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04-01-2022 - Polen POV


A TALE OF TWO MARKET MACHINES


WHILE SEVERAL FACTORS CAN AFFECT STOCK PRICES, WE BELIEVE LONG-TERM RETURNS ARE
ULTIMATELY DRIVEN BY SUSTAINABLE EARNINGS GROWTH




A METAPHOR FOR INVESTORS AND SPECULATORS

In a 1987 letter to Berkshire Hathaway shareholders, Warren Buffett stated that
“in the short run, the market is a voting machine but in the long run, it is a
weighing machine.” While simple, we believe the metaphor is remarkably accurate.
It implies that the market can behave like an (often irrational) electoral
contest in the short term, determining a company’s share price based on how
popular or unpopular it appears at the time. When markets behave like a voting
machine, they tend to ignore a business’ underlying fundamentals and are driven
by speculation, sentiment, and other factors shown below.


FIGURE 1: THE VOTING VS. WEIGHING MACHINE



Source: Polen Capital

During periods of ebullience, the voting machine can become overwhelmed by
optimism and propel a company’s share price beyond its fundamental value. We saw
a manifestation of this euphoric behavior during the “everything rally” of
2020-2021, when equities, bonds, and other assets surged in tandem. Amid the
risk-on environment, companies with negative operating profits and weak
long-term growth prospects reached record highs, exemplified by the “Reddit” and
“meme” stock run-ups.

In contrast, the machine can swing in the opposite direction when bearish
sentiment and volatility strike the market. When fear takes over, it is not rare
to see some market participants throw the proverbial “baby out with the
bathwater,” selling both high-quality and low-quality stocks as they rush for
the exit. In addition, the rise of algorithmic and high-frequency trading has
also exacerbated volatility in recent years. Machine-led trading programs (which
account for more than 60% of total U.S. equity volume1) buy and sell securities
based on defined criteria with little regard to company fundamentals, research,
or valuations. Thus, these “non-thinking traders” can trigger self-reinforcing
short-term selling loops.

While even the strongest businesses can experience bouts of indiscriminate
selling as the voting machine overlooks the long-term potential of these
companies, Warren Buffett believed that in the long run, the market would act as
a weighing machine. By this, Buffett meant that equity prices would eventually
reflect the fundamental characteristics of a business, including a company’s
earnings growth potential, financial strength, competitive advantages, and
management quality. Similarly, we believe that our portfolios’ performance will
track the fundamentals of our underlying holdings—even if, in the near term, the
two could become temporarily disconnected.

> When markets behave like a voting machine, they tend to ignore a business’
> underlying fundamentals.

Though some market participants such as day traders and speculators may tend to
be fixated with the daily fluctuations of the voting machine, we believe
long-term investors should center their attention on the weighing machine
instead.


PUTTING MARKET VOLATILITY IN PERSPECTIVE

As we make progress through the year, we believe that understanding the
differences between the two stock market machines will be essential to
navigating the current investment landscape. With prospects of higher inflation
and interest rates, it is worth noting that today’s market environment—one with
less monetary and fiscal stimulus—is meaningfully different than that of the
past two years. In our view, an active management approach will be essential
going forward given that while passive strategies might prove somewhat effective
in an environment where a rising tide lifts all boats, the current backdrop is
likely to draw a wider line between winners and losers.

Even though sharp market fluctuations can be difficult to endure emotionally,
staying the course and remaining patient through periods of heightened
volatility can help investors avoid making impulsive (and often costly)
investment decisions. By removing emotions from the decision-making process, we
at Polen Capital look at market dislocations as opportunities to become owners
of great businesses that rarely go “on-sale” given their competitive leadership
and resiliency. This independent mindset—a pillar of our investment
philosophy—has allowed us to look past temporary market noise and deliver
consistent results for more than 30 years to our clients.

--------------------------------------------------------------------------------

Important Disclosures
1 Spicer, J. & Lash, H. (2009, December 2). Who’s afraid of high-frequency
trading? Reuters. Retrieved March 17, 2022, from
https://www.reuters.com/article/us-highfrequency/whos-afraid-of-high-frequency-trading-idUSN173583920091202

This information is provided for illustrative purposes only. Opinions and views
expressed constitute the judgment of Polen Capital as of April 2022 may involve
a number of assumptions and estimates which are not guaranteed, and are subject
to change without notice or update. Although the information and any opinions or
views given have been obtained from or based on sources believed to be reliable,
no warranty or representation is made as to their correctness, completeness or
accuracy. Opinions, estimates, forecasts, and statements of financial market
trends that are based on current market conditions constitute our judgment and
are subject to change without notice, including any forward-looking estimates or
statements which are based on certain expectations and assumptions. The views
and strategies described may not be suitable for all clients. This document does
not identify all the risks (direct or indirect) or other considerations which
might be material to you when entering any financial transaction.

This information should not be construed as a recommendation to purchase, hold
or sell any particular security. Holdings are subject to change. There is no
assurance that any securities discussed herein will be in the portfolio at the
time you review this post or that any securities sold have not been repurchased.
The securities discussed do not necessarily represent the entire portfolio. It
should not be assumed that any of the securities, transactions or holdings
discussed were or will prove to be profitable or that any investment
recommendations we make in the future will equal the investment performance of
the securities discussed herein. For a complete list of Polen Capital’s past
specific recommendations for the last year, please contact
info@polencapital.com. Past performance does not guarantee future results and
profitable results cannot be guaranteed.

--------------------------------------------------------------------------------


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05-06-2022 - Polen POV


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03-09-2022 - Polen POV


THE CASE FOR HIGH YIELD INVESTING DURING TIMES OF UNCERTAINTY

Amid a confluence of economic uncertainties, an active investment approach will
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03-03-2022 - Polen POV


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