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The quality quotient in long-term alpha

Investors are generally taught that highly concentrated portfolios mean taking on more risk, but that may not always be the case. In Polen Capital’s…

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This article was originally published by Roger Montgomery

Investors are generally taught that highly concentrated portfolios mean taking on more risk, but that may not always be the case. In Polen Capital’s experience, the perceived risk of holding a concentrated portfolio can be offset by owning high-quality investments. By owning a concentrated portfolio containing only the highest quality companies, investors can potentially take meaningfully less risk than the market while generating greater long-term performance.

Data shows that owning financially superior and competitively advantaged businesses can offer a margin of safety in almost any market. By seeking to build active, quality growth portfolios containing no more than 20 to 35 of what Polen Capital think are the best businesses globally, Polen Capital believe they are favourably positioned to generate sustainable, above-average earnings over the long term.

A powerful differentiator: quality at the market level

Markets have shown how quality can be a powerful differentiator. Polen Capital examined the performance of the MSCI USA, ACWI, ex-USA, and Emerging Markets Quality indices. These indices, which are mechanically constructed around three objectively defined fundamental factors, have outperformed their broad market counterparts over the long term and, in Polen Capital’s view, illustrate how even modest improvements in portfolio quality can be worthwhile.

MSCI Quality indices select the top 20 per cent to 30 per cent of U.S. and international companies using three measures: high return on equity, low financial leverage, and stable year-over-year earnings growth.

MSCI’s fundamental factors of quality

  • Return on equity (ROE): Measures a business’s profits relative to the equity its shareholders have contributed.
  • Debt-to-earnings (D/E) ratio: Evaluates a business’s debt level.
  • Earnings variability: Identifies earnings stability over time.

The historical performance differentials between MSCI’s broad market indices and the MSCI Quality indices across geographies and investment horizons provide, in Polen Capital’s view, a strong case for owning quality, shown in Figure 1. Over 15 years, MSCI USA, ACWI, ex-USA, and Emerging Markets Quality indices provided a 3 per cent higher annualized return on average—with less risk (as measured by Sharpe Ratio).

Figure 1: Quality vs. Broad Market Indices

Past performance is not indicative of future results. Data as of 9-30-2021. Source: eVestment. Data based on monthly returns.

For illustrative purposes only. MSCI USA, ACWI, ex-USA, and Emerging Markets Quality indices consistently outperform their broadbased counterparts in absolute terms and when adjusted for risk (Sharpe Ratio). Sources: eVestment. Data based on monthly returns.

Setting an even higher bar for quality

Polen Capital has executed the same time-tested investment philosophy and process for more than 30 years. They think the process sets an even higher bar for quality by considering additional factors beyond MSCI’s standard quality fundamentals: ROE, debt-to-equity, and earnings variability.

Once Polen Capital apply their five investment guardrails to identify the quality universe of companies, they layer on additional research and their careful stock selection process to build a portfolio that they think offers long-term staying power.

What Polen Capital look for in a business: Five guardrails needed to invest

    1. Strong balance sheet with little to no debt and net cash
    2. High ROE
    3. Better than average earnings/free cash flow
    4. Stable or widening profit margins
    5. Real, organic revenue growth

These guardrails mark the beginning of the Polen Capital process by identifying the universe of quality companies. From this pool, Polen Capital select what they think are the best candidates for additional research and possible inclusion in a portfolio seeking to deliver outsized returns with minimal risk. Polen capital also integrate material ESG factors into their process – assessing risks based on materiality through the lens of all company stakeholders. Evaluating ESG factors is a natural part of Polen Capital’s overall process of considering all material risks and opportunities, and they believe a core component in assessing long-term resiliency and stability.

Quality as a safety net even in challenging markets

Polen Capital believe investing exclusively in growing, well-managed companies with strong balance sheets offers a smoother path to returns across market environments. In periods of market decline, earnings stability and financial strength can serve as a “margin of safety” that typically offers resilience amid downturns. Characteristics like earnings power, financial stability, and competitive moats can allow companies to weather tougher times and can enable them to power through a crisis faster and stronger than competitors.

