On the back of an unprecedented, macro-driven environment in 2022, the first quarter of 2023 has proven no less volatile. While plenty of uncertainty remains, particularly surrounding economic growth, the trajectory of interest rates, and the subsequent impact on financial markets, global equity markets started the year in positive territory.

January and February’s positive returns appeared to be largely driven by expectations of normalising interest rates, a relatively sanguine view on the global economy, and a rotation away from last year’s winners, namely Energy, into 2022’s weakest performing sector including Information Technology and Consumer Discretionary, which are large weights in the Fund’s benchmark. However, in March cracks appeared in the banking system, triggered by the collapse of Silicon Valley Bank, which made for a higher probability of normalizing interest rates, but with a worsening economic outlook. Subsequently, we’ve witnessed a banking crisis unfold.

These recent events underscore why we invest the way we do, owning what we believe are the highest-quality growth businesses in our asset class.

Businesses that are not reliant on external capital to grow due to strong balance sheets, that are not as influenced by interest rates, and that have the strong leadership to invest at high returns on capital. These are the hallmarks of our flywheel investment criteria.

It’s times like these that bring into sharp focus why we avoid banks and energy companies. Over the last year some of these lower-quality industries were perceived as a safe place to “hide” for quality growth managers given the relative outperformance. We believed this was short-term thinking and stuck to the key tenants of our disciplined process. Over time these industries have shown themselves to be highly vulnerable to demand destruction, and a tightening of credit availability and/or a recessionary environment would be particularly challenging for these companies.

When we invest in a business, we orient ourselves with at least a five-year investment horizon, making an evaluation on the long-term durability and sustainability of earnings growth. Our concentrated approach allows us to invest only in businesses meant to withstand changes in the funding environment, tighter credit, and economic downturns. This does not mean that our businesses or any business will be immune to economic disruption. However, it gives us greater confidence that the trajectory of earnings, cash flow, and value-creating reinvestment will be superior to the broader small-and mid-cap opportunity set. This has always been central to our investment philosophy.

While growing recessionary pressures may cause companies to downgrade their earnings expectations, it should also lead to the market distinguishing between good and bad companies again.

We believe this should be a positive for active management and our high-quality bottom-up approach.

Portfolio performance and attribution

Over the first quarter, the Polen Capital Global Small and Mid Cap Fund increased by 10.19 per cent net of fees, versus the benchmark the ACWI SMID Cap Index in AUD which returned 5.58 per cent.

Portfolio outperformance was driven by positive security selection and sector allocation. Security selection was strongest in the Financials and Consumer Discretionary sectors and outweighed weaker selection in Information Technology and Communication Services. Positive selection within Financials was exacerbated by the collapse of Silicon Valley Bank and the subsequent impact on the wider financial sector. As discussed earlier, we do not own banks nor any other consumer finance businesses as they generally do not meet our investment criteria.

Sector allocation, an outcome of our bottom-up selection process, also contributed positively to relative returns. Our overweight to Information Technology and underweight to Energy were both positive for relative performance, while our underweight to Industrials and overweight to the Health Care sector only marginally detracted from relative performance.

From a style perspective, we saw a reversal of what appeared to drive markets through 2022, with momentum the standout underperformer in the first quarter of 2023. A result of this was the Growth and Quality factors outperforming the benchmark, which was supportive for the portfolio’s style footprint. Sectors we typically have less exposure to, such as Energy and Financials, which were some of the strongest performers through 2022, were also weak this quarter. We remain focused on finding companies with competitive advantages that we believe can compound earnings and cash flows over the long-term independent of commodity swings or economic cycles.

Our most significant individual contributors to performance over the first quarter were Goosehead Insurance, Floor & Decor and CompuGroup Medical on both an absolute and relative basis.

Goosehead Insurance

Goosehead Insurance, a personal line property and casualty insurance brokerage primarily focused on home and auto markets, was the strongest performer, rising over 50 per cent over the quarter. The company has continued to deliver strong results despite weakness in the housing market. They reported full year 2022 results with revenues growing 38 per cent year-on-year and guiding to continued 25 per cent organic revenue growth with expanding margins. The company continues to show that they are among the best operators in a difficult macro environment, leaning into their value propositions around great customer service and a better agent experience, and kicking off thoughtful, value-add strategic growth programs.

Floor & Decor

Floor & Decor, a leading retailer of hard-surface flooring in the U.S, reported quarterly earnings that exceeded market expectations. Earnings growth was strong, with continued market share gains from both its larger multi-national home improvement peers and smaller local businesses.

CompuGroup Medical

CompuGroup Medical, a European health care software solutions business, posted double digit revenue growth for 2022 despite a challenging backdrop and raised 2023 guidance, with opportunities in its data solutions offering.

Our most significant detractors from performance included Azenta, Netcompany and Endava on both an absolute and relative basis.

Azenta

Azenta, a position we sold early in the quarter, reported disappointing sales growth amid several execution issues.

Netcompany

Netcompany, a Danish IT consulting business, reported good results for the fourth quarter of 2022, with revenue growth and margins exceeding expectations, however management guided more conservatively for 2023 with growth expected to slow and margins to be impacted by higher costs.

Endava

Endava, another IT services consulting business that we own, was impacted by the same factors. They have seen activity slow into the end of the year amidst a more cautious operating environment where discretionary IT spend is being paused. Longer-term, however, we trust their ability to play a critical role in facilitating digital transformation for their clients across a variety of industries and end markets. It’s worth noting that while both businesses are classified as IT consulting firms, each company offers different digital transformation services to very different client bases in very different industries and across different geographies.

Outlook

We continue to stay focused on the long-term value propositions, competitive advantages, ongoing initiatives, growth opportunities, and potential earnings power of our Portfolio companies. As a reminder, our investment time horizon is five years. This allows us to think and act like owners. The markets continue to have a lot of uncertainty and general noise, but we believe that quality companies can weather the uncertainty and come out of the other side stronger. Our trading activity remains at the higher end of our normal range, as we continue to take advantage of unique opportunities in the market. As we have said in prior commentary, our pipeline of new potential investments remains attractive.

If you would like to learn more about the Polen Capital Global Small and Mid Cap Fund, please visit the fund’s web page to learn more: Polen Capital Global Small and Mid Cap Fund

Past performance is not an indicator of future performance. Returns are not guaranteed and so the value of an investment may rise or fall.

This report has been prepared for the purpose of providing general information, without taking into account your particular objectives, financial circumstances or needs. You should obtain and consider a copy of the Product Disclosure Document (‘PDS’) relating to the Fund before making a decision to invest. The PDS and Target Market Determination (‘TMD’)  are available here: https://www.montinvest.com/our-funds/polen-capital-global-small-and-mid-cap-fund/and here: https://fundhost.com.au/  While the information in this document has been prepared with all reasonable care, neither Fundhost nor Montgomery makes any representation or warranty as to the accuracy or completeness of any statement in this document including any forecasts. Neither Fundhost nor Montgomery guarantees the performance of the Fund or the repayment of any investor’s capital. To the extent permitted by law, neither Fundhost nor Montgomery, including their employees, consultants, advisers, officers or authorised representatives, are liable for any loss or damage arising as a result of reliance placed on the contents of this report. Past performance is not indicative of future performance.