Polen Capital JRo Show transcript
Topic: Interview with Dan Davidowitz from Polen Capital on Quality Investing
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Interview with Dan Davidowitz from Polen Capital on Quality Investing
JRo Show podcast transcript:
JOHN
I'm John Rotonti and this is the JRo Show, a podcast that explores what it takes to achieve mastery, sustained performance and longevity. The show hopes to uncover the processes, structures, frameworks and mindsets that professionals put in place to maintain winning performance in their respective fields. Today, I am joined by Dan Davidowitz of Poland Capital. Dan is lead portfolio manager of Poland Capital's focused growth strategy. The Poland focus growth strategy generated net returns of 39% in 2023 and the strategy has some of the best long term returns I've ever come across. The focus growth strategy generated 14% annualized net returns over the last ten years and 14.6% annualized net returns over the last five years. Since inception going back 35 years, the Poland focus growth strategy has generated 13.5% annualized net returns and you can see these returns are remarkably consistent with roughly 14% net annualized returns over five years, ten years, and since inception over 35 years. Dan, welcome to the JRo show.
DAN
Thank you John. Thank you for having me on your show.
JOHN
So glad to be doing this. Dan. I don't normally start with a question about culture, but I'm going to do it here because Poland has been named a best place to work by pensions and investments for eight consecutive years. And I got a glimpse into this culture recently. So, Dan, you and I ran into each other a couple weeks ago at the student investment conference at the University of Alabama, where you were giving a presentation on competitive, competitive advantages. And before your presentation, you and I got to catch up one on one. And we talked a bit about markets, and we talked about a stock, and we talked a bit about thesis drift. And then I asked you about a dear friend of mine that is a superstar analyst at Poland.
JOHN
And you told me that my friend is doing well. And then you went on to tell me that she was supposed to travel with you to visit Thermo Fisher, but that she had to miss the work trip because her husband parent passed away in India. And so my friend had to stay home with their newborn baby. But what struck me, Dan, was that you knew my friend's husband's name and her baby's name while telling me this story. You called her husband and baby by name. And it was in that moment that I realized why Poland is named a best place to work year in and year out. And it was in that moment that I realized that Poland really is family. So my question is, what else can you share about Poland's culture?
JOHN
What makes it such a great place to work?
DAN
Well, John, first of all, I love that we're starting with culture because it's what makes Poland capital unique, I think. And it was your friend's husband's grandparent. But I just only want to correct you because you put it in such detail.
JOHN
I'm glad that you corrected that. Thank you.
DAN
That's one of the unique attributes of our culture, is that we really care about our colleagues. And I think one of the things that our culture embodies is a radical candor approach. Radical candor means we can be open and honest with each other, not in a mean way ever, but in a helpful way that we all want to help each other be better. The only way you can really have radical candor is to really care about your teammates, really care about the people around you, or else it's going to not the candor itself. Your advice, your constructive criticisms are not going to land very well. If my teammates don't believe that I care about them, well, certainly they're not going to care about what I'm delivering in constructive criticism. So in order to be a open and honest place to work, where we can be helpful to each other and deliver candid feedback, you have to really care about each other. And so trust and caring is kind of a unique thing, I think, at Poland Capital that allows us to not only have a great place to work, as we have been highly rated on that, but also that we all become the best versions of ourselves, which makes us the best at what we do for our clients as well.
JOHN
And I love that. It's a culture built on radical candor and striving to become the best versions of yourself. And to do that, it's really built on trust and caring. Dan, tell us about Poland capital.
DAN
Poland capital, as you mentioned, is the portfolio that I managed, which is called focus Growth, was the original flagship Poland capital product that goes back to 1989. The firm itself actually goes back to 1979. Our founder, David Poland, who passed away about twelve years ago, created an investment philosophy that was based on owning a highly concentrated group of very high quality growth companies. David, when he started pulling capital, was in his forties, so he had already been around and on Wall street for a long time. He was a broker. He had made a lot of mistakes in how he invested his clients’ money. It was through this journey when he eventually started his own investment firm. And he learned from all of his mistakes.
DAN
He learned from studying Ben Graham and Warren Buffet. And when he finally got around to what his true investment philosophy was going to be, it was a very disciplined way of investing that takes some of the core tenants of value investing and applies them to growth stocks and we can get into more detail on that if you’d like. What he did was really created this portfolio. What became the focus growth portfolio, which is a 20 to 25 stock portfolio, highly concentrated. But in companies that have to meet very strict financial hurdles, very high quality hurdles, and have to have very unique and persistent competitive advantages and real long term growth to them. So it's a very small subset of the world that we look at for our portfolios, and then we stay very disciplined on that. So David ran the portfolio for over 20 years this way, basically on his own. I came in in 2005, I became a portfolio manager with him, co portfolio manager in 2007, and then I've been leading the product for a long time now about 1516 years.
DAN
And we remain very disciplined doing it the exact same way, same philosophy, same process, a bigger team now doing it. And then Poland Capital has then extended into new products. So my team is our large cap investment team, and we manage three now four products that are mostly separated by geography. And then we have three other investment teams at pull in capital that are separate and autonomous. And there's one up in Boston that focuses on small cap companies. We have an emerging markets team that's based in London and Hong Kong. And then we also have a credit team, which is in Waltham, Massachusetts, actually not too far from our Boston office, that does mostly us high yield, but is extending into other credit products as well. So the firm has become more diversified over the years.
DAN
But one of the key attributes is we have some core tenants. I already mentioned radical candor, but some of the core tenants of Poland capital are autonomy, mastery, and purpose. And so autonomy, you have the ability to do work the way you want to do it. We call it freedom within a framework. So we have kind of guardrails on what you can do, but within those guardrails, you can do it however you want. It also applies to our teams. We have four investment teams, but they're separate. They're autonomous from each other.
DAN
And we have shared services that do the business management, the distribution, the trading and operations. We have that common shared infrastructure, but the teams themselves are autonomous. We believe in mastery, which means everybody should be striving to continuous improvement. Marginal improvements, we actually document those every year. Every employee has three marginal benefits, that there are marginal improvements that they're going for during the year, which, as you’d imagine, is amplified across the 260 employees of Poland capital. And every employee gets a budget every year of over $5,000 that you have to spend on training. And it could be on whatever you want, whatever is going to make you a better person or a better professional. And it doesn’t have to be directly applicable to your job.
DAN
It’s something we want. So every year you get that budget to use, and then purpose. And our purpose is first and foremost to our clients, to make sure that we do all the right things, to allow them to protect and grow their capital, but also to our people, again, to make sure that we are the best versions of ourselves, and then, of course, to our communities. And now we're present in a number of communities, not just where our headquarters is in Boca Raton, Florida, but in the Boston area, in London and Hong Kong. We strive to do the best for our communities, to make them a better place, because that's where we live, right? We want to make the places where we live better. So all of those are kind of part and parcel of polling capital. And there’s a lot more detail, of course, behind that, but that’s the big picture.
JOHN
That was a beautiful overview of Poland capital and how the culture is built on these core tenets, one of them being mastery. And this is a podcast that tries to explore what it takes to achieve mastery and the processes that go into that. So I love that. Another was, um, you know, this idea of freedom within a framework and, and autonomy, which I'm going to ask you about in a, in a second. But I wanted to double back quickly on the three marginal improvements. Do the employees choose those on their own, or are those chosen in conjunction with the help of the, of the manager they report to? How do they choose what three improvements they're going to work on every year?
DAN
Yeah, it's originally chosen by the employee themselves. It's things that they want to improve upon themselves. Of course, the manager will go over them with them to make sure that they are relevant or that they think it makes sense. I would say, without knowing for sure, I would say that 90’ish, 99 maybe percent of the time they stand. What the employee chooses is what they end up doing. Maybe you have your manager or your supervisor, you know, nudging you. They think you might be able to incorporate in there. And these are not giant improvements.
DAN
They're called marginal for a reason. You want to be a little bit better at, or maybe blind spots that you have that you want to start to make progress against. They're not big audacious goals. Right? These are, these are marginal improvements, and it's just something that makes you better. For instance, one of my marginal improvements years ago was to talk a bit less in meetings. And one of the things that I found was I was kind of crowding out my team sometimes. I was the most experienced member of the team, and so I felt like it was my duty sometimes to kind of keep putting opinions forth or keep talking.
