Day Hagan Smart Value Strategy Update November 4, 2024
Downloadable PDF Copy of the Article:
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
During October, the S&P 500 and Nasdaq declined -0.91% and -0.52%, respectively. Global equities (MSCI ACWI index) fell -0.92%, while fixed income (U.S. Treasuries) declined by approximately -3.26%. Small caps were down by -3.28%.
The recent pullbacks in both equity and fixed-income markets can be attributed to several interconnected factors. First and foremost, bond yields spiked significantly higher following the Federal Open Market Committee (FOMC) rate cut in September. Investors appeared to have already priced in much of the anticipated adjustments, leading to a rapid recalibration of yield expectations.
Moreover, encouraging economic data released in the past weeks suggested resilience in the economy, prompting investors to scale back their expectations for additional rate cuts in the near term. Technology giants Microsoft and Meta Platforms reported solid earnings in the corporate sector, but their forward guidance failed to meet the market’s high expectations. This led to increased scrutiny around their substantial capital expenditures in artificial intelligence, raising concerns about the timeline for realizing the benefits of such investments. This negatively impacted the Information Technology sector and the AI darlings that have been getting most investors’ attention.
Furthermore, the looming uncertainties surrounding the upcoming elections have added another layer of caution among investors, stalling some decision-making. On a global scale, economic growth is showing signs of deceleration. China’s recent stimulus measures, aimed at invigorating its economy, have not yielded the anticipated results, causing disappointment among market participants who hoped for a robust recovery. Lastly, it’s worth noting that investor sentiment had become excessively optimistic at the beginning of the month, which, from a contrary investing perspective, can act as a headwind. These combined factors have led to a reevaluation of risks, resulting in the pullbacks we are currently witnessing in the markets.
From a quantitative perspective, the Stock/Bond/Cash model improved slightly but remains neutral regarding the equity versus fixed-income allocations. Indicators calling short-term global stock momentum, breadth, overbought/oversold, and downside volatility are still at bullish levels for stocks. However, many of these indicators are in the process of reversing from peaks. Should the indicators continue to deteriorate and move to levels that have historically presaged market weakness, we will be quick to institute a more defensive positioning.
Our models also show that investor sentiment, positive global earnings estimate revisions, and measures of global manufacturing are losing momentum. Given the elevated valuations of the MSCI All Country World Index (ACWI), we are most concerned with earnings growth at this point in the cycle. For example, ACWI’s Forward Price/Earnings multiple is 17.9x, arguably the third-highest level since 1995. Similarly, the Price/Cash Flow multiple is 15x, approaching levels seen in 1999 and 2020. For perspective, the ACWI Price/Cash Flow multiple was below 11x prior to the Great Financial Crisis (2007-2009).
We are also watching U.S. dollar sentiment measures, which, on balance, have reversed from Excessive Pessimism levels and are now neutral. A stronger dollar has tended to negatively impact U.S. Corporate earnings, with a 2015 study finding that for every 10% rise in the dollar, U.S. multinational companies experienced a 3%-4% decline in earnings per share. All this is to say that markets are generally expensive, and earnings need to achieve analysts’ expectations or be subject to a potential multiple re-rating.
Equity markets are now entering a seasonally favorable time of year, even though U.S. elections will likely deliver a speed bump. Looking at the Dow Jones Industrial Average’s performance during different Presidential and Congressional Combinations since 1901, we note that a Republican President and Split Congress have historically had the lowest returns since 1901. However, that condition has only been in place 11.4% of the time, which is a relatively small sample size. A Republican President with a Republican Congress has historically been better for equities (7.3% annualized return, 22.7% of the time), as has a Democratic President with a Democratic Congress (7.0% annualized return, 33.9% of the time). Nonetheless, we take these kinds of studies with a grain of salt in that it is the policy initiatives that will most influence the financial markets, and getting a bead on what each party is actually promoting is proving to be elusive. At this point, the most glaring and “investable” difference would be around potential tax policy changes. Very simply, if corporate taxes are increased, stocks will suffer.
History shows that a “High Tax” environment does not support high valuation multiples. For example, when inflation is neutral (between 0% and 4%) and taxes are low, the S&P 500 typically traded around a 20.1x Price/Earnings ratio. However, when inflation was neutral and taxes were high, the average multiple dropped to 16.3x, which would equate to more than a 21% drop in prices from the multiple reset alone. (Source: Valens. Data from 1914-2020.)
With regard to tariffs and protectionism, it’s hard to say what the end results will be, given that the President has the authority to issue executive orders on tariffs and immigration. Nonetheless, using campaign rhetoric to make investment decisions has proven to be folly over the many election cycles in which we’ve participated.
We do note that, based on a historical, quantitative, and unemotional analysis, the monetary and fiscal policy index that we track (measuring economic liquidity) has increased, on average, during election years (tapering off toward the end of the year) and then entered a downtrend for the First and Second Presidential years. Note that even though stimulus declined, on average, during the First Presidential Year, the S&P 500 continued to move higher. It wasn’t until the 2nd Presidential Year that equities demonstrably weakened. We’ll continue to closely monitor stimulus and liquidity indicators for signs that the credit backdrop is tightening up. So far, credit conditions remain positive and most global central banks are focused on more stimulative policies.