Consider the performance across four geographic universes: U.S., global, international, and emerging markets. Figures 2-4 depict the growth of $100 across three crisis environments for the MSCI Quality Indices, Broad Market Indices, and applicable Polen Portfolios where available. In all three scenarios – the Tech Bubble, the Global Financial Crisis, and the COVID-19 Crisis – quality better protected capital and rebounded stronger than the broader market. For the COVID-19 Crisis in particular, Polen Capital acknowledge this represents a short period of performance, with the drawdown and recovery occurring within an unusually compressed window. The COVID-19 recovery across regions has been ongoing and uneven to date. Longer term, we expect that Polen’s higher bar for quality will continue to provide a clearer path to compelling long-term outcomes.

Figure 2: COVID-19 Crisis

Figure 2

The performance data quoted represents past performance and does not guarantee future results. Based on monthly returns. Current performance may be lower or higher. Please reference the following GIPS reports: Global Growth, International Growth, Global Emerging Markets, Focus Growth. Source: eVestment. Data from 12-31-2019 to 9-30-2020 and 1-1-2020 to 9-30-2020.

Figure 3: 2008 Global Financial Crisis

Figure 3

The performance data quoted represents past performance and does not guarantee future results. Based on monthly returns. Current performance may be lower or higher. Please reference the following GIPS reports: Focus Growth.  Source: eVestment. Data from 12-31-2006 to 12-31-2009.

Figure 4: Tech Bubble

Figure 4

The performance data quoted represents past performance and does not guarantee future results. Based on monthly returns.  Current performance may be lower or higher. Please reference the following GIPS reports: Focus Growth.  Source: eVestment. Data from 12-31-1999 to 12-31-2003.

By focusing on identifying quality companies that have the potential to weather challenging market environments, Polen Capital believe they can provide a favorable foundation for their portfolios to generate attractive relative performance. Polen Capital’s time-tested investment process is reinforced by our more than 30 years of data and research that they think shows concentrating on quality, principal protection, and long holding periods are key characteristics of a strong investment discipline that can work over time and across geographies.

Montgomery in partnership with Polen Capital currently make available two global equity strategies employing the time tested approach.

To learn more about the Polen Capital funds, please visit the fund web pages:

POLEN CAPITAL GLOBAL SMALL AND MID CAP FUND

POLEN CAPITAL GLOBAL GROWTH FUND


Author: Polen Capital

Economics

MSTR Stock Sees Setbacks From the Bitcoin Crash and the SEC

Cryptocurrencies themselves aren’t the only assets suffering at the hands of the market crash. Relevant crypto stocks are also bearing the punishment,…

Cryptocurrencies themselves aren’t the only assets suffering at the hands of the market crash. Relevant crypto stocks are also bearing the punishment, from crypto-mining stocks to the exchange-traded funds (ETFs) that have launched in the last year around crypto. MicroStrategy (NASDAQ:MSTR) is one such company suffering from the market’s rampant volatility. Combine this with the U.S. Securities and Exchange Commission’s (SEC’s) recent blow to the company’s accounting, and the MSTR stock losses make sense.

Source: Shutterstock

MicroStrategy doesn’t necessarily seem tied to crypto in any way at first glance. After all, the company deals mainly in business software and cloud-based computing. But, if one knows the company’s CEO, Michael Saylor, they’d immediately understand the connection. Saylor is a massive Bitcoin (CCC:BTC-USD) bull, using his Twitter profile to constantly promote the currency.

With Saylor at its helm, MicroStrategy has become increasingly entrenched in crypto. In fact, Bitcoin holdings account for a significant portion of the company’s capital allocation strategy. As of late December, the company is in possession of over 124,000 BTC, worth over $4 billion at its current value of around $34,000.

