Ronald Canakaris has survived four market bubbles.
Since joining Atlanta-based investment-advisory firm Montag & Caldwell in 1973 at age 29, he has watched the Nifty Fifty turn sour in the 1970s, energy go bust in the 1980s, Japan implode in the early 1990s and the tech dream turn nightmarish the past three years. Not only has he emerged with his wits, his job and his investing integrity intact, he has managed to beat the majority of his peers and post outsize gains over the long haul.
In this week's
, the fund skipper -- who manages the
ABN Amro/Montag & Caldwell Growth and its near-clone
Enterprise Growth -- explains why this bubble is so much more pervasive than the previous ones, why it's still with us and why he shies away from most tech companies.
He also offers plenty of examples of companies and sectors he likes. In fact, the laid-back Canakaris gets pretty excited when discussing "high-quality" large-cap companies like
Johnson & Johnson
, saying the combination of strong earnings growth and depressed stock prices make for very compelling investments. Canakaris -- whose fund's 10.11% average annual return over the past 10 years ranks it in the top 6% of its peers -- even mentions some surprising favorites among technology companies, including
and a certain dividend-paying company from Redmond, Wash. that he's recently taken a shine to.
Bubble-battered equity investors seeking sagely advice on finding true "high-quality" companies -- and fund investors looking for great offerings helmed by a sure hand -- will want to read on.
1. Where are the markets and the economy headed? Most managers profess to be "bottom-up" stock pickers, but you also factor in "top-down" macroeconomic trends. What are they telling you?
Our thinking is that the market will move within a range this year. We've been thinking maybe 800 to 1100. But I probably feel a little bit more comfortable now with something less than that on the high side. Somewhere between 15 and 20 times earnings; and we're using $52
in per-share earnings on the
. That would work out to 800 to 1000, maybe 1100.
Ronald E. Canakaris
Top Three Holdings:
Enterprise Fund Info: www.enterprisefunds.com or (800) 432-4320
Montag & Caldwell Info: www.montag.com or (800) 992-8151
I think 2003 is forming a base and setting a stage for positive returns in subsequent periods. Hopefully, the market will be up, but I don't think there's any guarantee to that. I know you're aware of market history -- there's only once when the market was down four years in a row, 1929-1932. But the market never recorded 20% returns for five years in a row like we did in the late '90s. So, the market could be down some or up some for the year.
There are plenty of positives. We have a moderate but ongoing recovery in the economy and corporate profits, 40-year lows in inflation and interest rates, accommodative monetary and fiscal policies, reasonable valuations in relation to the level of bond yields and the third year of a president's term tends to be a good one for the market.
Limiting the gains -- and why you should be thinking in terms of a range for the year -- is that we're already at 40-year lows in inflation and interest rates. The optimistic scenario would be if the economy and corporate profits perk up, you would expect interest rates to go up, which would have a dampening effect on price-to-earnings multiple expansion. Once a trend is in place, it usually continues -- they could easily go from 4% to 6% in a relatively quick period of time. We're not forecasting that, but that's the risk.
The negative scenario for equities is if interest rates and inflation go down much from here, the reason being a weaker-than-expected economy and corporate profit environment.
We also think earnings expectations are still on the high side. The slope of the earnings recovery, particularly for technology, may disappoint. The reasons for a more moderate recovery in earnings are the lack of pricing power and a trend toward more conservative accounting -- it's very unlikely that CEOs and CFOs are going to pushing the envelope after all the corporate misdeeds took place. And you have a moderate recovery in the economy ahead. You already have autos and housing operating at very high levels. The recovery in capital spending will happen, but it should be a slow one given the low utilization rates that exist.
Regarding technology earnings, these bubbles do end badly. The reason: Excess capacity results in a prolonged period of price weakness and disappointing gross-margin trends. The slope of the earnings recovery continues to disappoint. Actually, P/E-multiple compression usually takes place after the earnings recovery gets going. That last chapter of the bubble sets in and investors become disappointed. We've been concerned on a short-term basis that the numbers don't really support some of these valuations of technology companies. That could result in some downward pressure for the overall market.
