Portfolio Manager Q&A: Seeking Durability in Small-Cap Companies

Money Life podcast host Chuck Jaffe talks to Polen Capital’s Tucker Walsh about searching for small company prospects in a pandemic

Tucker Walsh, Head of Team, Portfolio Manager & Analyst recently joined Money Life with Chuck Jaffe to discuss applying the Polen investment philosophy to U.S. small companies and the prospects he sees in today’s pandemic environment. Read the podcast interview highlights below and learn more about the Polen U.S. Small Company Growth strategy.

Q: Can you explain your methodology and the Polen U.S. Small Company Growth strategy?
A: Polen Capital has been around since the 1980s. The track record for the Polen Focus Growth strategy goes back to 1989, so it’s 30 years of investing as business owners in that kind of mindset. The U.S. Small Company Growth strategy that I manage is a little more than three years old and employs the same 30+ year Polen philosophy and process. We have a very collaborative approach to find the best companies in our category for our portfolios. The Small Company Growth Team is a team of six people. I co-manage the U.S. Small Company Growth strategy with Rayna Lesser Hannaway, and we’re seeking to own the best companies in our category.

Q: Where’s the art and the science in deciding what means “the best?”
A: We have very high hurdles for a company to get into the portfolio. We run a very concentrated portfolio, especially for the small-cap category. We own 25 to 35 securities, so we have very high active share and high conviction in the companies that we own.

To have that conviction, we need to have a framework that we call our investment flywheel. That flywheel starts with having a strong competitive position and tailwinds from a long-term trend. It also means the business must have a repeatable sales process where they can continue to generate organic growth robust margins and cash flow. It must also be run by an effective management team that is skilled at reinvesting back into the business to continue that growth and maintain or strengthen the competitive position. That’s why we consider it to be a flywheel.

Q: How long is your investment time horizon? And, does the current pandemic environment change your timeline or how you evaluate companies?
A: We generally look out three to five years with all our investments. But, we want to buy a company that is benefiting from a trend that will persist for longer than three to five years. We want to see appropriate appreciation over our holding period.

An important thing to note is that really well-run businesses might have some short-term hiccups. But, in our experience, if the management team is agile and they have a culture that can adapt to situations, these businesses can find ways to continue to grow and also generate the cash that’s necessary to maintain the strong business model. It really depends on the company, and we feel that the companies that we own are well suited to be able to not only survive in this period, but in some cases really thrive due to the current conditions.

Q: Can you discuss a company that you like and explain how it fits your methodology?
A: Wingstop is a great example of the kind of company that fits our methodology. This is a fast-growing restaurant concept centered around chicken wings, as you might imagine from the name. It delivers on its value proposition, which it considers to be great flavor, but it’s also done at a really good price point. It’s benefiting from a long-term trend of consumers wanting to get food from fast casual-type establishments with really good quality. Wingstop, in our view, has done an exceedingly good job of franchising this model. Even though it does have some its own stores, most of its growth is coming from franchising. In fact, it also has great economics for the franchisees, which continues to allow the business to grow units.

With about 1,300 restaurant units today, we believe Wingstop can be four to six times larger. The growth, we believe, will come from openings of new stores and new units, and then strong same-store sales over time as they continue to advertise and gain awareness. This creates very high levels of cash generation for the company.

The franchisees, as I mentioned before, are also seeing really good economics in their units. What is great about the franchise model is that the franchisee, not the company, puts up the capital to grow for every incremental unit.

With Wingstop, we see strong cash generation that can then be reinvested into growing units, and they are also working on the brand itself. We believe that the company has a very strong culture and that it’s very well run. In this particular period, we’ve seen that the management team has been able to deliver on serving customers that really want take-out and delivery—that was 80% of its business going into the pandemic. Its been able to adapt and continue to grow, showing good results in this period. We think this opens up a lot of opportunities for Wingstop going forward.