MSTR Stock Hits Rough Patch After SEC Ruling, Crypto Crash

Of course, with the massive BTC holdings that MicroStrategy possesses, the recent crash in Bitcoin prices is also affecting MSTR stock prices. As Bitcoin dipped below $33,000 early this afternoon, MSTR stock was down nearly 9%. But there’s another reason for MSTR’s downturn, and it’s thanks to the SEC.

Late on Thursday, the SEC responded to MicroStrategy’s unorthodox method of accounting for its Bitcoin holdings. Indeed, MicroStrategy has been using non-Generally Accepted Accounting Principles (GAAP) methods of reporting information related to its stock of Bitcoin. Previously, the company had been tweaking its data in order to exclude what it calls “cumulative impairment losses.” The company says that it is doing this in order to present investors with a consistent performance across reporting periods.

GAAP practices were not created with cryptocurrency in mind. Still, the SEC is not accepting MicroStrategy’s methods of reporting this data. The governing body is objecting to MicroStrategy’s practices and ordering the company to refrain from reporting its data in these ways going forward.

As the afternoon continues onward, Bitcoin is showing signs of life, trading up by about 3%. MSTR stock, meanwhile, continues to lose. The stock is currently down about 5%. Over 1.2 million shares of the stock are trading hands, against a daily average of just 487,000.

On the date of publication, Brenden Rearick did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.

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Economics

5 Important Investing Lessons From Allakos’ Price Collapse

Allakos (NASDAQ:ALLK) is a clinical-stage biopharmaceutical company that recently saw a pretty dramatic price collapse at the end of December. I believe…

Allakos (NASDAQ:ALLK) is a clinical-stage biopharmaceutical company that recently saw a pretty dramatic price collapse at the end of December. I believe that ALLK stock, and its subsequent collapse, is a learning opportunity for the investing community.

Source: Pavel Kapysh/ Shutterstock.com

In mid-December 2021, shares of Allakos were trading near $83 per share and they tanked to a stock price of $7.43 at close on Jan. 19, 2022. At some point last year, ALLK stock reached a 52-week high of $157.98. Now the 52-week low stands at $6.38 which is around where ALLK stock currently sits.

So is that a good reason to invest in Allakos now?

I argue that it is a naïve and very dangerous investment decision. Luckily for the investment community, Allakos has given us plenty of food for thought regarding the all too many common mistakes novice or uneducated investors make when they decide to invest in stocks.

There are at least five stock market investing lessons that Allakos has reminded me of. Here are my thoughts on all these.

1. Investment Markets Are Not Casinos

When you go to a casino the expectations to win playing various games are slim to none. People just want to have fun, enjoy, have a cosmopolitan lifestyle for a bit, and wish to get lucky and make a profit. They generally have no plan at all. Wishful thinking is the reason for gambling.

Stocks should not be anything like this. There is a business plan behind each company: good, bad; successful, or terrible. ALLK stock has been alluring investors to gamble on a business plan that is too risky and without delivering any results yet. It’s a clinical-stage biopharmaceutical company with no revenue yet.

Is it any wonder the stock crashed off its 52-week high?

2. Invest in What You Know

Biopharmaceutical companies are inherently very risky, and clinical-stage biopharmaceuticals are multiple times riskier as they do not generate revenue.

I argue that investors in these cases of biotech stocks do not dig deep enough into the pipeline products and ignore the underlying fundamentals. Investing in a stock without knowing inside out the real product or services of the company, the latest news and key catalysts is like going sailing without checking the weather or even knowing how to swim. The investment markets can be like a very stormy sea that, at times, will make you feel uncomfortable, scared, and anxious.

It is not wise to sail without checking the weather first, then why buy stock in a company you know nothing about?

3. Volatility Is Your Best Friend and Your Worst Nightmare

Highly volatile stocks can quickly stir emotions. Just remember the hot meme stocks back in 2021. Biotech stocks are in general very volatile and can either deliver stunning profits too quickly that tend to deflate also very fast or deliver massive losses over time.

