On February 7, we sold our positions in Microsoft, CA, Inc., FactSet and Oracle, and for the time being, are holding those assets in cash. Together, those holdings represented approximately 11% of our portfolio.  Following the sales and some slight additions to existing positions, we now have almost 31.4% of the portfolio in the safety of cash. 

The sale of the positions was primarily due to the overall Software industry's value reaching our price target, coinciding with the majority of the stocks within the industry reaching our specific calculations of fair value. Although the average total return for the basket was more than 23% since we purchased the group on August 28, 2015, continued upside opportunities weren't strong enough to justify the increased risks that had been building as the stock values increased. Buy low and sell high, we say. Or said another way, given our focus on dividend yield-based valuation and the inverse relationship between price and yield, buy when yields are high and sell when yields are low.

For example, when we purchased Microsoft it was pretty clear that Wall Street had lost sight of a solid cash flow generator. As most of you know, our goal, using our disciplined and unique valuation methodology, is to purchase solid operating businesses that are being excessively discounted by investors. On the day we purchased Microsoft, our detailed scenario analysis concluded that investors were pricing in zero percent revenue growth each year for the next five years. Clearly, investors were excessively pessimistic.  Furthermore, our work illustrated that investors were also concurrently pricing in a two-percentage point decline in Microsoft's operating margins each year for the next five years! In other words, investors were pricing in zero sales growth and a massive decline in profitability. Given Microsoft's run rates, cash flows, and pristine capital structure already in place, it was an opportunity that provided exactly the type of buy candidate profile we strive for based on our valuation modeling. We were able to invest in a strong operating company's cash flows at significant discounts to their most recent, and historical, achievements.

Our goal is to own a fully-invested diversified portfolio of these types of opportunities.

We are always looking to put our cash to work, but will only do so if there is a buyable industry available, supported by buyable stocks within it. Buyable is a key word. A lot of companies are "somewhat" buyable if one wants to settle for a lower reward-to-risk profile and is willing to overlook some "minor" discrepancies. Our objective discipline won't "allow" us to buy these industries and companies, as over time taking on more risk for lower returns never works out for anyone. As you know, our evaluation criteria starts with a sophisticated analysis of absolute, relative and median industry and company dividend yields over time to determine attractiveness. The process thoroughly covers the cash flow statement, balance sheet and income statement to further determine eligibility. An industry has to be at a cycle low in price (based on a time-tested quantitative appraisal incorporating capital structure and tangible cash returns to shareholders) and the stocks we select must have solid operating businesses, pristine balance sheets and fundamental soundness.

At this point, we are very comfortable with the stocks we own in the portfolio. In fact, our current holdings have upside targets that are greater than 45% higher on average. Of course, changes in the operating environment for each company/industry will realign the targets, but the point is that what we own has significant upside in our view.

The same can't be said of the broad market. One of our broader measures for position sizing within our portfolio is the chart below. It illustrates the average percentage by which our eligible universe is overvalued or undervalued. You can see that currently, the market is as overvalued (about 27.1%) as we've seen since at least 2012. Note that when this composite reaches the zero percent level, it identifies a low-risk environment for equities, and you will find that we fill out the portfolio quickly when this occurs.

Day Hagan Tactical Dividend Strategy Eliqible Universe Percent Overvalued

The Tactical Dividend process has been in place since 2002, and has prevailed throughout bull markets, bear markets, sideways markets and all of the curve balls thrown during that time (QE, Greece, Arab Spring, Russia/Crimea, Democrats, Republicans, Brexit, and hundreds of other crisis events). It has prevailed for a very simple reason: It stays true to its discipline.

The discipline is: If there aren't enough industries—and companies within those industries—that meet our time-tested criteria to be included in our portfolios, we will hold cash until investable companies become available. We will not relent or water down our discipline by buying stocks that have poor reward-versus-risk profiles.

In other words, our cash position is a direct reflection of how many good opportunities there are in the equity markets based on a disciplined process. If there aren't a lot of good buys, we will hold a lot of cash. Our view is that we'd rather own a portfolio of companies with great prospects than force investment into companies with not-so-great prospects. Cash has served us very well during historically weak market periods, most recently in 2008 where the strategy outperformed the S&P 500 by roughly 2000 basis points. Also, as a reflection of only holding names we have a great deal of confidence in, our equity-only performance in 2008 also drastically outperformed the markets.

And that's the current environment we find ourselves in—there aren't a lot of great prospects. We have a few industry groups that are nearing buy thresholds, but none are quite there yet.

At this juncture in the market, even with our portfolio achieving strong results in 2016, we are now even more cautious. With the market moving higher, our discipline is moving our cash position higher.

We are most certainly looking forward to putting our cash to work. Not only do we increase our potential return, but our view is that historically, when the process gives the all-clear to add exposure, it's not just an all-clear for buying more stocks, but an indication that the global business environment is likely improving—and that's good for everybody.

Until that time, we will continue to manage risks, which, based on the level of our portfolio's cash holdings, are relatively lofty.

To reiterate: Buy low, sell high.

If you have any questions or would like more detail, feel free to call anytime.

Have a wonderful week,

  • Donald L. Hagan, CFA
  • Robert Herman
  • Jeffrey Palmer
  • Art Day

— Written 2-11-2017

The S&P 500 Index is based on the market capitalizations of 500 large U.S. companies having common stock listed on the NYSE or NASDAQ. The Russell 1000 Value Index measures the performance of the large-cap value segment of the U.S. equity universe. It includes those Russell 1000 companies with lower price-to-book ratios and lower expected growth values. Indexes are unmanaged, fully invested, and cannot be invested in directly.

Disclosure: The data and analysis contained herein are provided "as is" and without warranty of any kind, either expressed or implied. Day Hagan Asset Management (DHAM), 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. DHAM, accounts that DHAM 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. DHAM uses and has historically used various methods to evaluate investments which, at times, produce contradictory recommendations with respect to the same securities. When evaluating the results of prior DHAM recommendations or DHAM performance rankings, one should also consider that DHAM may modify the methods it uses to evaluate investment opportunities from time to time, that model results do not impute or show the compounded adverse effect of transactions costs or management fees or reflect actual investment results, that some model results do not reflect actual historical recommendations, and that investment models are necessarily constructed with the benefit of hindsight. For this and for many other reasons, the performance of DHAM's past recommendations and model results are 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.