Day Hagan Smart Value Strategy Update February 2025
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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.
Strategy Update
Major equity indices performed well in January, with the S&P 500 up 2.78%, the S&P SmallCap 600 up 2.91%, and international equities generally positive. Major bond indices were also up, with the Bloomberg U.S. Aggregate Bond index gaining 0.53%. Interestingly, the only S&P 500 sector negative in January was Information Technology (down -2.90%), with sector leadership shifting to more cyclical/defensive areas of the market.
The Federal Reserve maintained the fed funds rate at a steady range of 4.25%-4.5% during its January 2025 meeting, aligning with market expectations. This pause follows three consecutive rate cuts in 2024, totaling one percentage point. Chair Jerome Powell emphasized the central bank’s cautious approach to lowering interest rates, aiming to gauge further developments in inflation. Recent indicators reveal robust economic activity, with the unemployment rate stabilizing at low levels and labor market conditions remaining strong. However, inflation persists at elevated levels, leading the Fed to exclude its previous comments about ongoing progress toward the 2% target. The uncertainty surrounding the economic outlook prompted the Fed to remain vigilant regarding risks affecting its dual mandate.
In currency markets, the dollar index lingered below recent highs. Still, it rallied modestly after stronger-than-expected U.S. job growth data showed an increase of over 180,000 private-sector jobs in January, outperforming forecasts of 150,000. This data underscores the economy’s resilience amidst ongoing uncertainty. Futures markets continue to predict two rate cuts by the Fed within the year. However, trade tensions have escalated between the U.S. and China following the imposition of a 10% tariff on Chinese imports, which prompted China to retaliate with levies up to 15% on U.S. goods. Although Xi Jinping appears more cautious than the Trump administration, tariff risks remain a significant concern. Upcoming discussions between President Trump and Xi are anticipated to address these trade developments. Earlier this week, Trump agreed to postpone the scheduled 25% tariffs on Mexico and Canada for a month following successful negotiations.
The S&P Global U.S. Manufacturing PMI, a monthly report detailing manufacturing trends, was revised upwards to 51.2 in January 2025, exceeding the preliminary estimate of 50.1, marking an improvement from December’s reading of 49.4. The index indicates a modest recovery within the manufacturing sector, which we have been looking for to signal renewed economic activity. New business inflows rose for the first time since mid-2024 despite declining export orders. Production expanded for the first time in six months, and employment increased for the third consecutive month. Conversely, backlogs of work and purchasing activity continued to decline. On the pricing front, input costs surged, while selling prices experienced their sharpest increase since March 2024. Notably, business optimism reached a 34-month high, reflecting the strongest sentiment improvement since November 2020. We are monitoring closely to see whether the improvement is due to “pre-ordering” (pulling forward orders) ahead of potential tariff increases or renewed momentum in the manufacturing sector.
In contrast, the S&P Global U.S. Services PMI fell to 52.9 in January 2025 from 56.8 the previous month, slightly above the preliminary estimate of 52.8 but below initial market expectations of 56.5. This decline marks the weakest expansion in services activity since April of the prior year. Although output expanded for two consecutive years, it experienced a noticeable slowdown, partially due to increased new orders. Job creation in the sector reached its highest rate since 2022 as companies aimed to enhance capacity. However, higher labor costs contributed to increased input inflation, impacting materials and utilities while driving up output charges. Notably, the slowdown in new business undermined confidence among firms regarding their prospects over the next 18 months.
The U.S. economy recorded an annual growth rate of 2.3% in Q4 2024, the slowest pace in three quarters, down from 3.1% in Q3 and below forecasts of 2.6%. Personal consumption remained the major growth driver, with an increase of 4.2%, the highest since Q1 2023. Spending accelerated for both goods and services, reflecting consumer resilience. However, fixed investment contracted by 0.6% for the first time since Q1 2023, primarily impacted by equipment and structures. Investment in intellectual property continued to rise, and residential construction rebounded. Notably, private inventories negatively impacted growth, reducing it by 0.93 percentage points. Both exports and imports contracted, largely neutralizing net trade’s contribution, while government spending growth slowed to 2.5%. For the entirety of 2024, the economy advanced by 2.8%.
Labor remains strong, and the ADP report indicated better-than-expected job growth in the private sector, reinforcing labor market strength. Regarding earnings performance, which is key to continuing the secular uptrend, 32% of S&P 500 companies have reported, with 74% exceeding fourth-quarter earnings expectations, consistent with average performance over the past four quarters. Approximately 62% of companies reported revenues above estimates, an improvement from 60% in the previous period. About 52% of firms achieved double beats on both sales and net income, while only 16% experienced misses on both metrics. Sectors such as Communication, Technology, and Financials have demonstrated notable strength in earnings performance thus far.
Turning to individual stocks for a moment, we made several adjustments during the month:
On January 21, we adjusted our portfolio by selling our Morgan Stanley (MS) position. The stock was initially purchased in May 2020 and had since appreciated approximately 231%*, excluding dividends, in contrast to the S&P 500's price return of about 103.68%. Over the previous 12 months, the stock experienced a rally of around 59%, pushing its price above our estimated fair value. Given this situation, we see an opportunity to realize gains and reallocate capital into positions that, according to our analysis, present a higher probability of delivering favorable returns.
