Day Hagan Smart Value Strategy Update August 2024
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
In July, global equity performance varied, with developed markets slightly higher, the EAFE showing good gains, and emerging markets weaker. U.S. large caps struggled, especially the Nasdaq, due to tech stocks’ earnings generally not meeting elevated expectations. U.S. small caps (and equally-weighted indexes) gained after the July 11th CPI inflation print as the probability of U.S. rate cuts increased, and investors placed better odds on renewed economic growth.
However, equity markets have recently been weaker, with the S&P 500 index falling from its peak on July 16, which has been driven by concerns about the economy, the potential impact on earnings, and the delayed Federal Reserve easing cycle. Although recent inflation data has shown some improvement, it followed a period of unfavorable readings earlier in the year, which had postponed the easing process. The potential for interest rates to remain “higher for longer” has some investors wondering if the Fed is waiting too long to reduce rates.
Market optimists believe that the Federal Reserve will manage inflation and employment levels effectively, while pessimists argue that the market weakness may foreshadow a continuation of the sell-off. At this point, we see a deceleration in the economic backdrop, but our models continue to point to positive economic growth. In other words, a soft landing. This would be supportive for further equity gains, though our view is that companies deemed to be quality with high profitability are likely to be the leaders. We continue to position the portfolio in exactly that caliber of companies.
In the optimistic scenario, supporters believe that inflation is heading towards a resolution that will satisfy the central bank, and pandemic-related factors driving inflation are expected to normalize post-COVID. The timing and extent of potential rate cuts by the Federal Reserve are also a point of interest. Additionally, the strong foundation of the U.S. economy, as indicated by recent GDP data and a resilient labor market, supports the optimistic outlook.
Supporters of the pessimistic scenario argue that concerns about inflation and the potential impact on the Fed’s policy decisions, along with worries about recession risks and valuation levels, could lead to a continued market selloff. They are cautious about the potential erosion of purchasing power for lower-income households due to inflationary pressures. We continue to see negative economic releases around mortgages, credit cards, and other credit-related delinquency rates—especially in the lower-income categories. Ultimately, the market’s direction hinges on how these competing views unfold in the coming months.
It is considered that the current stock market valuations are reasonable, given the expected interest rate trajectory lower. The S&P 500 index is trading at 20.7X forward 12-month earnings estimates, which is relatively high but not considered excessive given the anticipated Fed easing cycle (the 5-year average is 19.3x). The earnings outlook is an essential part of the valuation discussion. The ongoing 2024 Q2 earnings season is showing stability in corporate profitability, with expected growth in the coming quarters. Many companies across various sectors, including Technology, are reporting favorable business trends and strong quarterly results (78% of SP500 companies have reported positive earnings surprises and 59% positive revenue surprises). However, several companies, while beating estimates, guided lower for the second half of the year in response to growing concerns around global economic activity, increasing U.S. unemployment, geopolitical risks, and election uncertainty, to name a few. Prior to the end of July, consensus expectations for this year and next reflected anticipated strong growth after two years of below-trend profitability, but during July, ten of the eleven S&P 500 sectors had net negative earnings forecast decreases for the third quarter of 2024. We’re monitoring this closely as we view earnings as the necessary lynchpin for the next leg higher.
In response to the aforementioned points, we currently hold an above-average cash position in the portfolio and continue to reduce exposure to companies supported by exaggerated future expectations in favor of companies that have historically generated significant cash flow and with management teams that have proven to be shareholder-friendly.
In conclusion, our overall view of the U.S. economy and inflation remains unchanged from last month. Our models continue to portray a constructive equity environment supported by positive, albeit below-average, economic growth accompanied by disinflationary pressures. Global central banks are past the point of peak hawkishness, and many have already pivoted toward easier monetary policies, which, in turn, have historically supported financial assets. Of course, there are caveats, with geopolitical risks high, broad market valuations relatively expensive, and election uncertainties around the globe, to name just a few. In light of these factors, we continue to focus on companies with strong balance sheets, growth opportunities, and valuations that provide a reasonable margin of safety. This focus is a key part of our investment strategy and ensures we select investments aligning with our long-term goals.
With earnings season in full bloom, we thought it would be instructive to highlight some of the results and the main factors driving performance. Since the start of July, twenty-five of our holdings have reported earnings better than expected, while five fell short (three of those rounded to misses of less than 1 penny). Below are a few examples:
Clorox (reported on 8-2-2024): Clorox’s earnings performance for the quarter ending June 30, 2024, was influenced by several key factors. The health and wellness segment outperformed the household segment, driving over-delivery in Q4 earnings. Margin expansion was achieved through strong cost savings, portfolio optimization via divestitures, and modest cost inflation, leading to a significant improvement in the gross margin, which stood at 46.45%. Additionally, the company benefited from a favorable commodity cost environment compared to the previous high inflation years. In terms of financial metrics, total revenue for the quarter was $1,903 million, with the health and wellness segment contributing 34.26%. Earnings per share (EPS) showed a growth of 22.26% compared to the previous quarter, reaching $1.74, while net income reflected a 22.73% growth, amounting to $216 million. Collectively, these factors enabled Clorox to exceed its earnings expectations for the quarter, showcasing a strong and promising performance.
