Q: David, how did you get started as a money manager?
A: For me, the process was an evolution that took over fifteen years. I started my investment career 34 years ago, as a stock broker in New York. In 1979, I founded Polen Capital Management Corporation (PCM). Initially PCM was basically a brokerage firm. In the early 1980s, I became exposed to the Graham and Dodd school of value investing. It dates back to 1934, when Graham and Dodd co-wrote the textbook “Security Analysis.” My study of Graham and Dodd led me to Warren Buffett, another great mind in the investment world, a student of Mr. Graham’s, who is better known than Graham or any other investor. I immersed myself in the various books, articles and other sources of information by and about these great minds. Mr. Buffett’s writings are contained in his Berkshire Hathaway letters to shareholders and I believe they should be required reading for any serious investor. PCM's investment objective was when I started, and is to this day, to produce consistent returns in excess of the market and most other money managers while incurring moderate risk, and we’ve accomplished that goal over the years.
Q: You certainly have. In fact, you’ve outperformed your benchmark, the S&P 500, for most of the last decade.
A: I believe we are one of the very few managers to have outperformed the S&P 500 Index in nine out of the last ten years and in each of the last seven. We are very proud of this record.
Q: Would you please describe Polen Capital’s investment methods and how they are modeled after those of Benjamin Graham and Warren Buffett?
A: This is a great place to start. It is true that the foundation of our approach to investing is modeled after the teachings of Benjamin Graham and the methodology of Warren Buffett. And we are very pleased that our application or interpretation, if you will, of their methods has produced excellent results for our clients over the years. As I said before, this is my 34th year in the investment business, so I’ve had quite a bit of time to reflect on the investment scenario. Our interpretation of Graham and Buffett begins with their approach to the investment process and we’ve learned that if you stay within that framework, you’re going to be successful over time. There are three principal themes that together have created a successful investment discipline for us: our attitude towards the stock market; margins of safety; and investing in businesses, not just stock shares.
Q: Warren Buffett’s creed is to buy a business, not a stock. How does your investment style reflect that philosophy?
A: That is exactly where I was headed. Our intellectual framework is that whether you are buying 100 shares or 10,000 shares or 1 million shares of a business, you are now a part-owner in that business. You may own a very small stake, perhaps a tiny fraction of a percent, but you are an owner. As an owner, you should prosper as the business prospers. With this perspective, your thinking and actions all become very long term. It would be no different than if we invested in a private company, perhaps a car wash or a pizza parlor, which you and I owned 50-50. As the business did well over the years, we would both prosper from the increased profits the business produced. We approach investing in common stocks no differently. Of course, owning small pieces of public companies listed on the New York Stock Exchange or the NASDAQ has the convenience of an easy exit. But, if you changed your mind every night, or very often, about being an owner, the chances are you wouldn’t likely be very good at investing. We believe this is the proper perspective. This mindset in and of itself, in my opinion, puts you way ahead of most stock market participants, and is a big advantage.
Q: Do you apply the equivalent of Buffett’s and Graham’s “margin of safety” concept to your investments?
A: Absolutely. The second theme or concept we adopted from Graham and Buffett was their “Margin of Safety” attitude. It was Graham who coined the term yet each investor may practice it slightly differently, as did Buffett from Graham, and as we practice it differently from both Graham and Buffett. Buffett actually has an interesting way of relaying it. He says: “There are only two rules to investing - (1) Don’t lose and (2) Don’t forget the first rule.” On the surface this statement may seem comical, but if you think about it, it is really quite profound. If you don’t place yourself in a position to lose, you can only profit. I believe we have been very successful because throughout our history at Polen Capital Management, we have not had any big losers. That is not to say that we haven’t made any mistakes - we have. But we have never had big losers and I believe strongly that this is a central point to successful investing.
Q: Do you pay attention to overall economic developments such as changing interest rates or inflation when you invest?
