November 16, 2020

Montag & Caldwell Celebrates 75 Years

This week marks a milestone for the Montag & Caldwell team as we celebrate our 75th anniversary and approach our fourth consecutive decade of outperforming the S&P 500. Founded in 1945, Montag & Caldwell is an independent registered investment advisory firm that seeks to provide superior risk-adjusted investment returns through the competent, disciplined, and fundamental analysis of individual securities.

We would like to take the time to celebrate the source of our success and what has defined our culture – the evolution of the team and the implementation of our proprietary equity investment process.

“Building a successful investment firm requires focus, a strong work ethic, and an impeccable character – operating as a team with a uniform philosophy and using a discipline that works.”

Ron Canakaris

The Origin Story

Louis Montag started the firm in 1945 with the wealth generated from the family-owned Montag Paper Company and the popular Blue Horse composition books. Initially a hobby, his wealth management practice eventually grew into one of the most established investment firms in the southeast.  Louis, who later mentored our Chairman Emeritus Ron Canakaris, was a true quality growth pioneer.

Gene Caldwell joined the firm in 1953 and was made partner in 1956 when the firm’s name changed to Montag & Caldwell. He brought with him a bias for earnings momentum and a knack for market timing.

These two investment influences would later be combined to create our time-tested signature investment discipline.

One of the firm’s first influential hires was Solon Patterson , who joined the firm as an analyst in 1962.  By 1966 Solon convinced the firm to start a mutual fund to establish a daily valued product that the public could follow.  The firm started the Alpha Fund in early 1968, which became the South’s first mutual fund.  In 1973 Solon became the firm’s CEO and his leadership set the foundation for Montag & Caldwell’s future growth and investment identity.

The Process

Ron Canakaris arrived at Montag & Caldwell in 1972, the peak year of the “Nifty Fifty” – an informal designation for the fifty most popular large cap stocks. These companies were regarded as “buy and hold forever” stocks, and as a result, many of these companies soared to very high valuations.

“The process came out of this challenging environment – the “Nifty Fifty” bubble burst, which led to the 1973/1974 bear market and the subsequent increase in inflation and interest rates, which resulted in massive price to earnings multiple compression as discount rates climbed higher.”

Ron Canakaris

The “Nifty Fifty” stocks were soon overvalued and fell hard during the following 1973/1974 bear market. Rather than starting with a sharp crash, the market’s slide began gradually in early 1973 amid rising inflation and slowing economic growth. The OPEC oil embargo of that year and the Watergate scandal that led to Nixon’s resignation in 1974 accelerated the declines. Double digit inflation amid a steep recession coupled with global uncertainties all contributed to an erosion of confidence.

This was the seventh worst, and the second longest bear market in history as markets shed over 45% of their value.

“The ‘73/’74 bear market was the toughest of my career – it was a painful environment with nowhere to hide.”

Ron Canakaris

It was during this time that Ron was asked to become the firm’s Director of Research and to introduce a better valuation methodology, as preservation of capital became a risk management priority. While the team still paid attention to relative valuation metrics, absolute ratios continued to decline for many of the firm’s holdings due to the sharp increase in inflation and interest rates. Given the challenges the 1973/1974 bear market introduced, the team needed a better valuation discipline to identify quality growth opportunities.

“Nobody used present value models back then and it seemed to me that this was the way to go – to have an investment approach where you would come up with an absolute value that was competitive with bonds.”

Ron Canakaris

Ron looked at many different approaches to valuing stocks, but with interest rates climbing, near-term discounting made most investments look too expensive relative to bonds.

Ron then began to look at annual reports, to learn how CFOs considered capital expenditures when viewing investment opportunities. He concluded that it may be more prudent to value a company’s aggregate cash flows in the same way a corporate executive might invest in their own business. While most CFOs were using a 7-12-year time period to discount cash flows, Ron settled on 10 years.