DAN
And I was getting feedback from my own team that they didn't really like that. And that's, by the way, again, radical candor that they were not getting enough opportunities to opine. So one of my marginal improvements was not just to not talk as much, but to write down more during the meetings. And what that means is when things would pop in my head that I would normally want to say, I would first write it down so I won't forget it, and maybe if nobody else talks about this, we'll come back to it. But what happened was I started to learn a lot more in those meetings because I was fully paying attention now to what everybody else was saying. Nine times out of ten, somebody else already talked about what I would have wanted to talk about anyway, and they had a slightly different view on it, and that changed my mind or brought me new learnings or something. So this little marginal improvement, talk a little less, write down what you want to say and then listen a little bit more. Pay attention, be intentional.
DAN
I started to see some real improvements in what I was getting out of our meetings.
JOHN
Yeah. And those marginal improvements compound over time and they build up over time. And when you do it across the entire organization, it just speaks to how well run Poland is and what you all are able to accomplish for your investors. So you talked about freedom within a framework. The analysts can go look for businesses that meet what you said were very strict criteria. And you all look at a very tiny subset of stocks in the world, because only a very tiny subset of stocks meet all of your strict criteria. So what types of businesses do you like to buy stock in? What are these guardrails that your analysts have to work inside of?
DAN
Yeah, I'm going to give you a little detail on that. One thing I'll say before I start is the freedom within a framework applies to everybody at pulling capital, not just the investment teams, and not just what they can look at. That's our framework. Right. We have our framework that's based our guardrails. But freedom within a framework applies to every Poland capital person in their specific role. They have kind of an area with which they have to kind of stay within, but then once they're within there, they can figure out the best way to do that. And that applies to your whole life at Poland Capital, which we can also get into later if you'd like.
DAN
When it comes to our team and the framework that you mentioned, we have five guardrails that every company has to meet. You have to meet all five of our guardrails to be included in what? In our portfolios for the large company team. So the five guardrails are number one, you have to have a cash rich balance sheet with very little debt. We really don't like debt at all. We will limit to roughly three times current free cash flow in net debt. So set another way that you'd be able to pay off all of your debt in less than three years.
JOHN
Sure.
DAN
And really, if you look at focus growth, you’re going to see that the portfolio is mostly in a net cash position. Almost every holding is in a net cash position. We want number two companies to have excess free cash flow every single year, not just when times are good. Number three, you have to have a sustainable return on capital above 20%, which is a very, very high hurdle for most companies. We have to have stable to increasing profit margins and we have to have organic revenue growth that’s better than the average company, at least mid to high single digit revenue growth organically. And each one of these hurdles is fairly high in and of themselves. But we string together all five, meet all of these. And when we look for our large company team, were looking at large cap companies across the globe.
DAN
The focus growth strategy is a us centric portfolio. But our team is global. And when we look across the globe, there’s really only about 300 to 350 companies that even meet those guardrails at any particular time in the large cap space. And when we do our research, there is some freedom then within that group to do your research and to figure out what you think are the best ones. Really only about 160 to 170 of those companies do we think have real sustainability that are ones that we understand quite well and are potentially a candidate. When you think about how many large companies there are in the world, we're looking at maybe five to 10% of them as potential candidates for any one of our portfolios. So the universe shrinks very fast just by these quality criteria before we even do our research.
JOHN
Yes, I love how you put numbers around how large your potential. I mean the size of your potential universe. It's not large, it's very small. But you put numbers around the size of your potential universe and then how you whittle that down based on those that you think have what you call a persistent sustainable competitive advantage. And that's even before you start doing the deep research. Yeah, and I just want to mention quickly the emphasis that y'all do place on the persistence and durability of that competitive advantage. I just heard your speech a couple of weeks ago, your presentation you gave, it was the best presentation I've ever heard around competitive advantage. And you talked about not just how to potentially identify one, and you talked about not only the potential sources of competitive advantage, but also how to think about that durability.
JOHN
And I've heard lots of presentations on competitive advantages over the years. And it's something I think a lot about. But it was the best all-around presentation on moats and their sources and the durability of those moats I've ever seen. So it was excellent.
DAN
That's very kind of you, John. I think the competitive advantage, I think we all have a view on what competitive advantage is. A lot of people spend some time on it. It's well documented. Warren Buffett talks about wanting to own castles with large moats around them. So he's really kind of coined that moat term around the idea of competitive advantage. But competitive advantage comes in a lot of different shapes and sizes and a lot of different types, and some of, of them are very durable and some of them are a little weaker, and some of them require a lot more reinvestment than others do. And you have to know a lot of people shorthand it with the terms like narrow moat, wide moat.
DAN
And that's probably a good visual on a lot of them. But what we really want to find are companies that have many competitive advantages, overlapping competitive advantage. Yeah, because sometimes you'll have one nice competitive advantage and then all of a sudden it’s not so much of a competitive advantage anymore because this is the real world, your real businesses that compete in a capitalistic type environment, they’re going to try to get excess profits. So if you have multiple layers of competitive advantage, that’s where the real excitement is, especially when it meets a very large market opportunity. And so those are the kinds of businesses were always looking for, which means were not always going to have the fastest grower in the short term or the most exciting companies. But we're going to have these durable, almost like marathon runner type companies as opposed to the sprinters. We're going to have a lot more of those durable companies that are going to compound for long periods of time. Oftentimes they're not super exciting companies.
DAN
We've owned Accenture now in our portfolio for over 17 years, almost as much time as I've been at Poland Capital. And it is a very durable, unsexy, low teens earnings grower, mid-teens annualized investment return. Its doubling every five years. And I can count the number of times on one hand that a client has asked me about Accenture. It never comes up in conversation, but Accenture is kind of a down the middle pull in capital holding. Theres just like durable, competitive, multi layered competitive advantages, wide open growth potential, very differentiated a product or service that can compound for very long periods of time without a whole lot of headaches or stress. That's the company we're looking for.
JOHN
Trey, I like how you used the analogy of a marathon runner, because these are long duration compounders, long duration growers that have a long Runway of reinvestment, and they have these reinforcing competitive advantages. Just really quickly back to the universe. You and I have been talking, I think, back to 2018 or even before that. And I think at one point you told me that the Poland focus strategy, over its lifetime had only ever owned 200 stocks or something like that over 30 years.
DAN
That number you're quoting is a little high. It's actually, I'm high quite a bit lower than that. The number as of right now, we're in the process of buying one right now. It'll be number 132.
JOHN
Wow.
DAN
We've ever owned. And that includes the 23 that we own right now. And that's an important statistic, not just because we strive to have the lowest number possible. That's not really what the number is, the output.
JOHN
It speaks to the discipline.
DAN
Yeah. And it speaks to the way we think returns are generated, at least for our style of investing. There are lots of ways and lots of great investors that do very interesting and different things than we do. What we’re trying to do is to create earnings growth, a portfolio of mid-teens earnings growth. If we can be disciplined to not pay too much. And were not buying 50 cent dollars here, were buying dollar dollars. But those dollar dollars are compounding at a mid-teens rate. What we’re trying to do is allow the earnings growth to drive the returns of the portfolio.
DAN
You quoted our historical net returns, they correlate extremely well with the underlying earnings growth of the portfolio as well. And that’s exactly what we’re trying to do. So to do that, you want to find companies that can compound for long periods of time, like an Accenture, and you don’t have to continuously replace those companies as long as they continue to compound. So the number that 132 is really just telling you the compounding is happening with a small group of companies that continues to do this for long periods of time. So we don’t have to replace that many of them over time.
JOHN
And you spoke to the correlation. If you’re targeting 15% earnings per share growth at the portfolio level over time and over time you’ve generated 14% annualized returns and that’s after fees on a gross level, it’s probably very, very correlated.
DAN
Yeah, it’s almost spot on, right?
JOHN
Exactly.
