How does the founder of a star agency with a position of 40 billion US dollars select stocks in a system?

David Polen's investment experience and philosophy

Faced with so many stocks, what if you don't know how to select stocks? Futubull has many tools to assist in stock selection, such as institutional tracking. Investors can see what star institutions are buying and selling, and may get some inspiration.

Among them, there is an institution called Polen Capital Management (Polen Capital Management). As of November 3, 2023, this institution's holdings reached about 40 billion US dollars. Today I would like to introduce you to its founder David M. Polen (David M. Polen).

David began his career as a Wall Street agent, then traveled Wall Street and worked as a financial executive. In addition to being the founder, CEO, and chief investment officer of Polon Asset Management, he also managed several investment management companies. Additionally, he was included in the Marquls (Marquls) World Who's Who (Finance and Commerce)).

Most noteworthy is his stock selection strategy — Systematic Valuation Discipline (SVD). David himself is a value investor. His investment philosophy was influenced by Graham and Buffett, and he paid great attention to margins of safety. Based on this, the SVD strategy emphasizes bottom-up (from individual stocks to the macro) and focuses on investing in a few high-quality companies.

David mentioned many times in interviews that their portfolio holds an average of 20 stocks. He sees investing as a very detailed job, and his portfolio is selected based on very strict stock selection criteria.

After selecting the combination, David believes that the best investment is to never have to consider selling, so he has held each stock for an average period of more than 6 years.

David Polen's Law of Systematic Evaluation

According to the conversation transcript in “The Wall Street Transcript (The Wall Street Transcript)”, David's system evaluation rules mainly include several points:

1) Total market capitalization of more than 500 million US dollars; 2) Excellent financial strength; 3) Sufficient free cash flow; 4) Good surplus momentum; 5) Compare the company's internal rate of return (IRR) with other companies and fixed income investment instruments to determine whether the stock price is undervalued; 6) Risk diversification.

These standards take into account dimensions such as size, debt situation, free cash flow, profitability, growth, valuation, and risk. Indeed, as shown in the name of the strategy, they are quite systematic.

The scale is easier to understand. Since the margin of safety is emphasized, focus first on companies with large market capitalization to avoid small-cap stocks that are generally relatively unstable and have a greater risk of fluctuation.

In the book “What Works on Wall Street (Fourth Edition)” (What Works on Wall Street) by James O'Shaughnessy (James O'Shaughnessy), a pioneer in stock volume analysis, there is empirical data showing that small-cap stocks have had high absolute returns over the years, but also high risk.

However, in measuring financial strength, one very important factor is the debt situation. “debt status+cash flow” is something that many investment masters value.

For example, the famous American investment fund manager, W. Whitney George (W. Whitney George), emphasized that the company must have a good balance sheet and a large amount of cash; Michael Lauer (Michael Lauer), a “top trader” in the “Financial Geek” series, also believes that “a company must have a strong balance sheet and reasonable cash flow.”

So how do you understand surplus momentum? This includes better profitability and higher growth. Profitability can be measured by indicators such as net profit margin (net profit/revenue), return on total assets (net profit/total assets), return on net assets (net profit/net assets), etc. Growth can be viewed through indicators such as net profit growth rate.

Let's talk about valuation. David used the internal rate of return IRR as an indicator. How do you understand it?

All capital inflows/outflows over a period of time are discounted to the present, and all present values are added up to obtain net present value. If the net present value is 0, then the discount rate is IRR.

This indicator is usually the bigger the better, because it's actually a measure of earnings. Normally, if the IRR is greater than the base rate of return, this investment is considered more viable.

Corresponds to David's valuation standards, that is, if a company's IRR is higher than other companies and fixed income investment instruments, then the price can be considered underestimated. This is actually a relatively uncommon but effective way to measure valuation.

Finally, risk diversification is also easy to understand. Although it is necessary to concentrate on investing in a few high-quality companies, diversification in the industry can usually reduce overall risk.

How do we apply this strategy?

After understanding David's stock selection rules, how can we go further in practice? Let's look at it in a few points.

1. The market capitalization is > 500 million US dollars, which is very straightforward.

2. In terms of debt situation, the balance ratio (total debt/total assets) can be used to measure overall solvency. It is generally considered that a balance ratio of < 50% is excellent.

3. In terms of free cash flow, you can see if it is higher than the market average, but this is more difficult to quantify in more detail, so you can look at it again in further screening.

4. In terms of profitability, it can be measured by the return on net assets ROE (net profit/net assets). This is usually the profit indicator that shareholders are most concerned about, and it is also an indicator that Buffett values very much. According to Buffett, ROE > 20% is an important stock selection criterion.

5. In terms of growth, you can consider the more commonly used net profit growth rate. How can this be quantified? For example, with reference to Benjamin Graham's (Benjamin Graham) standard, this indicator can be set at 7% or higher.

6. In terms of valuation, the IRR internal rate of return is difficult to calculate; we can only use more common valuation indicators, such as price-earnings ratio (total market capitalization/net profit). Here, you can select stocks that have a valuation score of < 70% in the past year and are ranked in the top 100 in the industry. Of course, everyone can also set them according to their own understanding.

7. In terms of risk diversification, this is also difficult to quantify; it can be examined further after initial screening.

What else can be done in specific practical terms?

Well, at this point, let's take US stocks as an example and use a bull-bull stock selector to practice.

72 stocks were initially selected (based on November 10, 2023 data). Next, how can they be analyzed from any perspective?

For example, in the part that cannot be specifically quantified above, let's take a look at which of these individual stocks have sufficient free cash flow, and see how the industry distribution of these individual stocks is, so that the investment portfolio can be better distributed among different and promising industries.

You can also consider individual stocks, timing, etc. by combining information and indicators that you are interested in, such as fundamentals and technical aspects.

Of course, David Polen's strategy and practical exercises introduced today do not guarantee profit, nor are they necessarily suitable for all markets and periods, but I hope they will inspire you.