Why Allocate to Mid Cap?

August 3, 2023

Mid cap stocks are often overlooked or under-utilized in portfolios, crowded out by large and small cap allocations. We believe, however, that mid cap stocks could represent the sweet spot of the market capitalization spectrum. Mid cap stocks offer greater stability and safety compared to small cap stocks, and superior growth potential relative to more mature large cap stocks. Typically, mid cap companies have exited the early, high-risk stage of their life cycle and have entered a period of steadier, perhaps even faster, growth.

Relative to small cap, mid cap companies have already achieved a certain level of success establishing their business models. They also tend to be on more secure financial footing, generating superior free cash flows that can be used to support growth — either through reinvestment in the business or through acquisition. They also have less trouble accessing credit markets for needed capital. Stronger balance sheets and cash flow support this asset class in market downturns, allowing them to not only survive, but thrive as they emerge from such periods in stronger competitive positions compared to smaller, weaker rivals. They outperform small caps during periods of economic contraction and heightened risk aversion and outperform large cap during expansionary periods characterized by greater risk taking.

The Montag & Caldwell Approach

The Montag & Caldwell Mid Cap Growth portfolio is a concentrated, best ideas portfolio of high-quality mid-cap growth stocks.   The discipline’s objective is to identify stocks with secular growth characteristics that are selling at a discount to our estimate of intrinsic value and that have above-median near-term relative earnings strength.  We favor companies with leading franchises, proven management teams, and strong financials. The stock selection process is complemented by a risk-adverse approach that employs both diversification controls and a strict sell discipline.

Process

Our process is primarily bottom-up in which we inter-relate valuation with earnings momentum. Our growth equity philosophy utilizes a valuation technique which focuses on a company’s future earnings and dividend growth rates. The process utilizes a present valuation model in which the current price of the stock is related to the risk adjusted present value of the company’s estimated future earnings growth. The identification of appropriate stocks for consideration in our mid cap growth strategy begins with screening a universe of publicly traded U.S. securities for market capitalization of at least $2 billion, an expected 10% earnings growth rate, and a proprietary quality evaluation. The judgment based on qualitative factors and strong financial characteristics further narrows the universe to a select list of names. A holding will be reviewed for sale when it reaches our target price, which is normally 120% of the estimated fair value. A significant earnings disappointment will trigger an immediate review of the holding and a decision will be made to buy additional shares or reduce or eliminate the position.

A Valuation Discipline Creates a Margin of Safety

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 from our experience during the ‘73/’74 bear market.

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 refers to investing in a security when the current market price is below an estimation of intrinsic value. This approach may reduce 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.

A High Quality Bias

Rather than paying for growth at any price for companies that may or may not lead to profits in the future – in other words subsidizing short-term losses in the hope of future gains – we emphasize higher quality companies that are more reasonably priced and with a higher probability of profits today. Higher quality companies typically have stronger, and more assured, near-term earnings growth due to pricing power and, therefore, margin sustainability, in addition to stronger balance sheets that should provide support in a more challenging economic environment – allowing them to not only survive, but thrive as they emerge in a stronger competitive position.

Our stock-specific, risk-adjusted discount rate is determined by our proprietary financial scoring process which rewards high quality companies, and also advantages companies with historically predictable earnings.

Performance Expectations

Montag & Caldwell’s high quality mid cap growth investment strategy enables clients to participate fully in those market conditions that favor growth-oriented investment styles that are based upon earnings growth, not pure momentum that disregard valuation or profitability.  Typically, these are periods of low to moderate economic growth and low or declining interest rates.  In stable economic environments, the long-term consistent growth-rate of the companies in the strategy tends to be in favor with most investors, and helps to drive the higher valuations of these companies relative to more cyclically oriented stocks.  In low interest rate environments, investors are typically willing to pay more for high-quality and consistent and predictable earnings growth.

One of the hallmarks of Montag & Caldwell’s Mid Cap Growth investment process is that it does not stay out of favor for long periods – achieving above market returns throughout most market cycles. The trade-off for long term outperformance over market cycles can mean underperforming during periods of speculation.  The strategy’s attention to the valuation of the portfolio companies it invests in, however, allows it to find good opportunities even when the growth style of investing may be out of favor.

Our investment process also tends to experience less downside risk relative to peer processes, and it would not be unusual for the strategy to outperform its peers and benchmark in down market environments.  Our use of a stock-specific, risk-adjusted discount rate, which is a unique component of our valuation work, combined with our use of conservative growth assumptions in our quantitative valuation process have contributed to reducing risk in our portfolios while allowing us to maximize upside potential.

The most difficult environment for Montag & Caldwell’s approach is that of speculative excess driven purely by price momentum that is disconnected from fundamentals.

About Montag & Caldwell

Founded in 1945, Montag & Caldwell is a SEC independent registered investment advisory firm that seeks to provide superior risk-adjusted investment returns through the competent, disciplined, and fundamental analysis of individual securities.