A: That is a good question as it relates somewhat to our mindset about the market. While we are knowledgeable about overall economic developments and changes in interest rates and inflation, it is important to understand that we do not make any economic or interest rate predictions, or try to forecast what the stock market will do tomorrow, next week or during the next twelve months. We don’t believe that there is any way to forecast these items accurately. It would be like me trying to tell you what part of your car is going to break down next. I’m sure I could eliminate the extreme cases, but the exact cause would be tough to pick because there are too many moving parts and too many unknown variables. The world and the stock market are just like this, so we don’t exert the energy, and we’ve found it’s not necessary to produce excellent results. Benjamin Graham wrote about short-term stock market movements in his terrific book “The Intelligent Investor.” In essence, he says that the intelligent investor should not necessarily concern him or herself with the daily price fluctuations of the stock market or a particular stock. The stock market is there to serve you, as the investor, when you believe there is an opportunity to purchase a great business at an acceptable price or sell a business in your portfolio whose fundamental outlook has changed. Aside from that, most all of the other day-to-day activity should be ignored because it usually has very little to do with the long-term direction of the business.
Q: Tell us about your Systematic Valuation Discipline.
A: OK, but first let me tell you about our criteria in selecting stocks for our portfolio. We look for high-quality businesses that are going to be very successful over many years. The reasoning is that if the business becomes stronger and more profitable, the stock price will rise to reflect that, and we will benefit as owners. Now how can you tell today which companies will be successful in the future? It is not a perfect science by any means, but we have found that high-quality businesses offer this potential and do so at relatively moderate levels of risk to the owner. Our proprietary Systematic Valuation Discipline (SVD) helps us to define high-quality and low-quality businesses. It is a process designed to provide a measurement of a business’ intrinsic value in relation to its share price. The higher the quality of the business in terms of financial strength, free cash flow, earnings growth and internal rate of return, the higher the intrinsic value. Importantly, our SVD discipline allows us to continually employ the same rigorous analytical process on all the companies that are in our universe and construct portfolios based on this same consistent discipline. When we look for a business worth buying, we want one that will provide good profit opportunity for the investor over time, without offering a great deal of risk.
Q: What is the first step in identifying the companies that fit your valuation model?
A: The first step in our SVD process is to look at profitability and financial strength. We like to focus on companies that produce what we call “free cash flow”, companies that are able to produce cash far in excess of all of the needs of the business. Second, and equally as important, companies we invest in must have very high returns on invested capital or return on equity. And of course these are companies that have outstanding financial strength. These companies are like works of art in terms of financial strength. They are cash-rich, they have little debt and little need for outside capital to finance reinvestment in the future of their business. When a company meets these basic criteria, and you look behind the numbers, you will most likely find that the company has had and continues to have a very strong business franchise.
Q: Would you describe your methodology as bottom-up or top-down, and why?
A: We are clearly a bottom-up manager. After a company meets the important SVD criteria, we will spend our time studying the business and its competitors. We perform a fundamental review of the business, which may require a visit with the company in order to make a judgement as to that company’s ability to continue to earn high returns on capital and generate excess free cash flow.
Q: How much emphasis do you put upon knowing a company’s management team?
A: A lot, since outstanding management is critical. We will study the history of a management team to understand its track record. Good management is critical because the excess free cash flow generated by the business must be spent intelligently. And human nature being what it is, management can do foolish things with the excess profits. We have seen many, many examples of this. A team’s ability to allocate capital with intelligence and honesty is key.
Q: Are you as interested as Graham in favoring companies paying consistent dividends?
A: We believe that dividend payments are one way to return capital to the owners. We would much rather have our businesses reinvest their profits back into the business if they can continue to earn high returns. If they cannot, we would prefer that the company repurchase its stock at a reasonable price since the current tax law favors this return of capital option. Dividends are taxed at ordinary rates, which can run up to 40%, while long-term capital gains to the investor are levied at only 20%.
Q: When do you know it is time to sell a stock?