The good news is that investors can educate themselves to recognize patterns of abnormal returns. It is like gambling again, investors bet on clinical trial news.

The problem is that these clinical trials have a very asymmetrical path of delivering stock price movements. It is a zero-sum game. Toss a coin and invest in the outcome. The chances seem to be 50/50 to win or lose. Not bad.

However, this is not a recommended investment strategy at all. The reason is that investors cannot apply stop-loss limits effectively when things go bad. A 10%-15% stop-limit when buying a stock seems reasonable. With ALLK stock, the stock tanked from a closing price of $84.39 on Dec. 21, 201 to an open price of $10.58 on Dec. 22, 2021.

Any reasonable stop-loss would not have been triggered and investors would be left wondering why they lost approximately 90% overnight.

4. Realistic Expectations Often Seem Boring

I also argue that in most cases investors supporting biotech stocks have unrealistic expectations.

We know that inflation is too high and that the Federal Reserve will increase interest rates in 2022. This is a big reason why why the stock market is having a rough first month in 2022 as expectations have changed.

Biotech stocks are not all the same. There are reputable companies with solid fundamentals. There are questionable firms. And then there are companies like Allakos, with dreadful fundamentals.

Why would a company with zero revenue be expected to perform well?

What drives value for the investors?

The answer is the fifth reason below: strong fundamentals and attractive valuation.

5. Ignoring the Fundamentals Can Be Disastrous

At first glance, investors can discover two red flags for Allakos.

The company is unprofitable, has zero revenue and shareholders have been diluted in the past year, with total shares outstanding growing by 3.4%.

Analyzing the fundamentals of each public traded company puts the odds in your favor to make wise investment decisions. Not all your investment decisions will be a success, this is impossible, and there are no guarantees of outperforming the broader stock market. There is however a method, called due diligence that allows sorting great stocks from junk stocks. Finding a stock with great fundamentals is a start. Valuation is another story.

Allakos has a cash burn problem but has no debt yet on its balance sheet. Does this make it a company to invest in because it has a strong balance sheet? How does the company pay its operating and research and development expenses when it generates zero revenue?

Fundamental analysis may seem a tedious task at first to novice investors. The truth is that it is far easier than most think. The key concepts of analyzing financial ratios to evaluate stocks can be learned easily without any excuses. Valuation, however, is another story, but at least relative valuation can also be taught easily.

Bottom Line on ALLK Stock

Biotech stocks are a special category of investments that can easily turn from hot to cold in the blink of an eye.

If you study more of the fundamentals of stocks and stock trading then you can be more aware of the warning signs. And Allakos stock had severe warning signs foretelling of its collapse.

On the date of publication, Stavros Georgiadis, CFA  did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.

Stavros Georgiadis is a CFA charter holder, an Equity Research Analyst, and an Economist. He focuses on U.S. stocks and has his own stock market blog at thestockmarketontheinternet.com. He has written in the past various articles for other publications and can be reached on Twitter and on LinkedIn.

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Economics

Will Crypto Rebound or Should You Sell Cryptos Like BTC, ETH, SOL Right Now?

The crypto market is causing investors far and wide to sweat bullets. A market-wide crash is affecting nearly every asset of note. And crypto prices aren’t…

The crypto market is causing investors far and wide to sweat bullets. A market-wide crash is affecting nearly every asset of note. And crypto prices aren’t just being dragged downward, they are plummeting — fast. Some plays are down 25%, while others are down nearly 50%. As this massive volatility continues to siege the asset class, investors are wondering whether this is a time to buy, hold or sell. So, will crypto rebound soon? Or is it time to cut losses ahead of more red candles?

Source: Shutterstock

Crypto is seeing a downturn in the wake of some major global powers looking to crack down on the asset class. After China’s ban last year, the U.S. is looking to regulate crypto assets. India is looking to follow as well, with the government voicing an interest in banning digital currencies. And this week, a massive driving force behind the downturn is the Russian central bank’s scathing report on cryptocurrencies. The report is fueling calls for the nation to ban mining and trading of digital currencies within its borders.

