Day Hagan Smart Value Strategy Update November 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
Following a solid 7-month uptrend in equity performance to start the year, October’s closing levels evidenced the third month in a row when U.S. equities declined. For example, during the month, U.S. large-cap stocks declined 2.1%, while U.S. small-cap growth stocks were down 7.7%. The EAFE index (Europe, Australia, and the Far East) was down 4.0%, while international stocks were down 4.2%. The damage wasn’t limited to stocks, as all of the fixed-income sectors we monitor were also negative for October.
What caused the markets such distress? Unfortunately, the list is long, but here are a few highlights: surging interest rates, hawkish central bank policies, growing sovereign debt levels, sticky inflation, dysfunctional governments, rising geopolitical risks, global trade tensions, increasing levels of financial distress for lower-income families, a slowing labor market, higher energy prices, and signs that consumer discretionary spending is moderating.
While the aforementioned headwinds appear formidable, the reality is that the stock market operates a little differently: The sum of “already known” bad and good news is, by definition, already reflected in stock prices. In other words, if pundits are discussing an issue, that issue is known, and the potential market impact has been factored into equity prices by investors.
What actually moves markets in the future is whether the “already known” factors ultimately trend better or worse than current expectations. If expectations are low, then it can be easier for the markets to “overachieve” and trend higher.
Current investor expectations appear to be downbeat and are, based on our quantitative and objective modeling, pricing in a negative outlook. For example, investor sentiment is excessively pessimistic, consumer confidence surveys have been turning more negative, and institutional investors have largely reduced equity exposure over the past several months.
From an investment perspective, this is, perhaps surprisingly, good news. When there is excess negativity in the markets, it often means that most of the sellers have already sold and that the path of least resistance is higher. Warren Buffett famously said, “Be fearful when others are greedy, and greedy when others are fearful.” We don’t necessarily want to be greedy at this juncture just because others are fearful, but we do want to remain cognizant that a great deal of bad news is currently priced in.
To be clear, there are plenty of reasons to be concerned when looking through macro and geopolitical lenses, but the last three months of market performance have abridged many of the excesses in the markets. We are seeing more opportunities crop up and will continue to focus the portfolio on companies with strong cash generation, solid balance sheets, and shareholder-friendly management. These factors provide defense when times are tough and allow for appreciation when markets gain.
With that in mind, the Q3 earnings season has largely concluded, and our holdings did well overall. For example, our two most recent additions, Clorox and Target, spiked higher after reporting their earnings results. Both companies handily beat earnings expectations and moved higher on the news.
Our rationale for purchasing the two positions is as follows:
Clorox (Ticker: CLX)
Consumer Staples Sector
Clorox operates through four segments: Health and Wellness, Household, Lifestyle, and International. From Pine-Sol to Hidden Valley to Burt’s Bees, CLX is a quintessential staples provider, offering thousands of everyday items for businesses and consumers.
The stock price has been in decline, down -14.3% year-to-date and now at levels last seen in 2017. Moreover, the stock is down 48% from its peak in 2019. Part of the decline resulted from a cyberattack that led to a -25% drop in quarterly sales (about $500 million in revenues). Management has responded by beefing up network security. Our work indicates that the decline is overdone, and the current levels of pessimism are unwarranted. We are using this opportunity to initiate a position with a solid margin of safety.
CLX’s economic profitability was negatively impacted during the pandemic, when commodity inputs, distribution, and labor costs accelerated. Those headwinds are dissipating, and we expect CLX’s profitability to continue to increase.
CLX’s return on invested capital (ROIC) continues to outpace its cost of capital (WACC), and free cash flow generation has been solid, recently doubling from its trough in 2022. NOTE: CLX has generated positive free cash flow for the last 25 years. The current Free Cash Flow yield is 6.2%.
CLX’s balance sheet is healthy, with cash and cash equivalents of $368 million and free cash flow of nearly $1 billion. CLX has been paying down debt since the end of 2021. The company has the financial flexibility to withstand and possibly take advantage of any economic weakness that may arise.
At this juncture, we view CLX as a more defensive holding that concurrently offers an attractive value proposition and a dividend yield of 3.9%, which is at 10-year highs.
