June 7, 2017
The investment process at Montag & Caldwell seeks out high quality, large and mid-cap growth stocks showing above average near-term earnings momentum and trading at prices we believe to be a discount to our estimation of intrinsic value. 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 model is a modified dividend discount model that projects a company’s sustainable level of growth in earnings and dividends over a ten year period and discounts 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 risk. 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.
Clients and prospects frequently ask us about the accuracy and reliability of our valuation work. As with any model that requires assumptions and inputs, the adage of “garbage in-garbage out” can apply. Our analysts are expected to derive reasonable assumptions that are sustainable OVER THE COURSE OF A BUSINESS CYCLE (hence the ten year time frame). In most instances our assumptions, particularly that of the long-term earnings growth rate, are more conservative than those used by Wall Street more broadly. The 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.
M&A events in recent years within our large and mid cap products give us ample opportunity to test the validity of our valuation work. On this score, we feel pretty good. Indeed, since 2005, 17 stocks held by our mid or large cap portfolios have been acquired and one received an unsolicited takeover offer (which subsequently fell through). These holdings were spread across several sectors including healthcare, staples, consumer discretionary and industrials. These 18 holdings represent about 6% of the stocks we have owned across the two strategies. The average takeout price of those 18 transactions was just 10% higher than our estimate of fair value at the time the deals were announced. Considering the synergies that often exist in strategic combinations, one should not be surprised a private buyer may pay more than what “minority” investors in the public markets might deem a fair price for a stock. Of these 18 holdings, the distribution of the takeout price relative to our estimation of intrinsic value during this period was as follows: two were between 10%-12% less our intrinsic value estimate; one was roughly 5% less our intrinsic value estimate; four were right at our price target; and the remaining were at premiums of 10% to 30% above our estimation of intrinsic value.
Valuation is just one component of our investment process and it goes without saying that our valuation work can sometimes miss the mark, both to the upside and downside. And, of course, past performance is not a guarantee of future results. We believe, however, that these examples offer a proof statement that our time-tested valuation discipline derives reasonable estimates of intrinsic value of the companies we own and those in which we consider investing.