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Commentary
In 2023, the Polen Capital U.S. Small Firm Development Composite Portfolio (the Portfolio) returned 10.46% gross and 10.22% web of charges in comparison with a 12.75% return for the Russell 2000 Development Index. In some ways, we consider it served as a testomony to the resilience of our funding technique amidst fixed and extreme market fluctuations.
A lot of the yr was difficult for small cap shares broadly, given the universe tends to be decrease high quality in nature, populated with many unprofitable and/or extremely leveraged companies vulnerable to the financial cycle.
With the Silicon Valley Financial institution (SVB) financial institution failure in March and rising rates of interest via a lot of the yr, small cap equities underperformed their giant cap counterparts, which benefitted from a small subset of corporations which have come to be often known as the “Magnificent Seven (Apple, Microsoft, Alphabet, Amazon, Nvidia, Tesla, and Meta).”
Whereas the small cap class was challenged, our portfolio remained essentially strong. Guided by our flywheel, we purpose-built our portfolio for monetary resiliency—proudly owning solely what our analysis suggests to be the best high quality corporations in our asset class and solely corporations which have the monetary and steadiness sheet energy to self-fund their very own progress.
As we progressed via the fourth quarter, the market skilled yet one more drastic shift with rising proof the speed hike cycle was nearing an finish, and a rising consensus expectation for alleviating monetary situations in 2024.
Since the newest low in October, the Russell 2000 Development has outperformed the broader market by practically 8% and small cap shares stay traditionally low cost relative to historical past and to giant cap friends.
This makes us cautiously optimistic. Whereas speculating on the tempo of rate of interest cuts doesn’t affect our strategy to investing, as we’ve famous in our prior letters, we consider the portfolio is effectively positioned for a restoration. This has been our purpose all yr, to stay balanced by proudly owning what we consider to be high-quality companies with resilient monetary fashions which are drastically undervalued relative to the long run.
Navigating unstable markets is undoubtedly difficult, and it poses dangers for much less constant traders who discover themselves on the mistaken facet of the earlier yr’s successful bets. On this context, our steadfast long-term strategy supplies stability and resilience in an ever-changing funding panorama.
Portfolio Efficiency & Attribution
The highest contributors to the Portfolio’s relative efficiency within the fourth quarter had been Wingstop (WING), Hamilton Lane (HLNE), and Qualys (QLYS). In flip, the highest absolute contributors had been Wingstop, Hamilton Lane, and Globant (GLOB).
Wingstop is the most important quick informal rooster wing-focused restaurant chain on the earth with roughly 2,000 areas as of 2023. Over the course of this yr, the corporate has continued to exceed expectations, delivering double-digit similar retailer gross sales progress whereas increasing into new areas internationally. We proceed to be enthusiastic about Wingstop’s lengthy runway to open new shops coupled with a franchise enterprise mannequin that leads to strong unit economics.
Hamilton Lane, a personal markets advisory and funds enterprise for institutional traders, has showcased resiliency in 2023 amidst a extremely unsure macro and fundraising surroundings. Specialised funds proceed to be an space of energy, notably as the corporate has success scaling its efforts with high-net-worth shoppers within the wirehouse channels. This has been an underappreciated progress driver. Whereas Typically Accepted Accounting Rules (GAAP) earnings fluctuate as a consequence of efficiency charges, we worth the corporate primarily based on its core price earnings, which have been remarkably constant and have been sturdy via cycles.
Qualys, a cloud-based IT safety options firm targeted on vulnerability administration software program, delivered better-than-expected prime and bottom-line progress and raised full-year steerage for 2023—notably encouraging given the difficult macro surroundings. We proceed to consider Qualys may be very effectively positioned to learn from the secular development of rising cybersecurity demand, and that the corporate is uniquely positioned due to its platform strategy and disciplined steadiness of profitability and progress.
Essentially the most vital detractors from the Portfolio’s relative and absolute efficiency within the quarter had been Fox Manufacturing unit Holdings (FOXF), CCC Clever Options (CCCS), and XPEL (XPEL).
Fox Manufacturing unit Holdings is a maker of high-performance suspension merchandise utilized in energy automobiles and specialty sports activities merchandise (mountain bikes, and so on.) The inventory skilled some headwinds within the quarter associated to a reset within the bicycle shocks enterprise following above-average demand and provide constraints throughout COVID, manufacturing shutdowns from the UAW strike, and the announcement of a $572 million acquisition that was met with some skepticism from traders.
