Silver Linings: Companies with a Playbook for Tough Times
We seek businesses with the financial flexibility to stay on the offensive, in good times and bad
A common general impression is that small-cap companies are of lower quality. It’s a well-founded assumption if you look at the Russell 2000 Growth Index. Fifty percent of those businesses are not generating free cash flow (FCF). The index tends to be highly levered, and the return on invested capital (ROIC) is lower.1
If you look at Polen Capital’s portfolio, you’d see something different. We have a cash flow return on invested capital that’s two times that of the index, and our companies are in a net cash position.2 So, we think that while the index overall is lower quality, we’ve been able to create this extremely high-quality portfolio that is meant to weather any storm.
One of the biggest advantages of the companies we invest in is the strength of their balance sheets and cash flow generation. We only seek to invest in companies that are able to self-fund their own growth, and we do that in good times and bad. This gives them optionality – to reinvest in their businesses, buy back their shares, and position the business for better returns and long-term outcomes.
For example, RH is a holding in two of our strategies.3 Over the past year, CEO Gary Friedman has been very intentional about strengthening the balance sheet. The company has been buying back shares, and they’re not standing still. We’re in the middle of the second year of sales decline, yet the company continues to open new galleries in the U.S., and they just launched their first international property in England. We think that when the luxury home furnishing market returns, the company is very well positioned for success.
Another advantage our companies have is the ability to take advantage of strategic opportunities, and a big one right now is acquisitions. There are a lot of companies in our portfolio that have the cash and have been waiting for the right opportunity to do deals, which can really accelerate the long-term potential for those businesses.
Many companies will be impacted by an economic downturn, and very few are entirely immune. The key for us is finding businesses that can emerge from that environment even stronger, and we believe our investment horizon supports that. For most businesses, when times get tough, their focus shifts to the short term – to preserving their profits and cash and raising capital. In contrast, the companies we invest in don’t need to do that. They can continue to invest for future growth, widen their moats, and plant seeds for the long term.