During their recent interview with Value Investor Insight, Damon Ficklin and Jeff Mueller from Polen Capital discussed their five guardrails for finding the best opportunities. Here’s an excerpt from the interview:
Jeff Mueller: The guardrails are the first step in our process and have been in place since David Polen started Polen Capital in 1989. The overarching goal is to construct a portfolio of roughly 25 of the best businesses globally that in aggregate can compound underlying earnings per share at around 15%. As long as we don’t overpay, over time stock appreciation will match the earnings growth of each individual business, which when rolled up to the portfolio level will do the same.
There are five guardrails: strong returns on equity, strong profit margins, abundant free cash flow, real organic revenue growth and strong balance sheets. Any one of those in isolation is a high hurdle, and we think in combination they’re particularly potent. We look for sustained returns on equity of at least 20% – about twice the corporate average through cycles – and for stable to improving profit margins.
These two measures can signal competitive advantage. If there isn’t something special about your market position, competition will compete your returns and profitability down over time. The business model matters, so it’s important the company produces free cash flow far in excess of what the business needs.
That excess capital is then available for making value-creating investments and/or returning cash to shareholders. The industry context and tailwinds also matter, so we want businesses exhibiting what we believe is sustainable organic revenue growth. We don’t invest in companies where 100% of the growth comes from M&A.
We also believe in exceptionally strong balance sheets. There aren’t hard and fast rules, but most of our companies have more cash than debt and could pay down their debt in total with free cash flow within two to three years. These guardrails take the 3,000-business universe down to roughly 350 candidates.
From there as we continue our process we’re very focused on vetting the sustainability and predictability of the prospective earnings growth. We’re sensitive to anything faddish and to total addressable markets.
This is an old example, but a company like Crocs at one time might have passed our guardrail test, but for it to generate a long-term mid-teens return for our clients, some too-high percentage of people in the world needed to own at least one pair of Crocs.
These businesses may be great investments for a time, but it’s hard to be sure how durable their competitive advantages are given the narrow range of products.
You can find the entire interview here:
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