Day Hagan Smart Value Strategy Update September 2024
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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
In August, U.S. value stocks generally outperformed U.S. growth stocks, while riskier, lower-quality companies lost ground (we favor quality), facing significant market stress at the beginning of the month. This stress was accompanied by a considerable volatility spike driven by weak economic data, especially a disappointing jobs report and signs of rising unemployment. The VIX (volatility index) surged in response, prompting investors to shift towards defensive, quality sectors, favoring less risky, large-cap stocks over smaller, riskier ones. Although the broader equity market eventually rebounded, value stocks were less impacted by this rotation towards defensive assets and risk aversion during the market stress.
Some factors contributing to the value stock’s relative outperformance included economic uncertainty due to concerns about the U.S. labor market and concerns that a potential Federal Reserve rate cut wouldn’t be enough to stem the tide. Investors sought refuge in defensive, value-oriented stocks in sectors like utilities and consumer staples.
Moreover, on August 19, the dollar index hit 14-month lows as markets dissected major central banks’ expected monetary policy paths. Investors anticipated rate cuts by the Federal Reserve, with expectations of around 100bps in cuts throughout its remaining three decisions for the year. In fact, Federal Reserve Chairman Jerome Powell indicated that the central bank would cut its interest rate in the September 18th meeting during his speech at the Jackson Hole Economic Symposium. Powell pointed out that the U.S. labor market is cooling rapidly following the softer jobs report from July and the downward revision to payrolls. Likewise, he noted that the FOMC has gained further confidence in the slowing inflation, warranting a clear view that it is time to adjust monetary policy to less restrictive conditions.
Minutes from the Federal Reserve’s last meeting also suggested that most policymakers agree that lowering the Federal funds rate will be appropriate this quarter. However, doubts arose about the magnitude of total rate cuts due to a couple of signs of robust U.S. growth, such as a rebound in durable goods orders. The good news is that dovish signals from ECB policymakers also limited the dollar index’s decline. This is because countries lowering rates fastest usually see a concurrent decline in their relative currency value as currency devaluations are considered inflationary, which negatively impacts a currency’s value over time.
The U.S. economy expanded a robust 3.0% in Q2, supported primarily by consumer spending and a narrowed trade deficit. When looking through the lens of manufacturing vs. services, we note that the U.S. Manufacturing PMI fell to 48, indicating a second consecutive contraction, while the Services PMI edged up to 55.2, pointing to a slight improvement. Retail sales surged 1% month-over-month in July 2024, the biggest increase since January 2023, while the CPI increased 0.2% month-over-month in July 2024. The net result was that the fears of a hard landing abated somewhat as August progressed.
Turning to inflation pressures, oil prices declined (now under ~$70/b at the time of this writing), and the U.S. dollar strengthened against major crosses. Both occurrences are disinflationary. In the U.S., the Fed’s preferred measure of inflation (i.e., Core PCE) came in slightly lower than expectations, at 2.6% y/y, after increasing 0.2% m/m. The monthly increase is consistent with attaining the 2% inflation target and keeps the Fed on track to kick off the easing cycle on September 18. Separate data from the University of Michigan showed that one-year inflation expectations declined to the lowest since the end of 2020.
Data also showed that household spending picked up in July but less positively; income growth was sluggish, and the savings rate declined, which suggests potential softer consumer spending ahead. The key data release this month is likely to be Friday’s (August 6) jobs report. The Bloomberg consensus currently expects the unemployment rate to tick lower to 4.2% from 4.3% in July. Monthly job gains are expected at 162k, up from the weaker-than-expected 114k in July.
Internationally, the S&P Global U.S. Manufacturing PMI was revised slightly down to 47.9 in August 2024 from a preliminary of 48 and continued to point to the most marked deterioration in the health of the manufacturing sector so far this year. Production decreased for the first time in seven months as sales continued to fall amid increasing reports of demand weakness. A renewed reduction in employment was also recorded amid spare capacity in the sector. Also, input demand was scaled back in response to lower new orders, shortening three-month supplier lead times. The pace of input cost inflation quickened to a 16-month high, with output prices rising faster. Meanwhile, firms remained confident that output would improve and stabilize shortly.
The net result is that the current outlook for the U.S. economy and inflation is a continuation of the positive environment for stocks, driven by modest economic growth and decreasing inflationary pressures. Most global central banks have shifted towards accommodative monetary policies, which have historically benefited financial assets. Although geopolitical risks and expensive market valuations persist, we are committed to investing in companies with strong fundamentals, growth potential, and attractive valuations to align with our long-term investment strategy.
On August 5, as the market showed signs of intense oversold conditions and excessive pessimism, we put some of our cash back to work. The U.S. equity markets had stumbled over the previous three weeks, and several high-flying stocks had come back toward earth. We took advantage of the opportunity by initiating small positions in three companies that provided strong cash generation, quality businesses, opportunities for growth, and positive economic margins: Amazon (AMZN), Nvidia (NVDA), and Zoom (ZM).