DAN
Over almost every five year or more rolling time horizon, you're going to see roughly 15% earnings growth, roughly 15% gross returns in 14 net. Yeah.
JOHN
At the portfolio level, you’re targeting 15%’ish earnings per share growth over time. So let’s just dive a little bit more into the portfolio management philosophy. I think you said you own between 20 and 25 stocks right now. Its 23, I think. What else can you tell us? What’s the average starter position size? What would you consider to be a full position size?
JOHN
And do you hold cash typically or are you typically fully invested?
DAN
Steven? Yeah, I’ll the last part first is we try to stay very fully invested. We don’t really want to have transient cash in the portfolio for a couple of reasons. One, our clients don’t want us to. Most of our clients have separate cash or cash like allocations are the investment with them. In Poland, capital is an equity return. They really want to be fully invested. So that's one.
DAN
The other reason is because if you can compound at 14 15% per year, every 1% cash is a 1415 basis point drag on that form. And so it really doesn’t make sense to do that. And when I looked at our founder, David Poland, he had historically carried around 5% cash in the portfolio. That was a very big headwind to annualized performance when you're compounding over decades. So we decided we're not going to do that. So we keep as little cash as possible. As far as position sizing goes, I will tell you we have a theory on this or what we've done. I can tell you it's evolving, though, because our view is that we haven't been great at portfolio sizing.
DAN
So even though we've had good returns, our sizing hasn't delivered excess return, meaning our highest weights have delivered roughly the same returns as our mid-size and smaller weights. So it basically argues we should have been either equally weighted over time or we just should figure out a better way to create our weighting. So we're trying to figure out a better way right now. But what we typically do is a starter weight would be in the, call it one to 3% range. Building up to an average weight of between four and 6% is normal. And then if we feel like we have a unique set of circumstances that would create the willingness to have a larger position, then we'll do that. That has to be a confluence of four things happening at the same time. We have to have a company that has an unbelievably large competitive advantage.
DAN
We want all companies to have competitive advantage, but it has to be among the best of the best. For us to have a very large weighting. It has to have very fast earnings growth, even for our portfolio. It has to have a valuation that’s very exciting. I’d say we typically buy dollar dollars. It has to be better than that for us to size large. And then it also has to be somewhat timely, meaning there has to be a reason to want to have a large position. Now, I’m not necessarily talking about a catalyst per se, because I know a lot of people like to size based on a specific catalyst.
DAN
But when I say timeliness, I mean more are earnings and revenue growth accelerating. That would be you’re never going to see us size very large, a decelerating growth company, even if the other three criteria are met. If its decelerating, you’re not going to see us make it a large position. So we think we have extremely strong moat growth, very exciting valuation, and a timeliness factor on earnings growth accelerating. Thats when you’ll see us make big positions. Today, we actually have the largest position we’ve ever had, which is a 15% position in Amazon, which we went to about a year ago. We made it that large because we saw a confluence of those four things happening at the same time. It was a very discounted valuation trading at the time at only about 20 times free cash flow.
DAN
We saw a massive inflection cash flow coming, which is happening right now. That's when we'll do that is when we have those things. Now, I mentioned our sizing historically hasn't been a key differentiator for us. So what we're trying to do right now is get a little bit more systematic on those four factors. Can we weight some of those, weight the moat, the growth, the valuation and the timeliness so that it gives us a better idea of what the sizing should be as we rank those things and weight those things. And so we're in a process of figuring that out at the moment. And I think we'll be better at it going forward.
JOHN
Well, that's exciting because the portfolio has done so well over time with these.
DAN
Again, marginal improvements. We can always do that.
JOHN
Exactly. Marginal improvements. That's really exciting and I look forward to seeing how that develops. The other thing I just want to point out to my listeners is just how disciplined you all are with frameworks and guardrails. We started off this show, you talked about the five guardrails, the five checks that every single investment in your portfolio has to meet, and they have to meet all five. Then just now you talked about the four conditions in which you would size up a position and it has to meet all four. And so there's just so much structure and process behind what you and your team do. And I think that speaks to the success that you all have had over time.
DAN
I appreciate that, John. I mean, I think it's always a work in progress, though. I think that's the thing is we look, this is where making probabilistic investments in what are already great proven companies, but we only know their past, we don’t know the future. We hope we have a series of facts that backs up a reason to have a reasonable expectation in the future. But again, these companies operate in the real world with humans making decisions that aren’t always optimal. We have to also be very aware that whatever we’ve done or whatever we are doing may not always be the right way. What got you here may not get you there. We use that term a lot inside of Poland capital.
DAN
We're constantly going back over our processes and getting coaches to come in. We have coaches that are constantly working with us on everything to make it reevaluate what we do. Here at Poland capital, I think there are things that are sacrosanct that we would never get rid of, like our guardrails. Our investment guardrails are very, very important to keep us in a stocked pond of highly advantaged companies. I think you're not going to see a scrap those guardrails, but everything else that we do, we try to be very open minded. Is there a better way to do it? We never want to say, well, we do it this way because that's the way we've always done it. The world changes David Poland investing in 1990 and 1991, it was a very different environment to what we are doing today.
DAN
We're still investing the same way with the underlying philosophy and process behind that. But we're constantly trying to iterate on that process to make it a little bit better, a little bit more thoughtful, a little bit more open minded. So that when times change, we don't just sit there like, sticking our head in the sand and assuming that whatever worked in the pre pc era days is going to continue to work.
JOHN
Yeah. And it's that commitment to becoming the best version of yourselves. How do you think about risk management and managing risk in the portfolio?
DAN
I think the most important thing that we do on risk management is sticking to our guardrails. Right. Because if we stick to the guardrails, even if the business isn't wildly competitively advantaged, what it is going to be is cash rich, cash flow, generative, high return on capital, high margin growth. Right. So even, even our mistakes end up being more opportunity costs than they end up being capital impairments. Because these are still great companies. They have great financial. Just to be included in the conversation.
DAN
You have to have something unique and special and pristine financials. That is first and foremost risk to us is not the variability of the stock prices. Risk to us is the chance of permanent capital loss. And so the guardrails themselves keep us in a much safer place because it keeps us out of companies that have a lot of debt. Debt is very, very risky for businesses out of companies that have undifferentiated products and services that could easily be substituted for a competitor. Highly regulated businesses, highly capital intensive businesses, highly cyclical businesses, those don't meet our criteria. Those are automatically just pushed aside. Those are the risky characteristics of businesses.
DAN
So the genius of what David polling created was he's taking away the riskiest parts of businesses, and all you have left are businesses that have wonderful balance sheets and cash flows and revenue growth. And that's a cool place to start, right. Because it's just harder to lose money in those businesses. Then the next step is really understanding the competitive advantage and what can undo the competitive advantages. How can this business not be great going forward? Almost taking counterfactuals. What would be something that would undo this or make this less good? Maybe a technological change, or maybe a behavioral change of customers or something.
DAN
We have to really think it through and test it. And so we're constantly trying to figure out ways that a company won't be successful going forward. And that's really the key to risk management. Portfolio sizing or looking at borrow factor. We don't do any of that stuff. I understand why people would want to look at those things. But for us, it's about owning the best companies, the easiest way to compound mid-teens type earnings growth, or better, and doing it the easiest possible way. I talk a lot.
DAN
I don't like to quote Warren Buffett because everybody quotes Warren Buffett. I already quoted him once when I talked about moats. But his best quote for me is there's no extra points for degree of difficulty in investing. And I really, truly believe that when we invest we want to really understand the business. We want it to be crayon simple was a terminology that David Poland used to use and I love that terminology. And our best investments have been nothing earth shattering, nothing that we discovered that other people didn't know. Like Visa and Mastercard have been two of our best compounders for long periods of time. Our original investment thesis was people will spend more money every year than they do the year before.
DAN
There's a four to 5% uplift from cash and check going to digital forms of payment every year and they can raise prices three to 5% per year. That was our original investment thesis 15 years ago. It’s still the investment thesis and its actually just happening. It’s not that we discovered anything genius about Visa and Mastercard. We just saw how big the opportunity was, how enormous their competitive advantages are and how long this could go on for. And that was it. That was the key insight on those two companies. All of our big winners are like that.
