MI313: Small Cap Mastery w/ Rayna Lesser Hannaway

0:00You're listening to TIP. As you think about all of these pieces, they're all interconnected and they're mutually reinforcing. A company with durable competitive advantages can attract top talent for its management teams. Effective management can make informed decisions about where to reinvest for the future. These pieces all work together to drive the compounding engine of a business. And we require all of these pieces for every company that we invest in.

0:35In this episode, I chat with Rainer Lesser-Hanaway about her business flywheel model to identify great businesses, a use case of the business flywheel on one of Poland Capital's holdings, Globont, the strengths of a business with repeatable sales, the advantage of investing in small-cap stocks, how to deal with valuations in high-quality businesses, how to determine when to exit an investment based on a business's fundamentals, and a whole lot more. I'm a big fan of small cap businesses. They offer very high upside for two main reasons. First, many are in the early stages of their growth cycle and still have many years of growing 20 % plus for many years ahead.

1:10Second, because they are smaller and less well-known, there are less eyes on them, which can offer mispricings to patient investors. Poland Capital is one such fund that has dedicated a lot of time and resources to looking just at these types of businesses. So when I got the opportunity to speak to the head of their small company growth team, I jumped at the opportunity. After reading their perspectives and about the systems that Raina has put into place, I had many questions. I know Raina's answers will help listeners of the Millennial Investing Podcast better understand how to invest in the small cap space and better understand the mispricings in high quality businesses, regardless of market cap.

1:46Now, without further delay, let's get right into this week's episode with Raina Lester-Hanaway. You're listening to Millennial Investing by the Investor's Podcast Network. where your hosts, Robert Leonard, Patrick Donnelly, and Kyle Grieve, interview successful entrepreneurs, business leaders, and investors to help educate and inspire the millennial generation.

2:15Welcome to the Millennial Investing Podcast. I'm your host, Kyle Grieve. And on today's episode, I am joined by Raina Lesser-Hanaway. Raina, welcome to the show. Thank you, Kyle. I'm so thrilled to be here with you today. So you specialize in small cap growth companies, and I'd like to dive into this with you today. Before we discuss small caps in a little more detail, I'd like to learn more about your investing philosophy. Poland Capital focuses on high quality growth companies, and quality means different things to different investors. So I'd like to start off by understanding more about what it means to you.

2:46Quality is a term that often lacks a universally agreed upon definition in the world of investing. To us, quality can be separated into three dimensions, the business, the management team, and the reinvestment opportunity. On the business, it all comes down to a company's ability to generate sustainable profits over the long term. Some of the things that we care about here are a company's competitive advantage, its market position, the robustness of its business model. For the management team, we're looking for leaders who have great strategic vision that's also matched with strong execution skills and a capital allocation discipline that together those things can make that great vision a reality.

3:37And regarding reinvestment, we're focused on a company's ability to reinvest its profits for future growth. This is closely related to the business quality because it's about the potential for sustained value creation. To us, these things are all connected. And so with your extensive 27 years of experience in small cap investments, I'm interested in knowing what motivated you to concentrate on high quality small cap stocks as opposed to other approaches within the small cap world. I have researched thousands of companies in my 28-year career and have seen many successes and also many failures.

4:17My interest in investing in high-quality growth companies really grew from my early exposure to covering firms like Amazon and Netflix when they were small cap. Seeing these businesses rise to become industry giants while also witnessing many smaller companies with short-lived success has really influenced my investment approach. As time has passed, I've learned to value high-quality growth businesses because they really prioritize sustained long-term expansion over quick profits. They continually reinvest in their business. They enter new markets. They're always innovating. They're always laying the groundwork for compounding success.

5:05And watching these kinds of companies have, it's really convinced me of the power of long-term investments in these companies. You know, I've got a lot of appreciation for their journeys, as well as the pitfalls when companies lack the necessary attributes for lasting growth and consistent returns. So next up, I'd like to discuss your business flywheel, which is a set of five self-reinforcing conditions that increase the odds of long-term compounding. So they are one, uniquely positioned, two, repeatable sales process, three, a robust business model, four, effective management, and five, value creating reinvestment.

5:45So I'd like to know more about how this flywheel developed and how it has improved your filter for identifying wonderful businesses. I created our flywheel for investing based on the fundamental values and lessons that I've learned across my career, which have shaped my investment philosophy. In essence, our flywheel creates a strategic roadmap for our team. By focusing on these key conditions, our flywheel creates a clear and shared understanding of what it takes for a company to thrive in the long run. And having that shared vision helps everyone on our team focus on the right types of companies and the right types of features.