A: Optimally, the time to sell a stock is never. In our research to determine whether we want to invest in a business, we focus on looking out five, 10, 15 years at a minimum. Once we decide to invest, if the business is operating in line with our expectations and becoming stronger and more profitable over the years, we never have to make that sell decision. So, our preferred holding time is forever. Historically on average we hold businesses in our portfolios for over six years. Some we’ve held more than nine years and are still holding today. Having said that, we will get rid of a business rather quickly if management begins a pattern of reinvesting the excess free cash flow unwisely or if a fundamental shift or deterioration occurs in the business. Also, from time to time, we encounter a better business opportunity and to take advantage of it we need to sell a position or a partial position.
Q: How do you apply the methods of Graham and Buffett in today’s market, when the market favors high technology companies with astronomical price to earnings ratios?
A: The principles of Graham and Buffett, in our opinion, will never fade away. Those principles are quite simply, the most logical approach to intelligent investing. Over time, however, their specific application will change to reflect the business landscape of the day. When Mr. Graham was investing, most of the business landscape was made up of industrial, asset-driven, heavy plant and equipment businesses. Mr. Buffett, who is the most successful investor of our time, created tremendous wealth by investing in companies with great business advantages, such as newspapers, and great brands, such as Coca-Cola (KO). Today, it seems that the business landscape is re-orienting towards companies who heavily invest in R&D that results in patents or intellectual property. But the same rules apply. Those businesses that can sustain very high returns on their investment for the longest period of time will create the most value for their owners. That’s what we are looking for in our investments. So I would say that Buffett and Graham’s principles are as fresh and current as ever.
Q: Graham was a proponent of diversifying portfolios into bonds and stocks. Do you also follow this rule?
A: At Polen Capital, we are only concerned with investing in equities. Our specialty or forte is finding great companies for that portion of client assets allocated to common stocks.
Q: Buffett’s a proponent of maintaining a relatively small number of carefully chosen stocks. I see your portfolio contains what some might consider a concentrated portfolio.
A: I guess concentration is like beauty, it’s in the eye of the beholder. We typically hold 15-20 great companies in our portfolios at any one time. We strongly believe you can achieve the benefits of diversification with this number, if you focus on investing in high-quality companies. It makes sense. If you have a strong conviction that a business has a bright future and is operating from a position of financial strength, you should invest a meaningful amount so you can benefit significantly as the company grows stronger over the years. If your portfolio contains 40 or 50 or 100 stocks, then even if you invest in a truly spectacular business, and the stock price doubles in a year, the stock only makes up one or two percent of your holdings. So you are only going to add 1 - 2% to the overall value of your portfolio. That doesn’t make a lot of sense to me, not if you feel confident in the business and your investment discipline. Remember, Mr. Buffett made an enormous fortune by concentrating in very few companies, usually five or six. It’s hard to argue with that.
Q: What about the increased risk in owning fewer stocks?
A: What increased risk? The common perception in investments is that the fewer stocks you hold in your portfolio, the more risky the portfolio becomes. Now, we could spend considerable time debating how one should really measure risk, but let’s say for matters of this discussion that it is the volatility of the portfolio, as measured by the standard deviation. If you look back at our results, historically, going back over many years, you will clearly find that we actually took less risk than the market and most other equity managers who held more diversified portfolios. The common perception isn’t always true. I believe that we have significantly reduced the risk by investing strictly in high-quality companies and staying invested in them for many years as they prosper. Also, remember that we haven’t had any serious losers over the years, which has certainly helped. That all goes back to Buffett’s two rules of successful investing.
Q: Would you like to add any final comments in closing?
A: I’d like to just reiterate that our success has been a direct result of our intellectual framework that stocks are really just business investment opportunities. Our discipline identifies high quality businesses within this intellectual framework. Although I have no way to predict what the stock market will make available to us in future years, I have the confidence that it will offer us good opportunities. By staying well within our discipline we will be successful.