JOHN
Just real quickly thinking about Visa and Mastercard and going back to your idea of reinforcing moats, multiple reinforcing moats. If you just think about Visa and Mastercard really quickly, they have a globally trusted and recognized brand. That's one I'm sure I'm going to miss some. I'm not an expert. They've got this globally trusted and recognized brand, they've got global scale and then they've got network effects. And those three just reinforce each other to drive that sort of high single digit organic growth that you were talking about.
DAN
Yeah, that's absolutely right. They have multiple levels of competitive advantages. This industry, and those two companies in particular, are about the most competitively advantaged businesses we've ever seen. And that's a lot because that's all we play in, is highly competitively advantaged businesses. It's the reason we've owned both of them for such a long period of time and a meaningful weight in the portfolio. It is. We try to undo it too. We're like, okay, what would it take for someone else to replicate the network or for competing technology?
DAN
For a while, everybody thought blockchain technology might really upend this industry. Part of the problem with the bear cases on companies like Visa and Mastercard is they're often conflating things like interchange and the cost to retailers with what Visa and Mastercard do. Visa and Mastercard don't charge interchange. They make a small network fee off of every transaction. So people think about the two to 3% that the merchant gets charged, and they're always angry over. But Visa and Mastercard make basis points for transactions. The banks are the ones that make the interchange. And you're right.
DAN
We've tried to figure out, okay, if someone wanted to replicate this network, what would it take? You immediately say, well, it's like it's next to impossible for that to happen at global scale with the millions of points of acceptance and hundreds of banks that trust them being able to process transactions with 99.99% uptime and no latency, or to reverse those transactions on a fraud or return situation, and to do it at a cost that is so low, that would be extremely hard. When we were listening to people talk about blockchain technology as a potential disruptor, here we were like, okay, Visa and Mastercard process, or can process tens of thousands of transactions per millisecond. It takes blockchain technology minutes to process transactions and even a much smaller number of transactions. Blockchains only move in one direction. You can't go backwards for fraud or return. There are things that you can't do with blockchain. And then there was innovations for payments that were sort of blockchain that would take the transactions off the chain to speed them up.
DAN
Well, now you're just trying to do it. Visa and Mastercard already do a lot. So I don't understand the. We try. We're always looking for the holes that we can poke in these businesses, and if we find them, we may have to exit at some point. We're not so close minded, but it really is a high hurdle for some of these great companies.
JOHN
Yeah. And I love that you said that. The Warren Buffett quote that speaks most to you is there's no extra points for degree of difficulty. And it brings me back to your presentation again at the University of Alabama, because, so you gave this presentation on moats, and then you gave examples of companies in your portfolio that have these motes. And at the end of the presentation, you took questions from the audience, and someone in the audience said something like, I notice all of your companies are sort of secular growers, meaning that their growth is independent of the economic cycle. And so this person in the audience asked you, do you ever invest in cyclicals? And your answer was just so perfect. If I misquote you, please tell me.
JOHN
But it was something like, we have nothing preventing us from investing in more cyclical businesses. But our goal is to achieve that 15% earnings per share growth at the portfolio level in the easiest way possible, in the simplest path that we can. And you said cyclicals don't offer us that right now. Is that kind of how it happened?
DAN
Yeah, I mean, you hit it on the head. And the other thing I would remind everybody when you think about that is, yeah, we are not against the idea of a cyclical business, especially if there's a secular growth that's well in excess of the cyclical nature of the business. There are a lot of companies that have some cyclicality to them, but there's a giant opportunity for them and we'd be fine owning business. You’re not going to see us owning highly cyclical businesses where the earnings growth just never really has an upward trajectory to it. It just bounces around a mean. If it’s doing that, we have no interest, but if it’s a long term up into the right type growth with a lot of variability around it, that’s fine. But yeah, we want to get it the easiest way that we can. And we just happen to be lucky that we invest in this portfolio in mostly us companies and there’s a lot of, of highly competitively advantaged growth companies.
DAN
It's not like I mentioned, the universe is relatively small, like 100 6170 that we really look at as potential candidates for the portfolio.
JOHN
But that's enough.
DAN
You don't need to have a lot more than that when you're constructing a 20 stock portfolio of advantaged businesses. So we would consider, and we have considered, and we've even owned some businesses that I would argue have some cyclicality to them. But if we don't need to do it, why do it? There's not like a need for us to say, well, we don't have any cyclicals, we should throw one in there or we're going to predict that there's going to be an upswing in whatever infrastructure spending coming so we can invest behind that. With XYZ company, we're not really trying to do that. We're looking for these durable compounders that can go for years and years and years. If we can find those, great. If we need to put in a business that has some cyclicality to it, that's fine too.
DAN
But like you said, easiest possible way is usually the best way. Yeah.
JOHN
To yeah. Dan, how many people are on the investing team at Poland? And are the analysts, generalists or specialists?
DAN
Yeah, today we are an eleven person investment team and yes, we are all generalists by industry sector. We all have different companies, different industries, different sectors under our primary coverage. Most of us also are pretty generalist by geography as well. So we have companies all over the globe. There are some exceptions to that because I run a us centric portfolio, my coverage universe is very us centric. Our PM's that run our international portfolio, Todd and Dan, they're mostly covering companies outside the US, but everybody else is pretty much even distribution in different countries.
JOHN
So your title is lead portfolio manager and analyst. As lead portfolio manager, do you still serve as primary analyst on companies? And if so, how do you split your time between the analyst role and the portfolio manager role, which I assume involves things removed from research, such as travel to meet with clients or other things like that. So can you please discuss your various responsibilities and what percentage of your time they consume?
DAN
Yeah, in a general sense, most of my time is spent as an analyst. I think that's normal for investment teams like us that are fundamentally driven. We are low turnover. We tend to have turnover in the teens, all in, and so we don't have a whole lot of new investment ideas. If you think about that, if our turnover ends up being teens and that includes ads and trims, you're probably only adding one, two, three companies to the portfolio per year with eleven people trying to find that next great business. So most of my time is spent as an analyst. And yes, I do have primary research coverage on about ten or eleven companies. Like I said, mine are mostly us businesses.
DAN
Not all of them are in the portfolio. Some of them are not in the portfolio. And I do try to help out as an analyst for our other portfolios too, even though it's probably to a little bit more limited degree, especially with our international portfolio, because my coverage is mostly us. But if I can help with understanding us companies that compete, some of those international companies, and I do help with that, I really love the process of research. To me it's just fun. I'm a little bit of, I think, a different kind of researcher than a lot of my teammates or a lot of people I know in the investment industry love to just read and read and read. And I've heard some of your previous guests talk about that, being buried in papers and, and reading all day and finding joy out of that. I'm not like that.
DAN
I am not. I do read a lot, but I read in spurts. I don't tend to like, immerse myself for hours at a time. We have these, these lights, you know, we're in a lead building where the lights will go out if there's no motion for long periods of time. Some of my analysts, the lights go out and they're still grinding away, reading in there for hours and hours and hours. And I envy that, I really do. But that's not the way I work. I tend to work in, in like 30 to 60 minutes bursts, and then I need to kind of walk around, move around, interact with people, but I eventually get there with all the information I need to read.
DAN
It just happens in a more choppy fashion, I think, than most other people do. But yeah, most of my time is spent doing research, and not just on the primary companies that I cover, but on everybody's recommendations or coverage for that could be a focus group candidate. So I do a lot of my own work on the same companies that others are working on as well. I try to collaborate with them the best I can. Right now we have a very interesting situation, which has almost never happened, where we have a company that I'm working on with two of my colleagues on our team. It happens to be a company that one of our other teams owns as well in their portfolio. So we're actually doing cross team meetings as well, which rarely happens because there's not that many companies that overlap between our teams. It does happen more and more between our international portfolio managers and our emerging growth portfolio managers.
DAN
But yeah, I spend most of my time working on research. Portfolio management is a very small amount of my time. It's 5% or less of my time. We don't make a lot of decisions on the portfolio because of exactly what we talked about before, that these are companies that are compounding for years and years and years. Usually you let them be for the most part. Client interaction is a pretty big part of my job, and it is for all of my teammates too. Probably more so for the portfolio managers, definitely more so for the portfolio managers than the analysts. But I think it's a crucial part of research too, right?
