Panya Mingthaisong
Abstract
In 2024, U.S. SMID cap progress shares had been dominated by slender efficiency drivers—crowded AI trades and curiosity rate-sensitive sectors like housing and biotech—with the highest ten contributors accounting for greater than 1/3 of the Russell 2500 Progress Index (the “Index”) return. This created a difficult atmosphere for many worthwhile, high-quality firms and highlighted the market’s more and more short-term focus. The U.S. SMID Firm Progress Composite Portfolio (the “Portfolio”) delivered 3.0% gross of charges and a couple of.7% internet of charges for the quarter, barely outperforming the Index. This marked the top of an general disappointing 12 months wherein the Portfolio returned 2.6% gross of charges and 1.4% internet of charges, underperforming the Index’s 13.9% return. The highest contributors to the Portfolio’s relative and absolute efficiency within the fourth quarter had been Revolve Group (RVLV), Warby Parker (WRBY), and Goosehead Insurance coverage (GSHD). Probably the most vital detractors from relative efficiency had been Booz Allen Hamilton (BAH), TopBuild (BLD), and Hamilton Lane (HLNE). The numerous absolute detractors had been Booz Allen Hamilton, TopBuild, and Ground & Décor (FND). In the course of the quarter, we initiated positions in seven new investments: Rambus (RMBS), Entegris (ENTG), Bentley Methods (BSY), Perception Enterprises (NSIT), Pure Storage (PSTG), Willscot Holdings (WSC), and Dutch Bros (BROS). We additionally added to a number of present positions. We eradicated six positions—Euronet Worldwide (EEFT), Aspen Know-how (AZPN), Fox Manufacturing facility Holding (FOXF), Tyler Applied sciences (TYL), Clearwater Analytics (CWAN), and Alarm.com (ALRM)—and trimmed a number of present positions. There are numerous examples of excessive beta, AI-adjacent progress firms outperforming the broader investable universe. Whereas we didn’t personal these shares because of their low high quality, which harm our efficiency, we imagine the Portfolio is well-positioned to profit from the GenAI-driven transformation—albeit in a extra sustainable, long-term-oriented method.
The efficiency knowledge quoted represents previous efficiency and doesn’t assure future outcomes. Present efficiency could also be decrease or greater. Intervals over one-year are annualized. Efficiency figures are introduced gross and internet of charges and have been calculated after the deduction of all transaction prices and commissions, and embody the reinvestment of all earnings. Please reference the GIPS Report which accompanies this commentary.
The commentary just isn’t supposed as a assure of worthwhile outcomes. Any forward-looking statements are primarily based on sure expectations and assumptions which can be prone to adjustments in circumstances. Opinions and views expressed represent the judgment of Polen Capital as of the date herein, could contain a variety of assumptions and estimates which aren’t assured, and are topic to vary. Contribution to relative return is a measure of a securities contribution to the relative return of a portfolio versus its benchmark index. The calculation might be approximated by the under method, making an allowance for purchases and gross sales of the safety over the measurement interval. Please observe this calculation doesn’t have in mind transactional prices and dividends of the benchmark, because it does for the portfolio. Contribution to relative return of Inventory A = (Inventory A portfolio weight (%) – Inventory A benchmark weight (%)) x (Inventory A return (%) – Mixture benchmark return (%)).
All company-specific info has been sourced from firm financials as of the related interval mentioned.
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Commentary
As measured by the Russell 2500 Progress Index, U.S. SMID cap progress shares had been up 2.4% within the fourth quarter and 13.9% for 2024. In one other unstable quarter, SMID cap shares had been up over 10% after November’s U.S. Presidential election however relinquished nearly all these positive factors in December, with the U.S. Federal Reserve (Fed) setting the tone for a slower-than-expected rate of interest discount in 2025. Regardless of the volatility, our U.S. SMID Firm Progress Portfolio returned 3.0% gross of charges and a couple of.7% internet of charges, barely outperforming the Index. This marked the top of a disappointing 12 months wherein the Portfolio returned 2.6% gross of charges and 1.4% internet of charges, underperforming the 13.9% Index return.
