Talk about a concentrated effort: Over the past 26 years, long-only equities manager Polen Capital has invested in only 105 companies for its primary strategy.
This is a sign not of laziness but of fussiness among Polen’s seven-person investment team, which manages $5.9 billion for institutions, independent advisers and high-net-worth investors, a rapid rise from less than $300 million in 2008. The Boca Raton, Florida–based firm runs separately managed accounts (SMAs) as well as U.S.- and European-registered mutual funds. Nearly all of Polen’s assets are in its Focus Growth strategy, which invests in U.S. stocks; it launched a global fund this year.
There are nearly 5,000 publicly traded companies in the U.S., but Polen screens out most of them. “We shrink that investable universe to companies that are fairly large,” says CEO Stan Moss, “with a market cap of $4 billion and above, with pristine balance sheets and tons of free cash flow, 20 percent return on capital or higher, stable or improving margins and real-terms revenue growth.” That reduces the number “extremely quickly” to only 200 or 300 names, Moss explains.
“Then we do our first shallow dive into companies to see if their strong financials are truly sustainable,” he says. “That shrinks it down to 100 or 125 companies. This is where the vast majority of our research time is spent.” But Polen doesn’t stop there: Focus Growth limits its stock picks to between 15 and 25 at any given time.
This is the world of high-conviction investing, also known as concentrated active: betting on a small number of stocks in which the manager has great faith. Data provider Lipper has identified 90 high-conviction funds in the U.S. with combined assets of $84 billion. Firms that pursue this approach include Bruce Berkowitz’s Miami-based Fairholme Capital Management, London-headquartered Lindsell Train and Woodford Investment Management of Oxford, England.
High-conviction investing has many fans. “Concentrated portfolios can play a more prominent role than ever,” says Brian Meath, New York–based managing director and portfolio manager, multiasset investments, at $272 billion Russell Investments of Seattle. “Diversified active managers charge almost the same fees — perhaps the same — as concentrated active, but with lower potential for excess return.”
Mark Yusko, CEO and CIO at multiasset manager Morgan Creek Capital Management, is another believer. “My view on high-conviction investing has changed pretty dramatically over the last couple of years,” says Yusko, whose Chapel Hill, North Carolina–based firm manages $4 billion. “I’ve realized that diversification is less beneficial than having the ability to gain an edge and using it to invest with really high conviction. That’s the best way to compound wealth over the long term.”
Advocates of high-conviction cite a 2006 paper by Martijn Cremers and Antti Petajisto, then finance professors at the Yale School of Management, which introduced the concept of active share, a way of measuring the extent to which a portfolio deviates from its benchmark. An index fund is zero percent active, whereas a fund that holds no stocks at all in an index is 100 percent active.
Cremers and Petajisto found that funds with an active share of 80 percent or higher beat their benchmark indexes by about 1.5 percent after fees. Polen Focus Growth has an active share of 84 percent.
High-conviction investing can lead to spectacular underperformance, though. From 2003 to 2006, Polen lagged the S&P 500 index, judged by composite figures for all of its SMAs. Thanks to this poor showing, by 2008 its assets had shrunk to less than one seventh of their 2004 level of $2 billion. Polen also underperformed the S&P 500’s 32.4 percent rise in 2013 by 10.2 percentage points.
“In screaming up markets, it’s sometimes hard for our companies to keep up with the flavor of the month,” says Polen CIO and portfolio manager Dan Davidowitz. “However, our volatility tends to be a lot lower than the market.”
Davidowitz notes that the earnings-per-share growth for Polen’s portfolio of companies, a good underlying measure of the increase in a company’s true worth, has remained positive every year since the firm was founded — even in 2008, when the S&P 500’s EPS plummeted. EPS growth, including dividends, has averaged 14.5 percent since 1989, compared with an average of 6 or 7 percent for the S&P over a market cycle, he says.
This explains Polen’s strong historical showing: Its SMAs have returned 890 percent over the past 20 years, whereas the S&P 500 gained 555 percent. Polen’s assets began to climb swiftly in 2009, supported by strong relative performance in 2008–’09. For 2008 the firm’s EPS growth was 17 percent, versus a 40 percent drop for the S&P.
Polen selects household names that it deems undervalued for investors prepared to hold the stock for many years. The firm’s investments include MasterCard and Visa, the U.S. credit card companies that have “a global duopoly on payment processing if you exclude China,” Davidowitz says. This makes them highly attractive, he adds, particularly given the huge potential of the global market, helped by the growth of mobile phone payment technology.
Russell’s Meath warns that concentrated portfolios held by an investor may start by looking very different but overlap over time. His advice: Investors need to regularly check their overall portfolio’s concentration risks of all kinds. “You don’t want a portfolio that, through concentrated stock picks, ends up being highly sensitive to a particular interest rate environment,” for example, Meath says.
