Harness the Compounding Potential of Small Caps

Combining quality and growth to identify long-term compounders and avoid serial small caps

Gains acquired from gains or growth on top of growth. No matter the phrasing, compounding potential is what we believe most investors seek and what many agree drives long-term wealth creation. When it comes to small-cap investing, we think this compounding potential can often be underappreciated or overshadowed by the perceived risks of this group. In our experience, emphasizing high-quality businesses—rather than chasing illusory high growth with no to low profits—can offer sustainable and compelling alpha generation with lower volatility.

Two Sides to Compounding

Compounding has two faces—positive or negative. Just as growth and returns compound, debt, poor management, and a lack of fiscal discipline can also compound. Companies that are mired in debt, have little to no profits, or reinvest poorly can potentially put themselves in untenable situations that make it difficult to reverse course. In our view, aversions to investing in the small-cap space are often rooted in experiences with or perceptions of these types of “lower-quality” companies.

For the Polen Capital Small Company Growth Team, it is vital for us to avoid these types of businesses. Therefore, our investment process focuses on both growth and high-quality characteristics. We define and identify high-quality companies based on our “Flywheel” criteria, as shown in Figure 1. We believe companies with these high-quality traits combined with durable growth have the optimal conditions for positive, long-term compounding.

Figure 1: Our Flywheel

Graphic showing the Polen Small Company Growth flywheel attributes

We believe companies with these high-quality traits combined with durable growth have the optimal conditions for positive, long-term compounding.

Reinvesting to Play the Infinite Game

It’s critical to note that growth does not always equate to compounding. Compounding means that for an investment made, returns are captured from both the principal investment and the proceeding gains or interest made over time. Therefore, compounding occurs only in conjunction with current earnings, attractive growth opportunities, and reinvestment. High earnings growth and revenues, no matter how impressive, are not enough if a company does not reinvest those earnings into high-returning opportunities, based on our research.

In our experience, great companies flourish through evolution, not spontaneous combustion, and we believe companies seeking to sustain their competitive advantage must play the infinite game and constantly find ways to grow their product offerings, expand geographically, or attract new customers. We believe they must also look beyond financial growth drivers and remain attuned to non-financial matters like company culture, client satisfaction, quality of the product or service, professional development, employee morale, and autonomous leadership. From our perspective, all these factors contribute significantly to the company’s returns and ultimately to its compounding power.

Speculative businesses or those with limited profits, high debt levels, and low returns typically lack the excess earnings or high returns on invested capital (ROIC) investment opportunities that, together, are required for compounding. Mathematically speaking, companies that are unprofitable cannot compound their earnings and cash flow.

While it is possible to generate returns with these types of investments, our experience has shown us that these opportunities are often shorter-term in nature. We refer to these “point-in-time” investments as serial small caps and contrast them with the compounders we seek to own in the Polen Small Company Growth Team strategies.

Figure 2: Characteristics of Compounders vs. Serial Small Caps

Figure 2: Characteristics of Compounders vs. Serial Small Caps

Investing in lower-quality companies or serial small caps can often be less predictable and deliver uneven business performance, which drives more price volatility. In our view, significant price volatility makes it difficult to make good decisions consistently, which can debilitate an investor and reduce chances for success. In addition, investing with a shorter-term mindset may require managers to sell more quickly, thus creating taxable gains and the need to find new investment ideas more frequently.

Flywheel in the Face of Volatility

In our experience, continuous, dogged, incremental improvements over time drive compounding, and these improvements can result in sizeable growth when coupled with a long investment horizon. Returns from these incremental improvements may not be immediately visible or tangible, but it is why we believe patience and discipline can be a significant advantage.

Our Flywheel serves as our North Star, allowing us to remain disciplined and invested even in the face of volatility, as long as our required conditions remain intact. We think our Flywheel criteria ensure that the right characteristics are in place to support compounding and increase our chances of success. As a team, we often say that our high-quality Flywheel companies grow stronger and for longer than even we expect because their characteristics and behaviors are positively skewed to a virtuous cycle of compounding. Essentially, as the Flywheel gains momentum, each incremental improvement helps to sustain that momentum with less effort, and this cycle continues. For example, EPAM, Paycom, and Trex have been robust compounders. Although these stocks each had multiple drawdowns of 20-50% during our period of ownership, remaining invested allowed these companies to drive 6x returns for the strategy. We owned these businesses at the portfolio’s inception in 2017, and they have now graduated out of the strategy in terms of market cap.

By owning and holding high-quality companies for years, we aim to avoid the pitfalls of making many decisions due to short-term price volatility. In addition, our long-term investment approach leads to fewer transactions, reducing costs and taxes. In today’s investing environment where few information advantages remain, we believe our focus on high quality, growth, and long-term ownership gives us a behavioral edge. By prioritizing both quality and growth, we believe we can overcome the psychological obstacles that can lead to owning more volatile businesses, avoid permanent loss of capital, preserve capital during market declines, reduce bias in decision-making, and support long-duration participation in the asset class.

Figure 3: Growth of $10,000 – Polen U.S. Small Company Growth

Figure 3: Growth of $10,000 - Polen U.S. Small Company Growth

The performance data quoted represents past performance and does not guarantee future results. Based on monthly returns. Current performance may be lower or higher. Please reference the following GIPS reports: US Small Company Growth. Source: Polen Capital. Data from since inception to June 30, 2022.

Important Disclosures
Past performance does not guarantee future results and profitable results cannot be guaranteed. There can be no assurances that any portfolio characteristics depicted herein shall be replicated in the future. Returns are presented gross and net of management fees and have been calculated after the deduction of all transaction costs and commissions and include the reinvestment of all income. Net of fee performance was calculated using actual management fees.

This information is provided for illustrative purposes only. Opinions and views expressed constitute the judgment of Polen Capital as of December 2021 may involve a number of assumptions and estimates which are not guaranteed and are subject to change without notice or update. Although the information and any opinions or views given have been obtained from or based on sources believed to be reliable, no warranty or representation is made as to their correctness, completeness, or accuracy. Opinions, estimates, forecasts, and statements of financial market trends that are based on current market conditions constitute our judgment and are subject to change without notice, including any forward-looking estimates or statements which are based on certain expectations and assumptions. The views and strategies described may not be suitable for all clients. This document does not identify all the risks (direct or indirect) or other considerations which might be material to you when entering any financial transaction.

The Russell 2000® Growth Index is a market capitalization weighted index that measures the performance of the small-cap growth segment of the U.S. equity universe. It includes Russell 2000® Index companies with higher price/book ratios and higher forecasted growth values. The index is maintained by the FTSE Russell, a subsidiary of the London Stock Exchange Group.

The volatility and other material characteristics of the indices referenced may be materially different from the performance achieved by an individual investor. In addition, an investor’s holdings may be materially different from those within the index. Indices are unmanaged and one cannot invest directly in an index.