Meta (7-31-2024): In the second quarter of 2024, Meta experienced significant growth in daily active users, surpassing 3.2 billion people using their apps daily, particularly in the U.S. market. Advancements in AI technology enhanced content recommendations and engagement across Facebook and Instagram, with the introduction of a unified video recommendation system. Moreover, ongoing improvements in ad performance and monetization efficiency, facilitated by AI-powered tools like the Meta Lattice ad ranking architecture and the Advantage+ suite, further contributed to positive results. The rollout of Meta’s AI assistant showed promising early results, with projections to become the most widely used AI assistant by the year’s end. Additionally, the strong demand and performance of Reality Labs products, namely the Quest 3 headset and Ray-Ban Meta smart glasses, further boosted the company’s success. Financially, Meta reported a total revenue of $39.07 billion, with advertising revenue accounting for $38.33 billion (98.1%). Moreover, the company achieved an EPS of $5.31, reflecting a growth of 75.21% compared to the previous quarter and a net income of $13.47 billion, demonstrating a 72.89% increase from the previous quarter, with an operating margin of 38%.
Chevron (8-2-2024): Chevron’s earnings performance in the quarter was influenced by lower liftings, higher exploration expenses, and the absence of favorable tax impacts from the prior quarter. Meanwhile, lower refining margins and reduced capture rates affected Downstream earnings, albeit partially offset by timing effects. Additionally, a tax true-up had a negative impact. Heavier-than-usual maintenance and turnarounds at Upstream assets and the El Segundo refinery, along with a one-time payment related to discontinued operations, also contributed to the financial metrics for the quarter. The total revenue for the quarter was $46.58 billion, with Upstream Sales Revenue contributing 24.55% and Downstream Sales Revenue contributing 75.39%. The EPS declined by 24.55% compared to the previous quarter, amounting to $2.43. The net income for the quarter was $4.434 billion, with the overall operating margin at 11.89%. Despite these challenges, Chevron remains confident in its long-term earnings and cash flow growth.
Public Storage (7-30-2024): Move-in rents saw a larger-than-expected 14% decrease, attributed to intensified pricing competition in many markets. Occupancy trends surpassed expectations with positive net move-ins year-to-date. The high-growth non-same-store pool, making up 22% of the portfolio, experienced a remarkable nearly 50% growth in Net Operating Income (NOI). Furthermore, the waning development of new competitive supply supported an acceleration in operating fundamentals. The company also repurchased $200 million in Public Storage common shares during the quarter. Additionally, due to the lower move-in rents during the busy season, the company revised its same-store revenue assumptions and core Funds From Operations (FFO) per share guidance. Financially, the U.S. Self-Storage Revenue contributed $1,099.74 million, representing 93.74% of the $1,173.21 million quarterly revenue, while Ancillary Operations Revenue contributed $73.48 million, or 6.26%. Earnings per share (EPS) for Q2 2024 declined by 11.33% to $2.67, and net income decreased by 10.36% to $518.13 million compared to the previous quarter, with an operating margin of 47.96%.
Comcast (7-23-2024): Despite intense competition in the broadband market, Comcast managed to achieve strong ARPU growth of 3.6% by focusing on market segmentation and offering flexible products like NOW Internet and Mobile to cater to different customer needs. On the other hand, the parks business experienced a decline in revenue and EBITDA due to lower attendance at domestic parks, which was attributed to a COVID recovery pull forward and the timing of new attraction openings. However, Comcast announced an 11-year NBA rights deal, expected to drive growth by expanding its reach and enhancing its sports programming. The studio business saw a decrease in revenue and EBITDA, reflecting the timing of their film slate and tough comparison to the prior year’s successful releases. Financially, Comcast reported a quarterly revenue of $31.01 billion, with a slight decline in EPS and net income compared to the previous quarter. Operating margin stood at 22.35%.
Goldman Sachs (7-15-2024): In the second quarter of 2024, Goldman Sachs (GS) delivered a strong earnings performance. The Global Banking & Markets segment experienced robust growth, particularly in Equities, generating quarterly net revenues of $8.18 billion, while the firm achieved record financing revenues across Fixed Income, Currency, and Commodities (FICC) and Equities. Additionally, the Asset & Wealth Management segment saw continued growth in management and other fees, as well as private banking and lending revenues, generating net revenues of $3.88 billion. Furthermore, the investment banking backlog increased significantly, indicating a strong pipeline for future revenue generation. Notably, Goldman Sachs raised $36 billion year-to-date in alternatives and is expected to surpass $50 billion for the full year, contributing to positive future earnings. Moreover, the firm made progress in reducing its historical principal investment portfolio as part of its strategy to streamline operations. This outstanding performance translated into a quarterly revenue of $12.73 billion, an EPS of $8.73, marking a growth of 182.6% compared to the previous quarter, and a net income of $3.043 billion, reflecting a growth of 150.25% compared to the previous quarter.