DAN
Being able to get difficult questions from clients. Our clients never shy away from asking tough questions. And because we run a concentrated portfolio, you get a lot of questions on the individual companies. And if you can't articulate a really strong investment thesis, then maybe you don't have one. Maybe you need to rethink. And some of our clients questions are fantastic. We get really good, thoughtful questions. We write a lot of white papers.
DAN
Now, one of my colleagues, Steve Atkins, is the author of a lot of our white papers. And a lot of those white papers come from client interactions, where we get very thoughtful questions. We want to go back and do some more research on it and put out something thoughtful for all of our clients. I think client interactions are part of the research process now you just have to figure out how to balance all of those things to make sure that you have plenty of time to make sure you're learning about the companies you already own, not missing big things, finding new ideas. You need to figure out how to balance all those. But I think client interactions are crucial. So if I had to proportionate out, I would say roughly 30% of my time is with clients, 5% on portfolio management, and then the balance is research.
JOHN
Yeah. And those white papers that you all publish on your website are excellent. I read them all, sometimes I tweet about them, so I love them. You said that you cover about ten to eleven. You’re the primary analyst on about ten to eleven stocks. Roughly how many stocks do the other analysts typically cover? Is that kind of average across the team?
DAN
No. Portfolio managers tend to cover a little bit less.
JOHN
Sure.
DAN
And the analysts a little bit more. I would say the range is probably between ten and 20 ish. And so ten is a little bit on the low end, 20 would be on the high end, and it's somewhere in between. So averages out to about 15 per.
JOHN
Person and 23 stocks in the portfolio. Very low portfolio turnover. So how many new ideas are analysts expected to pitch each year?
DAN
This is maybe a little bit different than other firms. Analysts are not expected to do that. We're not expecting a certain number of actionable ideas or anything. What we want to do is to make sure that the universe of companies that we think are potential candidates are covered very, very well. And so if nothing that I cover is exciting or something that I think deserves to be in the portfolio, I am not going to recommend any of them. I'm not going to come forth with any of them. But what I am going to do is I'm going to write a research report on them every quarter. If you talk, we have, as I said, roughly 100, 6170 companies that are very actively followed.
DAN
Every one of those companies has a research note written at least once a quarter on them. Those research notes, there's a lot of autonomy here. You write it however you want to write it. The point is to convey to the team the most important aspects of what you know about the business at that moment in time. It doesn’t have to be on an earnings report. It can be, a lot of people do it that way because that’s what they’re in the flow of those companies. But it’s really open, like you write whatever you want. Usually the first time we research a company, because there are the initial research projects that we do, we usually have a deliverable in that case, and its only after probably a few weeks’ worth of work.
DAN
The primary analyst will be asked to present it to the whole team to kind of bring us all along with them. We don't want to have an analyst like 90 yards ahead of us, and we're trying to come from behind to understand the business. So we want them to start the process, bring us up to speed on the 80 20 rule, like what are the most important things we need to know about this business? What does it do? How does it work? What's the competition like, what's the industry like? And then were just going to ask a ton of questions at that first meeting. And it’s the things we would need to know if we wanted to invest in the company.
DAN
So that initial presentation, usually it’s a PowerPoint. I like them to be short, but they can be as long as you want them to be. And were going to ask a lot of questions. We’re not going to have a lot of answers yet. And then the research moves on from there to an iterative process where the analyst is now going to every quarter write a report that’s answering the questions that were, that were brought up. And hopefully over time, we get enough of those answers to then consider it as a portfolio candidate later, and it will likely be represented at some point when we feel like we have enough information, then there’s no votes at those meetings. We don’t have a research committee or anything. It’s our whole investment team that listens and asks a lot of questions and answers.
DAN
But as far as whether or not were going to own a company, that’s just the portfolio manager separately that will say for our product, do we want to own this company? If so, how much would we like to buy? Do we need to source cash from another holding? What would we be doing? So those are separate decisions away from.
JOHN
The rest of the team, just so I understand it. So you have these 160 to 170 companies that the team is really focused on. Each one of those is covered by some analysts, and the analyst will update the team with some sort of write up each quarter on those 160 or 170.
DAN
That's right.
JOHN
And then if an analyst believes a new name should be added to that list, to your investable universe list, for instance, then after a couple of weeks of researching it, they will put together some sort of deliverable a write up or a PowerPoint and present it to the team. And then from there. If the team thinks it's worth researching more, they'll continue to research it and it becomes an iterative process and they build up their knowledge on that name over time. Is that right?
DAN
Yeah, that's exactly right. And we have, our research meetings are kind of split up into a couple of different versions, and we do this on Wednesday. So Wednesday is kind of research meeting day. We used to during COVID we had them broken up on Mondays and Fridays. But now that we're, you know, kind of back to sort of normal, we have one day. And so what we do is in the morning we'll have two to 3 hours of discussions on two or three companies. And those companies are either those initial research report presentations or a report on one of our existing holdings, or a potential new addition to the portfolio. So it's either, you know, the initial research presentation, a more final research presentation, or a rehash on one of our existing holdings.
DAN
We do that once a year on all of our existing holdings too. So that's the morning is spent doing those kinds of presentations. And then later in the afternoon we do what we call our universe discussion, which is, are there companies that we don't have in our coverage universe that we should? And so we go through. David Poland had a process of flipping value lines and I know you've talked to some of your guests about doing that. You're certainly dating us when we admit to flipping value lines. And I worked at Value Line, by the way, so we can. Yeah, that is something that unique, I'm hoping from all of your guests.
DAN
But David Poland used to like flipping the issues of value lines. Now it's gotten a little bit archaic, even though I love the presentation of the page. We've recreated our own Poland page, basically, which uses data and analytics that our teams have put together that pull data out of Bloomberg and FactSet and put them in a, it's sort of like a value line page, but with the statistics that we want to see over, over time. Our universe discussion is going basically through those companies one at a time and saying, we don't cover this company. Let's look at the economics of the business based on what we have here on this page. Does anybody know this company or know the industry or know something like it? Should we bring this into coverage? And so that's also on Wednesday afternoons and probably once every few weeks there's a new company added at least to take a look at.
DAN
A lot of them don't make it past that initial research point, but, you know, usually once in a while, someone will be like, you know what? We've seen this company a bunch of times. The economics look really nice. Don't know enough about it. Let's have somebody take a quick look at it.
JOHN
I love that you'll have your own little pull in one or two pagers with the metrics that mean most to you, that matter most to you. So the analysts have freedom to look at any stock in the large cap universe across the world that meet all five of your strict criteria. Are analysts ever assigned companies to research from the portfolio managers?
DAN
Yeah. I mean, that does happen from time to time. I would say less frequently than the analysts wanting to pick them up themselves. Oftentimes, the most common way is either during the universe discussion or even outside the universe discussion. Analysts will say, hey, I think someone should take a look at this. I would like to do that. Our director of research, which is Brian Power, will decide yes or no, or somebody else should look at it. But 90% of the time, if you bring it up, you'll get to look at it.
DAN
There's no reason not to. As long as you have the ability and the time to be able to do it, then sure you can do it. We also don't hold super strict to the guardrails to start research. So if someone brings up a company that's not yet fully inside of our guardrails, but looks like it's getting closer, we'll look at it. We'll get ahead of some of those companies. We don't want to just be reactionary when all of a sudden the stars align. We have to start our research. We do have an eleven person team, so we can go a little bit outside the guardrails just to get up to speed on companies, and then we're ready.
DAN
Once they do come in the guardrails, we can then invest. We did that with Airbnb. Airbnb came public during COVID really during 2020, late 2020, early 2021. And as a private company, it did not meet our guardrails, but we picked up coverage of it once they filed their registration statement because we could tell right away that it would likely be well inside the guardrails very, very quickly. We had the research already started before it even came public, and we ended up purchasing the company not long after it came public. And so we have the ability to study companies even before they're in the guardrails.