Within that setting of a range-bound market and an ongoing but moderate recovery in the economy and corporate profits, we've been emphasizing a balanced approach in the fund. We think it's important to have high-quality companies that can achieve solid earnings growth regardless of slope of the economic recovery. Also, because you have an ongoing recovery in the economy, it's important to have high-quality cyclical-growth companies where you don't have a lot of excess capacity. It's not a detriment to at least achieving some level of pricing during the recovery.
2. What areas do you like in this environment?
We're overweighted in consumer staples and health care. Those would be the areas where you ought to be able to continue double-digit earnings growth and be accorded a higher P/E multiple. In a low inflation and interest-rate environment, the present value of future stream of income is greater. The key is to get that growth rate of that stream of income correct. These stocks, in addition to benefiting from solid double-digit earnings growth, should be accorded higher P/E ratios because interest rates are as low as they are.
After the global financial crisis, the higher-quality companies in the consumer-staples arena set realistic growth objectives that they can consistently achieve. We feel pretty good about their budgeting and business plans. In addition, for the first time in seven years, currency is not a headwind for these companies.
In the health care stocks, what we've emphasized are the research-driven pharmaceutical and medical-device companies. They've been weak, as you know. As you move ahead here, and they achieve solid double-digit earnings growth, they too will be accorded higher P/E ratios.
These two sectors -- consumer staples and health care -- are becoming compelling here. Their earnings have continued to grow while stock prices have either gone sideways or recently corrected. Based on our work, you have a superior combination of earnings growth and value. In this period of moderate economy recovery, the earnings growth should look very good.
What we've tried to emphasize in the high-quality cyclical growth area are companies where you don't have the baggage of excess manufacturing capacity.
In terms of actual market weightings, we're about 21% in consumer staples, vs. 9% for the S&P 500 and 11% for the Russell 1000 Growth. In health care, we're 23.9% vs. 15% for S&P and almost 27% for Russell. But we don't own these hospitals and HMOs; that's a fairly significant component of the Russell.
Why don't you like hospitals and HMOs?
Hospital companies are really dependent on fairly large price increases to support earnings growth. They are fairly capital intensive, too. We just haven't liked that business model. Regarding the HMOs, they really are cyclical companies -- maybe a little less so, now. At this stage in their underwriting cycle, what usually happens is the multiples tend to be on the high side after they've delivered a lot of earnings momentum and investors forget their cyclical because they have an underwriting cycle. Right now, you've been so far into this positive part of the cycle, we would be cautious that the price increases would cover their costs in gains.
Their earnings continue to grow. The stocks have become very attractively valued on our work -- Pfizer's really down, of course.
They are all strong financially, have productive operations, strong research and development budgets, global presence, financial discipline, good balance sheets. This whole high-quality area, I keep coming back to earnings continuing to grow and the stock prices getting more attractive by the day.
What about the energy sector?
In energy, we're 7% vs. 5.9% for the S&P and 1.3% for the Russell. We're overweighted in oil services for the first time in several years. Those stocks really haven't done anything and have been somewhat disappointing. But since the energy bubble in 1980, you've had 22 years to rationalize capacity. Their customers are simply not replacing their production and inventories are very low.
The price of oil and natural gas has moved up. But it's been a very unusual period where you haven't had a pickup in drilling and exploration activity. We think it's a matter of time given the fact that production hasn't been replaced and inventories are so low. We think the activity level will pick up during this year and that will improve earnings momentum.
Are they being affected by "geopolitical uncertainties" in Iraq and Venezuela?
I think they are being affected -- and this is what's quite unusual. With the price of oil so high -- there is some war premium there -- it's very unusual for the level of exploration and drilling activity to stay this low. I think the CEOs of these integrated-oil companies have a high level of uncertainty in terms of geopolitical risks and corporate governance.
