Day Hagan Smart Value Strategy Update October 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
September was the second month in a row that the U.S. equity markets declined, including all major styles (growth/value) and capitalizations (large/mid/small). The culprits behind the move were many, but most attributed the lion’s share of the decline to higher interest rates and the potential for continued monetary drag into 2024, as the Fed’s tightening policies tend not to fully impact the economy for at least six months. The increase in interest rates wasn’t limited to the U.S., as the 1-year change in the global median 10-year real rate for developed and emerging market sovereign bonds has been the fastest on record (going back to the 1950s). The point is that capital is more expensive, and companies now have a higher hurdle to achieve not just profitability but to maintain their current levels of profitability.
Higher interest rates have also historically tamped down economic growth. With consumer, corporate, and government debt burdens growing, a lot of disparate factions are trying to raise capital by offering debt. We can easily make the case that governments having to fund their ever-growing deficits by issuing more and more debt will crowd out non-government issuers. This increases rates for corporate issuers and further impacts profitability. Our view is that when the Fed held a zero-interest rate policy, increasing debt was a viable corporate strategy. In fact, investors cheered debt when the proceeds were used to buy back stock. But those days are over. Debt is now, once again, a four-letter word. Companies with large debt burdens are going to have to rethink their strategies.
An important facet of our analysis centers on companies’ balance sheets. We seek firms that have been, shall we say, frugal in their accumulation and use of debt to grow their businesses. To do so, we focus specifically on metrics that evaluate how well a company’s management team has utilized debt. For example, we seek to own companies that have lower debt/equity ratios, higher interest coverage ratios, higher ROA (return on assets), high cash flow from operations levels relative to debt service costs, and lastly, we review each company’s debt maturity profile and credit ratings. It is through this analysis that we seek to verify that the companies we own have the financial wherewithal to survive a potential debt-induced financial dislocation. This is not to say that there aren’t other risks swirling about, but our first order of business is to confirm that a company’s debt structure and cash generation meet our standards.
Solid debt profiles and strong cash generation supported our recent purchase of Coterra Energy (CTRA) and the increase in our Kinder Morgan (KMI) position. In our Trade Notification dated 9-25-2023, we wrote:
Coterra Energy was formed as a result of the merger between Cabot Oil & Gas and Cimarex Energy in October 2021. It currently owns land in the Marcellus, Permian, and Anadarko regions, with 73% of its products coming from natural gas, 13% liquid natural gas, and 14% oil-related.
Over the past five years, the company has seen annualized revenue growth of +19.3% per share and free cash flow growth of +62.4% per share. While increasing oil prices over the past three years off the Covid lows have contributed to some of the growth, the majority of production for Coterra is in the Natural Gas space, and those prices have been trading near historically low levels. Due to this, a modest pullback in oil prices could be offset by continued operational efficiency along with natural gas prices remaining at historic norms.
The company’s current balance sheet is in a strong position that gives management the flexibility to adjust to the dynamic operating environment. There is about $850 million in cash on hand, with $575 million in debt maturing in 2024, no maturities in 2025, and $250 million maturing in 2026. In addition to cash on hand currently, the company has generated positive free cash flow since 2016 and saw cash from operations of $5.4 billion over the trailing four quarters.
Management has shown itself to be prudent in balancing investment back into the business to drive future growth and returning cash to shareholders through dividends and share repurchases. They have a stated goal of returning 50% of the free cash flow back to shareholders. As of the August earnings call, they have returned 94% of free cash flow to shareholders year to date and have announced an expected $2 billion investment plan for projects over the next year, along with a $2 billion share repurchase plan.
Due to the volatile nature of commodity prices, Coterra’s dividend policy is a base dividend of $0.80 annually and a variable component to be disbursed at management’s discretion. Management pointed out in the last earnings call that they feel it is more prudent to increase share buybacks at current levels than return cash to shareholders through the variable dividend. We agree with their views based on the current valuation, which we believe to be inexpensive.
Investments in new projects over the years have paid off nicely, as the company currently has a return on invested capital (ROIC) of 17.24% with a cost of capital (WACC) of only 6.28%. In addition, they have posted positive economic returns over the past five years, even with a volatile commodity price environment.
From a valuation perspective, the Forward P/E is just 9.83x, the Price to Operating Cash is 3.85x, and the dividend yield is about 3%. EVA margins continue to be strong at about 21%, and the future growth reliance is at the bottom of its historic range on an absolute and relative basis.
For Kinder Morgan (KMI), the main points supporting our increase were:
KMI is one of the largest energy infrastructure companies in the country, with over 70,000 miles of natural gas pipelines, which move roughly 40% of all U.S. natural gas production.
Even with a volatile commodity price environment, management has continued to increase cash returned to shareholders while improving the balance sheet's strength by decreasing their total debt by -26.62%.
Management has announced an expected investment of about $2.55 billion in projects over the next two years. Most of that is able to be financed with cash generated from operations after paying the dividend. This provides management with a smooth runway to continue decreasing the already reasonable debt load. In addition, they currently have about $520 million in cash on hand.
The stock remains at attractive valuation levels with a Forward P/E of 12.85x, a Price to Operating Cash Flow of 7.23x, and a 6.69% dividend yield. Since our original purchase in December 2021, the stock handily outperformed the S&P 500 index, as the position is positive, versus the S&P 500 price index was down roughly -8%.
As you may have surmised, we like companies with pristine balance sheets, good cash generation, and management teams that have a record of making prudent financial decisions.
From a sector perspective, our current weightings are Information Technology (15.0% portfolio weighting vs. 9.2% benchmark), Health Care (9.3% vs. 15.3%), Financials (18.2% vs. 20.5%), Communication Services (12.7% vs. 5.0%), Industrials (11.2% vs. 13.3%), Consumer Staples (1.9% vs. 8.4%), Consumer Discretionary (6.9% vs. 5.0%), Real Estate (1.8% vs. 4.6%), Energy (6.3% vs. 9.1%), Materials (3.8% vs. 4.8%), and Utilities (4.1% vs. 4.7%).
Sectors where we are most overweight include Information Technology and Communication Services. Info Technology has benefitted from investors’ fascination with AI (artificial intelligence) and has been evidencing defensive characteristics as investors seek relative cash flow stability during volatile times. Rising interest rates are generally a headwind for technology and other long-duration sectors; however, our holdings generally have low debt relative to cash flow to service those debts and manageable maturity schedules. Our holdings within the Communication Services sector also continue to meet our standards. This was the only cyclical growth sector to outperform in September. Our two mega-cap portfolio holdings within the sector were Alphabet and Meta, both of which outperformed during the month.
Our most underweighted sectors included Consumer Staples and Real Estate. Both sectors are facing headwinds from higher rates, generally higher debt loads, and deteriorating profitability. Our holdings in the two sectors meet our standards but, in our view, are being dragged down by the overall sectors’ negative trends. All of our holdings in these sectors are under review at this time.
From a portfolio perspective, the median Forward Price/Earnings multiple is 12.5x, with the portfolio’s median Free Cash Flow Yield coming in at an attractive 7.3%. The dividend yield is 2.6%. The current portfolio’s median Price/Tangible Book is 2.2x vs. the 10-year median of 4.6x. From this view, in the aggregate, we are currently able to own our portfolio of companies at just 47% 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
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.