Target Corporation (Ticker: TGT)
Consumer Staples Sector
Target is a widely recognized general merchandise retailer with 1,900 stores across the United States. The stock has been under significant pressure due to backlash from a marketing initiative touting alternative lifestyle products. The stock price is down -26.5% year-to-date, -22.1% over the past year, and roughly -58% from its 2021 highs.
The stock’s price decline, in our view, positions the stock as attractive from a valuation perspective. Investors are currently pricing in economic margins of around 1.5% over the next five years versus the over 2%+ the company achieved prior to the marketing misstep. Given Target’s position in the marketplace and its recent initiatives to stem the damage (as well as initiatives deterring theft), we view the lower stock price as an opportunity to purchase a company that has raised its dividend for 50 years in a row at a reasonable price. The current dividend yield is roughly 4%, which is near a 10-year high.
TGT’s ROIC is greater than its WACC, and the 3-year average annual revenue growth is 15.7%. Profitability is improving, and even with the recent problems, the return on capital employed (ROCE) is a solid 14.6%. TGT’s balance sheet is manageable and offers management the flexibility to return cash to shareholders through buybacks and/or dividend increases or make strategic investments in the growth of the company.
Our view is that as Target moves past its misstep, profitability and sales growth will quietly return to previous levels. Should that indeed come to fruition, the stock’s upside potential is significant.
During October, twenty of our holdings reported earnings, with 16 beating earnings, three missing, and one matching. The companies most outpacing expectations were Meta, Blackrock, Merck, Public Storage, Owens Corning, Williams Sonoma, and JP Morgan. The three that missed are Chevron, Interpublic Group, and Goldman Sachs. Let’s discuss those.
Chevron: Earnings missed, but revenues beat estimates. Production increased largely due to the acquisition of PDC Energy, but upstream and global refining margins declined as oil prices moved lower. The Hess acquisition leverages Chevron’s strong position in the Permian Basin and is likely to enhance profits. There are also projects in Kazakhstan, Eastern Mediterranean, and Mexico that are capital intensive right now but are expected to reach the company’s Return on Capital Employed of 15.7% quickly. In other words, they are spending money to make money. The dividend yield is just over 4%, and the Forward P/E is only 10.3x. They are aggressively buying back shares at these levels.
Interpublic Group: Earnings and revenues missed (note: year/year, earnings were flat, and revenues were up). The miss was attributed to IPG’s exposure to tech and telecom, which reduced spending but is expected to return to growth over the coming year. IPG’s balance sheet is solid, with $1.7 billion in cash and equivalents and no meaningful debt maturities until 2028. IPG generates significant cash flow, which can be used for acquisitions, dividends, and share buybacks. The dividend yield is 4.1%, and the Forward P/E is 14.4x.
Goldman Sachs: GS missed earnings (by 6 cents, hitting $5.47) and beat revenue expectations. Excluding unusual non-cash items like business divestitures (Personal Financial Management), EPS would have come in at $7.88 (source: MS). It looks as though GS is setting up for its next cycle of growth. The Price to Tangible Book Value is just 0.92, at the low end of its historical range. For perspective, it hit a low of 0.85 during the Great Financial Crisis. The dividend yield is 3.1%, and the Forward P/E is just 9.2x.
Each of these three companies is on our watch list due to the misses. However, we still view them positively given their strong cashflows, solid balance sheets, and shareholder-friendly management.
From a sector perspective, our current weightings are Information Technology (15.0% portfolio weighting vs. 9.2% benchmark), Health Care (9.5% vs. 15.3%), Financials (18.0% vs. 20.5%), Communication Services (12.7% vs. 5.0%), Industrials (10.7% vs. 13.3%), Consumer Staples (5.1% vs. 8.4%), Consumer Discretionary (6.8% vs. 5.0%), Real Estate (1.7% vs. 4.6%), Energy (6.5% vs. 9.1%), Materials (3.8% vs. 4.8%), and Utilities (4.2% vs. 4.7%).
From a portfolio perspective, the median Forward Price/Earnings multiple is 13.1x, with the portfolio’s median Free Cash Flow Yield coming in at an attractive 6.6%. The dividend yield is 2.9%. The current portfolio’s median Price/Tangible Book is 1.95x vs. the 10-year median of 4.5x. From this view, in the aggregate, we are currently able to own our portfolio of companies at just 43% of the average tangible book valuation over the past ten years.
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
Steven Goode, CFA®
Disclosure: The aforementioned positions may change at any time.
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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.
