Day Hagan Smart Value Strategy Update February 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
For the month of January, the portfolio was up +4.78%* net of fees vs. the benchmark Russell 1000 Value Index Total Return +5.18%. The gains follow our outperformance during 2022, when the portfolio mitigated much of the market’s weakness, ending the year down -3.90%* net of fees, versus a decline of -7.54% for the Russell 1000 Value Index Total Return. For perspective, during 2022, the S&P 500 TR was down -18.11%.
From January 1, 2022, through the end of January 2023, during a period of significant market and geopolitical upheaval, the portfolio’s Beta was 0.76, illustrating that the portfolio outperformance was achieved while experiencing 24% less volatility risk than the index. The portfolio’s Jensen’s Alpha is +10.7, indicating that excess return was achieved relative to the risks being taken in the portfolio. Upside capture comes in at 99.2% vs. downside capture of just 64%. Our view is that this is testament to 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.
During 2022, the financial markets were buffeted by global Central Banks tightening monetary policies, interest rates ratcheting higher around the world, slowing global economic growth, persistent inflation, a chorus of growing fears concerning the risk of imminent recession, decelerating corporate earnings growth (and the deteriorating quality of those earnings), China’s zero-Covid policies dampening global growth further, energy price volatility, and a massive spike in geopolitical risk. (These are merely a sampling of the factors investors have had to contend with over the past many months.)
Yet, because of all the noise, it’s sometimes easy to overlook the fact that there have been two significant bear markets over the past three years (2020 and 2022). As we all know, each bear market was very different in character; 2020 was steep and fierce while 2022 was more gradual and nuanced. Both, however, were similar in that they were punctuated by investor fear and high emotion. Those are the conditions that historically have created longer-term opportunities as stocks ultimately became underpriced due to the pricing-in of excessive pessimism.
Near-term, we see some areas of the equity market evidencing pessimism, underpricing, and opportunity, though the opportunity set is narrowing. For example, looking at the NDR Multi-Cap Universe of Value stocks, the current Median Price/Earnings Ratio is 14.9x, which is -2.9% below the average since 1980. Growth stocks, however, are another story. The current median P/E ratio is an astounding 78.6x, which is 190.5% of the average since 1980 (source: Ned Davis Research, data as of 1-30-2023). The stark contrast indicates a couple of things: 1) There are opportunities, but investors need to stay focused on quality, profitability, valuations, and margins of safety for each individual company, i.e., stay disciplined, and 2) if one is to invest in growth companies, one mustn’t lose their focus on how money is made in stock investing, i.e., balancing the current stock price relative to rational expectations. This is why we focus so heavily on Economic Profitability. It provides an unvarnished view of a company’s ability to generate profits for shareholders. Currently, our portfolio remains heavily weighted toward equities we identify as value-oriented. However, we are not opposed to growth—we just need to see reasonable valuations relative to expectations. As opportunities arise, we will allocate capital as warranted.
Longer-term, for 2023, we see light at the end of the tunnel as many of the concerns of 2022 have improved. Central banks are nearing the end of their hawkish monetary policy initiatives, and interest rates appear to have peaked—at least for the time being, recent measures of global economic growth are somewhat encouraging (PMI measures stabilizing, employment still strong), inflation has peaked, supply chains are opening back up, China is showing signs of reopening and renewed stimulative policy, and energy prices are well off of their highs. The 2022 concerns that are languishing in 2023 are still-elevated geopolitical risks, a continuation of negative earnings trends, and areas of the market still evidencing valuation risk. All in all, risk vs. reward appears more balanced than what we witnessed last year.
Turning to individual stock holdings, we were quite active in January as we positioned the portfolio for what we believe to be a developing shift in the macro backdrop, as previously discussed.