This is one of the few times where you've had a significant increase in oil prices but not an increase in the level of activity. These oil-service companies' earnings have been disappointing. It's just a matter of time before activity picks up.
The other thing, too, is these oil-service companies' customers -- petroleum companies -- have benefited from these prices in terms of earnings. So the oil-service sector is one of the few industries where their customers are, from a financial standpoint, in a better position to buy their products. I think lots of stuff coming together to make this sector attractive.
Regarding Iraq: Once whatever happens in Iraq is behind us, the prime beneficiary is going to be
, a top-10 holding. There's just a tremendous amount of work that needs to be done there that hasn't been opened to companies like Schlumberger.
3. You're pretty heavy-weighted toward consumer spending. Are you concerned about the possibility of a retrenching consumer?
With consumer staples, there's fairly steady demand for those products. They shouldn't be too affected by a more moderate gain in consumer spending going forward.
Consumer discretionary, we're about in line with the market -- 14.8% vs. 13.4% for the S&P and 14.3% for the Russell. The consumer discretionary stocks that we do have are companies that don't sell real big-ticket items. Right now, I wouldn't be rushing out to buy
, for example.
We do own
-- which is actually in the consumer-discretionary area --
Disney and Marriott are down significantly from where they were and we think they represent good values. Gannett is a very high-quality company and it is benefiting now from a recovery in media spending.
What else do you like about Disney?
Disney is a high-quality company that has met the test of time and has an enduring franchise -- and the price is good at these levels. They have been impacted by the macro outlook and that's why the stock is where it is. We're getting close to an inflection point of improving earnings
Editor's note: This interview was conducted Thursday, before the company posted solid earnings and growth projections
. They have reduced their costs a great deal and are very well positioned to benefit from a moderate recovery in spending in their areas of activity.
4. What areas are you underweight vs. the broader markets?
Industrials, we're 9.6% vs. 11% for the S&P and 12.3% for the Russell. We do not own
, which is a significant component of both of those indices. What we own there are
We think these companies will benefit from the ongoing recovery and won't be penalized by a lot of excess capacity.
Why don't you like GE?
GE is attractively valued based on our work, but it just doesn't have earnings momentum. Our first screen is 10% secular earnings momentum, then we combine earnings momentum with value. GE's going to have down earnings in the first half of the year. For them to make their numbers this year, it's all back-end loaded. We're still staying on the sidelines there.
What about financials?
Financials, we're at 8% compared with 20% for the S&P and 9.8% for the Russell.
The fact that the financials represents such a large percentage of the S&P bothers us a bit -- that's the highest it's ever been. We're a bit leery about that. What we do own there is
Marsh & McLennan
Why have financials grown to such a big piece of the S&P pie, and why are you shying away?
They represent a larger part of the earnings than they have. There's been a good amount of debt put on over the past decade, both in the corporate and consumer sectors of the economy. Obviously that has benefited the earnings of a lot of these companies. We would like to see how some of these companies do as this debt is brought down -- there may be earnings disappointments in this sector.
Why do you like AIG, Citigroup and Marsh?
They have such a strong global footprint; they are all strong financially. They are showing good solid earnings growth. AIG actually has triple-A-rated bonds, is very well managed, is attractively priced and should have very good earnings growth.
We actually trimmed our Citigroup position recently because we were somewhat concerned about the level of lawsuits that might develop coming out of the financial scandals and the like.
Is that more of a headline risk overhang on the stock or is it a bottom-line issue?
Yes, mostly a headline-risk thing. But Citigroup has reserved a good deal of money owed to potentially satisfy these suits that might come against them.
5. OK, let's talk about technology. You have expressed cautionary sounds on the sector in recent weeks. What do you see for the sector?
In technology, we're about 10% vs. 15% for the S&P and 22.9% for the Russell. We would be careful still in technology. This excess capacity results in a prolonged period of price weakness and disappointing gross margin trends.
