The art of time arbitrage

Florida-based Polen Capital makes potential portfolio members jump over high hurdles. It is a strategy that is paying off for its new Dublin-domiciled Ucits fund 

FS Neal Underwood 160 byline

Florida-based Polen Capital made its first foray into the UK market in April with the launch of a Dublin-domiciled Ucits fund, the Polen Focus US Growth fund. Via this vehicle the firm will aim to build on its existing concentrated large cap US equity growth strategy which it has run since 1989, when the firm was founded by David Polen.

Stan Moss, chief executive officer of Polen Capital, says the firm has what it takes to offer an interesting proposition to UK investors. “There are a few things we think make us different. On average we hold only 20 positions in portfolios. Our time horizon also makes us unique – we hold companies in a portfolio for five years or longer.” In the past 24 years, Polen has owned fewer than 100 companies in total.

“Our perspective is long term,” says Moss. “Sometimes we use what you might call time arbitrage. That gives us our advantage. We position ourselves to be fully invested at all times; we do not try to time markets. I do not think many out there can predict market movements.” 

From a risk management standpoint, the firm focuses on the best growth companies with the highest quality balance sheets. “By only investing in those companies we can have our best 20 ideas and we are not over diversified into inferior businesses. The results have proven it. When the market has gone down the portfolio has only gone down half as much.”

Polen Capital’s belief is that underlying earnings per share (EPS) growth is the long-term driver of investment returns. “Short periods can be out of whack but over time EPS within a portfolio roughly tracks in line with its performance,” says Moss. Since inception in January 1989 to the end of March 2013 the firm’s flagship Polen Growth fund has delivered an annualised gross return of 14.19 per cent, compared with an annualised return of 9.78 per cent from the S&P 500 index over the same period.

The firm’s investment team is headed by chief investment officer Dan Davidowitz. “All our companies meet the criteria of strong balance sheet, high return on equity, high free cash flow [FCF], very little debt,” he says. He cites examples such as Oracle, which the firm has held for eight years. “It has a huge competitive advantage, good growth and an exceptional management team.”

Another stock Davidowitz likes is Nike, which he has owned on and off for many years. “It is a worldwide brand with global distribution and exceptional market share. Year in, year out it is somewhat insulated from the competition. There is always something protecting the franchise. Similarly with Visa, it has got a global duopoly on payment acceptance with Mastercard. 

“It is a high quality business with strong secular growth in a true organic sense, benefiting from the shift from cash and cheque to debit and credit globally.” 

High barriers to entry are key. Competition is what makes business risky,” says Davidowitz. “It all comes around to competition. High barriers are our starting point.”

Polen Capital uses a proprietary investment screening methodology, the Systematic Valuation Discipline (SVD). This is essentially a set of criteria used to identify those companies with the strongest balance sheets and the widest competitive advantages. The SVD requires that to become a candidate for the portfolio, a company must possess a pristine balance sheet with plenty of cash and little debt, generate FCF far in excess of what is required to run the business, have sustained a 20 per cent return on capital through a market cycle, have stable or expanding profit margins and have a shareholder-friendly management team. These are deliberately high hurdles, in particular the 20 per cent return on capital threshold, which is nearly double the US corporate average. A company is only of interest to Polen if it meets all these criteria and Davidowitz says it will continue to be at least that strong going forward.

“If you think about risk at the individual business level, requiring our companies to have fortress-like balance sheets ensures that they are encumbered to no one,” says Davidowitz. “This allows the businesses not only to weather tough economic times, but also invest more during those times to gain greater competitive advantage. In addition, companies that are able to sustain 20 per cent returns on equity usually possess a sustainable competitive advantage that creates high barriers for new entrants. In a free market, high margins and returns attract competition. So if a company can sustain high margins and returns, there is likely something that makes it difficult for others to compete with that business.” 

These advantages can take many forms, says Davidowitz, including, but not limited to, patents, network effects, high switching costs, and customer and brand loyalty. In his view, cash rich businesses with sustainable competitive advantages are inherently less risky. “We spend the vast majority of our time researching individual companies and industries to understand the competitive dynamics at work and the opportunities and threats those businesses may face in the future,” he says. “Even though most of the companies we research are of extremely high quality, we make very few purchases. 

“Our success in investing has a lot to do with our discipline and our decision to ‘not do’ a lot of things. There is a strong behavioural need for people to be ‘doing something’, such as buying and selling stocks. But it has been our experience that buying great companies and holding them for as long as they meet our expectations is a better way to compound high investment returns.”

Davidowitz says he likes to think and act like a business owner rather than a trader, so he only takes positions in businesses that he would theoretically want to own.

He says: “We only want to own the companies with the strongest financials and biggest competitive moats. We do not actively trade the portfolio based on short-term issues. Some of our companies have seen slower growth due to the decelerating economy, but as long as their competitive advantages are intact and the long-term prospects remain robust, we will continue to hold them, just as a business owner would. 

“As the US economy enters a more positive phase, we believe our high quality growth franchises will continue to deliver solid growth and are likely to find more favour in the market.”