Regardless of muted 2024 outcomes, we imagine the basics of our Portfolio companies are robust and enhancing. For a lot of the 12 months, the Russell 2500 Progress efficiency was largely pushed by crowded AI trades and firms that stood most to profit from declining rates of interest (housing, biotech, unprofitable “moonshot” firms like area exploration, quantum computing, and so forth). As proof of this narrowness, the highest 10 contributors to the 2024 Index efficiency accounted for greater than 1/3 of its return. That is decidedly not a conducive atmosphere for many worthwhile, high-quality firms to outperform, and for us, it represented a significant relative efficiency headwind. For our present holdings, the market’s time horizon appeared to shrink considerably with a heightened give attention to AI, excessively punishing companies that didn’t meet expectations for the quarter, far exceeding what their underlying fundamentals would justify. Final quarter, we highlighted Goosehead Insurance coverage as an illustration—down 40% at one level and later rebounding 60% as fundamentals proved stronger than anticipated. We witnessed a continuation of this development when firms reported earnings in October and November, which labored to our profit within the fourth quarter.
Quite a few lower-quality firms didn’t meet our Flywheel framework for high quality, weighing closely on relative efficiency. Probably the most notable instance is Tremendous Micro Pc, up almost 190% within the first half of the 12 months and driving a notable headwind. Significantly irritating on this situation—Tremendous Micro was reconstituted out of the index in late June and was down -62% within the second half of 2024. Many high-beta, AI-adjacent progress firms outperformed the broader investable universe. Whereas we didn’t personal these shares because of their low high quality, negatively impacting our returns, we imagine the Portfolio is well-positioned to profit from the GenAI-driven transformation in a extra sustainable and long-term method.
Whereas volatility and narrowly outlined, crowded trades within the Index have introduced short-term challenges for our high-quality, concentrated Portfolio, we imagine these dynamics create a wonderful atmosphere for inventory pickers like ourselves with a long-term, business-owner mindset. We stay dedicated to our collaborative, rigorous analysis course of to determine the most effective long-term SMID cap compounders. We goal to generate returns by figuring out nice underappreciated companies all through their long-term compounding potential. In environments like this, many are additionally missed because of the market’s short-term focus and incapacity to see previous the subsequent rate-cut resolution. This has led to crowding in some securities and skittishness in others. We use our five-point Flywheel funding standards to see previous the noise and depend on our analysis course of to take a number of views and leverage our group’s in depth expertise. We’re disciplined about paying the best value to succeed in our mid-teens return goal and infrequently make the most of our library of vetted Flywheel firms to attend for the best alternative to purchase when volatility works in our favor. Consequently, we’re excited in regards to the prospects for our Portfolio even amid an unsure financial atmosphere.
Portfolio Efficiency & Attribution
In the course of the fourth quarter, the U.S. SMID Firm Progress Composite Portfolio returned 3.0% gross and a couple of.7% internet of charges, respectively, in comparison with the Russell 2500 Progress Index return of two.4%.
The highest contributors to the Portfolio’s relative and absolute efficiency within the fourth quarter had been Revolve Group, Warby Parker, and Goosehead Insurance coverage.
Revolve Group, an internet attire retailer focusing on primarily Millennial and Gen Z demographics, was the highest performer after demonstrating enhancing fundamentals following a difficult interval, with the inventory’s whole return up over 100% for the 12 months. Whereas the patron atmosphere stays beneath strain, we’re inspired by the corporate’s efforts to drive price efficiencies, cut back return charges, develop product traces, and proceed its worldwide push. We imagine Revolve is well-positioned to develop earnings at an accelerating fee over the close to time period whereas the long-term outlook stays intact.
Warby Parker, a U.S.-based omnichannel retailer of eyewear merchandise with a novel vertically built-in direct-to-consumer enterprise mannequin, reported encouraging quarterly outcomes. The corporate skilled robust progress in its glasses enterprise and continued momentum involved lenses and optometry.
Funding in optometrists is yielding outcomes, driving improved gross margins via enhanced utilization. Warby Parker seems to be rising from a difficult interval the place it was adversely impacted by post-pandemic adjustments in shopper habits. Firm administration’s steps to cut back prices look like paying off. Extra lately, we’ve seen fundamentals enhance, with advertising and marketing spend recovering now that margins have settled. We imagine the corporate has the potential to reinforce its profitability as demand continues to recuperate and it completes and capitalizes on heavy investments in areas equivalent to optometry companies, which beforehand weighed on margins.