JOHN
You've mentioned on here that you listen to some of my shows and how some of my guests have talked about value line. I want to show you that I read all of your stuff. So I still remember your Airbnb blurb that you put in your quarterly letter when I believe you said that you thought there was the potential over time for like 1000 basis points of margin improvement.
DAN
And they've done a lot better than that.
JOHN
And they've done better than that. That's exactly right.
DAN
In a very short period of time.
JOHN
Yeah, it was incredible. It was incredible what they were able to achieve and scale.
DAN
I think I'm also learning that I'm quite conservative on margin improvement on network effect businesses. I did the same thing when we bought Mastercard way back, many, many, many years ago. Mastercard's margins at the time were roughly 20%. And I said, I think over time their operating margins can get to at least 35%, which sounds like a lot.
JOHN
15 percentage point improvement.
DAN
Yeah, I mean, it sounds like a little bit of a prediction. Right. And now they're getting close to 60. So, yeah, I tend to be a little. We all are, right? Polling capital is relatively conservative people, but even when we make predictions, sometimes we can be wildly low and look, I'd rather be wildly low and exceed those expectations, but sometimes it's laughable. Like in the case of Mastercard. Yeah, with Airbnb, we predicted about where they are now, a little bit lower than where they are now, but they're marching past it quite quickly.
DAN
And they could get, I don't know if they will because there's so many things they can invest in, but they could get up to Mastercard type margins if they let it.
JOHN
Incredible. With Mastercard and Visa, it's just that the incremental margins that a great wide moat business can own when they have a fixed cost business model and all of that infrastructure is built out, or a lot of it is built out. And so every incremental dollar that flows across that infrastructure, the margins on that are very, very, very high.
DAN
Yeah. The beauty Visa and Mastercard today, because their margins are already so high, means they don't have that same kind of flexibility. The income profitability is a less contributor to their earnings growth. And obviously, when they were teens, margins like every 100 basis points. When you have a 16% margin, that's a lot better than every 1% on a 60. Right now we have that with Amazon. Amazon's margins bottomed at 1.9%. And our view is that they would get to likely the mid-teens over time and they're already back to eight in less than a year.
DAN
They went from 1.9 to eight. Wow. Incremental margins. When your margins are relatively lean like that, very lean, that's massive cash flow growth, massive earnings growth. Those are rare. Most of our companies have high margins already and we're hopeful that they can just keep expanding a little bit over time. But that's why we made such a large position in Amazon was we saw the obviousness of this massive margin improvement that was coming, and it didn't take a lot of bold predictions on our part to make sure that that was going to happen.
JOHN
Yeah. So you’ve emphasized that you all are bottoms up. You’re looking for these best 100 and 5161, hundred and 70 companies in the world with long term profitable growth ahead of them. But my question is, do you think about macro at all? How much or how does that flow into your process?
DAN
We used to always say that we never really cared about the macro, bottom up, blah, blah, blah. The reality is you never fully ignore the macro because there are macro things that affect businesses that you better be aware of. Right. Some of those macro things are just the ebb and flow of the economy that we're a little bit less concerned with because that's just the natural order of the economy and our long term holding periods. And the advantage companies we have are going to be able to grow through that. But we do have to understand things like tariffs and trades, regulatory regimes, and massive impacts on currencies, because our companies are mostly global businesses. They don't just operate in the US. So you do have to understand, is there going to be any big currency risks in some of the geographies that they sell in?
DAN
Are they naturally hedged against those currencies? We really have to understand things that can affect them that are exogenous to themselves. Those are things that we do pay pretty close attention to. We did see in 2022 that rapidly rising interest rates can have a very deleterious effect on the PE multiples of even the most advantaged companies in the world. And we underappreciated how big that could be. We knew there’d be multiple compression coming. We didn’t expect it to be that big that fast. And our companies happen to hit a COVID grow over, which made the earnings growth quite low in that year, too.
DAN
So we got stuck in a storm where if we had maybe appreciated a little bit that duration impact, we could have protected the portfolio a little bit more by staying a little bit longer in some of the safety companies that we had sold before pivoting into some of the faster growth companies. I think we could have done a little bit better on that so were still learning a little bit too, because we hadn’t really seen a rapid rising rate environment in our 35 year history. Now we know, but we do incorporate these things, but we don't become paralyzed by them either. If you're going to be able to own a great company, that's going to compound for very long periods of time, and you may have some headwinds, we're going to try to be a little bit tactical with how we add to it, maybe how much we own right away, but it's not going to stop us from owning great businesses that are going to be able to deliver, you know, exceptional earnings growth for decades.
JOHN
Dan, you're one of the most humble people I know. And you know, earlier in this discussion you said that you haven't been, the team hasn't been exceptional at position sizing. Meaning me? Because I'm. No, no, meaning you haven't added a lot of alpha based on position sizing. The portfolio has done exceptionally, but it's something that you are working on. And just now you said that you and your team underappreciated the multiple compression and how fast it happened once interest rates started rising very quickly. My question is, do you regret selling one or two of those safety stocks?
JOHN
And just for our, our listeners, really quickly, Poland has historically invested across the growth spectrum, meaning on one end, and I only know this because I've interviewed you so many times and spoken to you so many times, meaning on one end of the spectrum, you have some slower growers that are very safe and stable. And then on the other end of the spectrum, you have so much faster growers that maybe have a wider range of outcomes. That's right. And maybe O'Reilly was one of those in the past. Maybe Nestle or Unilever, I can't remember, was one of those in the past. Do you think you regret getting out of those safety growers, those safety stocks? And if so, do you look to add one or two of them in the future?
DAN
Yeah, it's a great question. First of all, on safeties, you said it exactly right. Our safeties are a little bit slower growing, but they are very, very stable. And today you could think of companies like Abbott labs in that Abbott lab, Accenture is oettis. These are companies that are very, very stable. They’re not slow growing. They’re just slower than our portfolio average. So they still are double digit earnings growers, which is a lot faster than, say, the S and P 500 earnings growth.
DAN
But they're on the low end of our portfolio.
JOHN
Right.
DAN
And there is always a place for those companies. We love to have them. We don't have a targeted percentage of safeties. It's basically what the market will give us. If safeties are available at good prices, we're happy to own them. If they're not, that's fine. We'll find other places to go in the time period that we're talking about, which is late 2021. Let me give you my thought process on why we sold some of those.
DAN
And yes, I do regret the timing of some of those sales, but the logic I think made sense. But if I had known then what I know now, we would have waited a little bit longer. In late 2021, everything felt a little expensive like it does now actually. And everything felt a little expensive. And we looked at our portfolio, company by company. And the way we think about valuation is what is the return, the expected return on this company over the next five years. Given a combination of earnings growth we expect and likely multiple compression most of our company over time, the multiples will compress a little bit over time. What we want from each one of our companies is at least a double digit annualized return to continue to own it.
DAN
If it starts to fall into the single digit total return category, we're really less interested. We're going to find something else now in late 2021. I wrote a commentary where I said our portfolio was trading on the high side of normal. That's the terminology I used. I used it very specifically because I didn’t feel that the companies in the portfolio were overvalued. It was just that path to a double digit return was getting narrow. It was getting hard for them to get much higher than that. There were two companies in particular where we were saying its likely to be down into the single digits.
DAN
It’s not going to be a double digit annualized return. And we sold those two companies. It was dollar general and Starbucks. The interesting thing about that is I’m telling everybody that valuations are high and what I’m selling are safeties, not the faster growing companies, because we felt the valuations and safeties were actually worse than in the growth companies. We sold those two companies. And my logic at the time, and I talked about it with our team is, look, we know that PE multiples are going to contract as interest rates start to rise. Remember, this is at the time where the tenure is like 1%. We know interest rates are going to start to rise.
DAN
PE multiples are going to contract. Safeties are expensive, were having to sell them. So the way we can fight this multiple compression is by leaning into growth, leaning into faster growing companies because the valuations are better there anyway, we can go in that direction. We started to add Amazon. We used the proceeds of dollar general to buy Amazon. We leaned in on Netflix. We leaned in on a few of these faster growing companies. The only problem with that decision was those same companies were about to hit on tough comparisons from the COVID period when they saw accelerating.