Speaking of central banks, there’s been a lot of press around the recent increase in U.S. Treasury yields, with the 10-year up 48 bps over the past month to 4.29%. Given the 50-bps rate cut by the FOMC, many market participants expected rates to head lower, not higher. However, heading into the meeting, we noted that sentiment measures calling U.S. fixed income were excessively optimistic, indicating that most of the rate cut expectations were likely priced in. That proved to be the case. We don’t see the backup in rates as unusual. History shows that, since 1970, rates have been mixed following first rate cuts. For the 63-day period following the 12 instances analyzed (not including the most recent), six evidenced higher rates and six lower rates—a toss-up. For perspective, the 10-year Treasury yield was 4.15% three months ago, 4.69% six months ago, and 4.88% one year ago, leaving the longer-term downtrend rates intact. In our view, the relationship between the eventual direction of rates and economic activity is the most important factor to monitor. Historically, rates continued lower when a recession or pronounced economic weakness occurred. We are not calling for an imminent recession, but there are signs of global economic weakness, especially in the manufacturing sector.
Several changes were made to the portfolio during October: After a roughly 10% pullback (starting on July 16 and ending on August 5), the S&P 500 subsequently gained over 14% through the trade date on October 21. We used the rally as an opportunity to upgrade the portfolio while keeping our cash position roughly the same.
Werner Enterprises (WERN), Landstar Systems (LSTR), United Parcel Service (UPS), and Charles Schwab (SCHW) have been sold. WERN, LSTR, and UPS are all part of the shipping industry, which, along with other cyclical sectors, is currently facing pressure due to weakening economic indicators, decelerating global trade, and a decline in overall shipment volume. Given the softening macroeconomic environment and the rising costs associated with the trucking industry—such as those from the new UPS labor contract—we closed out three transportation-related positions. We reallocated this capital to companies we believe have greater upside potential.
Charles Schwab was initially added to the portfolio in March 2023. We made our first reduction in the position on June 28, 2024, as the stock rallied and approached our estimated fair value. Over the preceding twelve months, Schwab outperformed the broader S&P 500, including dividends. Due to this significant price appreciation, the stock surpassed our fair value assessment, prompting us to exit the remaining position entirely.
The proceeds from the sales were used to purchase Franklin Templeton (BEN), Lululemon Athletica (LULU), Terex Corporation (TEX), and Ulta Beauty (ULTA).
Franklin Templeton Investments (Ticker: BEN), established in 1947, is a prominent player in the financial services sector, offering a diverse range of equity, fixed-income, and multi-asset funds across public and private markets. Traditionally recognized for its presence in the mutual fund space, the firm has shifted focus in recent years towards expanding its exchange-traded fund (ETF) offerings and entering private markets by acquiring three major private equity firms since 2019. Over the last three years, Franklin Templeton has demonstrated solid financial performance, achieving an annualized revenue growth of 12.3% and an impressive EBITDA growth of 19.1%. The company’s gross margins stand at an impressive 80.4%, complemented by operating margins of 15.31%. Currently trading at a forward price-to-earnings (PE) ratio of 7.92x and offering a dividend yield of 5.94%, the firm’s stock appears undervalued, reflecting significant market pessimism that does not account for expected growth over the next five years. Given its robust growth trajectory, strong balance sheet, and attractive valuation metrics, initiating a position in Franklin Templeton Investments seems prudent.
Lululemon Athletica (Ticker: LULU), founded in 1998 and based in Vancouver, Canada, has emerged as a premier global athletic wear company. The past three years have been particularly fruitful, with Lululemon reporting an annualized revenue growth of 31.1% and an EBITDA growth of 37%. The company’s gross margins are at 58.54%, with operating margins of 23.02%. It possesses a strong financial position, boasting $1.6 billion in cash and no debt, enabling management to potentially increase shareholder returns through share buybacks or initiate dividend payments. Analyzing its economic value added (EVA), Lululemon consistently delivers strong margins. Moreover, the market, in our view, is undervaluing its future growth potential compared to the excellent operating performance management has generated since 2010, presenting an attractive entry point. Despite a significant decline in share price (down ~42% YTD) due to valuation concerns and broader consumer sentiment, our analysis indicates that this pullback has been excessive, making it an opportune moment to invest in this high-quality company.
Terex Corporation (Ticker: TEX), founded in 1933 and headquartered in Norwalk, Connecticut, specializes in manufacturing and selling aerial work platforms and materials processing machinery globally. The company recently reported annualized revenue growth of 19.8% and impressive EBITDA growth of 78.3% over the past three years. With a forward PE of 9.85x, Terex maintains gross margins of 22.76% and operating margins of 12.15%. The company’s financial health is characterized by minimal debt, over $300 million in cash reserves, and consistent positive operating cash flow over the past decade. While EVA analysis reflects positive margins, the market has assigned a negative value to Terex’s expected future growth. Given these factors, the current stock price presents a compelling opportunity to initiate a position in a company demonstrating strong operating metrics and a solid balance sheet, offering an attractive risk-to-reward ratio.
Ulta Beauty (Ticker: ULTA), one of the largest cosmetic retailers in the United States, was incorporated in 1990 and is headquartered in Bolingbrook, Illinois. Over the last three years, Ulta has recorded an annualized revenue growth of 27.6% and a remarkable EBITDA growth of 49.1%. The company has gross margins of 38.69% and operating margins of 14.03%. Ulta’s balance sheet is strong, with no debt and over $400 million in cash. It allows for significant operational flexibility and the ability to increase its share buyback initiatives. The stock trades at historically attractive levels based on forward PE, price-to-cash, and enterprise value multiples. From an EVA perspective, Ulta has consistently generated positive and growing margins since 2008. Yet, the market reflects a negative outlook on its future growth, suggesting that today’s stock price sets a low bar for future operating performance.
Overall, each of these companies presents unique opportunities for investors, marked by positive financial metrics, strategic positions in their markets, and attractive margins of safety.
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
Website: https://dayhagan.com or https://dhfunds.com