Goosehead Insurance coverage, a digitally enabled insurance coverage brokerage enterprise, was a high contributor on the again of optimistic earnings outcomes together with a rising 2024 income steering. The corporate continues to execute effectively amidst a difficult macro backdrop, driving sturdy expense administration, greater productiveness, and compelling agent headcount progress.
Probably the most vital detractors from relative efficiency within the quarter had been Booz Allen Hamilton, TopBuild, and Hamilton Lane. The numerous absolute detractors had been Booz Allen Hamilton, TopBuild, and Ground & Décor Holdings.
Booz Allen Hamilton confronted strain in the course of the interval, not because of basic enterprise weak point however relatively considerations surrounding the Trump administration’s proposed Division of Authorities Effectivity (DOGE). Led by Elon Musk and former Republican presidential candidate Vivek Ramaswamy, DOGE has been mandated to curtail authorities spending, together with funds to authorities contractors like Booz Allen Hamilton, which derives almost 100% of its revenues from the U.S. authorities. Whereas we view these considerations as extra noise than actuality, we’re monitoring developments carefully and can react accordingly.
TopBuild, a U.S. market chief in insulation distribution and set up companies within the residential building, business, and mechanical insulation markets, was weak over the quarter after posting tender quarterly outcomes. We imagine the corporate presents publicity to secular tailwinds from years of underbuilding in new properties and a high-return enterprise mannequin that ought to show extra resilient than conventional homebuilders.
Hamilton Lane is a non-public markets advisory and funds enterprise serving primarily institutional traders. A sturdy performer for the higher a part of 2024, the inventory got here beneath strain within the again half of the quarter, which coincided with rising charges in anticipation of the Fed pulling again on its 2025 fee lower expectations. We preserve our perception that the corporate is well-positioned given the expansion in personal markets throughout asset lessons, in addition to Hamilton Lane’s extremely sturdy and recurring price income and price earnings.
Portfolio Exercise
In the course of the quarter, we initiated new positions in Rambus, Entegris, Bentley Methods, Perception Enterprises, Pure Storage, Willscot Holdings, and Dutch Bros. We additionally added to a number of present positions.
Rambus performs a foundational function in fueling innovation within the knowledge heart and server environments, serving giant reminiscence OEMs (Authentic Tools Producers) and hyperscalers. With its fabless mannequin, Rambus generates sturdy free money move whereas sustaining a gradual R&D reinvestment to maintain its industry-leading reminiscence interface chips and silicon IP options. We estimate Rambus is well-positioned to compound earnings and free money move per share at a high-teens fee via the cycle.
Entegris is a number one provider of supplies and course of options targeted totally on the semiconductor {industry}. The corporate has developed experience in varied chemical substances, gases, and filtration options that assist probably the most superior semiconductor progress manufacturing processes. The enterprise has lately seen weaker-than-expected progress in its mature nodes enterprise, which we count on to normalize into 2025 and 2026. General, we expect supplies, fuel filtration, and dealing with—all Entegris core competencies—shall be more and more vital in enabling semiconductor {industry} advances. We count on Entegris to ship sustainable high-teens EPS progress on the again of double-digit income progress and margin enlargement from working leverage.
Bentley Methods is a long-established chief in infrastructure engineering software program—particularly horizontal infrastructure networks equivalent to roads, bridges, rail and transit, water and wastewater, utility grids, and the sources sector. Over 40 years, Bentley has developed complete options for infrastructure engineering, protecting all elements of a challenge lifecycle. The corporate is actively extending its moat by investing in new applied sciences like digital twins (digital fashions of a bodily object, course of, or system that makes use of real-time knowledge to simulate its habits in the actual world) and AI to reinforce its choices and deal with the rising demand for infrastructure and asset intelligence. Bentley solely went public in late 2020 however has an extended monitor file as a traditional compounder, reaching a +8% CAGR (Compound Annual Progress Price) in whole revenues over greater than 20 years. Bentley boasts excessive and increasing working and free money move margins, a resilient steadiness sheet, sturdy returns on capital, and a extremely recurring income mannequin. We imagine we’re paying a good FCF (free money move) a number of for a mission-critical, secure enterprise benefitting from a number of secular tailwinds and guided by an aligned, long-term-oriented administration group.