Pepsi (7-11-2024): The recovery of Quaker’s supply chain, with expectations of nearly 100% supply by Q4, is anticipated to have a positive impact on earnings as they replenish shelves and pipelines. The company also foresees easier year-over-year comparisons in the second half, providing confidence in achieving mid-single-digit growth. PepsiCo’s international business demonstrated strong growth of 7% in the first half and is expected to maintain this level in the second half. In the U.S., PepsiCo is taking targeted actions to provide more value to certain consumers and parts of its portfolio to address a more challenging consumer environment. Additionally, the company is investing more in advertising and marketing for growing beverage platforms, particularly in North America. Despite facing difficult net revenue growth comparisons and subdued category performance, PepsiCo plans to elevate productivity initiatives and make disciplined commercial investments to stimulate growth. As a result of these actions, PepsiCo now expects to deliver approximately 4% organic revenue growth and projects at least 8% core constant currency EPS growth for the full year 2024. In the second quarter of 2024, PepsiCo's revenue was $22.5 billion, with significant contributions from PepsiCo Beverages North America, Frito-Lay North America, and Latin America. The earnings per share (EPS) for the second quarter of 2024 was $2.24, showing a growth of 12.44% compared to the previous quarter, while the net income for the same quarter grew by 12.19% compared to the previous quarter, amounting to $3.083 billion. PepsiCo also demonstrated strong operational efficiency with an operating margin of 18.51% in the second quarter of 2024.
PayPal (7-30-2024): In the second quarter of 2024, PayPal (PYPL) demonstrated strong performance across various key factors. The total payment volume grew by 11% to $417 billion, showcasing robust transaction activity. Revenue also increased by 9% on a currency-neutral basis, reflecting a strong underlying business performance. Moreover, the growth in non-GAAP earnings per share was particularly impressive, showing a 36% year-over-year increase. The company also observed substantial improvements in customer engagement and monetization, with increased use of Venmo balances within the ecosystem. Furthermore, investments in mobile and SMB offerings, along with Braintree’s return to profitable growth, were highlighted as key growth drivers. Financial metrics for the quarter were also noteworthy, with quarterly revenue reaching $7.885 billion, a significant portion of which came from transaction revenue and other value-added services revenue. Additionally, earnings per share (EPS) grew by 16.88%, reaching $1.08, and the net income increased by 9.62% to $1.128 billion. The operating margin of 17.86% indicated strong operational efficiency, further underlining PayPal’s solid performance.
The common thread among each of these companies is positive returns on invested capital, manageable debt structures, cash generation, and positive economic margins. Historically, these factors have led to portfolio appreciation.
From a fundamental perspective, the portfolio’s Forward P/E is 14.9x (vs. 20x for the S&P 500), median cash flow yield is a positive 7.5% (vs. the 10-year median of 5.4%), and Price/Tangible Book is 2.59x (vs. the 10-year median of 6.1x).
The portfolio’s current sector weightings are Information Technology (15.0% portfolio weighting vs. 8.6% benchmark), Health Care (2.9% vs. 16.4%), Financials (19.3% vs. 20.9%), Communication Services (13.3% vs. 4.2%), Industrials (12.1% vs. 14.3%), Consumer Staples (7.0% vs. 8.1%), Consumer Discretionary (5.4% vs. 6.1%), Real Estate (1.7% vs. 4.9%), Energy (5.3% vs. 7.2%), Materials (1.8% vs. 4.5%), and Utilities (3.9% vs. 4.8%).
The Smart Value portfolio strategy utilizes measures of economic profitability, balance sheet sustainability, cash flow generation, valuation, economic trends, monetary liquidity, and market sentiment to make objective, rational decisions about how much capital to put at risk and where to put that capital.
Please let us know if you would like to discuss the portfolio in more detail or learn more about our approach.
Sincerely,
Donald L. Hagan, CFA®
Regan Teague, CFA®, CFP®
Rob Herman, MBA
Jeffery Palmer, CIPM
Steve Zimmerman, MBA
Steven Goode, CFA®
Disclosure: The aforementioned positions may change at any time.
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.
For more information, please contact us at:
Day Hagan Asset Management, 1000 S. Tamiami Trail, Sarasota, FL 34236
Toll-Free: (800) 594-7930 | Office Phone: (941) 330-1702
Website: https://dayhagan.com or https://dhfunds.com Future Online Events