You do like a few tech-oriented companies, most notably Qualcomm, Electronic Arts and eBay. What distinguishes them from the rest of the technology sector, in your opinion? Do they all fit comfortably within your "growth at a reasonable price" model?
The distinguishing characteristic is they are establishing record levels of sales and earnings
the bubble. Most technology companies are significantly below their peak level of earnings in 2000. These three continue to grow.
is very attractively priced based on our work.
is still at a discount to fair value.
is still just a little bit below our fair value.
eBay's growth targets are exponential, but they've managed to keep hitting them. Do you think that will continue?
Yes, we do. They have a really good business model and a very disciplined management team. We feel good about its prospects.
Are you going to have a firm discipline about selling once eBay hits your fair value levels?
Yes, we'll stick to our discipline. We have a rule that when a stock gets to a 20% premium to its intrinsic value, that results in a reduction of our position.
6. You were research director at Montag & Caldwell back during the Nifty Fifty bubble -- making the tech-stock mania in the 1990s your fourth bubble, as you noted at a recent conference. How did this one differ, and how will it continue to shape the investing landscape in 2003 and beyond?
I think this bubble is different because it's more pervasive. It's affected so many businesses in addition to the technology sector itself.
It's surprising how many parts of other businesses had some sort of exposure to the strong technology spending that occurred during the bubble. It created some bad habits and corporate governance misdeeds. That all translated into a lower quality of earnings that we're dealing with now.
The excess capacity that was created was a function of many tech-company CEOs getting fooled by a demand that wasn't there. They built up their capacity to meet demand and it was artificial. Those were honest mistakes.
Technology spending became an end in and of itself rather than a means to an end. Companies bought technology products to not get dot-commed out of existence. That was the thing to do in order to keep up with other companies. So it was more pervasive; its tentacles reached a lot of companies, affecting those businesses more than people thought. It resulted in some bad business decisions. It simply takes time to be corrected.
Also, mentioning bad habits, a lot of business managers got caught up in the excitement of the bubble and overestimated how much growth they could achieve. That contributed to lots of disappointments and, in many cases, too-aggressive accounting in order to satisfy expectations.
The previous bubbles were more confined. Think of the Nifty Fifty; that didn't have that broad an impact on the economy. The energy thing, when it deflated, lots of areas benefited from that. We were in Japan, but its impact was more or less on that area of the world.
A more positive note on this latest bubble involves this corporate governance and, in some cases, outright fraud. One thing about our country is that we address our issues head on; we don't let them persist for a long period of time. We're dealing with this in a positive way and you'll have a higher quality of earnings as you exit this period.
Do you think investors remain too bullish on technology?
I think so. (Laughs.) That's a natural outcome of a bubble. Investors continually try to recapture the moment in those areas that did well.
The final chapter in how bubbles end badly is that investors become very disappointed in the slope of the recovery. You have all this excess capacity, prolonged period of price weakness, gross margin pressure and earnings disappointment.
7. Your top-10 holdings read like a list of companies cited in "Good to Great" and books on great companies that have come in the wake of the bubble -- companies like Colgate-Palmolive, 3M, Johnson & Johnson, Medtronic, Coca-Cola. Do you sense that investors are returning to these types of companies in the wake of the accounting scandals and the busted tech bubble?
No. (Laughs.) We don't expect people to come back to them yet, and that goes back to the mentality of the bubble -- people still want to recapture that moment.
This is the case for both institutions and individuals. On the institutional side, I don't think these high-quality companies have been viewed as companies that you would want to use offensively. They are viewed more as a defensive investment.
Part of all this is that institutional investors have many more fully invested mandates than they had before. I think one of the reasons this bear market has lasted so long is because of these fully invested mandates. In the old days, people would go 20% and the bear market would get finished faster.
A lot of institutional investors, because of these mandates, have hidden in these high-quality earnings stocks. When these managers become more positive on the market, they want to go back to those areas that did well during the bubble, and don't recognize what we believe is going to happen when bubbles end.