Perception Enterprises is a world supplier of IT options to small- and medium-sized companies throughout varied finish markets. Perception has developed capabilities in {hardware} administration and software program and companies and has demonstrated a powerful long-term monitor file of double-digit returns on invested capital and sturdy free money move era. The corporate has cemented itself as a crucial accomplice to its shoppers’ digital transformation initiatives. Our analysis suggests Perception will profit from a return to regular IT spending ranges within the coming years as firms prioritize {hardware} upgrades and proceed emigrate workloads to the cloud. We estimate Perception will compound earnings per share at 18% over the subsequent 5 years, pushed by its deep buyer relationships and main cloud companies enterprise.
Pure Storage gives knowledge storage options primarily to enterprise prospects with personal clouds and, extra lately, hyperscalers. Pure stands out as a high-performance, all-flash storage supplier with no legacy onerous disk enterprise. Its aggressive benefit stems from its DirectFlash modules, the custom-built NAND flash chips managed by the corporate’s proprietary Purity software program. DirectFlash’s benefits embody greater storage capability, longer life span, and higher efficiency with decrease latency. This interprets to a premium, high-performance providing that generates excessive gross margins of ~70%, which we count on to develop over time. Though enterprise knowledge storage demand has been muted in comparison with computing or server demand, we imagine storage demand will speed up, pushed by GenAI and general IT spending restoration. Traditionally, enterprise prospects have been keen to pay up for efficiency, whereas hyperscalers opted for low-cost, bulk storage options. This dynamic is shifting as Pure’s all-flash storage system permits for superior power financial savings in comparison with conventional onerous disc storage. Consequently, Pure has received its first hyperscaler contract, and we count on such success to proceed. The online result’s rising EPS and money move. We count on Pure’s earnings to develop at a 20% CAGR with growing returns on invested capital.
Willscot Holdings gives turnkey area and storage options with main market share in North America, serving prospects via 250 department areas. The corporate presents cell workplaces, transportable storage containers, climate-controlled storage, clear-span constructions, and related companies, together with supply and set up. The enterprise mannequin is extremely predictable as belongings are leased with a mean length of three years—this stability has enabled administration to allocate capital successfully. Building markets (industrial, non-residential, and residential) have been sluggish over the previous couple of years, and we anticipate an improved quantity backdrop forward. We count on this, mixed with continued pricing positive factors via greater connect charges of their Worth-Added Companies, to result in mid-teens EPS progress over the subsequent 5 years.
Dutch Bros, a drive-through espresso and beverage firm with almost 1,000 areas, reported compelling quarterly outcomes, elevating its full-year income and EBITDA (Earnings Earlier than Curiosity, Taxes, Depreciation, and Amortization) steering. Strong same-store gross sales and regular unit progress have pushed top-line progress of +28% year-over-year. Earnings progress seems poised to speed up as the corporate ramps up unit progress in 2025, innovates its menu (into the untapped alternative to drive meals gross sales), and margins inflect greater with scale. We imagine it’s nonetheless early days for Dutch Bros, which has a novel idea and is simply beginning to faucet into confirmed worth drivers like on-line ordering and meals. We imagine Dutch Bros has the potential to be a considerably long-duration EPS (earnings per share) progress enterprise.
We eradicated six positions—Euronet Worldwide, Aspen Know-how, Fox Manufacturing facility Holdings, Tyler Applied sciences, Clearwater Analytics, and Alarm.com—and trimmed a number of present positions.
We exited Euronet Worldwide given our warning in regards to the existential challenges dealing with its ATM enterprise because of the speedy shift towards a cashless society. We imagine this limits the corporate’s appreciation potential even when the basics stay engaging. Whereas we nonetheless see Euronet as a high-quality enterprise, we recognized higher alternatives for our capital.
We exited our place in Aspen Know-how because of its introduced acquisition, which we expect limits its future return potential.
We offered our place in Fox Manufacturing facility Holdings, which has been an unsuccessful funding. Fox Manufacturing facility makes high-end shocks for bicycles and powered autos. The corporate was negatively impacted by pandemic disruptions within the bicycle provide chain.
