Polen Capital Focus U.S. Growth Fund: Q2 2017 Commentary

Fund Update
26 July 2017 Print article
Damon Ficklin Fund Manager
Dan Davidowitz Fund Manager

Summary

  • During the second quarter of 2017, the Polen Capital Focus U.S. Growth Fund returned 6.20% net of fees. The Russell 1000 Growth and S&P 500 indices  (the “Indices”) returned 4.68% and  3.09%, respectively.
  • Consistent with the first quarter of the year, the information technology and healthcare sectors outperformed. A particularly tough retail environment weighed on many consumer companies, including a few we own.
  • Despite the relative differences in our sector exposures versus the  benchmarks, the vast majority of our outperformance during the second quarter was due to stock selection rather than sector allocation. Our performance was very much a  function of  the  businesses we owned.
  • Our Portfolio’s underlying earnings per share grew more than 20% in each of the past two quarters and we are confident that, once all our companies have reported results, the Portfolio will have delivered at least mid-teens earnings per share growth for the second quarter as well.

Commentary

During the second quarter of 2017, the Polen Capital Focus U.S. Growth Fund (the “Fund”) returned 6.20% net of fees. The Russell 1000 Growth and S&P 500 indices (the “Indices”) returned 4.68% and 3.09%, respectively. Returns were mixed across different sectors of the economy, but the overall market has maintained a generally strong positive trajectory and our Fund has continued to outperform with solid returns supported by robust earnings growth.

Consistent with the first quarter of the year, the information technology and healthcare sectors outperformed and most of the sectors that led the market in 2016 (energy,  materials, telecom and utilities) continued to trail. Financials and industrials delivered steady absolute returns and improved relative performance during the second quarter, but a particularly tough retail environment weighed on many  consumer  companies,  including  a  few  we own. Despite  the  relative  differences  in our sector exposures versus the benchmarks, the vast majority of our outperformance during the quarter was due to stock selection rather than sector allocation. Stated more plainly, our performance was very much a function of the individual businesses that we owned rather than our relative sector exposures.

Our sector exposures can certainly impact our relative returns during shorter periods, given that market leadership tends to rotate, but over more meaningful periods of time our relative results are very much driven by our specific investment selections and the underlying earnings growth that our fund companies collectively deliver. Staying focused on long‐term earnings growth rather than trying to capture the short‐ term movements of the market has allowed us to consistently outperform over time.

Fund Performance & Activity

Overall, our Fund continues to deliver solid results with strong year‐to‐date returns supported by robust earnings growth. Our Fund’s underlying earnings per share grew more than 20% in each of the past two quarters. While we expect earnings growth to moderate a bit for the second quarter (most companies haven’t reported actual results yet), we are confident that the Fund will continue to deliver mid‐teens earnings per share growth, outpacing the broader market.

During the second quarter the leading contributors to the Fund were Regeneron Pharmaceuticals, Inc., Alphabet Inc. (Class C shares) and Align Technology, Inc.

A phase 3 study in asthma is expected to complete later this year and we believe that indication could be even larger than atopic dermatitis, which has multi‐billion‐dollar sales potential on its own.

Regeneron shares appreciated more than 25% during the second quarter due to the solid ongoing growth of its lead drug Eylea and the strong initial launch trajectory of Dupixent, which was recently approved for atopic dermatitis. As we have noted before, Dupixent is a completely novel drug that is being studied across a variety of allergic indications. It has already shown proof‐of‐concept with positive phase 2 results in four separate indications adding credence to management’s hypothesis that many of the different allergic conditions reflect the same underlying disease process and can be treated effectively with Dupixent. A phase 3 study in asthma is expected to complete later this year and we believe that indication could be even larger than atopic dermatitis, which has multi‐billion‐dollar sales potential on its own. We continue to believe that Dupixent will be a very large drug in time. The early launch trajectory suggests there is strong demand and management has done a good job working with payors to establish good patient access to the drug.  In an environment where pricing pressure is likely to remain a reality, we appreciate that Regeneron is bringing real innovation to the market and management is working constructively with payors to strike the right balance between price and patient access.

Alphabet continues to deliver very strong results, especially for a business of its scale. During the second quarter, its shares appreciated almost 10% as it reported 24% revenue growth in constant currency. Margins also improved due to good cost discipline, driving earnings per share growth of 28%. Alphabet saw a slight acceleration in Google Sites revenue growth and in North America, which grew 23% and 25%, respectively, in constant currencies. This is notable given these are the company’s most important business and largest geography. The underlying drivers are the same as they have been for a while now: the substantial growth in mobile and strong growth from YouTube. Strong growth in programmatic ad buying from Google network members as well as growth in Google Play, Hardware/Pixel and Cloud are also bright spots. These and other areas offer meaningful growth potential over time, but we believe the core Google Sites business delivers more than enough growth to support a strong investment case.