Until you get out into this year and see how earnings develop and see how these high-quality companies continue to produce good, solid growth. Maybe that'll be the period where these stocks are viewed more favorably.
Again, these stocks are becoming really compelling. You're not paying any premium for quality at this stage. People still want to take on a lot of risk. That's the aftermath of the bubble. Right now, you're paying 20 times earnings for
Johnson & Johnson
Procter & Gamble
. Their earnings are continuing to grow at a double-digit rate; you're paying very little for quality.
Do you think the large-cap arena will outperform smaller-cap sectors?
large-cap growth will. You're paying very low premium for quality here. These are moderate multiples. It looks to us like the year-to-year change in corporate profits on the S&P 500, according to First Call, was the fourth quarter. It looks like this first half of the year, the year-to-year change in pro forma operating earnings will grow at single-digit rates. These high-quality growth companies that can achieve double-digit earnings growth will do well.
In the rally from Oct. 9, these stocks didn't participate, and I think that was sector rotation -- people were selling these stocks to get onboard to bubble-period stocks.
During this recent correction this year, there's probably partly technical. Technicians are thinking that because they have held up well they're due to retreat. This is one area of the market that has held up well the past few years. Again, this is helping fuel that very favorable combination of earnings growth and stock value.
8. Your stock screens traditionally have been firm: Find companies that can generate earnings of at least 10% for several years whose stocks are below 20% of true value. Have you tweaked the methodology at all over the past year or so -- perhaps to hunt for stocks that trade at a deeper discount -- or has it remained steady?
When a stock gets down to 50%-60% of our definition of fair value, it often concerns us more than intrigues us. We scratch our heads and think, are we missing something in terms of valuation assumptions? When it does get down to a deeper discount to fair value, it makes us question our assumption.
It's like with Enron -- we just did not understand that company. When the stock came down quite a bit, it started popping up on our valuation screen. But we didn't understand it, so we passed.
Companies such as AOL Time Warner and Tyco have lured many fund managers, but you've shied away. Why?
AOL Time Warner
. We sold most of it in the high $20s and $30s. We were concerned about the AOL part of it being able to achieve the objectives needed to get to the growth rate that management was using.
We have always been suspicious of
. We knew that if we were to buy it, we would feel uncomfortable about it the very next day. We simply didn't feel comfortable about the qualitative aspects there.
9. You pointedly said that GE was "not" a buy, in your book. Is that still the case? Any other popular stocks that you remain cool on? What about Microsoft -- it's been in the news lately with its starter dividend?
, we have been recently purchasing, just in the last few days. (Laughs.)
I'm glad I asked!
We bought a very small position late last year and we've just recently added to it again with this weakness.
It's a company that will benefit from a recovery -- you're having a recovery in technology spending, but it's going to be more moderate than what people are thinking. Microsoft has broad exposure to the pick-up in tech spending that's likely to develop during the next 12 to 24 months. It's going to increase from an increase in personal-computer spending and an increase in enterprise-computer spending. It's broadly represented. And it's a very high-quality company.
What are your thoughts on the dividend?
It's a good thing. They haven't been real successful in spending that money in terms of investments and that has been penalizing the return on capital, such as a huge amount of cash. We like the idea of reducing that cash and giving it back to shareholders.
10. Whenever I interview a good fund manager who has beaten the pack these past few years, I invariably get emails from readers saying: "They lost money just like everybody else. They don't deserve my money." How do you respond to this point?
Most stocks go down in a bear market.
Also, investors need to know a managers' philosophy as well as the sector in which they invest. The very large-cap companies have been extremely weak for a long period of time. The fact that we've been able to go down less than the Russell Growth index and our competition is because of our discipline. But most stocks in the large-cap area are down.
What mistakes are investors -- professional and individual -- making in the market today?
Investors still want to take on a lot of risk. There's very little premium being paid for quality these days.
I had a question recently, "What advice would you give to investors?" My advice: Stick with quality companies that have met the test of time and pay attention to price.