Day Hagan Smart Value Strategy Update April 2023
Downloadable PDF Copy of the Article:
Summary
The DH Smart Value Portfolio continues to invest in companies producing excess returns through positive economic profitability, supported by solid balance sheets (quality), significant cash generation (profitability), and trading with considerable margins of safety (valuation). We believe these factors will continue to provide rational opportunities for the foreseeable future. Using our consistent and differentiated investment approach, the DH Smart Value Portfolio is focused on outperformance, seeking higher total returns with lower volatility.
Strategy Update
Year-to-date through the end of March, the portfolio was up +1.96%* net of fees vs. the benchmark Russell 1000 Value Index Total Return up +0.97%.
Over the three-year period from 2-29-2020 thru 2-28-2023 there have been two major bear markets, a global pandemic, the most restrictive Fed in recent history, and Russia starting a war, among many other things. Over those tumultuous three years, the portfolio gained at a +12.8%* net of fees annualized rate, vs. 10.7% for our benchmark.
The first quarter of 2023 was fraught with bad news, yet the markets were able to climb the proverbial “Wall of Worry.” Investors contended with elevated recession fears, skyrocketing interest rates, persistent inflation, unprecedented bond market volatility, negative earnings revisions, a continuation of the Russia/Ukraine war (and the distinct possibility of it expanding to other countries), China’s unsteady improvement, qualms around the “de-dollarization” of trade, and last but not least, major upheavals in the U.S. and global banking sectors.
Why did the market go up? First, the market has been rebounding from the lows set on October 13 of last year. At the time, our work indicated that the U.S. equity markets had declined to oversold levels consistent with what we measured at the worst of the pandemic (3-23-2020) and the Great Financial Crisis (3-9-2009). Investors had become far too pessimistic given the weight of the evidence.
Second, investors began to realize that the Fed was closing in on the end of the rate hike cycle. But it’s been a bumpy ride. To wit, the 10-year Treasury bond started the year at 3.88%, dropped to 3.37%, ran higher to 4.08%, and closed March at 3.48%, illustrating the Fed-induced roller-coaster ride of monetary policy expectations. At this point in the cycle, we are projecting a stabilization in rates and a wait-and-see attitude from the Fed following their May meeting. The overall decline in interest rates spurred long-duration assets like technology stocks to outperform, while commodities were hit hard as supply chains opened up and slowing global economic growth generated headwinds.
Lastly, following the bottom in October, FOMO (fear of missing out) began to assert. Many investor categories, from hedge funds to individuals, found themselves holding too much cash as the markets spiked higher. In fact, there was over $5 trillion dollars being held in money market fund assets, far higher than in 2008-2009 and above the levels seen pre-pandemic. It was the highest in history, and it remains close to that level. The chase for performance ensued, as low-quality companies with weak operating cash flows, low free cash flow, high valuations, and low profitability outperformed. History has shown that these types of “low-quality, short-covering” rallies often stall, and quality companies once again move into favor. And that’s where we choose to invest.
As written last month, “At this point in the cycle, we continue to focus on value-oriented stocks as we navigate the tug of war between many of the major headwinds in 2022 being ‘Past Their Peak’ vs. some continuing concerns around a Fed-induced recession and greater-than-expected earnings decline. We continue to focus on companies evidencing the characteristics that have led to long-term outperformance: quality, profitability, and reasonable valuation.”
Turning to our portfolio holdings, we made several portfolio changes in March. On March 24, we purchased Mosaic (MOS) and Nutrient (NTR). Concurrently, we exited our position in Cigna (CI).
Mosaic and Nutrient provide many of the basic ingredients necessary to grow food for humans and animals. In Mosaic’s latest quarterly earnings update, MOS management stated that “Ag fundamentals remain very constructive.” Importantly, they also noted that “Inventory levels in our key markets for both phosphates and potash have declined considerably from the elevated levels observed in the second half of last year. Grower demand across the Americas has been very strong because of favorable affordability, but retailers have been hesitant to replenish inventories because of the volatility in global prices, especially in potash with the aggressive off-season marketing from the Russians and the Belarusians. U.S. spring demand is ramping up over the next coming weeks, and we believe we have reached a bottom in potash prices.”
Regarding our sale of Cigna (CI), it was sold as it had achieved our calculation of Fair Value. We originally entered the position on 6-15-2021 and added on 8-9-2021. Subsequently, the stock outperformed the market over our holding period, up over +20%* vs. the S&P 500 Total Return being negative. While Cigna is in the Health Care sector, we also view it as a quasi-financial due to it being an insurance company. With this sale, we are opting to deploy the cash into another area of the market as our models are showing growing pressure around both the Financial and Health Care sectors.
On March 13, during the height of the banking crisis, we sold our position in Aflac (AFL) and purchased Schwab (SCHW). Aflac had reached our measure of fair value and Schwab had become a better valuation opportunity. (We first initiated the position in Aflac during May 2020. It returned almost 3X that of the S&P 500 during our holding period.)