In every occasion, we consider these to be non permanent points which have resulted in an unwarranted outsized unfavourable response within the share worth within the near-term. The reset within the bike enterprise—whereas occurring sooner than anticipated—has been well-telegraphed by administration and doesn’t change our long-term view on that phase. The UAW strike is now over, and manufacturing has resumed. And eventually, on the Marucci acquisition, we had the chance to debate this intimately with administration and now have a deeper understanding of the strategic rationale within the broader context of the corporate’s progress technique. Our conviction is unchanged because it pertains to the corporate’s long-term strategic imaginative and prescient, skill to navigate and overcome short-term challenges, and the anticipated constructive trajectory as soon as these non permanent headwinds subside.
CCC Clever Options supplies software program and instruments to the automotive insurance coverage ecosystem. Their clients embody insurance coverage corporations, restore retailers, elements suppliers, medical insurance coverage carriers, and auto producers. In direction of the top of the third quarter, acquisition hypothesis drove the inventory greater. Because it turned clear an acquisition wouldn’t happen, the inventory shortly gave again a few of these earlier positive aspects this previous quarter. Nonetheless, nothing has essentially modified with the enterprise, and we proceed to consider CCC stays a lovely long-term funding from a high quality, free money move progress, and valuation perspective.
XPEL is a pacesetter within the automotive paint safety movie (“PPF”) market and a holding we initiated within the third quarter. Through the interval, the inventory bought off sharply on information that Tesla entered the market in 2 of their 100 service facilities. We consider the response was overblown and the mixture of accelerating connect charges, adjoining classes (as an illustration, new markets like architectural and Marine), and geographic growth present an extended runway of progress for XPEL. Of observe, we just lately visited the corporate’s company headquarters in San Antonio and got here away with renewed confidence within the energy of the administration group to execute towards their strategic priorities and ship worthwhile progress over the long run.
Portfolio Exercise
Through the quarter, we began positions in six new investments: Core & Fundamental (CNM), Medpace (MEDP), Generac (GNRC), LGI Houses (LGIH), Topgolf Callaway Manufacturers (MODG), and Bowman Consulting Group (BWMN). Moreover, we added to a number of present positions.
Core & Fundamental is an industrial distributor specializing in waterworks and hearth safety markets, distributing an in depth vary of over 200,000 merchandise, together with pipes, valves, fittings, water meters, storm drainage, and hearth safety gear. As one of many two largest gamers in a fragmented business, the corporate has a strong observe document of capital allocation expertise that can serve them effectively as they proceed to consolidate the business via disciplined acquisitions. We view CNM as a high-quality enterprise that’s at the moment undervalued by the market, given the structural tailwinds round an pressing have to restore and change ageing municipal water infrastructure. In our view, this positions the corporate for potential earnings surprises and a number of growth, making it a compelling funding alternative with an estimated IRR of roughly 20%.
Medpace is a mid-sized contract analysis group (CRO) that companies smaller biotech corporations with enterprise/PE backing. Particularly, Medpace handles these corporations’ scientific trial-related R&D, and their enterprise mannequin is constructed upon being a full-service solely answer. Given our high quality orientation, it’s notably difficult to purchase pharma and biotech corporations as a consequence of their earnings losses and FDA danger. The corporate’s spectacular observe document of sturdy monetary efficiency—emphasizing stability, profitability, and well-above-average progress—provides us broad-based publicity to this business. Medpace’s enterprise mannequin is designed to attenuate the binary dangers related to single-company FDA issues or unprofitability, making it an optimum selection for us as we search publicity to the groundbreaking innovation that comes with the biotech business.
Generac is the main model for a variety of energy gear, together with standby turbines for properties and backup energy for industrial and industrial markets. Generac is uniquely positioned as a consequence of its scale–it’s the most important producer within the U.S. and has the most important vendor/distributor community with 75% market share within the residential enterprise and elevated market share in industrial/industrial relying on the top market. Generac was beforehand held within the U.S. SMID technique previous to exiting the place in 2021 as a consequence of issues across the provide chain and a wider vary of potential outcomes given a surge in demand via the pandemic. Since then, earnings have declined as pandemic period pull-forward demand normalized and the valuation is much extra enticing. We consider long-term earnings per share (EPS) progress is within the mid to excessive teenagers, however that EPS will develop considerably sooner over the subsequent two years as margins inflect submit COVID re-set—one thing we’re already observing within the enterprise fundamentals.
LGI Houses is a homebuilder primarily concentrated within the southeast and Texas. To some, the addition of a homebuilder might come as a shock given the business has not sometimes been related to high quality, having been among the many worst performers through the International Monetary Disaster (“GFC”) of 2008-2009.
Nonetheless, over the previous 15 years the business has developed considerably (for the higher). Drawing on classes from the GFC, most of the main homebuilders at the moment are deploying asset-light methods and punctiliously constructing behind demand which in flip has led to higher returns, stronger steadiness sheets, and extra disciplined capital allocation. Past this, one other long-term driver for the business comes from the structural undersupply that has been in place for the reason that GFC. LGI Houses is concentrated on constructing entry-level properties within the ‘exurbs’ about 40 minutes outdoors of a significant metropolitan space. The corporate has a singular working mannequin to profitably construct reasonably priced properties for first time homebuyers, positioning them to serve what we consider is the a part of the market (first-time homebuyers) with the most important provide/demand shortfall long run.
