By Montag & Caldwell Investment Counsel
The stock market has delivered strong gains since the end of the financial crisis, but it has not been a smooth ride. The economic recovery following the financial crisis of 2008 has been tepid at best, with much of the market’s sterling rise fueled by extraordinary measures taken by governments and central banks across the globe. Whenever government has tried to step back and allow the economy to stand on its own by ceasing to prop it up with further liquidity, markets have shifted their focus to concerns over sovereign debt levels, leading to sharp contractions in equities. The potential for volatility increases as attempts to address fiscal policy and deal with mounting government debt is postponed.
Montag & Caldwell (Montag) believes that amid this troubled economic environment investors should look toward high-quality growth companies for their equity exposure. Many investors have become fearful of equities amid growing uncertainty and volatility in the market, driven by top-down government and central bank actions. In the long run, however, we think that strong company fundamentals will win out over the ephemeral charm of speculative earnings boosted by easy short-term financing. Montag is a $13 billion asset manager that has focused on high-quality growth stocks since the 1970s and has managed the ASTON/Montag & Caldwell Growth Fund (MCGFX) Fund since 1994. We think that now is a critical time for investors to once again embrace a disciplined, long-term approach focused on high-quality stocks.
High-Quality Growth Defined
With regard to our large cap investment philosophy, it might be wise to start with a definition of "high-quality growth." We define this type of growth as a company that can maintain a secular growth rate of an average of at least 10% annually over the next 10 years. The important distinction here in terms of quality is the ability for a company to sustain peak-to-peak or trough-to-trough earnings growth over such a long period. Within that framework, we then look for earnings momentum catalysts and stocks trading at a discount to what we think a company is worth.
The valuation component to our process ties in with our search for high-quality growth. We calculate a company's intrinsic value based on the quality of the fundamentals of each individual company, and use that valuation to initiate positions in stocks at roughly a 10 to 20 percent discount. For the earnings momentum catalyst, we demand that a company have near-term earnings growing faster than the overall market (as presented by the S&P 500 Index) for the next six-to-twelve months before a stock can be added to the portfolio.
Using this approach the Fund outperformed its Russell 1000 Growth Index benchmark (a 1.30% annualized gain to -1.19% for the index) since the beginning of the current secular bear market in March 2000 through the end of 2012. [Note: The Fund’s performance for the trailing 1-, 5-, and 10-year periods through 12/31/12 were 12.70%, 1.93%, and 6.35% annualized, respectively, compared with 15.26%, 3.12%, and 7.52% for its benchmark.] The Fund has been able to deliver this strong performance not only because we capture upside potential in the market, particularly during strong fundamental growth markets, but also because the portfolio typically suffers less during more volatile or down market environments. The caveat to the upside potential is that the portfolio tends not to do as well on a relative basis during more-speculative market environments. Thus, the Fund typically lags the benchmark when we think stock prices are not accurately reflecting company fundamentals, though it has done well on an absolute basis. In our view, more-speculative stocks certainly led the charge in 2012 and on and off during the past 12 years, most notably since the rebound from the financial crisis beginning in March 2009.
Challenging Year in 2012
There were plenty of headwinds in 2012—a recession in Europe, slowing growth within Emerging Markets, sluggish economic growth in the U.S., a contentious presidential election, and the year-end fiscal cliff—making for a volatile and challenging fundamental market environment. Although the Russell 1000 Growth returned more than 15% in 2012, much of that gain—and the Fund’s relative underperformance—came during the first two months of the year, when equity markets were up dramatically following the long-term refinancing operation (LTRO) carried out by the European Central Bank (ECB). Indeed, if you excluded January and February from last year’s results, the portfolio outperformed both the benchmark and the S&P 500 Index as market volatility increased on concerns about those economic headwinds.
The universe of S&P 500 stocks climbed and eventually maintained its gains during 2012, even as earnings estimates declined throughout the year. The US Federal Reserve and other central banks continued to provide liquidity via low rates and quantitative easing through asset purchases. As evident by Chart 1 above, the market was focused more on the speculative increase in Fed liquidity during the year than the fundamentally driven moderating earnings growth.