Invisalign’s strength was also very apparent in North American orthodontist utilization rates, which were up 20% during the quarter.

Align shares rose more than 30% during the quarter as the company reported exceptionally strong first quarter results. Almost all key metrics were better than expected with full‐year earnings per share estimates rising almost 10% after the company reported. Revenues were up 30%, driven by 27% Invisalign case shipment growth, including more than 40% international growth. Teen case shipments increased 32%, which is a big increase from the roughly 20% teen growth over the past year. Given that teens make up roughly 75% of orthodontic case starts (but a much smaller percentage of Invisalign volumes), this is a very significant positive development. Invisalign’s strength was also very apparent in North American orthodontist utilization rates, which were up 20% during the quarter. This is a much larger than average increase in utilization in the most important channel of Align’s business and a clear indication that invisible aligners are taking significant market share from traditional braces (wires and brackets). With Invisalign only accounting for roughly 10% of the cases that it can currently address, we think there is still a long runway of share gains remaining. The company has just recently started running its first global, multi‐ channel marketing campaign integrated for both consumers and professionals and is rolling out proven sales practices across the globe as it takes over direct control of distribution and moves manufacturing within key geographies. While the company has many growth initiatives in place, it has yet to hit the true inflection point in our opinion.

The three leading detractors for the quarter were O’Reilly Automotive, Inc., TJX Companies, Inc. and Automatic Data Processing, Inc. (ADP). Only the first two companies had a negative contribution. ADP’s shares were up slightly; they simply underperformed the market. Regarding O’Reilly and TJX, we believe that both businesses are competitively advantaged and relatively insulated from the “Amazon threat,” but it has been a particularly tough retail environment recently and any hint of difficulty has been met with swift share price declines.

O’Reilly had been growing at a very strong pace for the past few years, which we think was due to a combination of factors. In addition to the fact that it’s a best‐in‐class operator that continues to take share from both mom & pop and scaled competitors, the company was benefiting from a strong increase in miles driven (due to rising employment rates and low gas prices). It was also taking advantage of the fact that a key competitor was going through a messy integration after a large acquisition. These tailwinds have subsided recently and a mild winter, cold spring and some other marginal factors have all presented additional headwinds in an already tough retail environment. While the first quarter comparable store sales growth of 0.8% was disappointing compared to the mid‐single‐digit comps that the company has regularly delivered recently, we think  O’Reilly  remains well  positioned  for  the  long  term.   While  it  is possible that the company is seeing some competitive pressure on a small percentage of products sold to Do‐It‐Yourself (DIY) customers in the retail channel, most DIY sales have a service component or do not otherwise lend themselves to the online channel. If a customer isn’t quite sure what part they need, for example, they aren’t likely to order it online without any help and then wait a couple of days to figure out if they have the right part or they need to return it and try again. O’Reilly does sell some products that are susceptible to online competition, but we think it’s a small percentage of their DIY mix. Their Do‐It‐ For‐Me (DIFM) business, where they sell to professional installers, requires fast delivery of a broad assortment of products (in some instances multiple times per day) and high service levels. This segment is roughly half of O’Reilly’s overall business and is not at all susceptible to online competition.

Attribution

The top three contributors (Fund average weight multiplied by return) for the second quarter of 2017 were Regeneron (1.37%), Align Technology (1.00%) and Alphabet (0.66%). The bottom three contributors were O’Reilly Automotive (‐0.83%), TJX Companies (‐0.27%) and ADP (0.04%).

Overall, we continue to be very pleased with the Fund’s performance. Most of the underlying businesses that we own are delivering strong results and we think the Fund in aggregate remains well positioned to continue to deliver mid‐teens earnings per share growth over the long term. While all sorts of things can influence the market over shorter periods, we believe underlying earnings growth (and dividends) is what drives returns over the long term.

Investment Team

We are pleased to announce that we have promoted Research Analyst Jeff Mueller to co‐portfolio manager of the Global Growth strategy. Since joining the Large Company Growth Team in 2013, Jeff has demonstrated exceptional research skills, a clear understanding of and adherence to our investment discipline, and proven skillful in recruiting and mentoring new members. He will manage the Portfolio collaboratively with Lead Portfolio Manager Julian Pick, who launched the Global Growth strategy in 2014.

The way the Large Company Growth Team operates today will not change meaningfully, but we feel that with Jeff in this role, the Team will be even stronger in the future.

Thank you for your interest in Polen Capital and please feel free to contact us with any questions or comments.

Sincerely,

Dan Davidowitz & Damon Ficklin