Although every stock is bought with the intention of holding it over the long term, there are some scenarios which would prompt it to be sold. Davidowitz says: “Most importantly, if we sense a deterioration in its competitive advantage or long-term growth profile [we will sell it].” 

Then there are one-off situations such as that affecting Cognizant Technology, which has a mostly India-based workforce and is likely to fall foul of the US immigration reform bill and its impact on those requiring US work visas. For this reason, despite believing in the company, Polen sold its position. “Sometimes we simply find a better company. In this case we usually have to sell [an existing holding] to make room.”

Everything is focused on individual stocks. “We do not really try to make any predictions [at a macro level],” says Davidowitz. “We are aware of what is going on in the US market and we do try to at least be cognisant that there are bigger risks for some companies. We are focused mainly on individual businesses, although there can sometimes be big macroeconomic risks.”

For Moss, there were some good reasons for launching a product into the UK and European markets. “The attraction is twofold. We have some existing client demand. When you look at the global picture, US domestic long only [equities] in terms of asset flows has had fairly consistent net outflows over the past few years. We have done extremely well in that competitive area, but we have also seen in other areas net positive inflows into long-only for years to come. 

“We want a product in that marketplace, where we can have a compelling product and flows are positive. We happen to be located in South Florida so we have many Latin American investors who want to access an offshore vehicle through Ucits.”

Polen Capital’s client base is split roughly 50/50 between institutions and high net worth individuals. At present the majority of assets in the Ucits fund come from Latin American investors. Going forward the firm will target more high net worth investors through its relationship with Spring Capital Partners, which is running sales and marketing of the fund in the UK.

“We are looking at family offices as opposed to going directly to the institutional marketplace,” says Moss. “The distribution channels we are looking at are wealth managers, fund of funds and platforms. We already have the fund on global platforms in the US, such as Citi Private Bank.”

Moss says Polen Capital’s success can be measured not just by fund performance and growth in assets. “What we are trying to do is the right thing by investors – grow their capital over the long term. We also need to attract and retain quality people. If we can have a great group of high quality individuals preserving capital in the long term our brand will be known in the US and the UK.”

The firm’s history is rooted in concentrated portfolios of large-cap US equities. “That is very much who we are and what we do,” says Moss. “Over the long term we could see ourselves expand into other areas. We could move into global equities.” 

For now, the one sub-fund of the Dublin investment vehicle will be the focus. “It all circles back to concentration, being active and focusing on alpha generation. I do not think of active versus passive; passive is a wonderful way for some to invest. But if you go active, you have got to go into a concentrated port-folio. There are not many others that do that, and that gives us an advantage in the market.

“If you’ve got 50 or 60 stocks you are in a kind of no man’s land. There are various studies out there that show what happens each time you add a stock [to a portfolio].”

“Our investment team will continue to operate as we have for many years,” concludes Davidowitz. “For each company we evaluate, we are focused on ‘the next 10 years’. Our goal is not just to beat the market over the long term, but to beat it by a similar margin as we have done over our history. 

“We believe we have a sustainable competitive advantage in investing, driven by our concentration, long-term orientation and discipline. In both investing and in managing our business, we have a long-term focus and a culture of hard work, simplicity and risk aversion.”

The independent views

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Tim Cockerill, head of collectives research, Rowan Dartington

“We look at mainstream and smaller companies’ US funds. For a large-cap fund such as this, one of the key things would be the style of the fund. Often firms come to the UK and show a respectable record but often things go wrong. We would look for one that performed consistently, outperforming the S&P 500. If we see outperformance in different types of market that is the ideal. Then we look at things like volatility. There are not many funds out there as concentrated [as the Polen Focus US Growth fund] so that would need careful consideration from my point of view. You have got some chunky weightings and some stock-specific risk is quite high.”

 Simon Evan-Cook, senior investment manager, multi-asset funds, Premier Asset Management

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“At the highest level this is the kind of thing that ticks a few boxes. We like large cap managers to be concentrated and genuinely active. Having a high active position [in stocks] appeals. We like bottom-up based fundamentals rather than market timing, and low turnover is an indicator that they are good at picking stocks. But I’m also concerned about price and valuation. In the US there has to be an element of growth but you do not want to pay too much for it. We like them to be contrarian and active. Now in the UK for the first time in a while there seems to be a choice of good [US equity] funds. We like to have a blend of value and growth and mix up the market cap.”

John Husselbee, CEO, North Investment Partners

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“Generally speaking if you take the [US equities] sector versus the S&P index funds have underperformed over time. The number of funds in that sector that have outperformed are barely a handful. Part of the reason is the market is very efficient. Part of the challenge is there are very few pragmatic investors in the US, particularly when you look at US-based managers. They tend to fit into a particular style box. [Polen Capital] sound like they are value-driven. In order to outperform [as a fund of funds manager] you need to take a specific style bet and review it on a frequent basis, so most of the time we invest with different managers with different styles, almost neutralising style.”

Polen Capital

Polen Capital, based in Florida, is a US large-cap equity manager which was founded in 1989. The firm is independently owned and runs separately managed accounts for individuals, corporations, public funds, endowments and foundations. Assets under management currently stand at just over $5bn. In April this year the firm launched its first Dublin Ucits fund.