Focusing on Profitability: Big Opportunities in Small Businesses

Some of today’s small-cap companies have the potential to grow into large ones, but we believe profitability will define tomorrow’s biggest winners

The small cap universe has long been the cradle to some of the fastest growing businesses in the world. So far this year, the group has generally benefited from positive tailwinds stemming from the ongoing economic recovery. While it is not unusual for both higher- and lower-quality small cap companies to “rise with the tide” during periods of fast economic expansion, this dynamic could shift as growth normalizes further down the road. As a result, we believe that a selective and disciplined investment approach will be essential to capturing attractive small cap opportunities while avoiding riskier corners of the market in the future.

Small cap equities offer investors the opportunity to own businesses typically in the early stages of a long-term growth trajectory. In our view, this makes intuitive sense as it is much easier for a company to grow 15% if it is generating $500 million in sales than if it were generating $500 billion in sales. However, investors looking to gain exposure to tomorrow’s leading businesses should be aware that investing across the broad small cap market without fully understanding its constituents carries some unforeseen risks. For one, it is worth noting that a disproportionately large number of companies in the Russell 2000 index are currently unprofitable (see Figure 1).

In our view, financial discipline is a powerful competitive advantage and a key requirement of the businesses we invest in.

Therefore, those who aim to capture small cap opportunities through certain passive investment strategies (such as an index fund or index ETF) are making an ‘active’ decision to “buy into” every business in the index. This includes companies failing to generate profits, which often carry higher volatility given their distressed business models. While smaller companies are sometimes excused by investors for their lack of profits due to the elevated levels of investment needed in early stages of growth, we believe profitability matters. In our view, financial discipline is a powerful competitive advantage and a key requirement of the businesses we invest in.

This is one of the reasons that – among other criteria – we seek to focus on companies that embrace innovation and creativity while exercising responsible fiscal management. In addition, businesses able to strike a balanced approach to growth and profitability tend to have more flexibility to “play offense” and make investments even during challenging economic scenarios. In contrast, high debt levels and an over-reliance on the capital markets for funding can potentially erode a business’ profitability and limit its financial flexibility. As investor Benjamin Graham once stated, “in the short run, the market is a voting machine but in the long run it is a weighing machine.” Said differently, while trends and sentiment can often influence markets in the short term, fundamental values – such as a business’ profitability and earnings growth – can be inextricably linked to performance in the long term.

Figure 1

Figure 1 shows a growing percentage of profitable companies in the Russell 2000 index as of July 31, 2021

Source: Bloomberg (as of July 31, 2021)
Past performance is not indicative of future results.

Important DisclosuresThis information is provided for illustrative purposes only. Opinions and views expressed constitute the judgment of Polen Capital as of August 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.

This information should not be construed as a recommendation to purchase, hold or sell any particular security. Holdings are subject to change. There is no assurance that any securities discussed herein will be in the portfolio at the time you review this post or that any securities sold have not been repurchased. The securities discussed do not necessarily represent the entire portfolio. It should not be assumed that any of the securities, transactions or holdings discussed were or will prove to be profitable or that any investment recommendations we make in the future will equal the investment performance of the securities discussed herein. For a complete list of Polen Capital’s past specific recommendations for the last year, please contact [email protected]. Past performance does not guarantee future results and profitable results cannot be guaranteed.

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.

The Russell 2000® Index measures the performance of the small-cap segment of the US equity universe. It is comprised of 2,000 of the smallest securities in the Russell 3000 Index. The index is maintained by the FTSE Russell, a subsidiary of the London Stock Exchange Group.