DAY HAGAN TACTICAL DIVIDEND STRATEGY UPDATE JANUARY 2017
Happy New Year!
For the full year of 2016, the Day Hagan Tactical Dividend strategy (DHTD) ended up +12.8% gross of fees (+12.2% net*), compared to the S&P 500 Total Return of +12.0%. Since the strategy's inception in April 2002, the strategy has produced annualized returns of 9.8% (8.6% net) versus the S&P 500 Total Return of 6.8%. The outperformance in the DHTD strategy was accompanied by a beta of 0.60 and downside capture of 50% (52.9% net) since inception.
No one can accuse 2016 of being a dull year. The year kicked off with a myriad of worries (around the falling price of oil, deteriorating credit conditions and a weakening Chinese currency to name a few) leading to substantially negative market index performance in January and early February. In fact, the first ten days of the year was the worst start to a year for the DJIA since 1897. Nevertheless, DHTD, true to its capital preservation roots, managed the risk well and was virtually flat for the first two months of the year.
Fast forward to a meaningful post-election rally in November, and the net results were healthy returns for most U.S. equity markets in 2016. While some strategists at the end of 2015 may have roughly predicted the actual percentage changes for the markets in 2016, we have yet to see anyone that correctly predicted how we would get there. Again, not a dull year and we expect more fireworks in 2017.
The fourth quarter of 2016 was an active one for the DHTD portfolio. By the end of the quarter, we held seven industries, 29 individual companies and a still meaningful cash position. We would note that the cash position reflected an ever-diminishing opportunity set, as determined through our disciplined modeling. It was clear that a reduced number of industries and stocks were able to meet our stringent evaluation criteria.
In mid-October, we sold Forward Air (FWRD) from our Airfreight & Logistics industry holdings in exchange for the more attractively valued, and more liquid, FedEx (FDX). Through 12/31/2016, FDX has gained over 8%* since being added to the portfolio. We also swapped names in our Asset Management industry group. Janus was sold after an eight-month holding period and gain of roughly 14%*, largely because of its announced merger with UK-based fund company Henderson Group. Eaton Vance (EV) was added as a replacement. Furthermore, Fidelity Information Services (FIS) was also sold from our IT services industry holdings after gaining about 40%* since our May 2014 purchase.
The most significant portfolio move in October, however, was the purchase of the Discount Stores industry grouping, which also served to reduce our cash holdings. After having been out of Consumer Discretionary sector since the profitable sale of our Restaurant industry holdings in July, the Discount Stores industry moved into a clear purchase range based on our process. Four names in particular showed as meaningfully undervalued and fundamentally sound with attractive upside potential. Our goal is to seek out trough valuations as defined by our methodology—and it is typical for us to take a contrarian perspective in terms of what defines attractive industries and companies within those industries. Through 12/31/2016, the discount stores were up an average of approximately 8%* (since the industry purchase in the latter half of October).
In early November, continuing with the contrarian theme, we added McKesson (MCK) to our Medical Distributors industry holdings, following the extreme price decline at the end of October (after not meeting analysts' earnings estimates and guidance). We have held MCK in the past and this current purchase provides a good case study with regard to our strategy. (Previously, MCK was held between October 2011 and May 2014 when we realized about 130%* in long-term gains.)
After the recent pullback in the share price, MCK became a buy candidate based on our modeling process. Upon finalizing the next steps of our qualitative and quantitative fundamental overlay process, we determined that MCK's underlying fundamentals were strong, and were supported by a mid-teens free cash flow yield at the time of purchase.
We also determined that concerns around price competition in the pharmaceutical distribution business (and to a lesser extent, reduced brand price inflation) were exaggerated and unlikely to persist at the pessimistic levels investors were pricing in. In our view, aging demographics, the expansion of medical insurance and the increasing use of pharmaceuticals for patients all support a healthy longer-term demand outlook. Since early November purchase, MCK had gained over 10%* and we continue to view it as attractively valued.
