Montag & Caldwell seeks steady growth opportunities among mid-cap stocks.
By Kerry O'Boyle, Aston Asset Management
Montag & Caldwell Investment Counsel has been investing in growth stocks for a long time—more than 65 years. Since the early 1970s they have developed a strategy focused on identifying companies, mostly large-caps, with long-term sustainable earnings growth trading at discount prices. Much of their success has come from the blending of strong company fundamentals and attractive valuations with short-term earnings momentum as a catalyst. In recent years, notably with the launch of the ASTON/Montag & Caldwell Mid Cap Growth Fund (AMCMX), Montag has applied this process to picking mid-cap stocks. Although the firm has analyzed mid-caps for quite some time in surveying the landscape for growth stocks, what’s new is investors’ ability to benefit directly from their growth expertise with mid-sized companies.
The Mid-Cap Advantage
One of the primary reasons Montag developed a mid-cap strategy comes from a greater appreciation for the risk/reward potential of mid-caps as an asset class, as outlined by Fund co-manager Scott Thompson in his commentary The Mid-Cap Advantage. In comparing the Russell Midcap and Russell 2000 Indices, Thompson describes how mid-cap stocks occupy a “sweet spot” in the market-capitalization spectrum having historically offered greater stability and less volatility than small-caps stocks while typically superior growth than larger companies. Mid-sized companies are more likely to have exited the early, high-risk stage of their life cycles and settled into a phase of steadier growth. Such companies have often successfully established their footprint in the marketplace, yet have not reached such a size that growth becomes a challenge, as often happens with more mature firms.
Montag has been able to take advantage of this market sweet spot because the firm has historically researched companies with market-capitalizations down to $3 billion. It was only a minor adjustment to bring that screen down to $2 billion to encompass the full mid-cap universe. The mid-cap Fund’s mandate is to invest in stocks between $2.5 billion and $10 billion. Otherwise, the research process is exactly the same as Montag’s flagship growth fund, the ASTON/Montag & Caldwell Growth Fund (MCGFX), which has a 17-year track record.
That process uses an 11-factor financial score—including historical long-term growth, earnings predictability, balance sheet strength, and profitability—to measure firm quality and serve as the basis for a stock-specific discount rate that’s the key to Montag’s valuation model. Montag developed this model after the crash of the so-called Nifty Fifty stocks during the 1970s revealed the need to consider absolute valuations in addition to relative valuation measures (such as price/earnings ratios) to better understand the risk of each investment. Seeking the best combination of quality, earnings growth, and valuation (both relative and absolute) allows them to adjust to differing market conditions, with relative earnings momentum serving as a timing element for a company’s growth potential and value to be recognized by the market.
Although Montag researches all growth stocks in essentially the same way, there are some differences in how the mid-cap portfolio is constructed to better suit the requirements of that more dynamic area of the market. The most obvious distinction is that there are more holdings in the mid-cap Fund because of the greater potential for volatility. Individual company news can cause much larger swings in stock prices for mid-caps than is typically the case for large-caps. This is especially true for one- or two-product/service firms that are more sensitive to changes in their businesses than larger, more-diversified companies. This business momentum can work both ways, to the upside or the downside, and holding more names helps as a check on overall portfolio volatility. With 45 to 65 holdings, though, the Fund is still more concentrated than its typical mid-growth fund peer, reflecting Montag’s conviction in its stock-picking process.
Fund co-managers Thompson and Andy Jung also point to the different characteristics of the mid-cap market that a growth manager must be aware. Jung notes that there are more opportunities to find growth in smaller industries and niche areas of the market than are typically available to large-cap investors. For instance, the Montag Mid Cap team has found growth opportunities in areas like specialty chemicals and auto parts, areas not typically represented in the large-cap oriented flagship Aston/Montag Fund.
In addition, sector positioning can sometimes play less of a role in the mid-cap Fund. Jung says that one can’t necessarily make the same generalizations related to defensiveness or cyclicality about certain sectors as with large-caps. A notable example of this is in the Healthcare sector. Traditionally a low-beta (volatility), defensive area of the market driven by huge pharmaceutical companies, within mid-caps Healthcare contains more cyclical, higher-beta biotech firms and capital equipment/instrument makers. This can make it a more volatile area in which to invest, and more subject to economic cycles.
It is the volatility in the market since the financial crisis of 2008 that has Montag especially focused on earnings predictability in its mid-cap portfolio these days. Amid what many now refer to as a muddle-through economy of slow economic growth Jung believes that the consistency of company earnings has become a distinguishing factor in picking mid-cap stocks. The idea is to own companies with a proven track record of producing solid results regardless of the economic environment, which adds to the confidence that these companies can continue to deliver. Montag keeps an eye on Value Line’s earnings predictability measure, which is a 40-quarter weighted average of a company’s standard deviation of earnings. They also prefer companies with cleaner balance sheets (i.e. low debt) to show that they are not “cheating” (using leverage) to achieve growth, which may distort a firm’s true growth potential.
One typically pays more for what are perceived to be steadier companies, but in this uncertain economic environment the confidence in more consistent earnings is likely worth it over the long haul. That was reinforced in 2008 and 2009, when mid-caps with consistent earnings were knocked down along with all the rest in the volatility and market turmoil of the period. The stock of Varian Medical Systems, for example, was hard hit during the third quarter of 2008. Yet the company continued to grow earnings by 10% throughout the economic crisis, giving the team the confidence to stick with it, as that growth subsequently powered a strong recovery in the stock.
Montag & Caldwell’s formal venture into picking mid-cap stocks is also important in demonstrating the depth of talent at the venerable asset manager. Co-managers Thompson and Jung represent the next generation of stock-pickers at Montag. The firm has grown and prospered for several decades under the guidance of veteran manager Ron Canakaris, but it recognizes the need for its younger investment professionals to show their talent at running a portfolio. Thompson has been with Montag for more than 19 years, progressing from research analyst to co-Director of Research at the firm. Jung is the other co-Director of Research, having joined Montag as a research analyst a decade ago after working on both the sellside and buyside for several years. He brings the perspective of having seen firsthand how others manage growth portfolios which helps in understanding the market, and fostered an even greater appreciation for a firm like Montag unified behind one process for identifying investment opportunities.
Given the experience of Thompson and Jung and the long history of Montag as growth investors, the ASTON/Montag & Caldwell Mid Cap Growth Fund represents less of a “new trick” than an extension of a tried and true process for selecting growth stocks. Having identified the potential advantages of investing in mid-caps, Montag has carefully crafted a strategy that leverages its expertise in finding companies with quality growth characteristics. Thus, the Fund can serve as an aid to investors seeking to diversify their own portfolios across a greater range of growth companies.
Kerry O'Boyle is an Investment Strategist with Aston Asset Management. Prior to joining Aston he wrote on a variety of investment topics as a mutual fund analyst for Morningstar, Inc. He is a graduate of the U.S. Naval Academy, and holds an M.A. in Liberal Arts from St. John's College, Annapolis, MD.
As of February 29, 2012, Varian Medical Systems comprised 1.51% of the portfolio’s assets. Holdings are provided for informational purposes only and should not be deemed as a recommendation to buy or sell any security mentioned.
Note: Small- and mid-cap stocks are considered riskier than large-cap stocks due to greater potential volatility and less liquidity. Growth stocks are generally more sensitive to market moves and thus may be more volatile than other stocks. Parameters set by the subadvisor are not a fundamental policy of the Fund and are subject to change at any time.
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