Importantly, LGI has a founder-led administration group that has confirmed capital allocation ability over time, greatest demonstrated by the truth that they remained worthwhile via the GFC. Trying forward, we anticipate a low 20’s inner fee of return (IRR) via the cycle with a comparatively wider vary of potential outcomes, which is mirrored within the place measurement.
Topgolf Callaway was created in 2021 with the merger of Callaway, a longstanding and slower-growing assortment of high-quality golf manufacturers, and Topgolf, an rising sports activities and leisure firm. We spent over a yr researching Topgolf Callaway as we sought to achieve consolation with the extent of earnings post-pandemic (golf recognition elevated considerably and the Topgolf working mannequin. Importantly, we consider the Topgolf enterprise mannequin has vital room for progress each in items and in unit-level profitability. On the similar time, the core Callaway manufacturers present ballast and money move to be reinvested to drive future progress. Past shops/items, Topgolf Callaway has invested in nice manufacturers and golf expertise that we consider will create further runways for progress. Whereas the corporate is worthwhile, earnings have been underneath stress over the previous yr. Nonetheless, we consider they are going to attain an inflection level primarily based on enterprise combine and progress in Topgolf someday in FY24, earlier than rising at a constant low-to-mid teenagers fee pushed by retailer/unit growth.
Bowman Consulting Group is an engineering consulting enterprise that serves various finish markets together with infrastructure, power, actual property, residential and industrial. The engineering consulting business is fragmented. There are a number of giant gamers, however their cumulative market share is comparatively low given the numerous small gamers within the business. We consider Bowman has a singular place available in the market as one of many few mid-sized gamers that also has an extended runway of progress from rolling up smaller companies. Bowman has an extended observe document of buying small companies at enticing valuations and strong return on funding—companies which are too small to be significant for bigger gamers. Importantly, Bowman has persistently improved its enterprise, diversifying its venture kind and business publicity, successful bigger and longer contracts, and growing cross-sell and scope of companies. Total, we anticipate Bowman to develop earnings at a mid-teens fee via a mix of natural progress, acquisitions and modest margin growth.
Through the quarter, we trimmed our publicity in a number of present holdings, and we exited one place, 5 Beneath (FIVE). 5 Beneath is a reduction retailer promoting toys, video games and merchandise concentrating on teenagers, tweens, youngsters and their mother and father. It has been a remarkably constant firm over a few years, with the potential to double its retailer rely over time. 5 Beneath has been a profitable funding, incomes a lovely IRR over our holding interval.
Given the bigger market capitalization, we’ve got determined to re-deploy the proceeds in direction of new concepts and so as to add to present holdings.
Outlook
2023 was a unstable yr that ended on a excessive observe for Small Cap equities. It was additionally a extremely differentiated yr for our technique. All through 2023, market sentiment appeared to shift drastically quarter-by-quarter, creating many potential traps for these with a short-term orientation, which frequently drives reactionary decision-making. Whereas market sentiment has improved extra just lately and we’re cautiously optimistic about stabilizing rates of interest, the fact is that uncertainty persists. This underscores why we keep targeted on the long-term and on competitively advantaged, financially versatile companies. We consider that proudly owning companies with strong steadiness sheets and the flexibility to reinvest in any surroundings trumps short-term temptations to personal decrease high quality companies pushed by rates of interest, commodity costs, or leverage.
Looking forward to 2024 and past, we see vital alternative for the asset class, and notably for our fashion of investing. In our opinion, top quality small cap corporations have better latent potential for progress relative to extra mature companies. One of the best-of-the-best small cap corporations will benefit from strong steadiness sheets and continued reinvestment to advance their aggressive place, deal with adjacencies and have a greater potential alternative for value-added acquisitions. After all, many corporations don’t meet this excessive hurdle, which is why we maintain a concentrated portfolio of corporations that don’t simply provide progress and excessive potential returns but additionally sturdiness, strong monetary fashions, the flexibility to self-fund progress, and what we consider to be superior administration groups.
We consider nice investing requires a transparent and confirmed philosophy, a disciplined course of, and conviction. It additionally requires nice humility and a willingness to vary your view when the proof requires it—one thing we’re at all times ready to do. We look ahead to conserving you up to date on our views in future commentary.
Thanks to your curiosity in Polen Capital and the U.S. Small Firm Development Portfolio. Please contact us with any questions.
Sincerely,
Rayna Lesser Hannaway, CFA | Whitney Younger Crawford