To put this into perspective, Chart 2 below shows how our style in managing the Fund varies from the benchmark during different types of market environments since its 1994 inception. On a calendar year basis, the Fund’s relative returns versus the Russell 1000 Growth tend to underperform amid speculative market environments, such as the 1998-1999 technology bubble, cyclical bounces in 2003 and 2009, and the Federal Reserve driven quantitative easing (QE) and Operation Twist rallies beginning in 2010 and continuing on-and-off through 2012. Thus, there have been a number of external headwinds to a high-quality growth investment approach since the financial crisis of 2008. Policy headwinds that we do not think can last much longer.
The performance data quoted represents past performance. Past performance is no guarantee of future results. Investment return and principal value will fluctuate so that an investor’s shares, upon redemption, may be worth more or less than their original cost. Current performance may be lower or higher than the performance data quoted. For performance data current to the most recent month-end, please visit our website at www.astonfunds.com. The total expense ratio is 1.06%.
Secular Bear Market
The current bear market for equities essentially started in March 2000. From that time through the end of 2012, the Russell 1000 Growth Index delivered a negative return compared with a positive return for the Fund. One of the most important pillars to investing is that you simply cannot give up a lot on the downside and expect to create wealth over the long term. During this ongoing secular bear market, the Fund has actually gained ground, not lost, following strong absolute returns during the 1990s. The bear market has been going on for 13 years, and we think it is our valuation discipline and emphasis on quality that has allowed the portfolio to do so well during the difficult periods.
It has been so long since the last secular bull market that people forget that the Fund achieved strong returns prior to the technology bubble. We think another period led by high-quality growth stocks is approaching after the liquidity-driven rallies ultimately subside. In 2012, fundamentals weakened, but the Fed was successful in propping up the market and pushing share prices higher through its unconventional monetary policies. What was different in 2012 versus 2010 or 2011 was that the Fed policies did not end. The market began to correct downward toward the middle of the year in anticipation of another end to the liquidity boost when the Fed suggested that they were likely to maintain Operation Twist and additional quantitative easing through the end of the year. By year-end, they were “all in” in terms of continued easing. Right now, the Federal Reserve is buying $85 billion of government bonds a month, essentially financing the entire U.S. deficit on an annual basis. All indications are that they plan to continue this deficit financing through the rest of 2013.
We haven't been big fans of quantitative easing. The government has never manipulated asset prices like this before—it is truly historic. It has changed historical, fundamental, and technical analysis applications, just as it has influenced asset prices. It has clearly had a positive effect on current stock, bond, and to some extent real estate prices, but now the government is more or less stuck with slow growth because of its heightened debt-to-GDP (Gross Domestic Product) ratio. Eventually the government needs to implement sound fiscal and monetary policies, stabilize debt-to-GDP, and address the fiscal deficit issues or the country will have some sort of financial crisis again.
Each time the Fed has paused in its quantitative easing, in 2010 and 2011, the market declined significantly. The fundamentals are about the same. The extra liquidity has not changed a great deal on that front. The global economy remains mature and sluggish amid a mature and weakened earnings cycle, with unresolved fiscal consolidation issues. Although we think the market is roughly fully valued, it can move higher as the Fed continues to implement quantitative easing and the fiscal consolidation issues are postponed. This policy of running trillion dollar deficits and unlimited money printing is not sustainable over the long run, however. While we are still hopeful that a fix is possible, and our outlook has been for an end to the secular bear market in 2013 or 2014, the worst thing that could happen is for these issues to continue to be put off and the debt allowed to be extended even further out.
Whither Profit Margins?
The main problem at the company level, as we see it, is that profit margins are near all-time highs. Historically, it is typical for there to be a cyclical recovery in employment along with a cyclical recovery in profitability. As seen in Chart 3 below, while there has been some progress in the unemployment rate this recovery cycle, it has been well short of historical norms. Corporations have benefited greatly from huge deficit spending and low interest rates as they have kept employment costs low. They have been very cautious in hiring people, focusing on stabilizing revenue growth and controlling costs as a means to profit growth. But most of the productivity benefits from lower costs have been realized now. With profit margins at very high levels and overall growth likely to be moderate going forward, we think profit growth is also going to be moderate, and that is without the highly likely potential for a reversion to a mean level of profit growth.
With margins as high as they are now, a resulting decline from any future disappointment could be steeper than typically experienced in the past. There has already been a big recovery in margins and many of the estimates for profit growth this year are dependent on significant margin improvement, which we believe is unlikely. Reams of academic work show that when an economy reaches the level of debt-to-GDP that the U.S. is approaching, you have slower growth (particularly after a financial crisis). Still, there is a solution. We are a very rich nation and with the right policies we can get back to healthier growth once our debt is stabilized.