For Schwab, the following points were detailed in our Trade Notification sent out on March 13. (If you would like copies of the March 13 and March 24 Trade Notifications, please reach out to your advisor.)
Schwab (SCHW) is the eighth-largest bank by assets in the U.S. with $7.05 trillion. At the end of last year, SCHW had 33.8 million active brokerage accounts.
With the TD Ameritrade acquisition complete and integration underway, we see ample opportunities for revenue growth and cost synergies to increase the company’s cash and profit generation capabilities in the future. For the near term, there are headwinds on the net interest margin front given the increase in interest rates and customers moving their cash balances into higher-yielding opportunities. Nonetheless, given the past few days of market declines, we now view this to be priced into the stock.
Over the coming months, a higher fed funds rate should translate into higher reinvestment rates for the bank as older securities with lower rates mature. This should be accreditive to the bottom line. Management agrees as they are guiding for at least a 300bps increase in net interest margins by the end of 2025.
SCHW scores highly for Profitability and Risk in our work. Its Free-Cash-Flow to Total Capital and Operating Cash Generation to Total Gross Capital ratios are in the top 13% and 8% respectively of their industry peers. With the recent failure of SVB Financial, bank balance sheets have come to the forefront of investors’ minds. As of their last report, Schwab has $366.7B of deposits and $148B of available-for-sale securities. These are securities that are reported at fair value and can easily be turned into cash to meet the potential withdrawal demands of banking customers.
From a valuation perspective, SCHW’s EVA-adjusted book value indicates that investors are somewhat pessimistic and potentially underpricing its growth opportunities, as it is currently near the low end of its historical range.
The forward dividend yield is currently about 1.86%, which is at the top end of its 10-year range and well above its 10-year median of 1.08%.
Overall, Schwab has a high-quality balance sheet and a low loan-to-deposit ratio, which should give it ample liquidity should banking customers continue to pull cash out of institutions. The effects from SVB Financial across the industry as a whole presented an opportunity to purchase SCHW at a historically attractive valuation.
From a sector perspective, our current weightings are Information Technology (17.2% portfolio weighting vs. 7.9% benchmark), Health Care (9.5% vs. 16.3%), Financials (16.8% vs. 19.9%), Communication Services (10.2% vs. 8.6%), Industrials (11.0% vs. 10.9%), Consumer Staples (2.2% vs. 7.6%), Consumer Discretionary (6.1% vs. 5.9%), Real Estate (4.2% vs. 4.4%), Energy (3.7% vs. 8.3%), Materials (6.7% vs. 4.5%), and Utilities (6.4% vs. 5.5%).
From a portfolio perspective, the median Forward Price/Earnings multiple is 13.4x, with a dividend yield of 2.26%. The median free cash flow yield is 6.9%.
Please let us know if you would like to discuss the portfolio in more detail or would like to know more about our approach.
Sincerely,
Donald L. Hagan, CFA®
Regan Teague, CFA®, CFP®
Rob Herman, MBA
Jeffery Palmer, CIPM
Steve Zimmerman, MBA
Disclosure: The aforementioned positions may change at any time.
Day Hagan Asset Management is registered as an investment adviser with the United States Securities and Exchange Commission. SEC registration does not constitute an endorsement of the firm by the Commission nor does it indicate that the adviser has attained a particular level of skill or ability. Day Hagan Asset Management claims compliance with the Global Investment Performance Standards (GIPS®). GIPS is a registered trademark of the CFA Institute. CFA Institute does not endorse or promote this organization, nor does it warrant the accuracy or quality of the content contained herein. Day Hagan Asset Management has been independently verified for the period June 30, 2008, through December 31, 2022. The U.S. dollar is the currency used to express performance. Calculation Methodology: Pure gross of fees returns are calculated gross of management and custodial fees. Net of fees returns are calculated net of actual management fees, transaction costs, and gross of custodian (trust) fees. Net of fees returns for wrap accounts are calculated net of management fees, transaction costs, and all administrative fees charged directly to the client by the broker-dealer. To receive a GIPS composite report, contact Linda Brown at (941) 330-1702 or email Linda.Brown@DayHagan.com
Disclosure: *Note that individuals’ percentage gains relative to those mentioned in this report may differ slightly due to portfolio size and other factors. Returns are based on a representative account. The data and analysis contained herein are provided "as is" and without warranty of any kind, either express or implied Day Hagan Asset Management, 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. Day Hagan Asset Management accounts that Day Hagan Asset Management 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. Day Hagan Asset Management uses and has historically used various methods to evaluate investments which, at times, produce contradictory recommendations with respect to the same securities. The performance of Day Hagan Asset Management’s past recommendations and model results is 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.
There is no guarantee that any investment strategy will achieve its objectives, generate dividends, or avoid losses.
Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. Jensen’s Alpha is a risk-adjusted performance measure that represents the average return on a portfolio or investment, above or below that predicted by the capital asset pricing model (CAPM), given the portfolio's or investment's beta and the average market return. This metric is also commonly referred to as simply alpha.