6:26So as a starting point, we're always looking for companies that are uniquely positioned with durable competitive advantages. For long-term compounding, a company must have something special that sets it apart from its competitors. This could be proprietary technology. It can be strong brand recognition, exclusive access to resources. Whatever it is, they need to have advantages that make it really hard for others to replicate what they're doing and that create a protective moat around the business. The next thing we look for as a part of our flywheel is a repeatable sales and growth process. To us, consistent growth is a key sign of success.

7:12And a well-defined repeatable sales and growth process really allows a company to scale efficiently and sustainably, ensuring long-term growth. What we want to make sure that we can see that a company has a real recipe for how they're going to repeat their success in the future. I've seen many companies that are one-hit wonders in the small cap space that really lacked this recipe. And I've seen companies that were lucky rather than skilled in where their growth came from. That's exactly what we're trying to avoid. Once we've determined that a company does have a repeatable sales and a repeatable growth process, we're looking for a robust business model.

7:57To us, a strong business model is the foundation of long-term compounding. It outlines how a company can create and deliver value while ensuring profitability and strong returns. A resilient business model is one that can adapt to changing market conditions and evolve with customer needs. Some of the hallmarks of a robust business model to us are strong gross margins. We want to make sure that a company has a margin model that's conducive to generating a lot of cash. And typically when you have very strong gross margins, it says a lot about the value that you're providing to your customer and the kind of pricing power you have and the stickiness of those relationships.

8:45The other thing that we're always looking for is really strong cashflow returns on investment. We want to make sure that these businesses are earning returns well ahead of their cost of capital and that they're earning enough to support their future growth. And that's from a position of maintaining their business today, but also reinvesting in ways that are going to enhance their growth in the future. And that may be by growing in different directions. It may come in the form of extending their growth runway. We want to make sure that they can self-fund that and that they don't have to rely on external capital to fund their long-term growth plans.

9:32The last piece that I would say on robust business models is because we're focused on self-funding businesses and we want to make sure that there's a business where success is really under management's control. We want to make sure our companies have very robust balance sheets. And we do not like companies that have a meaningful amount of financial leverage or that need leverage to deliver on their growth plans. We think that that is a risky proposition, especially in today's environment. The next piece that we look for is effective management teams. and leadership is critical for guiding a company towards long-term success.

10:14And it's particularly true of small caps. Effective management teams, they really set the direction and foster the culture of innovation, accountability, and adaptability. They make tough decisions when called for and they steer the company through challenges. We all can appreciate how important that is, having just lived through a pandemic. and now in this period where there's dramatic change in financial conditions. This is a really hard environment to be operating any business, especially a small cap business. And we want to make sure that our management teams have the chops to do it well. The last piece that I would point to in our flywheel is that we want companies that are always reinvesting for the future.

11:03When you think about successful small cap businesses that have these strong growth rates, strong margins, strong returns on capital, inevitably that attracts a lot of competition. And so they need to be making plans and taking steps to stay ahead of everyone else. Companies that can compound over time, they're always investing in their growth and in their evolution. And this could involve research and development, expanding into new markets. It could be mergers and acquisitions. It could be process improvements. But that reinvestment ensures that a company remains competitive and innovative and that their growth runway is long.

11:49And so as you think about all of these pieces, they're all interconnected and they're mutually reinforcing. A company with durable competitive advantages can attract top talent for its management teams. Effective management can make informed decisions about where to reinvest for the future. These pieces all work together to drive the compounding engine of a business. And we require all of these pieces for every company that we invest in. So I think the audience would take a lot from you using your business flywheel on a real world example. So a business I know you're an owner of is Globot. Can you let the audience know a little bit about the business and use your flywheel on that business as a case study?

12:33Certainly. Let's break down the Globot flywheel. So to start, Globot is a cloud native IT consulting company that specializes in helping its customers with digital technology. And this is an area where companies across the globe all need help with today. Let's start with what makes them unique. First is that they're digital pioneers. They're leading the charge in digital transformation, and that really helps them hire the top talent who want to work on the most groundbreaking projects and gives them a distinct edge in this rapidly changing landscape. It's all about having the right people on the bus.

13:17On repeatability, they've demonstrated time and time again that they can drive recurring revenue and strong growth within their blue chip customer base. They have an excellent partnership with their customer and they've proven that they can consistently grow within those customers. Working with giants like Google and Electronic Arts, LinkedIn, Coca-Cola. They don't just acquire these clients and work with them once or twice. They're growing alongside them. And we find that very exciting. They've got mid-teens adjusted operating margins that really outperform the industry standards. They really have a rock solid business model.

14:04With mid-teens adjusted operating margins, they outperform industry standards. And they've got robust cash flow, which puts them in a position to finance their growth without external help. On their management team, they have an experienced founder-led management team that boasts a deep understanding of the industry, has great strategic vision, strong execution skills, and we've seen that they're very wise decision makers. And then on reinvestment, they're always investing in the future. They've acquired and integrated complementary acquisitions. They're always expanding their offerings and their reach.