Whereas these headwinds have abated, the corporate faces extra weak point in its powered autos section, which we count on to proceed because of rising supplier inventories and a myriad of points on the auto OEMs. Given new inventory concepts, we imagine Fox Manufacturing facility will climate this difficult interval, however we don’t see it as the most effective alternative for our capital.
Over a number of quarters, we now have used our funding in Tyler Applied sciences as a supply of funds and totally exited our place within the quarter. We see it as a high-quality, engaging enterprise targeted on software program serving the general public sector, which has been a profitable funding in our view, reaching a $25B market cap. Nonetheless, we view the inventory’s return potential as much less compelling following its sturdy efficiency.
We moved on from Clearwater Analytics after substantial share value appreciation led to valuation ranges that diminished its relative attractiveness within the portfolio.
Lastly, we exited our place in Alarm.com, the cloud, SaaS-based (Software program as a Service) software program platform for residential and business safety firms. Whereas we nonetheless view Alarm as a high-quality enterprise, the EPS progress and return profile not evaluate favorably to newer concepts in our pipeline. Per our greatest concepts and alternative cost-driven mindset, we offered out of the place.
In the course of the quarter, we added to and trimmed present holdings that largely mirror the chance price mindset famous above. We added to positions with higher risk-reward profiles and stronger Flywheels and trimmed positions primarily based on valuation to fund new positions and add to present holdings. We added to our positions in Booz Allen Hamilton, Paycom Software program (PAYC), Ground & Décor, and Trex (TREX) and trimmed positions in Goosehead Insurance coverage, Houlihan Lokey (HLI), and Hamilton Lane.
Outlook
Seeking to 2025 and past, we’re optimistic about our Portfolio firms’ EPS progress outlook and the comparatively low valuations for SMID cap shares. We predict enterprise fundamentals will seemingly proceed to enhance because of rising proof suggesting 2024 was the EPS backside for SMID caps broadly, and the M&A market could proceed to enhance on early positive factors in 2024. Underneath the Trump presidency, we imagine diminished regulation and prioritized home companies could disproportionately profit SMID cap firms, which derive most of their income from the U.S.
We don’t count on persistent uncertainty to restrict our capacity to attain our long-term return targets, as the basics of our Portfolio companies and potential for superior earnings progress will finally drive the shares. Whereas we will’t predict how 2025 will unfold, we’re ready for continued volatility with financial uncertainty and shifting rate of interest expectations. We goal to spend money on resilient companies that may self-fund their progress. It is a key tenet of our Flywheel funding standards, which we uphold in good instances and dangerous.
Thanks in your curiosity in Polen Capital and the U.S. SMID Firm Progress Portfolio. Please contact us with any questions.
Sincerely,
Rayna Lesser Hannaway, CFA
Whitney Younger Crawford
Essential Disclosures & Definitions:
Disclosure: This commentary may be very restricted in scope and is supposed to offer complete descriptions or discussions of the subjects talked about herein. Furthermore, this commentary has been ready with out making an allowance for particular person targets, monetary conditions or wants. As such, this commentary is for informational dialogue functions solely and isn’t to be relied on as authorized, tax, enterprise, funding, accounting or another recommendation. Recipients of this commentary ought to search their very own unbiased monetary recommendation. Investing includes inherent dangers, and any specific funding just isn’t appropriate for all traders; there’s all the time a danger of dropping half or your whole invested capital.
No assertion herein must be interpreted as a proposal to promote or the solicitation of a proposal to purchase any safety (together with, however not restricted to, any funding automobile or separate account managed by Polen Capital). Recipients acknowledge and agree that the data contained on this commentary just isn’t a suggestion to spend money on any specific funding, and Polen Capital just isn’t hereby enterprise to offer any funding recommendation to any individual. This commentary just isn’t supposed for distribution to, or use by, any individual or entity in any jurisdiction or nation the place such distribution or use can be opposite to native regulation or regulation.