These countries alone account for over 3 billion of the world’s population. Of course, bans in any combination of the four nations would be devastating to global crypto adoption. The fear of these blows to adoption are certainly helping along the market crash. Now, investors are witnessing Bitcoin (CCC:BTC-USD) tumbling 20% in just seven days. Ethereum (CCC:ETH-USD), meanwhile, has lost over 30% in the same span, as has layer-1 competitor Solana (CCC:SOL-USD). Tokens are being spared no mercy, either, with Shiba Inu (CCC:SHIB-USD) tumbling 30%.

Will Crypto Rebound, or Is it Time to Sell?

With the market so drastically falling, investors are wondering whether a crypto rebound is becoming less likely. Indeed, one of the hallmarks of a crypto correction is in “buying the dip;” but if a rebound is not going to happen, investors will want to get out as fast as they can to prevent further loss.

Fear not, for only the most bearish on crypto are those expecting crypto to fall into the oblivion with this one crash. Even Peter Brandt, the well-known crypto trader who predicted 2017’s crash, is not warning of doom to the industry. Brandt says Bitcoin will bottom out at around $25,000 before regaining its footing, about $8,000 lower than current values. It’s certainly not as pretty as its $60,000 values of late autumn. However, that’s still a higher price than any other crypto in history has been able to reach.

InvestorPlace analyst Luke Lango is one of the majority who believe crypto will be righted once again after all of this is said and done. But, he compares the current market woes to those suffered in the late 1990s, where only the strongest survived. Like the dot-com bubble, crypto projects will be spared only if they are fundamentally strong:

“The crypto market will rebound, of course, because the decentralized architecture underlying blockchain technology represents the future of application development. However, not all cryptos will rebound.

We’re seeing a re-run of the bursting of the Dot Com Bubble. Throughout the 90s, the internet was the hottest emerging technology, but not everyone fully understood it, so investors blindly gave huge valuations to anyone that bought a domain. Bubble burst. Internet went on to change the world. But most internet stocks went to zero.

Same thing here. Crypto crash 2022 represents Nasdaq crash 2001. The Nasdaq rebounded from that crash, but lots of internet stocks didn’t join the rebound — and few (like Amazon) soared thousands of percent.”

The vast majority don’t see this as an “end of days” moment for crypto. However, there are plenty of traders who are not looking at holding their crypto for the long term. Should those traders start selling, so as not to lose more money?

Holding Crypto and Knowing Your Tolerance for Volatility

As the Liquid crypto exchange covered in its blog last autumn, crashes demonstrate the importance of setting limits, both for gains but also for tolerable losses. It’s important for investors to know when to sell and walk away with profit. But, it’s almost more important for one to know how much volatility they can tolerate before getting out.

In an already volatile industry, users need to have set prices for themselves when it comes to selling off their assets. Those who can’t tolerate losses like those recently demonstrated by SOL or BTC or ETH should consider cycling those investments into other areas. However, it’s worth noting that if Brandt’s prediction holds true, we are almost at the bottom of the Bitcoin correction. If one has held this far along, they can likely see the light at the end of the tunnel.

There’s also virtue in being selective with one’s investments. There’s no sense in buying a coin or a token whose only claim to value is in being a meme or a deflationary currency. As Lango puts it, the crash will be a major test for those less practical currencies:

“So what’s the game plan here? Don’t buy the dip in crashing coins that you don’t fully understand or whose value prop is questionable. Be selective. Only buy the dip in top tokens with great projects, great teams, great value props, and preferably great usage statistics and tokenomics. Those tokens will rebound big — many others may not.”

On the date of publication, Brenden Rearick did not have (either directly or indirectly) any positions in the securities mentioned in this article. The opinions expressed in this article are those of the writer, subject to the InvestorPlace.com Publishing Guidelines.

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