14:46They do a great job embracing emerging technologies and building new capabilities that help to keep them relevant and keep them at the forefront of their industry. And then, of course, they continue to invest in great talent, which is the most important part. All of these things, they work together to drive excellent long-term compounding for the business. To bring it to life, I first met the folks at Globant back in 2014. And at the time, the company was delivering about$200 million in revenue annually. This year, they should do over$2 billion. Let's take a quick break and hear from today's sponsors.

15:31Even Einstein had blind spots. That's why modern science is built on the idea of peer review. Investing may be more art than science, but that doesn't make peer feedback any less valuable. The tricky thing is finding qualified people who are interested and willing to help vet your investment ideas. That's why we built the Intrinsic Value Community. It's a place to connect, share ideas, learn, and get feedback. Nobody ever wishes they'd spent more time buried in spreadsheets, but connecting and building relationships with others who may be smarter on a topic than you, but who are also schooled in value investing, that's valuable.

16:04We make spots in this exclusive community available in cohorts every few months. And last time around, our 30 available spots filled up pretty quickly. If you're interested in our next cohort, which will be even smaller, you can join the waitlist at theinvestorspodcast.com slash intrinsic value community. That's theinvestorspodcast.com slash intrinsic value community. Support for the show comes from public.com. You're thoughtful about where your money goes. You've got your core holdings, some recurring crypto buys, maybe even a few strategic option plays on the side. The point is you're engaged with your investments and public gets that.

16:42That's why they built an investing platform for those who take it seriously. On public, you can put together a multi-asset portfolio for the long haul. Stocks, bonds, options, crypto, it's all there. Plus, industry-leading yields on your cash with no fees or minimums. Switch to the platform built for those who take investing seriously. Go to public.com slash TIVP and earn an uncapped 1 % bonus when you transfer your portfolio. That's public.com slash T-I-V-P. Paid for by public investing, full disclosures in podcast description. Just like everybody else, there was a time when I was a beginner investor and I have to say, investing is particularly filled with jargon that can just make it so difficult for new investors to understand what is going on.

17:27But it's never too late to get smarter about stock investing from the ground up. At The Investors Podcast Network, we've made a habit of studying the world's best investors, and now I'm distilling those learnings into a simple course for you or for anyone in your life who you might want to share the gift of knowledge with. With my How to Get Started with Stocks course, you can master the principles of excellent lifelong investing with valuable insights for both beginners and pros. The course covers 10 different sections, beginning with the basics of what a stock actually is and how the stock markets work, to strategies to optimize your retirement savings, how to pick great companies for the long term, what to look for in ETFs, and how to monitor your investments, plus so much more.

18:06To begin getting smarter about investing, just visit theinvestorspodcast.com slash get started with stocks. That's theinvestorspodcast.com slash get started with stocks. And for a limited time, you can use code stocks15 for a 15 % discount at checkout. All right, back to the show. So let's discuss small caps in some detail now. Depending on who you ask, small caps have all sorts of definitions. I'd love to know what your definition of a small cap business is. The short answer is that we currently consider companies below$6 billion in market cap as small cap. But it's changed a lot over time. When I started in the mid-1990s, we defined it as being below$750 million.

18:53The reason why the definition has shifted over time has to do with the fact that small cap is a relative classification. It depends on how a company's market capitalization compares to that of the broader market, which changes over time. So let's talk a little bit more about your diversification strategy for small cap stocks. How do you approach portfolio diversification in the small cap space? We believe that there are misconceptions about diversification in the small cap space. Many investors assume that diversifying a portfolio is the key to reducing risk and volatility. And while this is generally true for larger, more established companies, the dynamics are different in the small cap space.

19:42In the small cap universe, the profitability and broader quality dynamics are different. Not all companies are equal and many are lower quality, really low quality. As one proof point around this, only 50 % of the companies in the Russell 2000 growth are profitable over the past year. So as you add more holdings to a portfolio, there's a higher and higher likelihood you're making trade-offs on the quality of those businesses, which actually works to increase risk rather than reduce it. This is why at Poland Capital, we manage concentrated portfolios. We believe this is the only way to truly have a high-quality portfolio in small cap.

20:29Our small cap strategy typically owns 25 to 45 companies, making us one of the most concentrated managers in the asset class. What this does is it allows us to stay focused only on high quality companies. We do not need to own low quality or even mediocre quality businesses. We can keep the bar really high on what we do own. And at 25 to 45 companies, this still affords us the opportunity to achieve broad diversification without diluting the quality of the portfolio. And you can see this in our portfolio. We own businesses across the growth spectrum with different characteristics, and that has the overall effect of reducing risk in the broader portfolio.