We purchased a position in Realty Income (Ticker: O), a leading net lease operator with a robust portfolio of high-quality tenants across economically resilient industries. Realty Income stands out with 29 consecutive years of positive operational returns and an excellent dividend history. Despite the challenges posed by the Federal Reserve’s restrictive interest rate policy, the current market presents a compelling opportunity to invest in this industry leader at an attractive valuation, with a price-to-FFO ratio of 14.1x and a dividend yield of 5.7%, both favorable compared to their 10-year averages.
We also added a position in LyondellBasell (Ticker: LYB), a global producer of commodity chemicals. Management is optimistic about potential profit growth, supported by improved operating conditions and significant cost-saving initiatives. The company has demonstrated strong financial health, generating $3.4 billion in operating cash flow, effectively covering its dividends while maintaining a solid cash reserve.
Lastly, on January 30, we exited our position in International Business Machines (IBM). International Business Machines Corporation (IBM) and its subsidiaries provide integrated solutions and services globally, operating through segments that include Software, Consulting, Infrastructure, and Financing. We initially acquired our position in IBM in November 2021, and since that time, the stock price had appreciated approximately 106%, significantly outperforming the S&P 500, which recorded a return of 31%. However, following this strong performance, we believe the stock now exceeds our assessment of its fair value. As a result, we have decided to exit this position and reallocate our capital to opportunities that present a more favorable risk-to-reward dynamic.
We initiated positions in Nike (Ticker: NKE) and VIVI Properties (VICI) with the proceeds. Nike, Inc. and its subsidiaries are global leaders in the design, development, and marketing of athletic footwear, apparel, and related services, known for trademarks like NIKE, Jumpman, and Converse. Over the past year, Nike generated approximately $7.8 billion in operating cash flow while distributing $2.2 billion in dividends, yielding around 2%, nearing a decade high. The company boasts a strong liquidity position with $8.4 billion in cash, no significant near-term debt maturities, and $7 billion remaining under its share repurchase program. With industry-leading gross and operating margins, Nike reports a return on invested capital (ROIC) well above its weighted average cost of capital (WACC), showcasing solid financial strength and operational efficiency. From an economic value-added (EVA) standpoint, Nike consistently delivers positive shareholder returns in the mid-to-high single digits, presenting an attractive risk-reward profile supported by robust financial metrics. Consequently, we are initiating a position in Nike based on its strong cash flow generation and compelling valuation. Similarly, VICI Properties Inc., a premier experiential real estate investment trust (REIT), maintains a high-quality portfolio that includes iconic properties like Caesars Palace and MGM Grand. With a strong financial foundation, VICI offers an attractive dividend yield of 5.7%, positioning it well for investment.
During January, 14 of our portfolio holdings reported earnings, with 12 beating estimates and two missing: Kinder Morgan (KMI) and Chevron (CVX).
Kinder Morgan (KMI): Pipeline stocks experienced a significant decline due to concerns surrounding China’s new DeepSeek AI model and its implications for energy demand. However, we view this as an opportunity for investors seeking attractive yields. Pipeline stocks had previously thrived on the expectation that AI adoption would enhance power demand, and the DeepSeek announcement that their approach used significantly less energy created a downdraft, which we view as an overreaction. Many analysts have opined that DeepSeek is unlikely to impact earnings for 2025-26, as the associated AI data centers are still under construction. Moreover, demand for natural gas, essential for producing plastics and fertilizers, remains robust. In our view, Kinder Morgan will continue to benefit from the energy needs of new data centers. Additionally, natural gas pipeline stocks may gain from the current administration’s energy policies following the Federal Energy Regulatory Commission’s reversal of previous regulations.
Chevron (CVX): In a recent update on Chevron’s performance, CEO Mike Wirth highlighted record production levels for 2024, with U.S. Permian production increasing by 18%. Key achievements included the integration of PDC Energy and startup projects in the Gulf of America, alongside the first oil from TCO’s growth project. The company returned $27 billion to shareholders through dividends and buybacks, reducing its share count by 10% over two years. CFO Eimear Bonner reported Q4 adjusted earnings of $3.6 billion, or $2.06 per share, slightly below analysts’ estimates. Special items related to restructuring and impairments reached $1.1 billion. She noted Chevron’s strong financial position, with a 5% dividend increase marking 38 consecutive years of growth and a net debt ratio of 10%. The company plans to maintain annual buybacks between $10 billion and $20 billion, depending on market conditions. Looking forward, Chevron expects an additional $10 billion in annual free cash flow by 2026, with production in the Gulf projected to reach 300,000 barrels of oil equivalent per day. The company aims for $2 billion to $3 billion in cost reductions while keeping capital expenditures between $14 billion and $16 billion, emphasizing operational efficiency and financial discipline.
We continue to hold both energy companies in our portfolio as they meet our buy criteria.
Turning to equity sectors for a moment, our largest sector allocations are Financials, Information Technology, Communication Services, and Consumer Discretionary. Our target weightings versus the Russell 1000 Value Index are as follows: Information Technology 11.4% vs. 9.4% benchmark, Healthcare 1.2% vs. 14.5%, Financials 18.8% vs. 23.2%, Consumer Discretionary 12.6% vs. 6.2%, Communication Services 13.5% vs. 4.2%, Industrials 9.4% vs. 14.4%, Consumer Staples 5.7% vs. 7.7%, Energy 5.6% vs. 6.7%, Utilities 4.0% vs. 4.5%, Materials 4.4% vs. 4.3% and Real Estate 5.4% vs. 4.6%.
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.
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.
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