Day Hagan Smart Value Strategy Update June 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
Following a weak April, global equities rebounded nicely in May. As we noted in our May Strategy Update (published on 5-1-2024), given the stability around credit spreads (still narrow) and positive global economic growth prospects, data suggested the uptrend that started in October 2022 was still intact. This was and continues to be the case.
Central Bank policy is also becoming less of a headwind. Out of 31 global central banks we track, 28 are expected to reduce policy rates at the next scheduled meeting, with three on hold. Central Banks for Canada, Mexico, the Euro area (ECB), the U.K., Chile, Columbia, Peru, Hungary, and the Czech Republic are expected to lower rates in June. The expectations for a U.S. rate cut are slowly being pushed out from June, with July now being the current expectation. (While there have been discussions around the possibility of a Fed rate hike, the data assigns this a very low probability.)
The overarching question is how this will impact inflation. Our models and indicators show that inflationary pressures are still mildly disinflationary and, at worst, neutral. As described in last month’s Update, a world with positive economic growth and muted inflationary pressures is good for equities. Add a more friendly Fed and other global central banks to the mix, and the probability of a large downside move is reduced.
In last month’s letter, we wrote that our models calling U.S. and international economic activity are at levels denoting positive growth, with the odds of a major global slowdown heading significantly lower. However, models tasked with evaluating inflation pressures indicate that upside pressures may be building. To be clear, our models are still in the “moderate disinflation” zone. However, the model’s direction has been slowly transitioning toward a more neutral inflation message.
The reason we strive to correctly identify economic growth and inflation trajectories is that history shows during periods when growth is rising and inflation is neutral, U.S. equities (S&P 500) gained at a +16.8% annualized rate (since 1972). What about periods of rising growth and rising inflation? On average, U.S. equity gains were more muted but still good at +9.2%. What macro backdrop do we not want to see? Economic growth is falling and inflation is falling. Historically, U.S. equities have declined at a -15.7% annualized rate with those conditions in place. (Source: NDR) If economic growth decisively rolls over and inflation pressures start to build in earnest (confirmed by our models), we will look to become more defensive in our positioning.
During May, we made one change to the portfolio holdings. On May 14, we exited the remainder of our position in Williams Sonoma (WSM). Our rationale was as follows:
Williams Sonoma strongly outperformed the market since our initial purchase in January 2023. However, valuations have also moved to levels above what we deem Fair Value.
Over the past 12 months, the price of WSM is up roughly +178% versus the S&P 500’s return of +26%.
We still viewed Williams Sonoma as a strong company, but after the stock’s significant move higher from our initial purchase, the current risk-to-reward profile justified selling the position.
For investors in our strategy who have been invested with us for over a year, the position was sold as a long-term capital gain.
Interestingly, the position was sold about a week before the company was slated to report earnings. At the time, our analysis quantified that earnings, revenues, and guidance needed to be exceptional for the stock to continue its uptrend. The report was, indeed, good, with the company exceeding profitability estimates (with an operating margin of 19.5% and earnings per share of $4.07). WSM also raised the company's operating margin guidance for fiscal year 2024 and reiterated the company’s long-term guidance of mid-to-high single-digit revenue growth with operating margins in the mid-to-high teens. The result: WSM reported after the close on May 22, and the stock initially spiked higher by nearly 10%! To be fair, we were a bit surprised. However, overnight, the stock began to slide lower as investors digested the news, and by the next morning’s opening, the stock had plunged almost 21% from its high, showing that even good companies with solid underpinnings are eventually subject to gravity due to expensive valuations and high expectations hurdles.
Turning to the overall portfolio, 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. For example, as of this writing, the overall portfolio is 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 median cash flow yield is a positive 7.65%, return on invested capital is 48.2% (non-financial companies only), EPS growth is 14.6%, and shareholder yield is 5.1%.
The portfolio’s current sector weightings are Information Technology (12.9% portfolio weighting vs. 9.2% benchmark), Health Care (3.2% vs. 14.1%), Financials (21.8% vs. 22.6%), Communication Services (10.6% vs. 4.5%), Industrials (12.2% vs. 14.2%), Consumer Staples (6.9% vs. 8.0%), Consumer Discretionary (5.2% vs. 4.8%), Real Estate (1.5% vs. 4.6%), Energy (5.5% vs. 7.8%), Materials (1.8% vs. 4.7%), and Utilities (3.7% vs. 5.2%).
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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