Current Market Environment

Many investors today are understandably concerned with the durability of their investment portfolios in this challenging market environment.  The S&P 500 had one of its worst starts to any calendar year in 2022 and has remained volatile throughout.  High priced growth stocks and pandemic themes initially sold off indiscriminately after surging inflation expectations, the war in Ukraine, and the Federal Reserve’s (“Fed”) subsequent pivot towards a tighter monetary policy, colluded towards a valuation reset.  The first quarter, in particular, was challenging for most investment managers as strong positive stock price correlations (indiscriminate selling) led to fewer opportunities to exploit stock price fluctuations to add alpha.

As the year progressed, however, investors had become increasingly more discriminating and shifted their focus. Rather than paying for growth at any price for companies that might or might not lead to profits in the future – in other words subsidizing short-term losses with cheap money in the hope of future gains – investors turned to higher quality companies that were more reasonably priced and with a higher probability of profits today. The end of extraordinary monetary accommodation has forced investors to re-evaluate their “free pass on risk” and to manage higher levels of market volatility in a more normal environment of price discovery. The change in sentiment towards quality was inevitable in this market transition. 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.  A time-tested discipline around stock selection should also lead to greater efficacy in valuation, diversification, and disciplines around risk management – which may not advantage passive index investors to the degree that it has in the past.

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. Risk management is an important contribution of most active managers – a discipline mostly absent from passive market indices. We write about this further in our piece entitled A Case for Growth at a Reasonable Price.

How We Got Here

We have exited 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.

A Valuation Discipline Creates a Margin of Safety

Video Discussing our Time Tested Process Around Managing Risk

Montag & Caldwell’s valuation discipline is one of our most proprietary approaches to risk management. Like many 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, and one we still use today. Our valuation methodology was born out of the ‘73/’74 bear market and has been instrumental to our clients long term investment success. 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.

Conclusion

We remain skeptical that this bear market has fully run its course and continue to wait for further evidence of investor capitulation on the economic and earnings outlook for next year.  Multiple contraction (valuation adjustment) – the initial phase of the current bear market – is largely complete. The next phase, however, will likely be downward estimates to earnings for 2023 as the lagged effects of a tighter monetary policy ripple through the economy. This phase of market volatility should be even more discriminating towards higher quality fundamentals and disciplines around managing risk as the market pays less attention to Fed policy and more towards company specific combinations of valuation and earnings quality.

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 strong investment results by delivering proprietary disciplines designed to better ensure that you meet your long-term 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. The views expressed represent assessment of the market environment as of December 2022, and are subject to change. All investments carry a certain amount of risk. There are no guarantees that a strategy will achieve its investment objective, and loss of value on investments is a possibility.