DAN
So we leaned in on faster growing companies right as they kind of hit stall speed a little bit. So our normal earnings growth is 15 16%. Even in a recession we can typically get 10% earnings growth, which is pretty awesome in a recession. In 2022 we only ended up with 5% earnings growth because of the stall out on some of the digital and healthcare businesses, on tough COVID grow overs. So we're eating multiple compression on higher PE multiple companies because these faster growers had higher PE multiples and their earnings stalled out at the same time. I didn’t anticipate the grow over being that difficult. I didn’t anticipate the PE multiple compression from duration and interest rates to be that big. So it ended up being a much larger double headwind than I thought.
DAN
Had I really appreciated those two things, we would have hung around the Starbucks and dollar generals a little bit longer, even though the valuations were not that great, and maybe waited a little bit longer to lean in on Amazon and Netflix and similar businesses. Once those growers were fully appreciated, I think we could have been tactically a lot better at it now. Our portfolio still would have been down a fair amount in 2022 just because the businesses that we own, as we’ve talked about, are financially superior, highly competitively advantaged. They don’t trade at discounts to the market, they trade at premiums to the market, typically. So the duration impact was going to hit us kind of hard. No matter what. Even if we had done a little bit better with our tactical positioning, we still would’ve been down a lot. But we could’ve done better for sure.
DAN
We could’ve protected some of the returns that year. I’m sure.
JOHN
I don’t know how you think about it, but I think you’ve got some great safeties in there. You mentioned Accenture and abbot labs, but even a visa or a Mastercard, a Microsoft, I don't know. I'm just thinking off the top of my head.
DAN
We've made an argument, and we actually wrote a white paper on this, that SaaS software businesses are safety like. What we meant by that we were trying to be a little provocative, but what we meant by that was the 100% recurring nature of essential software makes it as durable as a nestle or a Coca Cola, arguably better even than those businesses. Of course, the first time we got tested on that was a duration like PE multiple compression. So the businesses themselves were extraordinarily durable. Those companies continued to grow with almost no slowdown through the last five years. But the stock prices ended up being more volatile because the PE multiples were higher. And so they ate the duration impact a little bit, much more than we would have expected in a more normal, say, like a recession driven drawdown or a valuation driven drawdown. I think a lot of our businesses, even our faster growing ones, have very safety like qualities to the businesses.
DAN
Yeah.
JOHN
So you talked a lot about in the last ten minutes or so, multiple compression. And you mentioned that you even assume some multiple compression in your valuations in a lot of cases because these companies are faster growing, extremely high quality, and they trade at premiums to the market. So just how does your team think about valuation and what valuation methods are you typically using?
DAN
So again, there's a lot of autonomy here. I know a lot of people try to do discounted cash flow models and I built those in the past, too. I don't like the false precision of a DCF model because you naturally put numbers into the spreadsheet and it elegantly spits out a number and then you’re incredibly anchored to that number. What I do like about those models is seeing how the cash flows change based on your assumption, changes for revenue growth and margins and capital intensity. It’s good to see what the biggest levers are in value creation for companies. Obviously on a company like Amazon with extremely low margins, its highly sensitive to the margins that you predict. Where a company with already high profit margins, that they have a lot of flexibility in managing the expenses of the business. It's much more going to be the revenue growth that drives.
DAN
It's cool to see how that all plays out. But for us, like I said, we tend to look at this in an expected return construct. And we have an idea, the earnings growth. Obviously, we know what the earnings growth is today or the earnings power is today. We have a prediction on what it's going to look like five years from now on the average company, that would be ludicrous. Try to predict five years from now what the earnings power is going to be. But remember, the types of businesses that were investing in tend to be on fairly consistent and linear growth paths, often in industries that they dominate and often industries that they themselves created. And so its relatively, we walked through the growth algorithm on Visa and Mastercard before it’s a pretty predictable number now.
DAN
Were not going to get it spot on, bullseye accurate, but were not going to be wildly off either. So the biggest variable then is the multiple. Five years from now, what’s going to be the multiple that’s harder to predict? So what we do is we just stress test it. What kind of multiple would have to sustain five years from now for us to achieve that double digit return? And is that reasonable? And we do it based on a normalized interest rate environment. Wed never give credit in the out years to a lower than normal interest rate environment that would allow for higher than average PE multiples.
DAN
We want to assume a normal interest rate environment. And so from here to there, what does that look like? Now, the analysts themselves, myself included, we can use any valuation technique you want. You can build yourself a super complicated model if you want, but that's not going to be part of the decision making on putting a company into the portfolio. Again, crayon simple, what's it going to look like five years from now? If it's hard to predict, it's probably not for us. It's probably not something we should have in our portfolio. If it’s something where the outcomes are just wild, it could be five times the current size or half the current size.
DAN
I’m not interested in those businesses. We want companies that have pretty predictable growth and a reasonableness to their valuation that we can predict. We don’t ever really predict multiple expansion for our companies. We assume it’ll be the same or lower on the faster growing companies. We build in more multiple compression because they’re going to be slower growing at the end of that five year window. So not only do we have to have an expectation of what the five year growth is going to be, you also have to have an expectation of what it’s going to look like in five years from there, because that’s going to be an impact on how big the multiple is. Five years if we have a 20% grower for the next five years, but by year five it’s going to be a 3% grower. Well, the multiple is going to be quite low, that five year number.
DAN
So you have to have an idea of how growth is going to continue beyond the five year window.
JOHN
That was great. So I’m going to pull on this string just a bit. So let’s assume you find what you believe to be a super high quality, wide mode, multiple overlapping modes, long duration profitable growth company that meets all five of your guardrails, and its currently trading at a next twelve month PE of 30. Roughly speaking, how fast would your expectations for EPs growth have to be? And how much would the PE have to drop on five year out numbers for the valuation to sort of be attractive to you?
DAN
Yeah, so I can't do that math in my head right now, but we have, luckily, we have a tool for this that I think you've seen before. We have a heat map that essentially does exactly the calculation that you're laying out there. We have two axes that we look at. On one axis is the expected earnings per share growth rate, and on the other axis is the PE multiple contraction that we would expect. And so you say for XYZ company, if it's going to be a 30% or 20% earnings grower, we'll go down to that 20% earnings growth. And obviously, if the multiple doesn't change, we would expect a 20% return. But then we say, all right, well, let's build in. What kind of multiple contraction do we have to build in to still maintain that double digit number?
DAN
Then we'll say, well, does that sound reasonable? And if a company's growing fast enough, you can withstand a ton of multiple compression and still get a double digit annualized return. Oftentimes, on the companies that we're buying that are some of our fastest growers, you can withstand a 30, 40, 50% reduction in the PE multiple and still get a double digit or better annualized return. So that’s the way we think about it, is lets go to that heat map. What’s our best expectation of earnings? What kind of multiple contraction can we withstand and still get a double digit return? Does that look good to us? Then of course, you don’t want to just say, well, that’s what it is.
DAN
What if our expectation is off a little bit on the earnings growth? And if we are off on the earnings growth, the multiples likely come down even more. What's the worst case scenario if we expect a company to be a 15% grower over the next five years? A big error for us would be like, it's ten. That's a big error for us. We're really pretty close on these things. Over time, it's not going to be a minus ten. So if we say, all right, and we own Fastenal for a period of time, by the way, speaking of cyclical, we own Fastenal and we had an expectation of Fastenal being a 15% grower.
DAN
It turned out to be a ten. And the multiple contracted over that period of time by about a third over that period of time. And it gave us a basically zero return over a four year holding period. And so again, it was an opportunity cost. It was pretty big, but not a blow up. Not a blow up. Right. So that's the beauty of dealing with companies that have some consistency to them, is you're never going to be that far off on the earnings growth.
DAN
So you just have to be conservative on the multiple. You just can't be too far out over your skis on the multiple. And we've historically been pretty good at that.
JOHN
That was awesome. Lovely. Thank you. Under what circumstances do you trim and under what circumstances do you sell out completely?
