Day Hagan Smart Value Strategy Update August 2023
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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 July, the portfolio was up +10.21%* net of fees vs. the benchmark Russell 1000 Value Index Total Return, +8.72%. For the three-year period from 7-31-2020 through 7-31-2023, the portfolio gained at a +14.8%* annualized rate (net of fees) vs. +13.9% for our benchmark.
During that time, the portfolio’s Beta was 0.76, illustrating that the portfolio’s outperformance was achieved while experiencing 24% less volatility risk than the index. Upside capture comes in at 84.5% vs. downside capture of just 67.0%. Our view is that this reinforces our focus on companies supported by quality, profitability, and margins of safety. We believe that companies exhibiting the aforementioned characteristics provide positive risk vs. return opportunities regardless of where we are in the economic, business, and inflation cycles.
When reviewing the market backdrop, we see consumer confidence growing and investors exhibiting signs of optimism. The slow building up of confidence has resulted in five consecutive months of gains in the S&P 500. Over the last 50 years, this has happened 22 times, and subsequent gains have been good, with average returns over the next 3, 6, and 12 months being 3.3%, 6.1%, and 11.8%, respectively.
However, we also note that there are signs that investors might be getting a little ahead of their skis. For example, while optimism is good, excessive optimism can be a headwind. Excessive optimism happens when investors become overly enthusiastic, leaving little room for error and a low tolerance for bad news. For example, when the NDR Daily Trading Sentiment Composite Model (a composite of indicators evaluating investor sentiment) signaled excessive optimism, the S&P 500 tended to lose ground at a -3.42% annualized rate. When the model has shown excessive pessimism, markets have historically gained at a 24.52% rate (both statistics are since 2006). Sentiment, a market term describing emotions, is a contrary indicator. When investors are too bullish, be more cautious.
From a macro perspective, global economic activity continues to bounce along at slow-growth levels. Recent economic releases show tightening lending standards at banks, credit conditions deteriorating, loan demand drying up, credit card delinquencies increasing to the highest levels this cycle, and manufacturing still under pressure. These negative trends have been offset in part by better inflation numbers—which highlights the importance of inflation pressures continuing to dissipate. We do have some concerns around that view, as recent increases in energy and shelter costs may surprise folks hoping for inflation’s downside momentum to continue. We’re watching this closely as inflation influences interest rate trends, which in turn influences our sector analysis.
We note that the services sector segment of the U.S. economy is holding up and still growing, but the growth rate is slowing. Services have been a positive underpinning as the markets have spiked higher since March. To define service sector strength or weakness, we focus on the underlying data around employment as one of our preferred measures. Currently, we view the jobs numbers and levels of employment as positive, but when looking deeper, it becomes clear that the majority of new jobs being gained are low-income positions primarily in the hospitality industries and even then, many are being filled by people taking on second jobs. If this trend continues, it too may presage that a more cautious investment stance is warranted.
Turning to our sector allocations, our overweights are Information Technology, Communications Services, Consumer Discretionary, and Materials.
We have been slowly reducing our exposure to Information Technology after having been overweight for most of the year. The investor rush into perceived Artificial Intelligence (AI) beneficiaries has created some valuation issues, and we continue to sift through to find companies still trading at reasonable valuations. On the positive side, capital expenditures for software remains robust and many companies are looking to update technology to stay ahead of their competitors.
Communications Services was the second-best performer in July, with the more tech-related names outperforming—specifically Meta and Alphabet providing much of the upside. Valuations, outside of the big-tech names, are better, but when we evaluate a company, we want good valuations and solid profitability and pristine balance sheets. Our current holdings are Meta, Alphabet, and Interpublic Group, which all meet our criteria.
Consumer Discretionary is slightly overweight, with our holdings being Home Depot, Lowe’s, and Williams Sonoma. All are market leaders, have positive economic profitability (and margins), strong cash flow generation, and solid balance sheets. We view rising rates as a headwind to large durable goods purchases, therefore our focus is on companies that provide “picks and shovels” rather than having direct exposure to larger ticket items in the face of a potential consumer retrenchment as inflation erodes consumer purchasing power.
Materials is our final sector overweight. So far, it has been quite a ride with our holdings in Celanese, Mosaic, and Nutrien (detailed in previous letters). Each of the companies has well-above market profitability and well-below market valuations. Economic profitability is excellent while balance sheets are clean and sized appropriately for each company. These positions are likely to remain volatile until economic growth stabilizes. We remain bullish on the positions.
Our most underweighted sectors are Health Care, Consumer Staples, Energy, and Real Estate. Health Care, Staples, and Real Estate, at the sector level, remain overvalued and are subject to potential continued margin deterioration. Energy is on our list to upgrade, as supply/demand moves more into balance. In the energy sector, we currently own Chevron (an integrated oil company) and Kinder Morgan (pipelines/energy infrastructure). Our sole real estate sector holding is Public Storage, which provides welcome insulation from the negative trends in commercial real estate.
Lastly, from a sector perspective, our current weightings are Information Technology (14.1% portfolio weighting vs. 9.0% benchmark), Health Care (9.0% vs. 15.4%), Financials (18.7% vs. 20.6%), Communication Services (12.2% vs. 4.9%), Industrials (11.9% vs. 13.4%), Consumer Staples (2.0% vs. 8.4%), Consumer Discretionary (6.7% vs. 5.2%), Real Estate (1.8% vs. 4.9%), Energy (3.5% vs. 8.2%), Materials (6.0% vs. 4.8%), and Utilities (4.0% vs. 5.1%).
From a portfolio perspective, the median Forward Price/Earnings multiple is 15.0x, with the portfolio’s median Free Cash Flow Yield coming in at an attractive 6.6%. The dividend yield is 2.4%. The current portfolio’s median Price/Tangible Book is 3.0x vs. the 10-year median of 4.9x. From this view, in the aggregate, we are currently able to own our portfolio of companies at just 61% of the average tangible book valuation over the past ten years.
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 by reducing the gross number by a model investment management fee of .85% through 12/31/2020 and 1.00% from 1/1/2021 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.
