Rethinking Risk and Concentrated Investing in Small Caps

Many investors may assume that diversifying a portfolio can reduce risk and volatility. This can be true under certain circumstances. However, diversification can potentially have adverse effects on a small-cap investment portfolio, especially when it requires investors to move further out on the risk spectrum to achieve that diversification.

For over three decades, Polen Capital has built concentrated, high-conviction portfolios that exclusively invest in what we believe are the most compelling, financially sound companies. This capability extends to the small-cap universe and is led by a team with over 80 years of collective experience in the small-cap space.

Polen’s Small Company Growth strategy provides access to disruption with discipline, allowing clients the potential to benefit from the fast-paced growth of earlier life cycle companies, all through a repeatable and regimented process that seeks to protect and grow client assets. We want to own tomorrow’s leaders today—we refuse to own companies that are speculative, unprofitable on a cash basis, highly indebted, or where our research shows their success to date cannot be repeated.

Trade-Offs Between Quality, Diversification, and Risk

While we recognize that diversification should be part of constructing an investment portfolio, our primary goal is to be consistent in making disciplined investment decisions. Our experience has shown us that diversifying beyond a 25-35 stock portfolio could lead to owning lower-quality companies that are inherently riskier. Owning more companies also has the potential to dampen returns and produce undifferentiated results versus a broader index.

Diversification alone is often not a primary source of returns, nor do we think it should be the primary driver for meeting investors’ needs and goals. In our view, the quality of our portfolio and the growth potential of our best investment ideas should not be diluted. By maintaining the highest standards for company ownership, we believe we can offer an attractive risk-adjusted return profile that is differentiated from the market and competitors.

We examined this concept of owning only quality in a concentrated portfolio by simulating 1,000, 30-stock portfolios based on the Russell 2000 Growth Index (the “Index”). We screened the Index constituents for quality based on positive operating cash flow and Net Debt/EBITDA less than three times. We also excluded securities within the energy, utilities, and materials sectors, as defined by GICS. These sectors typically house companies that are heavily tied to the commodities cycle and do not meet our criteria for growth. We then averaged the three-year standard deviation and returns of the simulated portfolios and calculated the Sharpe Ratio.1

The results showed that a focused, quality portfolio provided a similar level of volatility to the broader Index while generating higher returns. Even further, as shown in Figure 1, compare the simulated Russell 2000 Growth Quality portfolio versus the broader Index—the difference is compelling, and even more so when comparing the Polen portfolio to the broader Index.

Figure 1: Comparing Risk-Adjusted Returns of High Quality + Concentration vs. Diversification

Sources: Bloomberg. Polen Capital. Statistics based on monthly gross returns. Please reference the GIPS Report.

Four Tenets of Risk Mitigation

At first glimpse, concentrated investing can seem like a risky endeavor, especially in the small-cap universe. However, based on the simulated results and our several decades of experience, we would assert that risk mitigation is supported by the four tenets of our investment approach: quality, concentration, durable growth, and a long-term orientation. We define risk as permanent loss of capital and believe these four investment tenets serve as risk mitigants within our process for the following reasons:

  • Exclusively Invest in Quality: The outcome is owning businesses that we believe have numerous structural competitive advantages that create barriers to entry and can grow even in economically challenging times. Our quality bias also means we generally do not own highly cyclical businesses, where the success of the business depends on factors outside the company’s control, like commodity prices or swings in demand cycles.
  • Concentrated Portfolio: This allows the investment team to develop a deep and thorough understanding of the businesses we own without the distractions of managing a broadly diversified 80+ stock portfolio. Our research efforts are focused on the most compelling opportunities and allow us to constantly be attuned to the developments of every business we cover.
  • Durable Growth: We require any business we own to have a strong balance sheet—roughly 2/3 of the portfolio companies have a net cash position. These companies tend to have little to no risk of insolvency. In addition, this financial health allows companies the opportunity to self-fund their future growth and play offense during difficult economic times to extend their competitive advantages.
  • Long-term Mindset: We are patient and disciplined investors with regard to both market fluctuations and valuation. We expect to see short-term price volatility in the companies we own. That said, we generally do not reposition the portfolio based on changing macroeconomic factors, breaking news, or investor preferences. Nor do we spend much time worrying about short-term factors that we view as more transitory in nature. We focus on understanding the underlying factors of each business and ensuring the right conditions, according to our philosophy, are in place that allows them the potential to compound year after year after year.

The Benefits of Exclusivity

Ultimately, our experience has shown us that a focused portfolio of durable and growing small-cap businesses can maximize an investors’ opportunity for compelling risk-adjusted results. Exclusively owning quality companies can potentially result in a portfolio positioned to deliver sustainable growth with persistently high returns and capital protection, which can be seen in our performance and our downside and upside capture ratios.

Companies that meet all our investment criteria are rare, in our experience. We think this is especially true in the broader small-cap universe, where many companies are unprofitable and lack the key foundational elements that we believe must be in place to drive long-term compounding. If the goal is to beat the market while also taking on less risk and lower price volatility, investors should consider revisiting the issue of diversification versus concentration and how they think about risk within small-cap investing.


Important Disclosures

Data calculated for the trailing three-year period ended August 31, 2021. Results were calculated using daily returns.

Past performance does not guarantee future results and profitable results cannot be guaranteed.

Sharpe Ratio: a ratio of the return on an investment relative to its risk.

Standard Deviation: measurement of the dispersion or volatility of investment returns relative to its mean or average.

This information is provided for illustrative purposes only. Opinions and views expressed constitute the judgment of Polen Capital as of November 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.

Methodology: The starting universe of securities is the Russell 2000 Growth with membership as of 2021-07-30. The “quality” subset of this universe is defined as any security not in the energy, materials, or utilities GICS Sectors, with greater than zero last-twelve-month Operating Cash Flow in USD and Net Debt on EBITDA of less than 3x, measured on 2021-07-30. The GICS Sector exclusions represent historical sector allocations in the portfolio, with securities in those sectors historically not being allocated to or defined by Polen as “Growth stocks.” Fundamentals-driven exclusions arise directly from Polen guardrails on profitability and leverage. 1,000 equally weighted, 30-security, and randomly selected without replacement portfolios are used to calculate a simulated average Total Return and a simulated average Standard Deviation. The Sharpe ratio is then calculated from these using a risk-free rate of 2%. Three-year return periods are used to yield at least 30 data points per security in accordance with the Central Limit Theorem to ensure statistical significance, and as a representation of the lower expected portfolio holding period. All data sourced from Bloomberg.

Simulated performance results have certain inherent limitations. Unlike an actual performance record, simulated results do not represent actual trading. Also, since such trades have not been executed, the results may have under or over-compensated for the impact, if any, of certain market factors, such as lack of liquidity. Simulated trading programs in general are also subject to the fact that they are designed with the benefit of hindsight. No representation is being made that any account will or is likely to achieve future profits or losses similar to those shown.  Presentation of simulated results do not reflect the deduction of advisory fees, brokerage or other commissions and any other expenses a client would have paid or actually paid.

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

The Russell 2000® Growth Index measures the performance of those Russell 2000 companies with higher price/book ratios and higher forecasted growth values.