Day Hagan Smart Value Strategy Update July 2024
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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
In the first half of the year, equity returns have been mixed. Indexes weighted by market capitalization (whereby large-cap stocks have more influence) have performed much better than equal-weighted indexes, showing that the market is divided. Only 22.4% of stocks in the S&P 500 have outperformed the index this year, which would be the lowest percentage in 51 years if this trend continues. While capitalization-weighted U.S. indexes are up 10% or more, the equal-weighted S&P 500 has only returned 5.1%, and the Russell 1000 Value index is up just 6.6% through the first half. However, historical data suggests that when equities (based on the capitalization-weighted S&P 500) have had 10% or greater returns in the first half of the year, the second half of the year has been positive 83% of the time, with an average return of 7.7% (compared to just 4.7% for all periods).
Our overall view of the U.S. economy and inflation remains unchanged. 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.
In that vein, we made a few adjustments to the portfolio last month. We reduced the Goldman Sachs and Charles Schwab holdings while adding a new position in Comcast. Although Goldman Sachs and Charles Schwab will still be part of our portfolio, their valuations no longer support an overweight allocation after their recent strong performance. In contrast, Comcast’s valuations justify initiating a position in the stock.
Highlights:
Goldman Sachs: In May 2022, we acquired Goldman Sachs, and it outperformed the S&P 500, showing a 48% increase in the past 12 months compared to the S&P 500’s 27% return. During the latest earnings call, management highlighted the firm’s strong interconnected franchises and emphasized progress in narrowing the strategic focus and prioritizing core strengths. They also mentioned the firm’s success in the new issue market and its leading position in global capital markets, assisting clients in accessing the markets. Despite considering Goldman Sachs a solid company, we believe it’s prudent to reduce the position from overweight to a neutral allocation based on the current risk-to-reward profile due to the substantial stock increase since our initial purchase. For investors in our strategy who have been invested for over a year, selling the position will result in a long-term capital gain.
Charles Schwab: In March 2023, Charles Schwab was acquired and has since outperformed the S&P 500. However, valuations are now nearing fair value. Over the past year, SCHW’s price has risen by around 34% compared to the S&P 500’s 27% return. During the latest earnings call, management emphasized consistent organic growth, high client satisfaction, strategic initiatives, and the potential upside from expected interest rate hikes. Despite considering Charles Schwab a strong company, we believe the risk-to-reward profile justifies reducing our overweight position to a more neutral allocation. Investors who have been with us for over a year can benefit from the sale as a long-term capital gain.
Comcast: Based on Comcast’s strong financial performance, including its high profitability levels, consistent economic value-added margins, and focus on shareholder-friendly policies, we initiated a position on June 28. From an EVA (economic value added) perspective, management has consistently achieved economic margins between 5% and 10% since 2013. Our analysis suggests that the current stock price reflects investors’ expectations of a margin decrease to around 2% over the next five years. Furthermore, the current stock price also indicates a projected decrease of almost 25% in the value of assets in place during the same period. We consider these assumptions overly pessimistic and view this as an attractive buying opportunity. The company’s vision and focus on execution, along with the growth potential of its major business segments, such as Residential Broadband, Wireless, Business Services, Theme Parks, Studios, and Streaming, indicate a positive outlook. The company’s investments in network capacity and the success of Super Nintendo World at theme parks also contribute to its favorable position for future growth.
Several of our portfolio holdings are slated to report earnings this month. First on the docket are PepsiCo (PEP), JP Morgan (JPM), Bank of New York (BK), Goldman Sachs (GS), and Blackrock (BLK). Expectations are as follows:
PepsiCo: PepsiCo’s international business has shown strong profit performance, with expectations of continued growth due to investments in innovation, understanding local markets, building capable teams, and expanding manufacturing and go-to-market capabilities. Analysts anticipate margin improvement at Frito-Lay as the business invests to sustain growth, aiming to grow the salty, savory category and gain market share. Confidence exists in stabilizing and growing volumes for Gatorade and Mountain Dew through investments and commercial programs. Focus on profitability improvements at PepsiCo Beverages North America (PBNA) includes strategies like revenue management and precise consumer value propositions. While the global consumer is generally resilient, caution exists around the lower-income U.S. and Chinese consumers. The commodity cost outlook is relatively benign due to the diversification of inputs and forward buying/hedging strategies, contributing to a positive analyst outlook for PepsiCo. Current fiscal year earnings revisions have been trending higher, with 75% positive over the past 90 days. Normalized earnings are expected to be $2.16, on revenues of $22.65B.