Turning to our portfolio holdings, we were quite active in January. We exited our positions in XLC, XLY, and SMH. We had used the ETFs as placeholders for our capital at year-end to maintain equity exposure in anticipation of a year-end rally, which occurred. During our holding period, XLC was up approximately +14.9%*, XLY +8.1%*, and SMH +13.8%* vs. +5.6% for the S&P 500 ETF (SPY 12-21-2022 through 1-23-2023). We subsequently repopulated the portfolio with individual stocks, repurchasing our positions in Alphabet (GOOGL), Qualcomm (QCOM), Meta (META), and Micron Technology (MU). We also increased our holding of Cognizant Technology (CTSH).
In addition, we initiated new positions in Williams-Sonoma (WSM), Celanese (CE), Owens Corning (OC), and Masco (MAS) Corporation.
Masco Corporation (MAS) designs, manufactures, and distributes home improvement and building products in North America, Europe, and internationally, headquartered in Livonia, Michigan. Some of its more well-known brands are Delta sink and bathroom fixtures, Hot Spring spas, and Behr paints and stains. Over the past 12 months, given an extremely uncertain economic backdrop, management has been able to generate consistent levels of free cash while returning over $1.3B to shareholders through dividends and share repurchases. The stock currently trades at 13.7x forward earnings and 13.8x free cash flow, with a 2.23% dividend yield, which is near the high end of its 10-year range. In addition, the EVA-adjusted Price/Book ratio is near historically low levels, indicating an attractive valuation opportunity for a strong cash flow generator. ROIC is 33.9% vs. a WACC of 8.8%.
At the same time, we sold Conagra Brands (CAG), Travelers (TRV), and Oracle (ORCL). CAG and TRV have cost-of-capital values that currently exceed their returns on invested capital, evidencing reduced profitability and lower cash generation. This foments increased risks, particularly with an unclear economic backdrop. Oracle had been a relative outperformer and was sold due to reaching our determination of Fair Value.
Lastly, we trimmed Merck (MRK), which had significantly outperformed over the past 12 months (~+43%*) and had become the largest holding in the portfolio. It was nearing our measure of fair value, so we trimmed the position to manage position sizing. The reduction decreased our overall Health Care sector exposure as we believe there are better opportunities elsewhere at this juncture in the market cycle.
Our new purchases and increased position sizes give the portfolio more exposure to the Industrials and Materials sectors, which rate as significantly undervalued in our work. We also increased our exposure to the Information Technology and the Communication Services sectors, both of which were hard hit in 2022 but appear to be stabilizing at attractive levels.
Each of our purchases exhibits attractive characteristics, including strong cash generation, positive economic profitability, revenue growth opportunities, a pristine balance sheet, a shareholder-friendly management team, and a margin of safety.
For more details on the changes, please see our “Day Hagan Smart Value Trade Notification” released on January 26, or give us a call and we’ll send you a copy.
From a sector perspective, our current weightings are Information Technology (16.8% portfolio weighting vs. 8.9% benchmark), Health Care (15.9% vs. 16.2%), Financials (17.9% vs. 20.3%), Communication Services (10.8% vs. 8.4%), Industrials (10.8% vs. 10.5%), Consumer Staples (2.4% vs. 6.8%), Consumer Discretionary (6.6% vs. 6.4%), Real Estate (2.4% vs. 4.8%), Energy (6.5% vs. 7.8%), Materials (2.0% vs. 4.5%), and Utilities (3.9% vs. 5.4%).
From a portfolio perspective, the median Forward Price/Earnings multiple is 13.7x, with the portfolio’s median Free Cash Flow Yield coming in at an attractive 6.1%. The dividend yield is 2.3%. The portfolio’s current median Price/Tangible Book is 2.4x vs. the 10-year median of 4.7x. Based on this view, we are able to own our current portfolio of companies at a significant discount—for just over 1/2 of the average valuation seen over the past 10 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
Jeffrey Palmer, CIPM®
Steve Zimmerman, MBA
Note: As the market environment evolves, Day Hagan Smart Value remains a strategy that has provided a consistent approach to valuation, with an emphasis on quality and risk management. Our track record speaks for itself with both attractive upside and modest downside capture, in the name of long-term outperformance. If you would like to schedule a virtual meeting, just let us know.
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 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, 2021. 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 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.
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.
