Day Hagan Smart Value Strategy Update September 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 August, the portfolio was up +6.88%* net of fees vs. the benchmark Russell 1000 Value Index Total Return, +5.79%. For the three-year period from 8-31-2020 through 8-31-2023, the portfolio gained at a +13.38%* annualized rate (net of fees) vs. +11.39% for our benchmark.
During that time, the portfolio’s Beta was 0.81, illustrating that the portfolio’s outperformance was achieved while experiencing 19% less volatility risk than the index. Upside capture comes in at 91.1% vs. downside capture of just 71.1%. 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.
Following a period of selling pressure in early August, U.S. equities entered oversold territory, accompanied by excessively pessimistic sentiment, paving the way for a late-month rally. However, only the energy sector managed to register a gain for the entire month. Interestingly, despite August being a negative month overall, defensive stocks performed poorly. For instance, the Utilities sector declined by -6.2%, and the Consumer Staples sector fell by -3.6%.
As we have highlighted over the past year, market leadership continued to be concentrated within a select group of companies within the U.S. Large Cap Growth stock category, which declined by -0.9% in August, compared to a -2.7% decline for Large Cap Value. Nevertheless, we believe that it is overly simplistic to categorize stocks solely based on style (value/growth) or capitalization (large/small).
Our preference is to assess factors that offer a more specific characterization of a company’s attributes. For instance, during August, companies demonstrating traits such as high quality, above-average profitability, positive liquidity, and analyst upgrades outperformed, albeit generally finishing the month in negative territory. Surprisingly, the most detrimental factors included valuation, style sensitivity (value vs. growth), and economic sensitivity.
In August, the S&P 500 Total Return Index experienced a decline of approximately 1.6%, ending its five-month streak of gains. During this period, market breadth significantly weakened, with 10 out of the 11 S&P 500 sectors reporting negative returns for the month. Notably, sectors associated with cyclical value, such as Financials, Materials, and Industrials, reversed their previous trends and underperformed the broader market, while Energy was the sole sector to register positive gains. The pullback in the S&P 500 Total Return Index followed a two-month surge of 10%, which coincided with a spike in bond yields. However, it is worth noting that the increase in yields has not reached historically disruptive levels for the stock market. There remains a potential risk of a policy misstep in late 2023 or early 2024.
To date, in 2023, the government has pursued an exceptionally expansionary policy, unprecedented in the absence of a recession. To align with the historical four-year presidential cycle, the stock market may exhibit increased volatility in the first half of the following year as an expected shift toward less expansionary government policies takes hold. Factors contributing to this potential shift include the possibility of a prolonged period of higher interest rates, the resumption of student loan payments, a government shutdown, and reduced cost-of-living adjustments in 2024, all of which could create a less favorable environment for financial markets.
Turning to bonds for a moment, bond yields have undergone a significant shift in a relatively short period, with ten-year Treasury yields rising by 100 basis points (bps) since April, primarily due to higher real yields. During this time, the 10-year Treasury Inflation-Protected Securities (TIPS) yield climbed by 91 bps, driven primarily by changes in growth expectations. Additionally, an increase in Treasury supply, which surprised the market with its extent, contributed to the elevation of real yields. The market had not anticipated the volume of issuance announced in August, although much of it was due to timing, reflecting a lower debt issuance in the previous quarter. Back in May, the Treasury had issued a warning about an impending increase in coupon supply.
During the Jackson Hole address, Federal Reserve Chairman Powell acknowledged the ongoing uncertainty surrounding economic growth and inflation, stemming from policy lags and evolving labor market dynamics. While a “soft landing” scenario is more likely, the Fed's policy stance will remain restrictive, which is expected to decelerate economic growth in the upcoming year.
On a global scale, the ACWI (All Country World Index) ex. U.S. Total Return Index witnessed a decline of nearly 450 basis points (bps) in August. Data from the S&P Global Purchasing Managers’ Index (PMI) indicates a gradual softening of the global economy. In July, the global composite PMI, which encompasses both services and manufacturing sectors, declined for the second consecutive month, reaching its lowest level since January. The strong momentum observed in the first half of the year appears to be waning, with leading indicators within the PMI reports, such as new orders, backlogs, and future output, all pointing to a weakening trajectory in the coming months.
With regard to inflation expectations, adjustments made to address pandemic-related imbalances have led to a significant easing of price pressures. The global composite input price index reached a 33-month low in July, with the manufacturing sector experiencing most of the price weakness. Despite this, services costs grew at their slowest pace since December 2020.
Despite these economic challenges, the risk of a global recession, historically linked to major equity market downturns, does not appear imminent. The latest PMI reading marked the sixth consecutive month of global expansion, contrasting with the decline witnessed in the latter half of the previous year. Additionally, the composite index remains comfortably above the historical threshold associated with global recessions. Moreover, many emerging markets outside of China have displayed resilience and contributed to the stabilization observed in the manufacturing PMI. Among developed economies, Japan continues to exhibit positive growth.
As stated last month, from a macro perspective, global economic activity continues to bounce along at slow-growth levels. Recent economic releases show tightening lending standards at banks, credit conditions deteriorating, loan demand drying up, credit card delinquencies increasing to the highest levels this cycle, and manufacturing still under pressure. These negative trends have been offset in part by better inflation numbers—which highlights the importance of inflation pressures continuing to dissipate. We do have some concerns around that view, as recent increases in energy and shelter costs may surprise folks hoping for inflation’s downside momentum to continue. We’re watching this closely as inflation influences interest rate trends, which in turn influences our sector analysis.
From a portfolio-holding perspective, we exited our position in Celanese Corporation (CE) on August 9, as the business’s operating environment faced increasing macro headwinds. We sold the position as it rallied near its 52-week high. The stock had performed well since it was purchased on December 20, 2022, up almost +27%* vs. +19.1% for the S&P 500 TR and +9.1% for the Russell 1000 Value Index. We were able to purchase the stock with a positive margin of safety. However, the stock’s rapid price increase has raised the current level of embedded operating expectations to overly optimistic levels. Therefore, we elected to take profits as the stock has achieved our measure of fair value. If you would like a copy of the Trade Notification, please let us know.
Lastly, from a sector perspective, our current weightings are Information Technology (15.1% portfolio weighting vs. 9.3% benchmark), Health Care (8.9% vs. 15.2%), Financials (18.6% vs. 20.4%), Communication Services (12.4% vs. 4.9%), Industrials (11.5% vs. 13.3%), Consumer Staples (2.0% vs. 8.2%), Consumer Discretionary (6.8% vs. 5.0%), Real Estate (1.8% vs. 4.8%), Energy (3.7% vs. 8.8%), Materials (4.0% vs. 4.8%), and Utilities (4.0% vs. 4.8%).
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 6.7%. The dividend yield is 2.4%. The current portfolio’s median Price/Tangible Book is 2.6x vs. the 10-year median of 4.8x. From this view, in the aggregate, we are currently able to own our portfolio of companies at just 54% 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.
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 by reducing the gross number by a model investment management fee of .85% through 12/31/2020 and 1.00% from 1/1/2021 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.