JP Morgan: The concerns surrounding JPMorgan Chase & Co. in the current economic climate include uncertainty regarding economic, geopolitical, and regulatory factors, as highlighted by Jamie Dimon. Additionally, there are potential implications for the real estate market and leveraged assets due to higher interest rates. There is also a possibility of reduced capital markets activity, particularly in M&A, later in the year. Other crucial aspects that must be considered are deposit migration, credit performance, balance sheet optimization, and capital deployment. Furthermore, the uncertainties surrounding Basel III regulations, GSIB score, and surcharge changes, and the 2024 DFAST stress test could impact JPMorgan’s financial position. The normalization of deposit margins and credit performance, along with strategic capital management and investments in technology and innovation, all collectively contribute to the analyst outlook for JPMorgan Chase & Co. Current fiscal year earnings revisions have been trending higher, with 81% positive over the past 90 days. Normalized earnings are expected to be $4.36, on revenues of $44.35B.
Bank of New York: Progress in transformation efforts and a constructive operating environment with potential tail risks like geopolitical conflicts were highlighted. Q1 showed strong financial performance with double-digit EPS growth, pre-tax margin and ROTCE expansion, and positive operating leverage. Initiatives include the Wove wealth advisory platform and virtual account-based solutions. The company is investing in AI and technology to drive efficiency and innovation. Key factors from investor relations events include resilience and preparedness to handle unexpected events and strategic reviews and changes. Demonstrated progress on strategic priorities through positive operating leverage, revenue growth, and fee revenue. The company is focusing on expense management, cultural transformation, and driving efficiency through its platform operating model. Current fiscal year earnings revisions have been trending higher, with 83% positive over the past 90 days. Normalized earnings are expected to be $1.42 on revenues of $4.5B.
Goldman Sachs: Along with our previous comments, Goldman Sachs’ Global Banking and Markets business performed strongly in Q1, delivering an 18% ROE, exceeding expected levels. The sustainability of its financing and intermediation businesses has improved, providing more stable revenue sources. The Asset & Wealth Management business also grew, with the 25th consecutive quarter of long-term fee-based net inflows. There are expectations for increased capital markets activity as they reopen, which could benefit Goldman’s investment banking and markets businesses. AI and technological developments offer significant opportunities for client advisory services and internal efficiency gains. However, concerns exist regarding the macroeconomic environment, the U.S. economy, inflation, geopolitics, and the impact of the upcoming U.S. election. Current fiscal year earnings revisions have been trending higher, with 95% positive over the past 90 days. Normalized earnings are expected to be $8.64 on revenues of $12.57B.
BlackRock: BlackRock achieved a record AUM of nearly $10.5 trillion in Q1 and reported strong growth opportunities across technology, outsourced solutions, and private markets. The company experienced positive organic base fee growth, double-digit revenue and earnings growth, and margin expansion. It also saw continued long-term net inflows, with ongoing demand for its technology offerings and Aladdin technology. The acquisition of Global Infrastructure Partners is expected to be transformational for BlackRock. The company also highlighted key factors from investor relations events, including client portfolio rotation, structural growth areas, organic base fee growth, and the resilience of the ETF market. Additionally, BlackRock emphasized the growth potential in private markets. Current fiscal year earnings revisions have been trending higher, with 86% positive over the past 90 days. Normalized earnings are expected to be $9.96, on revenues of $4.86B.
As described last month, an important aspect of our portfolio management activities, outside of rating individual stock and sector attractiveness, is to evaluate the combined portfolio’s sensitivity to several macro and micro factors. The overall portfolio continues to be positively correlated (the portfolio appreciates as the variable increases) with commodities (including energy), credit spreads, emerging market trends (including a positive correlation with China), small- and mid-cap equity trends, and value stock outperformance. Importantly, the portfolio is neutral relative to 10-year Treasury bond sensitivity and has a slightly negative correlation with inflation (as do most stocks). In other words, the portfolio is positioned for continued global economic growth and a neutral inflation backdrop.
From a fundamental perspective, the portfolio’s Forward P/E is 15.2x (vs. 21x for the S&P 500), median cash flow yield is a positive 7.84% (vs. the 10-year median of 5.3%), and Price/Tangible Book is 2.94x (vs. the 10-year median of 5.37x).
The portfolio’s current sector weightings are Information Technology (13.6% portfolio weighting vs. 9.6% benchmark), Health Care (3.0% vs. 15.3%), Financials (18.9% vs. 21.2%), Communication Services (14.4% vs. 4.2%), Industrials (11.8% vs. 14.4%), Consumer Staples (6.8% vs. 7.9%), Consumer Discretionary (5.7% vs. 6.0%), Real Estate (1.3% vs. 4.6%), Energy (5.4% vs. 7.6%), Materials (1.7% vs. 4.5%), and Utilities (3.6% vs. 4.5%).
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
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