21:23For example, our largest position is currently Houlihan Loki, a global investment bank that operates in a number of different segments. And they tend to deliver lower growth over the cycle, but with a narrower range of outcomes. But our second largest position, GUSAT Insurance, an independent property casualty insurance broker, they have a very differentiated, fast-growing business model that's attacking a very large market with a long runway. And so they are higher growth and earlier in their life cycle. And we have a nice balance of both these slower, more stable businesses that have already demonstrated strong margins and strong returns.

22:11foundational businesses that are growing a little bit faster, but growing at a pace that we believe is very manageable and where they too have demonstrated these high quality characteristics over a long period of time without a tremendous amount of cyclicality. And then we've got emerging growth businesses that are growing faster and where their businesses are a little bit earlier in their life cycle or perhaps less developed because they're investing a lot in the future or the returns are lower today than we expect them to be over time. We think it's a really powerful combination to have these three very different types of growth businesses all together in a single portfolio.

23:00And it helps us to both protect capital in tougher times and then also to participate in capital appreciation when the market is stronger. What would you say in the fund would be the average market cap size from when you make your initial entry price? Typically, we're buying companies that are between$1 and$6 billion. We will sometimes look at companies below$1 billion, but we're very firm around that profitability, cash flow positive commitment. And it's a lot harder within the smaller market caps to find that. They're not really ready for prime time. And so where we find ourselves is in the kind of larger market caps within small cap, rather than going more towards the very smaller micro cap end of the market.

23:55You've been analyzing and investing in small caps now for a few decades. So I think you would have some unique insights into the advantages of investing in small cap businesses over medium and large cap counterparts. So what are some of the advantages that are only found in small cap businesses? I believe there are many advantages. First, you can get enhanced diversification. You can get better returns over the very long term. And you can get access to the most innovative companies earlier in their life cycle. To me, it's really the second and third points I want to double click on. First, over the very long term, small caps have delivered better returns than large caps.

24:37And this is because they tend to grow faster. They're not often well covered or well understood. They get a lot less attention from sell side analysts or the media. And that is really good for a team like ours that's skilled at doing primary research. You can find many companies that are undiscovered or misunderstood. And then in terms of early access to innovation, who wouldn't want the opportunity to be an early investor in Amazon or Netflix? One of the reasons that I was particularly attracted to polling capital back in 2017, after 20 years of investing in small caps, is that when I looked at our polling capital Focus Growth Portfolio, which is our US large company portfolio.

25:28What I saw back in 2017 is that one-fourth of the companies in that portfolio at the time were companies that I covered as an analyst when they were small-cap. Think about how powerful that is. And so what we're trying to do as a firm is give our clients exposure to these great companies earlier in their life cycle. Our goal is to buy tomorrow's leaders today and to enjoy many years of long-term compounding that happen before they're on the radar screen of large cap investors. Now let's examine some of the disadvantages of investing in small caps. What do you think some of the common mistakes are that investors make when investing in small caps after maybe being used to investing in larger cap businesses?

26:20Sure. There are some potential disadvantages to small caps. First, they can be more volatile and liquidity is often lower. And many are lower quality, as I referenced before. Roughly half of the companies in the Russell 2000 growth are unprofitable. These companies, they may face difficulties in raising capital. There's more risk of dilution as they do large equity raises. And then there's other mistakes that I see people making. Over-indexing on a big idea or vision, given its growth potential, but without a lot of proof behind it. Or not understanding whether the management teams really have the ability to execute on their great ideas.

27:05I've seen so many companies fail that had great vision, but they just couldn't make that vision a reality. And it's for all of these things that I think you need to be really discerning, like we are investing in the small cap market. So I'd like to get your insights into how small cap cycles work in terms of business cycles. What observations do you see in the ebbs and flow of small cap businesses as it relates to the general market and compared to mid and large caps? So first, I think it's important to convey that we believe that the crux of long-term success lies in maintaining a steady long-term allocation to the small cap asset class.

27:48Echoing the principles applied to large caps, the long-term performance of small caps supports this approach. By owning small caps, as I described before, you can get enhanced diversification, enhanced returns and access to the most innovative companies earlier in their life cycle. But we also acknowledge that there are points in time that present excellent opportunities to amplify small cap exposure. And we believe that this is one of those times. Your question was about cycles. Typically, small cap and large cap, they trade off in leadership cycles that typically last about 10 to 12 years. And we're currently in what I believe is the end of a 10-year period where large caps have enjoyed that leadership.

28:37We often see changes in leadership coming out of periods where there's a change in financial conditions, just like we're seeing now. And then another thing I'd like to emphasize about the why now for small caps is to remind listeners of what happened in the early 2000s, following a period much like today when the large cap market became very concentrated and there were just a narrow group of companies driving the market like the magnificent seven is today. Coming out of that period, small caps outperform large caps by over 600 basis points per year for six years. So leverage is a subject that is rapidly changing sentiment in today's economic environment.