Day Hagan Smart Value Strategy Update May 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 April, the portfolio was up +2.43%* net of fees vs. the benchmark Russell 1000 Value Index Total Return, up +2.47%. During the three-year period from 3-31-2020 through 3-31-2023, there was a major bear market, a continuation of the global pandemic, the most restrictive Fed in recent history, and Russia starting a war, among many other potential hindrances. Nonetheless, over those tumultuous three years, the portfolio gained at a +17.86%* net of fees annualized rate.
During that time, the portfolio’s Beta was 0.72, illustrating that the portfolio’s outperformance was achieved while experiencing 28% less volatility risk than the index. The portfolio’s Jensen’s Alpha is +4.9, indicating that excess return was achieved relative to the risks being taken in the portfolio. Upside capture comes in at 82.2% vs. downside capture of just 65.9%. 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.
Since mid-March, the banking sector has garnered quite a bit of attention, for good reason. Currently, we have no direct exposure to regional banks and, in our view, minimal exposure to bank runs. Prior to the banking turmoil, we didn’t own any regionals. Currently, our Financial sector holdings include Bank of New York Mellon, Goldman Sachs, Blackrock, JP Morgan, Morgan Stanley, SEIC, and Schwab. Our largest holding is JP Morgan, at 3.6% of the portfolio. We see JPM as a beneficiary of the regional banks’ deposit outflows and the loan portfolios being auctioned off. For example, JPM acquired the majority of First Republic’s assets and certain liabilities through an FDIC-sponsored transaction, which are expected to increase JPM’s net income, through synergies alone, by around $700 million over the next year. Our other Financial sector holdings are each less than 3% of the portfolio and have diversified revenue streams that we believe help insulate them from many of the problems plaguing regional banks.
Widening our focus a bit, we currently view the macro environment as mixed, i.e., for every positive, there seems to be a negative offset. For example, although the Fed appears to be near the end of the tightening cycle, interest rates have increased to levels that are negatively impacting banks’ willingness to lend, customers’ ability to borrow, and corporate profitability. Consumers continue to spend, but credit card balances are spiking, and savings are being drawn down. Corporations are placing more emphasis on profitability and efficiency, though many are executing large layoffs to achieve their goals. Inflation has peaked, but core inflation remains at historically high levels. Energy prices are coming down, but heightened geopolitical risks imply that they could spike higher at any time. The list goes on.
The net result is that at this point in the cycle, we continue to focus on value-oriented stocks as we navigate the tug of war between many of the major headwinds in 2022 being “Past Their Peak” vs. some continuing concerns around a Fed-induced recession and greater-than-expected earnings decline. We continue to focus on companies evidencing the characteristics that have led to long-term outperformance: quality, profitability, and reasonable valuation.
We’d be remiss if we didn’t address the potential for a debt ceiling calamity. Those in charge of calculating how much money America has left in the bank guesstimate (yes, guesstimate—how’s that for instilling confidence?) that the U.S. will run out of money by early June to perhaps late August. There is the opportunity for Congress to pass a stop-gap measure that could extend the deadline, but at some point, the debt ceiling will have to be addressed. If it isn’t, the U.S. could be subject to a debt downgrade, international investors may further distance themselves from the U.S. dollar, and if the U.S. economy is running below trend, even temporary defaults could push it into recession.
The debt ceiling has been increased 78 times since 1960. This isn’t new. However, there have been three major credit events since 2011 (source: JPM). In August 2011, U.S. sovereign debt was downgraded for the first time in history. Although equity markets initially stumbled and interest rates moved higher, both eventually turned around as stocks bottomed out and interest rates reversed lower. The second event was another debt downgrade in October 2013. The markets barely budged, and interest rates ultimately moved lower as investors “sold on the rumor, bought on the news.” The third was in March 2014, when U.S. debt was upgraded. Again, stocks and bonds held relatively steady initially, and then stocks moved higher as the 10-year bond yield moved lower.
Our view is 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. We will be watching closely for good companies to “go on sale,” and as they meet our buy criteria, we will add them accordingly.
From a sector perspective, our current weightings are Information Technology (16.4% portfolio weighting vs. 7.4% benchmark), Health Care (9.6% vs. 16.7%), Financials (17.2% vs. 20.0%), Communication Services (10.9% vs. 8.8%), Industrials (11.2% vs. 10.9%), Consumer Staples (2.3% vs. 7.9%), Consumer Discretionary (6.2% vs. 6.0%), Real Estate (4.2% vs. 4.4%), Energy (3.9% vs. 7.7%), Materials (6.4% vs. 4.4%), and Utilities (6.0% vs. 5.6%).
From a portfolio perspective, the median Forward Price/Earnings multiple is 13.7x, with a dividend yield of 2.3%. The median free cash flow yield is 7.3%.
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.
