Investors tend to equate high concentration with high risk. Yet, with just 20 holdings, the $2.7 billion Polen Growth fund (POLRX) has proven to be more resilient than most of its large-cap-growth peers during times of market strife. In 2018, for instance, the fund’s retail shares returned more than 7.5%, while the S&P 500 (.SPX) declined 4.4%.
The key, says lead manager Dan Davidowitz, is to set extremely high standards for stocks that make the cut, and hold on for as long as it makes sense. Over the past 30 years, the strategy on which the fund is based has owned just 120 stocks.
Davidowitz recently chatted with Barron’s about some of the holdings in this select group. The conversation has been edited and condensed for clarity.
Q: How do you define high-quality?
A: There are five guardrails. The first one is a cash-rich balance sheet with very little, if any, debt. We want companies to have more free cash flow than they could possibly use in their business every year, so there’s the ability for them to do acquisitions or return capital to shareholders. Third, we want companies to have returns on capital north of 20%, and it has to be sustainable. Number four, we want companies to have stable, and hopefully, increasing profit margins. Then, number five is real, organic revenue growth.
Q: Name a holding that epitomizes these qualities.
A: Visa (V) and Mastercard (MA) both have tremendously strong balance sheets, with a net cash position for Mastercard and very manageable level of debt for Visa after it bought Visa Europe. They both have tons of free cash flow, well in excess of what they could possibly use throughout their businesses. Return on capital, depending on how you define it, is at least double the 20% we require.
Q: What’s the logic in owning both?
A: We get asked that a lot. There are very few companies that have all of the great attributes that both Visa and Mastercard have, and they’re just unique assets. They run a fixed-cost business so as transactions grow, their expenses don’t grow. More spending is moving to plastic globally, which means Visa and Mastercard can grow at a high single-digit revenue rate just by showing up for work.
Q: Adobe, another of the fund’s holdings, was a standout performer in 2018. Were you surprised?
A: Adobe (ADBE) is one of these companies that’s doing exactly what we hoped it would do. It has a monopoly on digital content creation, and that has been the case for a long time. What’s new about their digital media business is that, first, they turned it into a subscription business a few years ago and so instead of it being highly cyclical like it used to be, it is now stable. Then, with their recent acquisitions of Marketo and Magento Commerce, they have the ability to create content and measure how well it does. They’re the only company that does both, and that’s really powerful. Both sides of the business are growing at a 20%-plus rate.
Q: When did you initiate your position in Adobe?
A: We’ve owned it before, but last bought it in March of 2015. Before we bought it, the company decided to turn its whole business into a subscription-based recurring-revenue business. When you flip that switch, everything initially goes down because you’re not getting the revenue upfront; your margins, earnings, and free cash flow fall. When we bought Adobe it was violating many of our hurdles, although we made an exception because we understood that it was temporary. Now, Adobe exceeds on all of them.
Q: How does Nike fit into the portfolio?
A: This is our second go-round on Nike (NKE). This time, we bought it in June of 2012 at about $26. That was right around the time when Nike hit a wall in China. It was bad timing, but our research suggested that it wasn’t a brand problem but an inventory problem in China. And it wasn’t just Nike—everyone built up too much inventory.
Nike doesn’t have a recurring revenue stream, unlike, say, Adobe or Visa and Mastercard. But because of the high barriers to entry in this business, it’s hard to do it at global scale. So the business ends up being quite a bit more stable than you’d think. Even when they have these tough periods, they still grow. The company is well-positioned now. The culture of sport and athletic apparel is becoming more prevalent everywhere, so that helps. They also have extremely strong leadership. Mark Parker may be one of the best CEOs I’ve ever encountered.
Q: Let’s talk about a holding that is pretty polarizing right now—Facebook.
A: Everybody has an opinion on Facebook (FB). We bought it in 2013 and in less than a year, the stock doubled and the company announced the WhatsApp acquisition. We stayed out for a little over a year and then bought again in 2015 once we understood WhatsApp a little bit better.
We did get concerned at the end of 2017 because Facebook had already started talking about the election and having to invest more to solidify the network. We could see some margin pressure so we reduced our position in half.
Q: And now?
A: Recently, we felt it was a good time to start adding Facebook back in because the stock has been very weak. The company is being overly punished for a lot of the same news over and over again. We don’t dispute any of the stories, but they are well-accounted for already.
Q: What is the growth story for Facebook?
A: In the U.S. and Europe, the daily active users are a very high percentage of multi-active viewers. That shows you that they’re pretty fully penetrated. In emerging markets and some developed markets, there’s still room for growth through more engagement.
Meanwhile, there’s plenty of room for them to capture advertising dollars that are still being spent offline. We think there are a couple trillion dollars’ worth of opportunity that could move online, and there aren’t many places outside of China to go than Google and Facebook or Facebook’s other properties. There really is no other place to advertise on social media in a serious way.
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