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Steven Chen
Steven Chen
Articles (184)  | Author's Website |

What We Learned From Sold Positions at Polen Capital

Mega-merger, diworsification and digital disruption

May 26, 2020 | About:

As a stock investor, what can be better than learning from the mistakes of other investors and corporate managers? This is why we enjoy reading about the position-selling decisions of those consistent market outperformers. Investment managers often consider selling because 1) they decide that there was a mistake in the investment thesis in the first place; 2) they decide there was a mistake committed by the management from a shareholder perspective (often relating to capital allocation); or 3) hefty valuations. We at Urbem focus on studying the first two, as they help us mitigate the investment risk of picking “losers.”

Polen Capital follows a concentrated, long-term, quality-growth-oriented approach to invest in compounders of at least double-digit annual rates globally. All its funds have beaten their respective benchmarks by a sizeable margin. Its quarterly commentaries have been filled with wisdom, especially with respect to the situation of selling a stock. Below, we listed a couple of the positions that the firm recently sold. These stocks did not generate any alpha (or even any return in some cases) over the last few years.

Mega-merger

Below is an excerpt from Polen Capital's letters to shareholders regarding EssilorLuxottica (XPAR:EL), a company that faces "mega-merger" risk:

“French optical lens company, Essilor, recently completed a merger with Italian eyewear company, Luxottica. Complications with the merger have increased risks and decreased expected earnings growth for the newly combined company. This is unfortunate because we had been positive on the merger. Indeed, the combined group will be a vertically integrated industry powerhouse with dominant market share across the eyewear value chain. However, integrating two very different cultures is proving to be too difficult. More than two years have passed since the merger announcement, yet the combined business still lacks a common strategy or a finalized management team—a sign, in our view, that the problems are deep. In the most recent escalation, Leonardo Del Vecchio, former Chairman of Luxottica and largest shareholder of the newly combined group, is taking his Essilor counterparts to arbitration, which could be a drawn-out battle. With such acrimony, we cannot rule out the possibility that the two companies could attempt to reverse the merger. We no longer believe that the synergy benefits will accelerate earnings growth significantly in the next few years.

Worse, the spat risks becoming a distraction and could result in both companies losing their competitiveness. As such, we have sold EssilorLuxottica from the International Growth portfolios.”

- 1Q 2019 Commentary, Polen Capital

Investors may want to exercise extra cautions towards massive merger and acquisition deals, which historically prove to have a high probability of failing to generate shareholder value. Overpaying is one reason, while difficult integration is another (as demonstrated by EssilorLuxottica here). When it comes to the synergy, we would prefer Warren Buffett (Trades, Portfolio)’s attitude of simply not expecting it.

Diworsification

Below is an excerpt from Polen Capital's letters to shareholders regarding Baidu (NASDAQ:BIDU), a company that faces "diworsification" risk:

“Chinese internet search engine, Baidu, was the leading laggard for the Portfolio during the year. Our investment thesis failed when the company pivoted away from its cash cow business, Chinese internet search. Baidu is now repurposing its app as a content source meant to capture user time and attention with various video content, news, search, literature, and other offerings. This change requires significant investments while Baidu actively deemphasizes search. We believe strategic pivots or platform expansions are best executed when a legacy cash cow is maintained as a source of funding to scale in new areas. While Baidu has compelling long-term growth drivers beyond core search, like autonomous vehicles, leading AI technology and a cloud software business, deemphasizing the competitively advantaged core business is a change we felt we could not support.

We think steadier management might have been more measured in changing directions. We sold Baidu out of the Portfolio during the second quarter.”

- 4Q 2019 Commentary, Polen Capital

We have observed Baidu’s multiple strategic attempts to expand outside of its core 'competency. Back in 2014, China’s top search engine (often called the "Google of China) started its “groupon” and food delivery businesses. From that point on, the return on equity gradually declined from over 30% to low single-digits. It appears that the management could have allocated capital better, while we acknowledge the always-intense competition among Chinese technology companies that may erode high returns.

Digital Disruption

Below are a couple of excerpts from Polen Capital's letters to shareholders regarding Reckitt-Benckiser (LSE:RB.) and Prestige Consumer Healthcare (NYSE:PBH), both of which face "digital disruption" risk:

“We sold Reckitt-Benckiser on decreased confidence in the company’s ability to overcome evolving competitive dynamics and continue to deliver steady double-digit EPS growth. While ecommerce is still a relatively small percentage of overall sales, ecommerce proliferation alters the basis of competition within the industry. It seems to us that e-commerce may be eroding the company’s competitive advantages in some products and markets. Historically, the basis of competition in consumer staples had been brand-building, advertising, and dominating brick-and-mortar shelves. Scale created a real advantage in both of these dimensions, and Reckitt did well in this environment. Today, brands are increasingly strengthened through social media and search engine marketing and less so through television campaigns and distribution. As commerce continues to move online, shelf space becomes relatively unlimited, and price transparency increases, which is problematic for less differentiated products.”

- 4Q 2019 Commentary, Polen Capital

“We sold out of our position in Prestige Consumer Healthcare Inc, the marketer and distributor of many well-known over-the-counter healthcare brands including Monistat, Clear Eyes, Luden’s, DenTek and Debrox, among others. The company was the slowest growth business in our portfolio, addressing categories where consumption growth was 2-3% at best. We liked the business for its high CFROI, excellent cash flow, its strategic acquisition strategy, and the stability of its revenue as the leading trusted consumer staples brand in each of the categories it serves. The company remains a good cash flow generator with high CFROI, but the stability of its sales is now being called into question. The company’s considerable exposure to the drug store and regional grocery channels, each of which are experiencing challenges, have led to inventory destocking. This could potentially be an ongoing trend as these stores cede share to internet retailers and the mass and dollar channels. While Prestige is well positioned in the dollar channels, its online presence is less established. We are also concerned that e-commerce will threaten brand loyalty in the firm’s categories. We believe the company has a strong management team and that they are doing everything in their power to drive excellence. We appreciate that they have little control over some of the issues in distribution, and it could be an uphill battle for Prestige’s brands to maintain their strength and grow with this channel transition underway.”

- 1Q 2019 Commentary, Polen Capital

Our increasingly digital world is posing a secular threat to most consumer brands, and a true examination of the strength of their mindshare-based moats is required. While some companies, such as Reckitt-Benckiser, could suffer from this megatrend, we believe that a small group of long-standing brands can be at least technology-neutral or even benefit from a more extensive reach through online channels. For instance, it is unlikely for iconic heritages like Louis Vuitton, which are scarce and hard-to-replicate, to lose their desirability among status-conscious high-net-worth individuals.

Disclosure: The mention of any security in this article does not constitute an investment recommendation. Investors should always conduct careful analysis themselves or consult with their investment advisors before acting in the stock market. We do not own any security mentioned in the article.

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About the author:

Steven Chen
Steven CHEN is a quality-focused investor (with bottom-up opportunistic approaches), an ex-hedge fund analyst on Wall Street, a serial entrepreneur, computer scientist, and free-market capitalist.

Steven is the Managing Partner of Urbem Partnership, a value/quality-focused investment partnership fund (www.urbem.capital).

Steven can be reached at [email protected] or through LinkedIn.

Visit Steven Chen's Website


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