Q:  What’s another business that stands out to you in this current COVID-19 environment?
A: We really believe that some of the trends that were in place before the pandemic will probably get an accelerator effect as people have had to learn how to work a little bit differently. Many of us are working remotely, and that’s going to create different habits. One of the areas that we believe will continue to benefit is movement to the cloud. In our portfolio, we like AppFolio, which provides cloud-based solutions to property managers and the legal industry and serves small to medium-sized businesses.

They’re benefiting from the long-term trend of the movement of manual processes and information handling and dissemination to the cloud. That allows these small to medium-sized property managers to do everything on cloud-based applications all the way down to the customer level. This also includes the ability to provide virtual tours, which can help with the current situation where people can’t be physically present.

The business is a subscription as a software-as-a-service business, and it continues to grow by adding more functionality. The company has a very strong culture that’s connected very closely to the customer, and the customer helps them with feedback to continue to iterate product. It reinvests into expanding their product breadth. That makes the product itself stickier, increases the average ticket per customer, and also extends competitive advantage. For all those reasons, Appfolio really fits our framework well.

Q: What makes you sell a company out of the portfolio?
A: We have three reasons that would lead us to sell. One would include finding what we think is a superior alternative. We would also sell if there was a violation to our flywheel framework. Because we have a high hurdle to initiate ownership in a company, we also have a high hurdle to maintain ownership of a company. If the flywheel is interrupted for what we think will be a more permanent impairment to the way a company would compound value over time, not just a temporary adjustment to get back on track, we would sell.

Lastly, we are also committed to staying in the small-cap category. We will sell higher-market-cap companies and redeploy those assets into smaller-cap companies, those under 3 billion in market cap at the time of purchase, if we believe that moving those assets provides a similar or better return potential.

Q: What are your views on Etsy?
A: Etsy is a fantastic company, and we really like it. It is a beneficiary of the move to e-commerce, and it has a unique value proposition in our view. It serves as a unique marketplace for entrepreneurial interests, where there’s a very specific product that they want to get in front of customers. Furthermore, customers also know that they can find specialty-type products that are well-made. Etsy does a really good job of serving both sides of that equation. We do think that there is a very good chance that it could come out of this environment stronger, but it was already trending very well before the pandemic.

Q: Can you discuss your views on Five Below?
A: We believe Five Below is a really well-run retail organization. As you might expect you’re going to find items in their $5 or below. Five Below had to shut down stores, and that is obviously going to put a temporary setback into the business. But, we believe that it’s very well-run over the long-term and it does require folks to, especially the teenagers, to go to the store in order to get the products. And it makes more sense to get it at a Five Below than it does to get those products shipped online. We do like Five Below for a long-term holding with the near-term results being a little bit more challenged, but we think the management team is doing a really good job of navigating through this period.

Q: What are your thoughts on Pool Corporation?
A: We really like Pool Corporation. The company has done a fantastic job, in our view, of growing in a very steady fashion over the last ten years. It’s created a lot of value for the pool maintenance industry, and it’s also continued to innovate and make it much easier for those professionals to access their pool supplies. It also has done a very good job of generating controlled growth with really high returns on capital, excellent cash flow, and good capital allocation. We believe this is a company that has proven that it can execute this model, and we really like it for the long-term.

Q: Can you discuss your views on a company like Northern Oil and Gas?
A: We do not invest in energy. As a result of our bottom-up investment process, we tend to avoid the area because it is so heavily dependent on commodity prices and economic cycles. These companies do not meet our investment criteria. We stick with companies in areas that, we think, give the best ability to compound over time.

Listen to the full Money Life podcast interview here →

Important Disclosures
The information provided in these materials should not be construed as a recommendation to purchase or sell any particular security. There is no assurance that any securities discussed herein will remain in the portfolio at the time you receive these materials or that the securities sold have not been repurchased. The securities discussed do not 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. Past performance is not indicative of future results.