Over the September 2022 quarter the Polen Capital Global Small and Mid Cap Fund delivered investors a return of negative 2.58 per cent, whilst the benchmark, the MSCI ACWI SMID Accumulation Index in AUD, rose by 0.49 per cent. Both were assisted by the sharp decline in the AUD/USD exchange rate, to the tune of around 6 per cent.
This very volatile period saw heightened geopolitical uncertainty, persistently higher inflation, rising interest rates in many English-speaking economies, U.S. dollar strength, and concerns about slower global growth. This echoed themes which mostly commenced earlier in calendar 2022, creating a both a “risk-off” mentality and difficulty for Polen Capital’s investment style.
The top absolute contributors to the Portfolio’s performance over the September 2022 included Paycom Software, Tecan Group and Five Below. The most significant absolute detractors from performance included Netcompany, Azenta, and Euronext.
The Fund did not initiate any new holdings, nor sell out of any holdings, but used the volatility to opportunistically adjust some positions. Polen Capital remains focused on the long-term value propositions, competitive advantages, growth opportunities, and potential earnings power of the portfolio companies. The Boston-based Small and Mid Cap team continue to research and own companies where they believe the Polen Capital flywheel framework is intact and risk-adjusted returns are compelling.
In response to rising inflation, the U.S. Federal Reserve Board (the “Fed”) has ramped up its tightening of interest rates, prioritising curtailing rising prices over the risk of tipping the economy into a recession. Whether the Fed’s strategy proves successful remains to be seen. Among other macro developments, the absence of a resolution to the Ukraine-Russia conflict as well as China’s zero-COVID policy contributed to persistent inflation and rising energy prices. Investor sentiment has become increasingly negative as a result, and while broad multiple compression has slowed, companies have started to revise earnings expectations downwards in anticipation of growing recessionary pressures. Certain market segments, including consumer discretionary, are under more acute selling pressure given fears about consumer weakness in recessionary periods, however some of these more cyclical areas have also experienced modest bear market bounces. This is also reflected in the fact that small caps outperformed large caps over the quarter.
Another notable feature of the investment backdrop has been the outperformance of lower quality cyclical sectors, energy being the best example. With Polen Capital’s focus on what they believe to be high-quality compounders over the long term, cyclical businesses tend not to fit the Polen Capital investment criteria. As expected, during periods of heightened volatility and a shifting economic environment, Polen Capital are refining the Portfolio opportunistically. This includes adding to companies that have been unfairly punished and taking profits by trimming companies that have held up well where we believe there is a lower return expectation going forward.
Portfolio underperformance was driven primarily by security selection, as positive selection in communication services and consumer discretionary sectors was outweighed by negative selection in financials and information technology. Sector allocation also detracted from relative performance, primarily due to our zero weight in energy and underweight to industrials. As a reminder, the outcome of our sector positioning is entirely driven by bottom-up stock picking. The Portfolio style was also challenged by growth and quality underperforming the benchmark once again. Sectors we typically have less exposure to, including cyclical stocks such as Energy have continued to perform relatively well.
Polen Capital remain focused on finding companies with competitive advantages that we believe can compound earnings and cash flows over the long-term independent of commodity swings or economic cycles. The most significant absolute contributors to performance over the September 2022 quarter were Paycom Software, Tecan Group and Five Below.
Paycom, a high quality, high-growth leader in human capital management and payroll software, was the top contributor to returns over the quarter. The company posted a solid second quarter, with revenue and earnings both ahead of expectations, and raised its full-year forecast. The numbers highlight the continued demand for Paycom’s software as well as successful execution. The company continues to take market share from long-standing incumbents, and we believe the business has a long runway with only circa 5 per cent market share and a growing total addressable market.
Tecan Group, a Swiss-based healthcare technology company, also recovered from recent weakness. Polen Capital initiated a position in the stock in the last quarter, ahead of first half-year earnings. The company reported strong growth of organic non-COVID-related sales, which largely offset a substantial decline in COVID-related revenues recorded in 2021, whilst raising its full year sales outlook based on positive momentum in the June 2022 half-year. We believe this is a high-quality company with a favourable growth outlook and a narrow range of outcomes.
Five Below is a leading, high-growth, value retailer in the United States. The stock outperformed, in part due to a relief in selling pressure across retail stocks, but also as the company reported second quarter earnings. While revenues and earnings for the quarter were marginally below expectations, in a backdrop of slowing retail demand Five Below is seen to have an attractive value proposition with products that deliver on value as the customer wallet shrinks. Polen Capital believe the company can compound its value over the next five years, driven by a combination of mid-teens new store expansion, comparable store growth, and modest margin expansion from its fixed cost leverage.
The most significant absolute detractors from performance included Netcompany, Azenta, and Euronext.
Netcompany, a Danish IT consulting business, reported second quarter earnings that missed analyst estimates due to higher sickness levels, employee costs and project adjustments. The company also continues to digest its acquisition of Intrasoft from late last year. While the acquisition may cause some short-term headwinds, we believe it will support the long-term growth story for the company. Polen Capital continue to believe that the company has a robust competitive position, and the long-term growth opportunity remains intact.
Life science sample management business, Azenta, which is a relatively new position, missed on revenues for the quarter. The business was negatively impacted by foreign exchange headwinds due to a strong U.S. dollar and the COVID shutdown in China. The company has been transparent about how they benefited from COVID revenues; however, the decline was larger and quicker than expected. While the results were disappointing, we believe the company is a secular winner in a growing industry where their services are needed in an increasingly complex drug discovery world.
Finally, Euronext, which held up well in the previous quarter, underperformed despite posting satisfactory quarterly results amid a turbulent time for European equities. The leading European trading exchange showed durability despite the challenging market environment and promising signs that the Borsa Italiana acquisition made last year will be accretive to returns. Polen Capital continue to believe they are an industry-leading, volume-based business than can thrive and survive in any market environment and the shares are trading at an attractive valuation.
Polen Capital initiated no new positions, nor sold out of any existing holdings. We added to our position in Azenta, which we commenced at the end of the June 2022 quarter. We also used the volatility to add to several positions, including Goosehead Insurance, after witnessing an outsized drawdown in the stock price; Revolve Group, which has come down significantly due to some near-term uncertainties; and Keywords Studios, where fundamentals remain strong but the stock has come down about 25 per cent year to date. To fund these trades we trimmed FICO, which was up nearly 10 per cent over the year; TMX Group, in the context of other opportunities; and Pro Medicus, due to valuation, despite the quality of the company.
We continue to stay focused on the long-term value propositions, competitive advantages, ongoing initiatives, growth opportunities, and potential earnings power of our Portfolio companies. In challenging periods like these, we believe the strong get stronger. In other words, we believe businesses with robust balance sheets that can self-fund growth are poised to withstand a potential recession, maintain resilience, and gain market share while their competition retreats. We believe the opportunity for long-term investors like us is more favourable than it has been in years.
If you would like to learn more about the Polen Capital Global Small and Mid Cap Fund, please visit the fund’s web page to learn more: Polen Capital Global Small and Mid Cap Fund
Past performance is not an indicator of future performance. Returns are not guaranteed and so the value of an investment may rise or fall.
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