Tim Tebow, considered by many sports fans as one of the greatest players in American college football history, once stated that an important lesson he learned early in his career was not worrying about things he couldn’t control. To Tim, this meant not getting distracted during a game by what wasn’t within his power—like the current score, weather, or crowd noise—and setting his sight on those factors he could influence—like his attitude, effort, and focus.
When it comes to financial markets, several of the culprits behind this year’s volatile backdrop fall into the category of things we cannot control. Some examples include changes in economic conditions, interest rate movements, corporate earnings surprises, and geopolitical disputes. However, as investors, we do have the power to control one critical element of our portfolios: the quality of the businesses we own.
In our experience, investors can effectively hedge against an uncertain outlook by investing in high-quality businesses capable of delivering sustained earnings growth in different economic and market environments. Yet, the term “high-quality growth” tends to be ambiguously defined and, in our opinion, frequently used without any consistency in meaning. In this article, we explore some characteristics we believe set high-quality businesses apart from the crowd.
1. Competitively Advantaged Businesses
Competitive advantages are unique attributes of a business that give it an edge over its peers, helping it gain more customers and grow its market share. At Polen Capital, we look for companies with attractive business models and value propositions that have the potential to generate high levels of return on investment and free cash flow. Nevertheless, such attributes usually attract competition that, without any barrier, can erode margins and profitability.
Therefore, we believe high-quality companies must possess substantial, durable, and difficult-to-replicate protective moats that grant them the ability to potentially generate high returns today and for many more years into the future. In today’s digital age, competitive advantages come in different shapes and sizes, as seen below.
Source: Polen Capital
Given that there is no set framework for measuring or quantifying competitive advantages, investors must conduct diligent research and study the ins and outs of a business to gauge the durability of that advantage. Several innovative companies are increasingly investing and deploying intangible assets such as intellectual property (IP), research, technology and software, and human capital to create new competitive advantages and benefit from secular tailwinds.
2. Self-Financed Growth & Robust Balance Sheets
We expect high-quality companies to be “masters of their own destiny.” To us, this means generating healthy free cash flows and not depending on external capital sources to fund their growth. In our opinion, the less a business relies on debt or equity for funding, the more resilient its operations will be through times of market stress.
For over a decade, numerous unprofitable, cash-burning companies took advantage of ultra-low interest rates and ample liquidity to fund their operations and capital structure. With most central banks now tightening their monetary policies, higher borrowing costs could become a significant headwind for debt-laden companies at a time when input costs are also rising.
In contrast, we believe that businesses with clear earnings visibility, robust balance sheets, and stable cash levels offer a safety buffer in the case of an economic slowdown or profitability squeeze. Additionally, history shows that some of the world’s leading companies emerged even stronger following challenging economic environments. This is partly because high-quality companies typically have the financial bandwidth to play offense even during economic slowdowns, launching new products, making value-added acquisitions, or expanding their operations while their competitors retreat.
3. Trustworthy Stewards of Capital
In our opinion, another essential characteristic of high-quality businesses is that they tend to be led by outstanding management teams. In our experience, high-performing leaders are strategic in their execution and exhibit a clear long-term vision. We also value companies that have embraced a culture of excellence, humility, and trust.
A key element of our analysis of management capability is its track record of allocating capital—which refers to management’s decisions about how, when, and where to best deploy its financial resources. Efficient capital allocation is critical because a high-quality business’s excess free cash flow must be spent wisely to improve the business’s long-term performance. And as history shows, management teams don’t always act responsibly when allocating capital.
We have seen several examples of mismanagement and misallocation throughout the years. Therefore, a management team’s ability to reinvest resources back into the company with intelligence, integrity, and a long-term perspective is one of the most critical determinants of business success in our opinion.
4. Structural Growth Opportunities
Finally, high-quality growth companies showcase attractive growth potential, which we believe is a crucial component of shareholder value creation. Just because a company earns a high return on capital, it does not also inherently mean it can compound earnings or cash flows at high rates of return. For that to happen, we want to see structural growth opportunities that enable our companies to continuously reinvest their cash flows, driving the long-term growth flywheel.
Sell-side equity analysts typically build long-term earnings forecasts that project a company’s growth many years into the future. These models often depict growth accelerating in the company’s early years but decelerating—usually at a linear pace—over time as the business matures. Yet, we have seen great companies consistently sustain high growth levels for several years, surpassing analysts’ expectations.
Key Takeaway
During periods of elevated economic and political uncertainty, we believe investors can benefit from applying Tim Tebow’s advice of only focusing on things that matter and the factors they can control, such as the quality of their portfolio. In our opinion, high-quality businesses are well-equipped to play defense during difficult times, showcasing resiliency given their robust fundamental attributes. Likewise, they can play offense by finding new ways to innovate and grow while their competitors struggle to adapt to the new landscape.
Once we identify what we believe to be high-quality businesses that pass our investment guardrails, we believe that the best way to benefit from their underlying compounding potential is by becoming long-term owners of these companies—and then staying the course.
Important Disclosures
This information is provided for illustrative purposes only. Opinions and views expressed constitute the judgment of Polen Capital as of October 2022 and 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.