DAY HAGAN TACTICAL DIVIDEND STRATEGY UPDATE JUNE 2017

 

The Day Hagan Tactical Dividend Strategy (DHTD) was +0.45%* gross of fees (+0.40% net*) in May, outperforming the Russell 1000 Value, which was down (-0.10%) for the month, while the S&P 500 was +1.41%. All numbers are total return. The S&P 500 Index in particular continues to exhibit somewhat narrow leadership. When dissecting the S&P 500's index performance, we'd note that higher dividend-yielding, lower P/E multiple equities that are out of favor as measured by sell-side analyst ratings continue to lag year to date. The numbers are particularly striking when focusing on dividend yields, with non-dividend payers meaningfully outperforming the highest yielding names so far this year. Since the foundation of DHTD's investment strategy is based on dividend yield valuation metrics and finding deep value in contrarian plays, it is not surprising that our performance has lagged on a relative basis this year through May.

However, to quote Ray Dalio, founder of Bridgewater Associates, one of the world's largest hedge funds, "The biggest mistake investors make is to believe what happened in the recent past is likely to persist . . . typically high past returns simply imply that an asset has become more expensive and is a poorer, not better investment." These few sentences are a nice lead-in to illustrating how our industry rotation process works. We use an objective, methodical process based on the weight of the evidence to buy industries at trough valuations and to sell when they achieve fair market value. As a function of buying what goes against the grain of conventional wisdom, we can be early in industries and names. In the context of where we view the markets and our eligible universe currently, we see highly attractive risk-reward opportunities in the six industries and 25 names we hold in the portfolio. Based on our process, though, we are defensively positioned with significant cash since we are not presently able to find attractive enough stocks beyond our current holdings.

Taking a contrarian stance at times demands a strong stomach and an ability to tune out a lot of dissenting noise. Despite being positive year to date (+1.04% through 5/31) and fulfilling primary considerations of capital preservation and avoiding undue market risk, we have lagged the S&P 500 during 2017 thus far, although we are closing in on the Russell 1000 Value. Receiving questions around some of our industry holdings and underlying names, we felt it important to explain a bit more of our thinking given our strong belief in the current portfolio. Our four names in discount stores are one example.

After the company reported earnings in mid-May, Kohl's (KSS) saw a sharp sell-off due to a lighter topline than consensus expectations, although it is worth noting the company beat on earnings and left guidance unchanged. For the month of May overall, however, KSS was actually only down about 1.5%, as it has climbed back up close to $40. While the difficult performance year to date and the shifting retail landscape cannot be ignored, we think it is an overreaction. Although in a different industry and sector, this reminds us of McKesson (MCK) in Medical Distributors. Prior to being held in the portfolio, MCK dropped about 23% in late October due to a poorly received earnings call. We also viewed it as an overreaction and, based on our screening process, we purchased MCK in early November. Since then, we have seen it go up nearly 29%, higher than it was prior to the October call. Given our current view of KSS based on both traditional fundamentals and our proprietary valuation modeling, the thesis on attractive risk-return there remains intact.

Similarly, Target (TGT) is another currently unloved—to say the least—name. As a starting point, just as with KSS, TGT is a buy based on our absolute, relative and median yield-based valuation metrics. It passes several stringent screens related to balance sheet strength (in part to ensure the sanctity of the dividend) and ongoing free cash flow generation. TGT's attractive dividend yield (currently at around 4.3%) provides some total return downside protection over time with shareholder-friendly management being explicit about their commitment to cover and grow the dividend (and the clear wherewithal to do so). Beyond that, despite highly negative sentiment (which incidentally can be representative of our favorite kinds of opportunities), TGT has many factors that we view as tailwinds. TGT is taking a strategic approach to gaining market share from bankrupt retailers and store closings, with TGT estimating there could be $60 billion of opportunity in play. TGT has shown growth in stores near closed Macy's, Sears and J. C. Penney locations by emphasizing store remodels and promotions in those areas. They seek out vendors serving struggling retailers to build attractive and, in some cases, exclusive relationships moving forward. TGT has done an impressive job of reducing product design and development time, often using crowdsourcing feedback online. One related example is their launch of a new swimwear line within five months of Victoria's Secret's exit from the category. TGT's leading market share position in swimwear was further bolstered as a result, with evidence of this already clear in the last quarter's earnings release.

Overall, our discount store holdings are diverse enough to have produced reasonable industry performance to date. In May, our discount stores grouping was up +2.07%*, and since our purchase of these names in late October 2016, the industry has returned +5.24%* for the portfolio. If you look at our discount stores over longer periods with prior purchases and sales, we have generated +17.56%* in total returns. Costco (COST) and Wal-Mart (WMT) clearly have different value drivers than KSS or TGT, and both are up in the teens this year. However, in the context of much-maligned, out-of-favor names, it is worth remembering that in 2015, WMT's market capitalization dropped by nearly 37% from peak to trough. Since then, it has had a significant recovery, and from our entry date, we have realized attractive returns. Best Buy (BBY), while not part of our universe, is another example of a retail name that was left for dead. But BBY successfully adapted to new realities. It just hit its all-time high in May and remarkably has outperformed Amazon since the beginning of 2016. Just as with WMT and BBY, we believe sentiment will shift on KSS and TGT as well, especially given current valuations that, for example, show free cash flow yields for both names in the high teens based on our estimates.

Moving on from the retail space, a brief mention of financials and, more specifically, our holdings in asset managers. In addition to the industry and our underlying names showing as attractive based on our comprehensive yield-based and fundamental methodology, we view the pendulum swinging back to active from passive management as beneficial. This shift should serve to further underscore the value in our industry holdings. In the same "out-of-favor" vein, in the recent past it's been hard to find a day in mainstream and financial media where active management is not pilloried in favor of passive strategies. Apparently, as human nature goes, we have short memories, forgetting about 2008 and market history overall, and believing the S&P 500 Index will continue going up in a relatively straight line forever. While this is, of course, a simplification, it is accurate to say that underperformance of active management is somewhat cyclical. Moving forward, we expect domestic—particularly large-cap focused—active managers overall to beat their benchmarks, especially if recent outperformance of non-U.S. markets continue. The Department of Labor Fiduciary Rule is here to stay, even if changes are likely based on the department's ongoing review, and this does present potential headwinds for certain asset managers. However, the issues are name specific and we feel the positives of our asset management holdings far outweigh any negatives, real or perceived. Invesco (IVZ) is a good example of the diversity of our grouping. IVZ's global focus has begun driving higher fees, higher margins, lower taxes and generally a healthier sales environment with retail redemptions in the U.K. diminishing. More recent additions in the alternatives and multi-asset categories have helped. The PowerShares family of ETFs has seen uneven sales, but the overall business benefits from having a good passive management business as well as active. About half of IVZ's net income comes from outside of the U.S., a benefit to IVZ since the U.K., Canada and Japan all have lower corporate tax rates. Overall the asset managers industry grouping has returned +20.58%* since purchase in February 2016.

Since 2002 strategy inception, the Day Hagan Tactical Dividend strategy has annualized returns of +9.55%*, well ahead of the Russell 1000 Value (+7.25%) and S&P 500 (+7.18%), with attractive risk metrics indicative of the downside protection discussed earlier in this note. If you would like further details around the current portfolio or our process, we welcome your calls, emails and visits.

Sincerely,

  • 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.