Most small-cap growth investors are looking for the next great large-caps. That’s certainly true of Rayna Lesser Hannaway, a portfolio manager and analyst at Polen Capital, which oversees about $61 billion in mutual funds and separately managed accounts. The goal is to find high-quality companies early, she says, “and begin to enjoy their great long-term compounding.”
Hannaway has been doing just that for more than 25 years, including the past six at Polen, where she runs about $400 million and manages two mutual funds, the $81 million
Polen U.S. Small Company Growth
fund (ticker: PBSRX) and
Polen U.S. SMID Company Growth
(PBMIX), a $20 million institutional fund launched in 2021. (The acronym stands for small- and mid-cap.)
It has been a challenging few years for small-cap stocks, and Hannaway has the scars to prove it. U.S. Small Company Growth lost almost 43% last year, according to Morningstar, placing it in the fourth quartile in its category, although it was up 50% in 2020 and about 16% in 2021. The fund has returned 6.5% this year through May 9, putting it in the first quartile among its small-cap growth peers.
In an April 21 interview, Hannaway explained how she picks stocks and why she expects small-caps to rally. She also discussed three small companies poised to grow much larger in coming years.
An edited version of the conversation follows.
Barron’s: What was your path to Polen?
Rayna Lesser Hannaway: I began my career at Lord Abbett in 1996, working on their small-cap growth team. Later, I went to Jennison Associates, and then spent more than 11 years at Fidelity Investments. Before joining Polen in 2017, I took some time to pursue some of my passions, including investing in real estate and renovating homes.
In my first assignment as an analyst at Lord Abbett, I had the good fortune to cover software, internet, and IT [information technology] services stocks. It was an exciting time. I had a front-row seat to the dot-com boom and bust. I covered companies like
Amazon.com
[AMZN] and
Netflix
[NFLX] when they were small-caps. I also saw a lot of companies fail.
In hindsight, what distinguished the winners?
What impressed me then, and many times since, is that when you are investing in small companies, it is essential to focus on those built to last. In that regard, management teams are critical. Many management teams of the small-cap companies I covered had great vision, but they didn’t have the skill to execute on that vision. They didn’t have the necessary financial foundation or fiscal discipline. The management teams of the companies that survived that time and grew a lot larger were adaptable in the face of changing customer preferences and financial conditions. They operated from a position of financial strength and were able to get others behind them.
How do you identify future winners today?
I love high-quality companies with secular tailwinds that are superinnovative and have room to grow. That dovetails with Polen’s philosophy; we own high-growth, high-quality companies and do it in concentrated portfolios. We focus on owning the 30 or 40 best names we can find, and often hold them for five years or longer.
Concentration is pretty unusual for small-cap portfolios. I believe that the only way you can have a high-quality portfolio in small-caps is by taking a concentrated approach. The benefits of diversification are often misunderstood.
We look for companies with durable competitive advantages, operating in industries that lend themselves to competitive advantages. We also want these companies to be leaders in what they do, and solve a real customer problem.
What else do you look for?
We look for companies with a repeatable sales process. I’ve seen many companies that got lucky. We don’t want those. We want process-oriented companies that can continue their success by repeating the same steps taken to deliver success in the past.
Also, we look for a robust business model, which means the margin structure is conducive to generating a lot of cash. We want companies that are generating enough cash to fund their future growth. This is important today, when capital is hard to come by. And we like effective management teams, which have the right balance of strategic vision, executional know-how, financial discipline, and capital-allocation skills.
What metrics do you use in screening for companies?
We look at margin metrics including gross profit margin, operating margin, Ebitda [earnings before interest, taxes, depreciation, and amortization] margins, and more. The combination of several metrics and the corresponding scoring and ranking is more valuable to us than any single number. We like to invest in companies with good returns on invested capital. We consider a good ROIC to be around 15% or higher, sustained for several years. Among more-developed businesses, we like to see free-cash-flow conversion of 90% or more. That refers to how much of a company’s net income is available as cash.
Screening, however, is just the beginning of our process. Many companies that stand out in screens don’t make it into the portfolio because when you pull back a few layers, the drivers of growth don’t look sustainable. There must be lasting competitive advantages that match our long holding period. The good thing is that with our concentrated approach, we have the luxury of saying no more often than we say yes.