Until in any other case acknowledged on this commentary, the statements herein are made as of the date of this commentary and the supply of this commentary at any time thereafter won’t create any implication that the statements are made as of any subsequent date. Sure info contained herein is derived from third events past Polen Capital’s management or verification and includes vital parts of subjective judgment and evaluation. Whereas efforts have been made to make sure the standard and reliability of the data herein, there could also be limitations, inaccuracies, or new developments that would impression the accuracy of such info. Subsequently, this commentary just isn’t assured to be correct or well timed and doesn’t declare to be full. Polen Capital reserves the best to complement or amend these slides at any time, however has no obligation to offer the recipient with any supplemental, amended, alternative or extra info.
Any statements made by Polen Capital concerning future occasions or expectations are forward-looking statements and are primarily based on present assumptions and expectations. Such statements contain inherent dangers and uncertainties and should not a dependable indicator of future efficiency. Precise outcomes could differ materially from these expressed or implied.
The Russell 2500® Index is a market capitalization weighted index that measures the efficiency of the small to mid-cap progress section of the U.S. fairness universe. It’s comprised of two,500 of the smallest securities within the Russell 3000® Index. The index is maintained by the FTSE Russell, a subsidiary of the London Inventory Alternate Group. It’s unimaginable to take a position straight in an index. The efficiency of an index doesn’t mirror any transaction prices, administration charges, or taxes.
Previous efficiency just isn’t indicative of future outcomes.
Supply: All knowledge is sourced from Bloomberg except in any other case famous. All company-specific info has been sourced from firm financials as of the related interval mentioned.
Definitions:
Flywheel framework: Polen Capital’s framework to evaluate an organization’s high quality aimed toward supporting sustainable progress. It’s comprised of 5 self-reinforcing parts: 1) distinctive positioning, 2) repeatable gross sales course of, 3) sturdy enterprise mannequin, 4) efficient administration, and 5) value-creating reinvestment.
Fabless: a enterprise mannequin wherein an organization designs and markets semiconductors however outsources manufacturing to third-party foundries. This mannequin permits the corporate to give attention to innovation whereas counting on companions to supply the chips.
Mature nodes: an older semiconductor manufacturing course of with bigger characteristic sizes that’s cost-effective and extensively used for purposes like automotive and analog gadgets, the place modern efficiency just isn’t required.
Authentic Tools Producers (OEM): an organization that produces parts or merchandise which can be utilized in one other firm’s finish merchandise. OEMs may manufacture {hardware} or components which can be built-in into gadgets offered beneath one other model’s identify. Within the tech {industry}, it typically refers to producers supplying components like chips or software program to bigger system producers.
Hyperscalers: giant expertise firms that construct and function in depth, scalable cloud infrastructure to assist sturdy computing, storage, and networking capabilities. They supply cloud companies to companies and people, enabling speedy scaling of sources.
EPS Progress: the proportion improve in an organization’s earnings per share over a selected interval, indicating its profitability progress and talent to generate greater earnings for shareholders.
Compound Annual Progress Price (OTC:CAGR): annual fee of return that may be required for an funding to develop from its starting steadiness to its ending steadiness. Calculated by annualizing the speed of return over the measurement interval.
Free money move a number of: a valuation metric evaluating an organization’s market cap to its free money move, indicating how a lot traders are keen to pay for every greenback of free money move the corporate generates.
Headwind: an element or situation that may impede the efficiency or progress of investments, sectors, or complete economies. These obstacles could possibly be financial, political, or market-related and might negatively have an effect on funding returns.
Tailwind: a good situation or issue that may propel asset costs or monetary markets upwards. These can embody financial progress, technological developments, regulatory adjustments, or different exterior influences that improve the efficiency of investments.
Earnings Earlier than Curiosity, Taxes, Depreciation, and Amortization (EBITDA): a metric used to find out an organization’s monetary efficiency and gauge its profitability earlier than non-core bills and prices. It’s calculated by taking internet earnings and including curiosity, taxes, depreciation, and amortization again to it.
Contribution to relative return: a measure of a safety’s contribution to the relative return of a portfolio versus its benchmark index. The calculation might be approximated by the under method, making an allowance for purchases and gross sales of the safety over the measurement interval. Please observe this calculation doesn’t have in mind transactional prices and dividends of the benchmark, because it does for the portfolio. Contribution to relative return of Inventory A = (Inventory A portfolio weight (%) – Inventory A benchmark weight (%)) x (Inventory A return (%) – Mixture benchmark return (%)). All company-specific info has been sourced from firm financials as of the related interval mentioned.
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