Small cap stocks get a bad rap.
Critics say they have too much volatility and pose too much risk. But with the proper approach, small cap stocks offer growth and add diversity to a portfolio.
The challenge is finding the right stocks and managing the risk.
SHOOKtalks turned to Tucker Walsh, who heads Polen Capital’s small cap investment team, to get insights into how advisors can tackle the small-cap market. The session was moderated Raj Pathak, a wealth advisor with Morgan Stanley Wealth Management in Boston.
Polen’s U.S. Small Company Growth Investor Fund (PBSRX) posted a 49.53% return in 2020 after posing a 20.97% return the previous year. (The fund started operations in February 2019.) Polen also offers an institutional class of shares (PBSIX) that invests in the same stocks.
So how does Walsh do it?
“We look for companies that have a combination of strong, consistent revenue growth, strong margins and strong cash generation,” Walsh said.
Walsh leads a team of analysts who cull 2,000 small cap companies for potential investments. The list is whittled down to 20-30 potential candidates. “We take a concentrated approach to the sector,” he said.
“We are looking for companies that are benefiting from digital disruption but also offer a disciplined approach toward the market,” Walsh said.
Companies with a strong digital platform have the added advantage of having a direct line to the customer, Walsh said.
“Forty years ago, everything was sort of a multi-step distribution system. So, there were markups along the way,” Walsh said.
The growth and widespread acceptance of the Internet has made it easier for companies to set up their own low-cost digital distribution system. “We look for companies that create a direct channel to the consumer,” Walsh said.
Once the channel is established, Walsh said the best managed firms take the sales data they have collected and use it to deepen their relationship with customers.
One such company is the online retailer Revolve Group (2020 sales: $580.6 million). The Los Angeles-based company is an e-commerce fashion apparel merchant that sells men’s and women’s designer clothing, shoes and accessories catering to millennial customers. The company drives customers to its website by connecting with Instagram influencers, Walsh said.
“The amazing thing about Revolve’s business model is it is all data-driven so they never get in a position of where they have excess inventory,” Walsh said.
By keeping inventory low, Revolve (NYSE: RVLV) eliminates costly mark downs, which hurt profit margins. “They see what is popular based on past sales and they order more. This is one example of how digital has transformed business models,” Walsh said.
Another example of digital disruption is the restaurant company Wingstop
On the surface, Wingstop looks like most fast-food restaurant chains. But that ignores a key component behind the company’s growth story: how it leverages technology.
Wingstop invested in an online ordering system that allows customers to place orders from their mobile phones for carryout, curbside pickup or delivery. The average order is approximately $20 and online orders account for 80% of sales, Walsh said.
Walsh said Wingstop’s system collects data on past orders, customer satisfaction and it also assesses restaurant performance. This information is used by headquarters to decide where to locate new stores and place advertising.
“Data is key to Wingstop acquiring new customers,” he added. “Going digital with ordering has made Wingstop’s business much stronger. They are also better positioned for future growth.”
Walsh likes cloud-base businesses that eliminate paperwork and streamline processing. Polen’s small cap funds own shares in Duck Creek Technologies (Nasdaq: DCT) a cloud-based insurance servicer (2020 revenue: $211.6 million.) and BlackLine (Nasdaq: BL) a cloud software firm that automates complex, manual accounting processes (2020 revenue: $351.7 million).
Another Walsh pick: Exponent (Nasdaq: EXPO), a Palo Alto, Calif., science and engineering consulting firm. The company is a play on research and development outsourcing, bringing together 90 different scientific and engineering disciplines to solve problems. Exponent posted 2020 revenue of $399.9 million.
“Some of these companies may seem expensive by today’s valuations but we think given their digital scale, these companies can grow faster for much longer and that justifies the valuation,” Walsh said.
“Even though small caps are considered to be risky, we will own 30 of the best, companies have strong growth, good margin structure and good profitability. We feel these companies will weather the tough times.”