Day Hagan Smart Value Strategy Update December 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
Equity and fixed-income markets rallied strongly in November, reversing much of the August, September, and October declines. As written in our November Strategy Update,
What actually moves markets in the future is whether the “already known” factors ultimately trend better or worse than current expectations. If expectations are low, then it can be easier for the markets to “overachieve” and trend higher.
Current investor expectations appear to be downbeat and are, based on our quantitative and objective modeling, pricing in a negative outlook. For example, investor sentiment is excessively pessimistic, consumer confidence surveys have been turning more negative, and institutional investors have largely reduced equity exposure over the past several months.
From an investment perspective, this is, perhaps surprisingly, good news. When there is excess negativity in the markets, it often means that most of the sellers have already sold and that the path of least resistance is higher. Warren Buffett famously said, “Be fearful when others are greedy, and greedy when others are fearful.” We don’t necessarily want to be greedy at this juncture just because others are fearful, but we do want to remain cognizant that a great deal of bad news is currently priced in.
To be clear, there are plenty of reasons to be concerned when looking through macro and geopolitical lenses, but the last three months of market performance have abridged many of the excesses in the markets. We are seeing more opportunities crop up and will continue to focus the portfolio on companies with strong cash generation, solid balance sheets, and shareholder-friendly management. These factors provide defense when times are tough and allow for appreciation when markets gain.”
The prevailing negative conditions at the end of October did lead to support levels being held, allowing equity markets to reverse course and move higher. However, the spike higher happened quickly, and we now see signs that the markets may need some time to digest the move. Rather than excessive pessimism, our models indicate excessive optimism levels. Rather than the markets being deeply oversold, our indicators currently show overbought conditions. There are typically two ways these negative overhangs are resolved: 1) Through a period of sideways consolidation as prices catch up to newly optimistic expectations, or 2) an outright decline. Given positive year-end seasonality and investors starting to broaden their attention to stocks outside of the Magnificent 7, we view the probability of a sideways move and potentially a slight decline as most likely.
We note that macro conditions, overall, are still a headwind. Geopolitical tensions, potentially lagged impact from higher interest rates and sovereign debt balances, mixed signals from global measures of economic activity, and more hawkish monetary (higher for longer) and fiscal policies (reduced government spending) are typically harbingers of a higher risk environment over the long-run. With that in mind, we continue to focus on high-quality companies that we view as having the ability to withstand potential economic shocks.
To assess our portfolio’s overall quality, we monitor several measures to evaluate each company’s cash generation, balance sheet strength, and management skills. We review these factors individually as well as in aggregate to determine our portfolio’s relative risk and potential return. While these measures vary based on the company, industry, and sector being reviewed, they provide a potential roadmap as to where opportunities and potholes may exist.
First, we focus heavily on a company’s ability to generate economic profit. ISS writes, “The Wall Street community, along with the financial media and corporate bosses, would be far better served by a valuation paradigm that is based on reporting, analyzing, projecting, valuing, and discounting a firm’s underlying economic profit rather than its bookkeeping profit. Unlike accounting profit, economic profit—which we call ‘economic value added’—deducts the ‘cost’ of giving shareholders a minimum acceptable return on their equity investment in the firm. It also avoids financing distortions that occur when debt/equity ratios temporarily shift. It does so by measuring the return generated on all capital against a strategic, long-run, weighted average cost of the capital that is based on a target blend of debt and equity. And finally, it eliminates distortions introduced by the principle of conservatism. Under EVA, R&D and other intangible outlays, even outlays to restructure operations, are treated as investments and not expensed or charged to earnings accounting rules dictate. The EVA measures—with the adjustments described, and a few more—are actually far better at explaining and predicting stock prices, which is reason enough for an astute investor to pay attention.” (source: ISS EVA)
Peter Drucker wrote in Harvard Business Review that “EVA is based on something we have known for a long time. Until a business returns a profit that is greater than its cost of capital, it operates at a loss. Never mind it pays taxes as if it had a genuine profit. It still returns less to the economy than it devours in resources. It does not cover its full costs unless the reported profit exceeds the cost of capital. Until then, it does not create wealth; it destroys it.”
Each of our portfolio companies (outside of REITs, which are calculated differently) returns a positive Economic Value, meaning that they are exceeding their cost of capital as well as an additional capital charge to compensate investors for taking on the risk of owning stocks. The levels of adjusted economic profitability within our holdings range from Meta’s 24.8%, Public Storage’s 19.8%, Cisco’s 17.6%, Google’s 16.8%, and JP Morgan’s 16.8% to lower levels from Bank of New York’s 0.4%, CVS’s 0.6%, Target’s 1.9%, Mosaic’s 3.1%, Nutrien’s 3.2%, and OGE Energy’s 3.6% (data as of 12-4-2023). Our average economic profitability level is over 7.9%. While companies with lower economic returns may seem less attractive, we also review whether current levels have been impacted by a negative event that is likely to improve in the future, allowing economic profit levels to reset higher to historical averages. The bottom line is that in our portfolios, we maintain a mix of companies with already high economic returns, as well as companies that exhibit the potential for improvement but still generate positive economic profitability results, albeit below their historical norms.
We also view companies that pay dividends as a high priority. Dividends often signal that a company’s management team is shareholder-friendly and generates the free cash flow needed to pay out said dividends. However, if a company does not pay a dividend but has high levels of free cash flow, we will consider that company for investment, as the message, in our view, is similar.
We evaluate dozens of additional measures of corporate performance and valuation, which we discuss periodically in Strategy Updates. However, this month we turn our attention to “Sensitivity Analysis.”
Sensitivity Analysis is used to determine, in this case, an aggregate portfolio’s potential reaction to changes in variables, and in particular, macro variables. For example, the current makeup of our portfolio, based on historical analysis, will likely react positively to higher commodity prices, higher energy prices, wider credit spreads (indicating a defensive bias), a stronger U.S. dollar, continued inflation, stronger Emerging Market performance, and Value stock outperformance. Perhaps surprisingly, the portfolio’s sensitivity to 10-year U.S. Treasury interest rate trends is almost 0, meaning that our mix of holdings neither overly benefits nor is overly harmed by higher or lower rates (as long as rates don’t spike to levels that push the economy into a protracted slowdown).
Looking at standard measures, the average company in our portfolio has a cash-to-assets position of 12%, with an average (mean) gross profit margin of 44.2% and projected long-term earnings per share growth of 4.6%. The average shareholder yield is 3.8% (combining dividends, debt reduction, and share buybacks).
From a portfolio perspective using more standard metrics, the median Forward Price/Earnings multiple is 14.1x, with the portfolio’s median Free Cash Flow Yield coming in at an attractive 7.3%. The dividend yield is 2.4%. The current portfolio’s median Price/Tangible Book is 2.6x vs. the 10-year median of 4.5x. From this view, in the aggregate, we are currently able to own our portfolio of companies at just 58% of the average tangible book valuation over the past ten years.
From a sector perspective, our current weightings are Information Technology (14.3% portfolio weighting vs. 9.2% benchmark), Health Care (5.6% vs. 15.3%), Financials (18.7% vs. 20.5%), Communication Services (13.2% vs. 5.0%), Industrials (11% vs. 13.3%), Consumer Staples (5.6% vs. 8.4%), Consumer Discretionary (7.4% vs. 5.0%), Real Estate (1.7% vs. 4.6%), Energy (5.9% vs. 9.1%), Materials (3.7% vs. 4.8%), and Utilities (3.9% vs. 4.7%).
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 place at risk, as well as where to place that capital.
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
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.
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.