Using a present value model was not only unique, but a more conservative approach. Rather than using a generic discount rate for all stocks, Ron and his research team began adding filters to calculate a risk-adjusted company specific discount rate that adjusted for quality attributes such as balance sheet strength, growth, and profitability characteristics. Other factors such as earnings volatility, size and how well the stock traded were also incorporated.

Montag & Caldwell now had a process to determine a stock’s absolute value, but still needed to think about relative valuation.  The team looked at the stock’s intrinsic value relative to its current market price and rank ordered the opportunity set, from attractively priced to fairly priced and to overpriced. Montag & Caldwell now had a discipline that yielded both absolute and relative valuation measures.

While valuation was the key selection criteria, we still needed a timing device, which led Ron to Gene Caldwell’s earnings momentum work.  Earnings momentum would be the catalyst for the value to be recognized.  Gene was a gifted investor, but his model emphasized companies with the greatest earnings momentum. This approach proved too risky as the highly priced momentum stocks provided no valuation support and resulted in high portfolio turnover. After some consideration, it was determined to take a broader view by looking at the prior six months annualized relative earnings growth and the next six months annualized relative earnings growth to determine momentum.  Rather than looking at the companies with the highest current earnings momentum, the criteria expanded the opportunity set to include companies with earnings growth above the median stock and moving up or staying high in the universe over past and next six-month period. This became the timing device.

“Earnings momentum worked well – the valuation methodology worked well – but combining them worked the best.”

Ron Canakaris

The combination of valuation and earnings momentum defined the Montag & Caldwell approach – allowing our clients to participate in growth markets with a margin of safety that reduced volatility in challenging environments.  As a result, our clients have experienced above market returns throughout most market cycles.

Building the Business

With the process in place, performance followed, and Montag & Caldwell was on its way to building its defining track record.  Subsequently, the firm decided to focus primarily on this investment approach and to have all accounts, when appropriate, managed in a similar manner. The firm organized itself with more specialization including dedicated research analysts, traders, and portfolio managers. The firm began to attract talented investors, like Bill Vogel, who not only helped grow the business but contributed to the atmosphere of optimism, success and professionalism. It was a collegial environment with a significant capacity to grow. That culture persists today, with the entire team’s focus on successfully implementing the discipline with the highest quality service to our clients.

“This is a great field to be in if you believe in serving people.”

Solon Patterson

The Process is Tested

One of the earliest tests came in 1980, when the firm had a large energy position. As valuations increased beyond our estimates of intrinsic value, the team began to sell its energy positions in the final quarter of that year. This was near the peak of the oil bubble and relative performance suffered during that quarter as the energy stocks continued their climb. However, the following year energy stocks collapsed, and the firm posted strong relative and absolute returns.

As interest rates and inflation subsided during the 1980s, the market advanced and stocks got overvalued. Montag & Caldwell’s returns were strong prior to the 1987 crash – up approximately 40%. However, given the stretched valuations, we began selling stocks and raising cash to approximately 25%. When the market collapsed, we opportunistically invested the cash, side stepping much of the volatility, and ended with double digit returns that year.

Similarly, throughout the 1990s, technology holdings were a significant component of our client portfolios – a trend identified by Ron early that decade. However, as in many bubble periods, valuations for technology stocks exceeded any historical precedence and earnings growth expectations were unrealistically high. We began selling and trimming many of our holdings in 1998 with very little exposure by the bubble’s peak in the 1st quarter of 2000.  Estimates were ultimately revised down sharply and the subsequent collapse erased most of the gains by October 2002.

“Successful firms need a disciplined process that works – without it, when uncertainty comes, you won’t know what to do.”

Ron Canakaris

Conclusion

In the years that followed, the process continued to be tested in both speculation and correction environments.  We experienced policy and style extremes and both cyclical and secular growth trends – some of which were difficult markets for many investment managers.  Despite the inevitable near-term market challenges, we remain confident in our ability to produce above average market returns for our clients.  Our process combines the best elements of growth and value and incorporates strong risk controls with a high-quality bias.  We believe this discipline will provide a ballast to any future market challenges as we embark on the next 75 years.