In mid-December, our Eaton Vance purchase from October was sold for a gain of over 16%*. Typically our strategy does not have such brief holding periods for portfolio holdings. Nonetheless, the rapid price increase caused our model to downgrade it from a strong buy to a hold. From a risk management perspective, given the overall significant price increase in our Asset Management industry grouping since February 2016 purchase, we believed it was prudent to reduce the industry weighting and EV was the most appropriate candidate for sale. Our work continues to indicate that there is worthwhile (positive risk-adjusted) upside in the remaining four names being held. Finally, and also in December, we exited Xerox due to its impending separation into two independent, publicly traded entities which was scheduled (and completed) at the end of the year. Concurrently, we purchased IBM as a replacement within the Information Technology Services industry.
In our previous quarterly letter (just three months ago!), we described how the dividend yield on the S&P 500 versus the 10-year U.S. Treasury was at a relative 50-year high. Post-election, with rates ramping up measurably, the 10-year yield is now back above the S&P 500's dividend yield. How quickly the world changes.
Ostensibly, this could be viewed as a negative for dividend-focused portfolios. However, the DHTD strategy, while focused on dividend yielding names, is markedly different from most dividend-focused managers. Income (dividends) is a byproduct of our process, not the overriding goal. Rather than simply attempting to maximize the portfolio's dividend yield while potentially ignoring other important fundamental inputs, we use dividend yield as an objective means to evaluate value as the first step in a multi-step process. Once we define an industry and company's cash return levels relative to both their own independent ranges as well as our eligible universe, we then scrutinize the industry and company's attractiveness based on balance sheet strength, cash flow trends, returns on existing capital structures and measures of fundamental momentum. It is a multifaceted, risk-managed approach that has effectively navigated the markets since 2002.
Typically, while we can benefit from market interest in dividend payers, our methodology allows us to seek out opportunity even in periods where that is not the case.
Finally, as this letter is being written, we recognize change is in the air, in ways both large and small. It is hard to know how, for example, the undeniable advent of populism globally will impact the markets, much less the world moving forward. What we would suggest, for better or worse, is that there will be periods of heightened uncertainty as the status quo is being challenged. As it relates to the DHTD strategy, we believe the foundational capital preservation element (roughly 50% downside market capture over the last 14+ years) is essential to managing risk and volatility.
Wishing you the best in 2017, and as always, if you have any questions or would like further details, please feel free to contact us.
- Robert Herman
- Donald L. Hagan, CFA
- Jeffrey Palmer
- Arthur S. Day
Note: The S&P 500 Index is based on the market capitalizations of 500 large U.S. companies having common stock listed on the NYSE or NASDAQ. The Russell 1000 Value Index measures the performance of the large-cap value segment of the U.S. equity universe. It includes those Russell 1000 companies with lower price-to-book ratios and lower expected growth values. Indexes are unmanaged, fully invested, and cannot be invested in directly.
Disclosure: *Note that individual's percentage gains relative to those mentioned in this report may differ slightly due to portfolio size and other factors. The data and analysis contained herein are provided "as is" and without warranty of any kind, either expressed or implied. Day Hagan Asset Management (DHAM), any of its affiliates or employees, or any third party data provider, shall not have any liability for any loss sustained by anyone who has relied on the information contained in any Day Hagan Asset Management literature or marketing materials. All opinions expressed herein are subject to change without notice, and you should always obtain current information and perform due diligence before investing. DHAM, accounts that DHAM or its affiliated companies manage, or their respective shareholders, directors, officers and/or employees, may have long or short positions in the securities discussed herein and may purchase or sell such securities without notice. DHAM uses and has historically used various methods to evaluate investments which, at times, produce contradictory recommendations with respect to the same securities. When evaluating the results of prior DHAM recommendations or DHAM performance rankings, one should also consider that DHAM may modify the methods it uses to evaluate investment opportunities from time to time, that model results do not impute or show the compounded adverse effect of transactions costs or management fees or reflect actual investment results, that some model results do not reflect actual historical recommendations, and that investment models are necessarily constructed with the benefit of hindsight. For this and for many other reasons, the performance of DHAM's past recommendations and model results are not a guarantee of future results. The securities mentioned in this document may not be eligible for sale in some states or countries, nor be suitable for all types of investors; their value and income they produce may fluctuate and/or be adversely affected by exchange rates, interest rates or other factors.