Interestingly, Nvidia received the most attention, having declined from over $140 down into the mid-$90s where we purchased. Our rationale for buying was as follows:
The company’s partnerships and initiatives in accelerated computing and artificial intelligence (AI) were particularly noteworthy. NVIDIA is working with various companies and nations to transition traditional data centers to accelerated computing and establish “AI factories” aimed at driving the next industrial revolution.
The expansion of AI is expected to bring substantial productivity gains and cost/energy efficiency across multiple industries, creating new revenue opportunities. Furthermore, NVIDIA’s focus on generative AI has led to significant developments in consumer internet, enterprise, sovereign AI, automotive, and healthcare sectors, paving the way for multiple multibillion-dollar vertical markets. Additionally, the company has introduced new platforms and technologies, such as the Blackwell and Spectrum-X platforms, to cater to the growing demand for large-scale AI computing. NVIDIA’s advancements in AI gaming technologies and its success in the automotive and robotics industry, marked by collaborations with major players and the adoption of NVIDIA’s platforms, further showcase the company’s overall growth and positive outlook.
From an EVA perspective, sales growth is excellent, profitability is solid (free cash flow margin = 49.3%), and the company has lean capital requirements, expanding margins, low inventories, and good R&D (research and development) ROI (return on investment). Return on Invested Capital (ROIC) is over 144%.
We were planning to build up the position over time. However, the stock’s price bottomed that same day and subsequently appreciated by over 20%* in the eleven days since. Given the stock’s gain, it returned to unfavorable valuation levels, and we took profits. Should there be another opportunity to own the stock in the future, we would certainly consider adding it back to the portfolio.
The other two purchases, Zoom and Amazon, continue to perform well, but they still have an upside to our Fair Value targets. Below are examples of why we purchased the two positions:
Amazon (Ticker: AMZN)
Consumer Discretionary Sector
Rationale
Based on Amazon’s Q2 2024 earnings call transcript, the company displayed several positive indicators. AWS revenue growth accelerated to 18.8% year over year, attributed to increased focus on new initiatives and workload migration to the cloud. AWS’s operating income also rose by $4 billion year over year due to the company’s cost control efforts and measured hiring pace.
Amazon’s generative AI offerings, particularly Amazon Q, have gained strong adoption, benefiting developers by saving time and costs. Prime Video has garnered a large viewership, with landmark deals announced with the NBA and WNBA.
Project Kuiper, Amazon’s low-Earth orbit satellite constellation, is experiencing high demand from enterprise and government entities, and satellite manufacturing is accelerated. Additionally, the company’s focus on cost efficiency has allowed for the inclusion of lower ASP selection and increased consideration for customers’ shopping needs. Amazon’s advertising business has also seen robust growth, with sponsored ads driving the majority of its advertising revenue.
From an EVA (economic value added) perspective, sales growth is strong, SG&A expenses are controlled, and high R&D spending is yielding a margin and growth advantage. EVA margins are expected to increase over the next five years.
Zoom (Ticker: ZM)
Information Technology Sector
Rationale
Zoom’s recognition by Fast Company as one of the World’s Most Innovative Companies of 2024 validates its commitment to providing a high-quality, AI-powered collaboration platform.
The introduction of Zoom Workplace, their new AI-powered collaboration platform, has seen strong customer adoption, with over 2 million Zoom Rooms licenses purchased and over 100,000 desks provisioned for Workspace Reservations. Additionally, Zoom Contact Center has achieved significant growth, with 90 customers contributing over $100,000 in ARR, representing a 246% year-over-year growth. Furthermore, Zoom’s expansion in the enterprise market is evident, with five customers now having over 100,000 Zoom Phone seats.
The company has also experienced rapid growth, with over 700,000 customer accounts enabled in just eight months for Zoom AI Companion. Financially, Zoom has shown positive results, with total revenue growing 3.2% year-over-year, enterprise revenue growing 5.3% year-over-year, and significant growth in operating and free cash flow. The company continues to attract high-value customers and has a strong net dollar expansion rate for enterprise customers.
Our EVA analysis illustrated strong profitability, low capital requirements, and a strong cash conversion ratio. From a standard metric perspective, the Forward P/E is just 11x.
The common thread among each of these companies is positive returns on invested capital, manageable debt structures, cash generation, and positive economic margins. Historically, these factors have led to portfolio appreciation.
From a fundamental perspective, the portfolio’s Forward P/E is 15.2x (vs. 21x for the S&P 500), median free cash flow yield is a positive 5.7% (above the 10-year median of 5.1%), and Price/Tangible Book is 2.51x (vs. the 10-year median of 5.79x).
The portfolio’s current sector weightings are Information Technology (14.4% portfolio weighting vs. 8.6% benchmark), Health Care (2.8% vs. 16.0%), Financials (19.9% vs. 21.7%), Communication Services (13.0% vs. 4.1%), Industrials (11.7% vs. 14.2%), Consumer Staples (7.3% vs. 8.1%), Consumer Discretionary (6.6% vs. 6.1%), Real Estate (1.8% vs. 4.9%), Energy (5.1% vs. 6.9%), Materials (1.9% vs. 4.4%), and Utilities (3.8% vs. 4.7%).
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
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