in between, so what you get is more or less a cross section of the economy. Simply stated, by weeding out the average?to?poor companies and only focusing on exceptional businesses with durable advantages and growth, we believe the Portfolio will continue to significantly outperform over longer periods.
The chart below shows the S&P 500 rolling 3?year earnings per share (EPS) growth set against our Portfolio’s rolling 3?year excess returns during the past fifteen years. Keeping in mind that since inception we have outperformed the S&P 500 about 75% of time on a rolling 3?year basis, you can see that we underperformed the index during periods that followed or coincided with periods of aboveaverage earnings growth for the S&P 500. Most of the time a portfolio sustainably delivering 12?15% EPS growth looks pretty darn good; to us, it almost always looks good. But during periods when people believe that the market or other “trades” will produce even stronger growth, a sort of self?fulfilling cycle begins and works…until it doesn’t. And when it stops working, the underlying business fundamentals are weighed more carefully and valuations return to a more sensible balance, which is why over time share price performance closely reflects underlying EPS growth. The S&P 500’s earnings are highly cyclical, with 20%+ EPS growth in economic expansion years and ?20% or more EPS declines in recessions. Over time, though, 6?7% is the average. Our Portfolio’s earnings growth has been north of 10% in every year since inception and averages out to approximately 13% over time. We believe many “investors” put too much emphasis on the short?term growth of companies or the market and forget about regression to the mean and the downturns that inevitably happen. By only owning the most financially superior and competitively advantaged businesses, we end up with only businesses that have their own unique demand profiles and can sustain growth regardless of what is going on in the economy or particular industry cycles.
We have noted on many occasions during the past several years that broad market values were rising faster than the underlying fundamentals would support. While our Portfolio managed to keep pace with the rising market due to the continued strong earnings per share growth of our holdings (as seen in the chart below), it was a relatively difficult environment for our Portfolio to outperform the Indices during much of this period given our fundamental focus and strict adherence to only investing in the most financially sound and competitively advantaged businesses. The near zero percent interest rate environment, as described in more detail in our 2014 Mid?Year Investment Perspectives, favored risk taking and more leveraged businesses, but we remained steadfast in our belief that owning a portfolio of only the highest quality businesses that collectively deliver sustainable mid?teens earnings per share growth will outperform over the longer term.
Polen Focus – Portfolio Performance & Activity
Google, Nike and Starbucks, all long?term holdings and among our largest positions, were the leading contributors during the quarter. Google (now Alphabet, Inc.) reported strong second quarter results with advertising revenue growth accelerating, margins improving and free cash flow increasing significantly as capital expenditures receded after a period of heavy investment. The new CFO, Ruth Porat, offered several additional insights about desktop and mobile search monetization and the trajectory of YouTube, which helped provide some clarity on the overall health of the core business. She also shared her agenda, which includes greater transparency and strong expense and investment discipline. During the fourth quarter of 2014, Google shares had been lagging the market materially despite continued strong execution by the company. We used the opportunity to raise our position to our largest (roughly an 8.5% weighting) as we felt the tremendous competitive advantages and still excellent growth prospects were significantly underappreciated, with the shares trading at only a slight premium to the average U.S. company. The shares have appreciated approximately 19% since we added to the position, but earnings have also grown by a similar amount (excluding currency changes), so we believe our investment today is just as compelling as it was last year. Today, we have just under a 10% position in Alphabet.
Both Nike and Starbucks have continued to see amazing revenue and earnings growth despite the fact that each is already a large and dominant player in its respective industry. The innovation and consumer experience of both companies are clearly resonating globally. Even in markets with little economic growth (Europe) or decelerating growth (China), Starbucks and Nike are bucking trends and posting strong (and in some cases accelerating) growth.
Abbott Labs, Apple and Oracle were the leading detractors to our return in the quarter. Any company with heavy emerging markets exposure has had a rough go of it in the stock market recently, and with more than half of its revenue generated in emerging markets, Abbott’s stock was caught in the downdraft. Currency headwinds from emerging markets are, and will likely continue to be, a headwind for the company, but the constant?currency operations are not only healthy but actually accelerating. We expect the currency issues to neutralize over time, and more importantly Abbott has an extremely stable healthcare franchise.
Apple also came under pressure due to its exposure to the Chinese market, which is currently about 20% of the company’s total revenue. We believe Apple possesses a very strong brand and ecosystem in China, and with millions of mobile broadband subscribers being added in the country every year Apple should continue to see robust growth in that market. With a single?digit price-to?earnings multiple excluding cash, Apple continues to be valued as a declining franchise. We do not believe this to be the case.
Oracle is in the midst of a transition toward more of a cloud?based, subscription business model from its traditional on?premise, upfront license?plus?maintenance model. This transition tends to depress revenue and profits in the short term, but adds quite a bit more in the long run. We are still in the early stages of this transition when growth is anemic, but our analysis points to a much higher net present value of a cloud subscription versus an on?premise license, so we continue to hold Oracle for the better times coming. We expect the current fiscal year to be the nadir for revenue growth and profit margins, and twelve months from now there should be significant improvements.
In the third quarter, we did not add any new holdings to the Portfolio and only eliminated one, W.W. Grainger.
We continue to believe Grainger’s business has robust long?term growth opportunities and a large competitive advantage, but we believe management’s recent capital allocation decisions are suboptimal.
Industrial distribution companies like Grainger have strong economies of scale as they grow. This is a fairly low?margin business with very high fixed costs and, as such, the more volume you can handle allows more revenue to be spread over the same fixed cost base, which increases margins. With only 5% market share in North America and big competitive advantages, we believe Grainger should focus capital allocation and management bandwidth on the North American market. Unfortunately, management seems committed to acquisitions overseas to develop a more global business. We do not believe the national economies of scale for distributors like Grainger extend across oceans. The new business is not spread over the existing infrastructure but instead requires additional infrastructure. This sub?optimal capital allocation, especially at a time of difficult market conditions, made it difficult for us to continue owning Grainger. We determined that we had better places to invest the capital.
We utilized the proceeds of our Grainger sale to increase our weightings in Nestle and ADP, two strong businesses that we had smaller allocations to previously. Both companies have also seen their valuations come down recently, prompting our increased weightings.
Polen Focus Growth – Attribution
The top three contributors (Portfolio average weight multiplied by return) for the third quarter of 2015 were Google (1.34%), Nike (0.92%), and Starbucks (0.40%). The three largest detractors were Abbott Labs (?1.09%), Apple (?0.49%) and Oracle (?0.48%).
Polen Focus Growth – Investment Team
With the seasoning of our investment team and the addition of Julian Pick to manage our Global Growth strategy, we now have the strongest investment team that we have ever had. We plan to continue to add selectively to the team in the coming years and are also pleased to announce that we have promoted Todd Morris to the newly created role of Director of Research. During the past five years Todd has demonstrated exceptional research skills, a clear understanding of and adherence to our investment discipline, and he has also proven skillful in recruiting and mentoring new members to our team. While the way we operate today will not change meaningfully, we believe it is prudent to have a Director of Research who is focused on managing our process as our team increases in size and continues to research businesses across the globe. We are confident that, with Todd in this role, our team will be even stronger in the future.
Thank you for your interest in Polen Capital and please feel free to contact us with any questions or comments.
Dan Davidowitz, CIO & Portfolio Manager
Damon Ficklin, Portfolio Manager & Analyst