Given small-cap stocks’ losses in the past few years, is this a good entry point for investors?
In 2022, small-cap valuations became extremely attractive on both an absolute basis and relative to large-caps. We saw the small-cap growth universe begin to outperform large-caps starting in June. The outperformance lasted through February, which was something of a surprise to us. We have been talking for a long time about how we believe we may be on the front end of the next small-cap supercycle. In seven out of the past 10 years, large-cap growth beat small-cap growth. That equated to five percentage points of annualized underperformance from 2013 through 2022.
But what we know from looking at past cycles is that often, small- and large-caps trade off leadership. These leadership cycles last for long periods of time. Typically, leadership changes when you get a change in financial conditions, as we have recently seen. We also know from looking at past performance that small-caps tend to do well when we’re in the second half of rate-hiking cycles, and also when inflation is high but falling.
It is essential to be discerning, however, when picking small-cap companies, and I am by no means making a call to buy all small-caps. More than 40% of the small-cap universe is loss-making companies, or highly leveraged companies that need external capital to grow, or companies with inexperienced management teams that don’t have the chops to navigate this tough environment. But one counterintuitive aspect of small-caps is that the best companies can be more resilient than larger companies in the face of economic downturns. The right ones are more agile.
Let’s look at some companies you own, such as
Yeti Holdings
[YETI]. What makes you sure it won’t become just another consumer cyclical that grows slowly and faces earnings risk in rough economic cycles?
Many consumer-discretionary stocks are on sale right now, but there are good opportunities amid the pessimism. Yeti is an example, and the stock could double over the next three to five years. Yeti is a premium outdoor lifestyle brand. It is best known for coolers and drinkware, and also sells some bags and other accessories. We are excited about the brand this company has built, and its customer loyalty. We believe this gives Yeti license to innovate in new categories.
Overall, we expect low-teens annual revenue growth from Yeti over the next five years, with steady incremental margin improvements coming from a continued mix shift that we are seeing toward the direct-to-consumer sales channel. Yeti wants to own more of the customer relationship and take out the middleman. The business is capital-light and has a great return on capital. Yeti’s ROIC has been temporarily depressed but is normally above 20%. It could be 20% to 30% in the future.
Five Below
[FIVE], another holding, has been taking market share from competitors. How long can this continue?
Five Below’s pricing strategy, merchandising strategy, and shopping experience that appeals to younger customers allow it to occupy a unique position in the retail market. The stores are always getting new merchandise, and teens and tweens find them a fun place to hang out. The company currently has about 1,340 stores, and management is aiming to triple the store base by 2030.
As we think about long-term store growth coupled with our expectation for low- to mid-single digit comparable-store gains, we believe Five Below can compound its value at a high-teens rate over the next five years. Five Below generated about $3 billion of sales last year. We expect that sales can double in five years. This should translate into earnings growth that could at least double in five years, given modest margin expansion as the company benefits from scale. Margins are already robust; the company has four-wall [individual store] Ebitda margins of about 25%.
What do you like about
Etsy
[ETSY]? E-commerce already has taken a large share from traditional retailers.
While consumer spending is slowing and Etsy is up against difficult comparisons, we are impressed that the company has been able to sustain the gains it made during the pandemic. Etsy has managed to post decent growth largely due to an increase in the take-rate it charges sellers, driven by a price increase and a higher uptake of value-added services. Most of all, we are impressed with the recent trends in active buyers and reactivated buyers and the buyer-frequency metrics, reaffirming Etsy’s relevance with the consumer.
In terms of the future growth of e-commerce, this argument makes sense for more mature e-commerce players. But it likely is less true for Etsy, which is still in the early days relative to its long-term opportunity. Ultimately, Etsy could be multiples of its current size. Etsy still has large opportunities across users, categories, and geographies.
Thanks, Rayna.
Corrections & amplifications: U.S. Small Company Growth fund returned 16% in 2021. A previous version of this article incorrectly said it returned 6.5%.
Write to Jacob Sonenshine at [email protected]
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