Many investors today are concerned about the durability of their investment portfolios in a more volatile and choppy market environment, particularly with the S&P 500 at or near all-time highs. While we do not believe that this bull market is over, it could be difficult to make material headway in the near term with fears that runaway inflation may force the Federal Reserve’s hand with regard to tapering. Concerns of a “disorderly” rise in bond yields, full valuations, and elevated investor complacency have all contributed to the current “chop” with a potential increase in market volatility moving forward.
Given the near-term market uncertainty, we believe investors should be emphasizing, or incorporating, a more deliberate approach to risk management in their portfolio strategy. The spike in market volatility we experienced in 2020 may be the beginning of a multi-year period of higher volatility. Typically, such spikes have not been a one-year phenomenon – at least looking back over the past thirty years. Risk management is an important contribution of most active managers – and those in particular with a proven discipline should be well positioned going forward as actively managed strategies can exploit stock price fluctuations for alpha generation. We talk about this more in our discussion of A Case for Growth at a Reasonable Price.
In conversations about investing and active management, it’s important to understand the terms. “Risk management is the process of identification, analysis, and acceptance or mitigation of uncertainty in investment decisions.” (Investopedia.com) “Active management focuses on outperforming the market in comparison to a specific benchmark such as the S&P 500. Passive management mimics the investment holdings of a particular index in order to achieve similar results.” (Investopedia.com) Risk itself is also a term that needs to be defined; and while there are many variations, our clients’ preservation of capital is the basis of our approach.
We may be soon exiting an unusually low volatility regime. In the years following the Global Financial Crisis, the Federal Reserve’s zero interest rate policy and quantitative easing program successfully increased asset prices and depressed market volatility. The indiscriminate increase in asset prices disproportionately benefitted passively managed index funds and ETFs, which tend to be insensitive to price. Higher asset prices led to unprecedented flows into passive vehicles, which further supported higher asset prices, helping to drive equity valuations to extraordinary levels. This was ultimately a momentum play – a self-perpetuating cycle – that left investors with a classic overbuild of passive strategies that are highly concentrated in a handful of names at elevated prices. Passive investors may be particularly vulnerable today because these strategies, by definition, have no inherent mechanisms to manage risk. As we transition to a more “normal” market environment, with higher levels of market volatility, it may be an opportune time to review your portfolio’s capacity to manage risk using an active approach with an emphasis on high quality securities.
A Valuation Discipline Creates a Margin of Safety
In this note, we are highlighting one of our most proprietary approaches to risk management – our valuation discipline. Like most investors, we pay attention to traditional measures of valuation such as absolute and relative price-earnings ratios. However, the centerpiece of our valuation discipline is a proprietary model that we developed in the 1970’s, one we still use today. Our valuation methodology was born out of the ‘73/’74 bear market and has been instrumental in outperforming the S&P 500 for each of the past four decades. Read more about the history of our valuation process in our 75 year history.
We use a modified dividend discount model that projects a company’s sustainable level of growth in earnings and dividends over a ten-year period and discount those cash flows back at a company-specific, risk-adjusted discount rate. The manner in which we perform this analysis in many ways is a replica of what a CFO might do when considering capital expenditures on new pieces of equipment or new product introductions. As long-term investors, our objective is to own high quality, sustainable growth businesses at prices that compensate our clients for the risk they take. We believe it is prudent to value a company’s aggregate cash flows in the same way corporate executives might invest in their own business. Our valuation work is not meant to be an exact science, but rather “a test of reasonableness” on how a company’s stock is trading relative to conservative assumptions about future growth. This valuation approach emphasizes a “margin of safety”, which may be defined as purchasing a security when the current market price is below an estimation of intrinsic value. This approach reduces the downside risk when investing in securities, providing a built-in cushion during market declines and helps to ensure investors are compensated for any company-specific investment risk.
Our approach to asset management incorporates a time-tested and robust discipline around managing risk, and our approach to asset allocation is often less complicated, but may also be a more effective solution for most investors. We are committed to producing superior investment results by delivering professionally managed, customized allocations utilizing proprietary, time-tested investment disciplines designed to better ensure that you meet your financial goals. To learn more about how Montag & Caldwell can help you, please contact us.
Montag & Caldwell was founded in Atlanta, Georgia in 1945 and has served both private clients and institutional investors for over 75 years. While primarily known for managing equity securities, our Firm’s experience also includes fixed income and asset allocation strategies. With an emphasis on managing risk, our investment professionals provide a solutions-based approach to investment management.