Day Hagan Smart Value Strategy Update June 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
Year-to-date, through the end of May, the portfolio was -0.53%* net of fees vs. the benchmark Russell 1000 Value Index Total Return, -1.43%. Over the past three years, from 5-31-2020 through 5-31-2023, the portfolio’s Beta was 0.75, illustrating that the portfolio’s outperformance was achieved while experiencing 25% less volatility risk than the index. The portfolio’s Jensen’s Alpha is +3.6, indicating that excess return was achieved relative to the risks being taken in the portfolio. Upside capture comes in at 81% vs. downside capture of just 65%. Our view is that this reinforces 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.
Year-to-date, only three of the eleven S&P 500 sectors have positive returns: Information Technology, Consumer Discretionary, and Communications Services. The lion’s share of the gains for those sectors resulted from the outperformance of the FANMAG stocks (Meta, Amazon, Netflix, Microsoft, Apple, and Alphabet). Without the FANMAG stocks, the other 494 stocks in the S&P 500 are up just +1.73%.
Further illustrating the bifurcated market, we note that the remaining eight sectors are down an average of -5.57% through the end of May, with the defensive sectors particularly weak: Energy ‑12.89%, Utilities -8.51%, and Health Care -6.26%. During May alone, FANMAG stocks were up +8.71%, the S&P 500 Index was up +0.25%, and the other 494 stocks were down -2.01% on average. Value stocks, as represented by the Russell 1000 Value Index, were down -3.86%. Clearly, the FANMAG stocks are masking underlying weakness and what is often termed “a narrow market.”
We continue to own Meta and Alphabet. At this juncture, outside of the FANMAG stocks we own, the others continue to appear extended based on our multi-factor approach to valuation. To be clear, should any of the other FANMAG stocks achieve our standards for purchase, we will happily include them in the portfolio.
Those standards include investing in quality companies that exhibit positive economic profitability, strong balance sheets, solid cash generation, sustainable profitability, and margins of safety. This, by many definitions, is a more value-oriented approach.
By many indications, value stocks are poised for relative strength. Ned Davis Research points out that the percentage of stocks outperforming the S&P 500 is at a record low and on pace for the fewest stocks beating the index on record (since 1973). Following those periods of narrow leadership, S&P 500 returns have been below average, and value and high quality have outperformed growth. Relative valuations are also supportive, with the NDR Large Cap Growth Equity Index Forward Price/Earnings ratio now 34.7x and the NDR Large Cap Value Equity Index Forward P/E two-thirds cheaper at a relatively low 11.8x. This compares to 18.6x for the S&P 500.
From a portfolio perspective, the median Forward Price/Earnings multiple is 14.1x, with the portfolio’s median Free Cash Flow Yield coming in at an attractive 7.8%. The dividend yield is 2.4%. Interestingly, the current portfolio’s median Price/Tangible Book is 2.3x vs. the 10-year median of 4.54. From this view, in the aggregate, we are currently able to own our portfolio of companies at 51% of the average valuation over the past ten years.
During May, our top five performing stocks were Alphabet (GOOGL), Meta (META), Micron Technology (MU), Cognizant Technology (CTSH), and Cisco (CSCO). Other technology stocks that we hold also did well, including Amdocs (DOX) and IBM (IBM). In fact, we participated nicely in the move higher for technology-related companies. Our top five underperforming stocks were deep-value holdings like Mosaic (MOS), Nutrien Limited (NTR), Tyson Foods (TSN), UGI Corporation (UGI), and Chevron (CVX).
Mosaic and Nutrien were purchased in late March. We wrote that “Mosaic and Nutrien provide many of the basic ingredients necessary to grow food for humans and animals. In Mosaic’s latest quarterly earnings update, MOS management stated that ‘Ag fundamentals remain very constructive.’ Importantly, they also noted that ‘Inventory levels in our key markets for both phosphates and potash have declined considerably from the elevated levels observed in the second half of last year. Grower demand across the Americas has been very strong because of favorable affordability, but retailers have been hesitant to replenish inventories because of the volatility in global prices, especially in potash with the aggressive off-season marketing from the Russians and the Belarusians. U.S. spring demand is ramping up over the next coming weeks, and we believe we have reached a bottom in potash prices.”
Currently, Mosaic and Nutrien are trading inexpensively at just 7.8x and 8.2x their respective Forward P/E multiples. Even more compelling is that their Price/Free Cash Flow multiples are now a low 5.1x and 6.3x, respectively. Both have strong operating and free cash flow generation, returns on invested capital are greater than their weighted average cost of capital, each sport positive economic margins and profitability, and both have very manageable balance sheets. Moreover, the nutrient affordability index for North and South American farmers has moved into the “more affordable” zone for the first time since 2021, and fertilizer inventories in Brazil and India are low, such that the company expects demand to re-accelerate in 2023. So why did the two stocks decline in May? Our view is that we were too early in the restocking process, and concerns around Russia and Belarus reentering the market gained prominence—stoking fears of oversupply. We believe these concerns are overblown. Lastly, Mosaic and Nutrien are both associated with the Materials sector, which was under pressure last month. Given the low valuations and the continued free cash generation, we continue to hold. However, should the outlook dim, we will not hesitate to exit both positions. Note that both positions, together, are less than 4% of the overall portfolio’s holdings.
Last month we detailed our view of the debt ceiling, writing that “volatility will increase for stocks and bonds as we near the deadline. And that there are likely to be increased headwinds and fearmongering. However, it is highly unlikely that either political party has the will to force our economy into an untenable (and unnecessary) economic downturn for the sake of posturing.” Now that the debt ceiling angst is in the rearview mirror, from a macro perspective, we are focused on the Fed (which appears to be holding the line on its hawkish rhetoric), trends in economic activity (which, overall, are slowing but still positive), inflation (which is declining but persistent), geopolitical risks (which are elevated), and look to take advantage of value-based investing once again taking center stage.
From a sector perspective, our current weightings are Information Technology (17.4% portfolio weighting vs. 8.0% benchmark), Health Care (9.5% vs. 16.1%), Financials (17.1% vs. 20.4%), Communication Services (12.4% vs. 9.1%), Industrials (11.3% vs. 11.1%), Consumer Staples (2.0% vs. 7.5%), Consumer Discretionary (6.2% vs. 5.9%), Real Estate (4.0% vs. 4.5%), Energy (3.6% vs. 7.6%), Materials (5.5% vs. 4.3%), and Utilities (5.7% vs. 5.3%).
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
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 the 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, 2022. 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 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.