DAN
Yeah, trimming usually ends up being something like a valuation call where the valuation is just a little bit high. It shouldn't be one of our larger positions. If the valuation is not giving us a great look at a return, maybe something else is giving us a better potential future return. Sometimes we just have some concerns about either the business itself or maybe a management decision, or maybe there's just a timeliness factor to it. We own companies for such long periods of time, they all go through bumps along the way. Some of those bumps take a little bit of time to work out. If you're going through a period where you think there may be a year of not as exciting growth, maybe the growth is going to hit a pause for a little bit before reaccelerating. You might want to have a little bit lower position for a while, while others in the portfolio are compounding a bit faster.
DAN
So it’s usually when there’s either a shorter term valuation issue or a shorter term business issue that will likely work itself out over time. We may trim. The sellouts could be for a number of reasons, but the most common reason is because we find something better. The typical reason for an exit is that we found another idea. That’s not our 23rd best idea. Thats the most common reason. But if we think that there’s a potential risk to the competitive advantage or a real risk to the long term growth profile, well exit those businesses if we think the thesis is just not going to be good going forward or different. We’ve had times where we thought management was very poorly allocating capital, where well exit the position entirely.
DAN
If the company does something that pushes outside of our guardrails, we will have a serious discussion about how long is it going to be outside the guardrails. If it’s going to be a relatively short period of time, we can be patient. Oftentimes acquisitions may push the debt levels a little bit too high. As long as there’s a plan to get that back under control quickly, we can stay. But if it’s something that changes the financial characteristics of the business, so it’s unlikely to meet our hurdles. Well probably exit that business, too.
JOHN
Trey. Dan, I started this show by highlighting the Poland focus growth strategies, consistent outperformance over time with 510 and 35 year annualized returns, net of all fees of around 14%. And Dan, I've known you for a while. As I said, I first interviewed you and your partner Damon Ficklin in 2016, and then I interviewed you both again in 2018. And we've collaborated in other ways over the years as well. For example, I brought you and Damon and Raina Lester Hanaway, another of your colleagues, to speak to the investing team on different occasions. When I was at the Motley fool and back in 2018, when I asked you and Damon about what was the primary driver of your consistent returns of 14%, you all provided me one of my favorite investing quotes of all time. I don’t even know if there’s a question here, Dan, but I just want to read this quote to close out our show.
JOHN
You and Damon told me the primary driver of our returns has been earnings per share growth. But of course, strong revenue growth is the primary way that has occurred for our companies. It is important that each company have a big competitive advantage in a large growth market that allows the revenue to grow without competition and for margins to expand, leading to strong earnings growth. End quote. So I just love that quote. Is that your secret sauce, really finding these companies that you believe are early in their, in their profit cycle?
DAN
They’re not always early in their profit cycle. Just to be clear. They’re not oftentimes were late to the party of some of these. They have to be really proven. It’s the discipline, though, of sticking with those. It’s the discipline of not chasing butterflies. It’s the discipline of even when you’re underperforming, but you’re still delivering the earnings growth to not change what you do. And were a little bit lucky, Damon and I, especially the longest tenured members of the team, because we got to work with David Poland for a long time and see and study not just him and how he worked, but his whole track record and understanding, 20 years’ worth of work before we even got here, 15 to 20 years before we even got here, so that we knew it already worked and we knew that it required discipline and you had to stick to it.
DAN
And so that, I think, is exactly it. It's looking for those highly competitively advantaged companies that can deliver revenue and earnings growth in a very differentiated way for long periods of time. And just sticking with that, there’s a lot in our industry that is either fat or fashion oriented or just people really want to look smart and want to discover things that other people don’t. Theres almost a need to be more either a detective or a scientist or whatever, something that makes you look really, really smart. I think what Poland capital has done really well and it came from our founder, is, is not trying to look smart, is trying to do it, like we've said a couple of times now, the easiest possible way with discipline. And if we can do that and consistently do that, you're just allowing that compounding engine to keep on going. Right. I think that's the most important thing.
DAN
It's staying in the game, not making big mistakes. Compounding, compounding. Compounding over long periods of time. It doesn't have to be very fast. Right. Compounding at 15% may not sound, I mean, you have an appreciation for this, John. You know that that's very fast when you think about 15% per annum. Most people who don't understand the power of compounding may say, well, 15%, I can get 40% or whatever.
DAN
Doing 15 over decades is really hard, but it's doable if you have a good process and philosophy underneath it. And we're just sticking to that. That's what we're doing, Trey.
JOHN
And such a great lesson in there. You said you don't necessarily have to be early. If, if the company is as great as your research would believe it to be, if it ends up being as great and you can buy equity in that company at a fair price, then the Poland way would just be to do so and hold it and be disciplined about holding it as long as it remains great, correct?
DAN
Yeah. And the idea, too is you've heard me say it a few times. I'm not talking about individual company growth, portfolio level growth. Right. So each company contributes to that, of course. But not all of them are fast growers. Some of them are slower, but they all have to contribute. And then it's up to us to say, well, if this company cannot carry its load, just pull it out, move it aside.
DAN
We'll find another one. You talked about years ago. We had owned American Express for 14 years in the 1990s and into the two thousands. And we thought they were lending very aggressively in an undisciplined way before the financial crisis. And they had one poor quarter where they had to increase, their delinquencies increased, and it looked not Amex like. And after a 14 year holding period, we sold that company in one day. We just said they are risking the franchise, they’re risking the brand, they’re risking what makes them unique. And special and we're out.
DAN
We tend to be very long term, but we're also pretty ruthless. If we think that the compounding engine is at risk, we can always find another one to keep the portfolio. Compounding earnings and that mid-teens race. We're not married to any of them. We love owning companies like Accenture for 17 years, but if we thought something popped up that made Accenture not what we would like it to be, it's out. We'll find another one. We need to be able to change our mind to move forward and keep the compounding going.
JOHN
Yeah. Dan, you all really do think about it at the portfolio level. Compounding earnings at a mid-teens rate at the portfolio level for as long as you can. And you also think a lot about doing whatever it takes to prevent interrupting that compounding.
DAN
Exactly.
JOHN
If a company really surprises you out of nowhere with something, whether it's bad lending standards that don't meet their historical criteria, whether it's a bad acquisition, a string of bad capital allocation decisions you don't agree with, you'll get out and rethink it.
DAN
Yeah. And that's okay. And we can come back sometimes. Okay, well, we were worried. It really never really happened. No problem. We can come back again. It's okay.
DAN
The idea is don’t lose money. Do everything you can to make sure that the worst case scenario is an opportunity cost. Put yourself in the way of great businesses and let them do the hard work for you. We don’t need to. But before I came to Poland capital, I was a deep value analyst. I just found that really, really hard. You’re basically trying to just capture value the way they did it. You’re trying to capture valuation anomalies on relatively poor companies.
DAN
You just thought they were over, overbeaten down, and then they would eventually get valued higher. You have to do a lot of hard work as the investor then to generate the return. By constantly identifying undervalued companies in the types of businesses that we invest, the companies are compounding all the time. They're doing the hard work for us. If their earnings compound, and we're pretty disciplined on the price that we pay, the company is doing all that hard work. That's why we only had to own 132 of them in 35 years, because they're doing all the hard work. We're just allowing them to do it. And if it looks like something's wrong, we just push one aside and bring a new one in.
JOHN
Dan, this was incredible. We dove very deep into the Poland investing process. Is there anything we missed or anything else I should have asked you about Poland, its process, or how the team is structured.
DAN
John, I think you know us as well as anyone who works inside polling capital knows us. No, I think we really covered a lot. I just want to tell you I appreciate the way you get to know investment managers and their philosophy and process and articulate it so smoothly. I think you can tell the polling story as well as anybody can, and I've heard you do it with other investment managers as well. And so I just appreciate a great, thoughtful discussion as usual.
JOHN
Dan, I really, really appreciate you saying that. Thank you so much for coming on to the J row show. And before we sign off, I'd like to provide a quick reminder. Anything discussed on the J row show by myself or my guest is solely our own opinions and does not constitute formal advice or a recommendation. The J Ro show is for entertainment purposes only, so please do your own research on any securities discussed in this podcast. Thanks for tuning in and we will see you next time.