We are optimistic that amid this environment the outlook for high-quality large-growth companies is relatively brighter than other equity options because these types of stocks are reasonably valued with what we believe is more-assured growth owing to their financial strength and global diversification. In addition, many of these companies have above average dividend yields and dividend growth prospects as investors shy away from a developed world that still has too much debt. Whether the government procrastinates or addresses the issues, growth and yield are going to be scarce in the period ahead and we think that these companies are best positioned to provide both in this kind of environment.
In terms of valuation, the picture closely mirrors what we saw in 2000, but this time in favor of large-cap stocks. Back then, the sentiment was very negative toward the value of the “average” stock, so the pre-conditions were in place for the average stock to do quite well. Now, the average stock is fairly priced, margins are in the process of peaking, and earnings momentum is slowing. In contrast, larger companies (as represented by the 25 biggest companies in the S&P 500 Index, as seen in Chart 4 below) in general, and high-quality large-growth companies in particular, are attractively valued relative to the broader market and we think likely to exhibit a stronger earnings stream over the next several years. We also see this trend in the price/earnings (P/E) ratios of various segments of the market, with small-value stocks the most expensive—trading at 93% of their average P/E for the last 20 years—and large-growth companies the cheapest at 73%.1
1 Source: JPMorgan Chase. P/E ratios are calculated and provided by Russell based on IBES consensus estimates of earnings over the next 12 months. Data as of 12/31/12.
The Fund’s holdings are currently trading at roughly 72% of our calculation of fair value of the market. In terms of 2013, we think these high-quality growth companies could show about 10% to 12% earnings growth and secular growth rates of 10%. We typically take a balanced approach to sector positioning in the portfolio, but now it is tilted more toward defensive growth areas because of the maturity of the earnings cycle and our work showing a big deceleration in earnings momentum and low overall long-term earnings growth. We think more-cyclical stocks are fully priced, based on the need for margin improvement. The market seems to be counting on a second half recovery in 2013, which we believe is too optimistic.
The Federal Reserve's quantitative easing has desensitized the market to valuation for the past several years, but this situation cannot last. After favoring high-quality cyclical stocks prior to the financial crisis that performed well, we thought that the recovery would be a two-stage process. First, a volatile period when high quality would probably hold up better than most stocks followed by a full economic rebound that would set the stage for the next secular bull market, led by a rotation to high-quality growth companies. We think that this outlook still applies, just that the Fed altered the timing of the true rebound as it fueled a speculative interlude with its unprecedented monetary policy. Although the timing remains uncertain and the Fed’s excesses may have to be corrected for, we continue to believe that a new secular bull market is coming, led by high-quality growth companies. We think these types of stocks simply are the best positioned to provide relatively attractive growth at reasonable valuations, just as small- and mid-caps stocks were so poised in 2000.
Note: Growth stocks are generally more sensitive to market moves and thus may be more volatile than other stocks.
Before investing, consider the Fund’s investment objectives, risks, charges, and expenses. Contact 800 992-8151 for a prospectus or summary prospectus containing this and other information. Please, read it carefully. Aston Funds are distributed by Foreside Funds Distributors LLC.
The information contained in this article originated from excerpts from a January 17, 2013 webcast, and is provided by Montag & Caldwell Investment Counsel (“Montag & Caldwell”), a subadviser utilized by Aston Asset Management, LP (“Aston”). Montag & Caldwell is not an affiliate of Aston and their views do not necessarily reflect those of Aston.
This material is not intended to be a forecast of future events, does not constitute investment advice, and is not intended as a recommendation to buy or sell any security. Investors should consult their investment professional regarding their individual investment program. Since the date of this report, economic factors, market conditions and Montag & Caldwell views of the prospects of any particular investment may have changed. Investors should consider the investment objectives, risks and associated costs carefully before investing. Forward-looking information is subject to certain risk, trends and uncertainties that could cause actual results to differ materially from those predicted. Past performance is no guarantee of future results. For more information about Aston Asset Management, LP and its subadvisors, please call 800-597-9704, or visit www.astonfunds.com.or visit www.astonfunds.com.