Hopefully by the time this letter reaches you, spring has finally and completely sprung. It was an odd and unpredictable winter in many places: 75 degrees in February, snow in March. Odd and unpredictable could also be used to describe recent market behavior, as well as the macro and political backdrop, during the first quarter of 2017. For the quarter, the Day Hagan Tactical Dividend Strategy (DHTD) returned +0.97% gross, +0.83% net. Since early 2002 inception, with modest beta of 0.6, the strategy has produced annualized returns of +9.66% versus the S&P 500 at +7.09% and the Russell 1000 Value at +7.35% (all numbers are gross of fees and total return), consistently generating positive alpha.
Every investment strategy, relative to its benchmark, has an underperforming quarter. After a long period of return outperformance accompanied by lower relative risk, Q1 qualified as such for DHTD, even though performance was still positive. It is important to note that the performance for the quarter is consistent with our approach. More specifically, the results reflect the highly defensive stance of the portfolio. At this juncture, our methodology indicates that the overall eligible universe of industries and companies are meaningfully overvalued. As a result, our objective discipline allows us to only buy and hold positions that are trading at trough valuations with significant upside potential. Since 2002, our strategy consistently accumulated companies trading inexpensively and selling those positions when they achieve fair value. By design, our strategy will not capture the last dollar of gains off the table, for that last dollar is the riskiest dollar of an uptrend. We will sometimes be early.
There is instruction that can be gleaned from history, and upon a detailed review of the historical performance of the DHTD strategy, we would note that looking back at similar three-month periods of relative underperformance versus the S&P 500 since our inception, those periods had subsequently and reliably produced attractive buying opportunities. We believe we are extremely well positioned for the future with the stocks we hold in our current portfolio.
We are not alone in holding defensive cash positions to protect against downside. The well-respected Baupost Group, managing about $30 billion in assets, has lost money only three times in the last 34 years. As of their last quarterly letter, they, too, held more than 30% of their portfolio in cash. On the broader topic of risk mitigation, it is worth noting that a central focus of the DHTD strategy since 2002 has always been downside protection. Why? Because we know that if we are able to protect against major declines, our targeted upside capture will lead to meaningful outperformance versus the benchmarks over the course of a market cycle. The simplified math is compelling: to outperform the market, an investor only needs about 30% of market gains during up periods if they don't participate in market losses during the down periods (source: Crestmont Research). While we obviously don't strive for zero percent downside capture, since inception, our ~50% downside capture and ~74% upside capture has led to about 251 basis points* of outperformance annually versus the Russell 1000 Value (257 basis points* versus the S&P 500).
Early in the month of February, we sold the holdings within one of our two technology industries, Software, while modestly increasing the target weighting in the Asset Management industry. Among software names held, Oracle was still clearly in an attractive buy range, but the other names had approached fair market value. As a result, the lack of available diversification and the overall value of the industry led us to a sell. In holding the industry since August 2015, it generated an average of +25%* return. We continue to hold positions in the Information Technology Services industry. Overall, the portfolio now holds six industries and 25 companies, the low end of our historical range of holdings.
A meaningful part of our risk management process involves evaluating names on an industry basis. In other words, we will not consider buying one, two or even three names in a given industry grouping. There must be four or more names in an eligible buy industry to purchase at a given time. This also means that on the front end of our screening process, an "orphaned" name that is not part of a buy industry is not eligible for consideration. The industry approach leads to additional risk diversification and a more thorough screening of the underlying names in an industry.
In our search for trough valuations, we expect that we will often take a contrarian stance in picking industries and names. If we want it cheap, even though our valuation process is proprietary and differentiated, we know that many investors will have already built in very negative attitudes and expectations. That's fine with us, as it generally gives us strategically attractive entry points. While we can't pretend to know what an unloved name or industry will do next week or next month, our track record would suggest we have a strong sense of industry upside/downside.
Our current holdings in the Medical Distributors industry—AmerisourceBergen (ABC), Cardinal Health (CAH), McKesson (MCK), Owens & Minor (OMI) and Patterson Companies (PDCO)—provide a good case study, representing about 15% of the current portfolio. Since the industry was purchased in May of last year, the average return has been about +8%. MCK was opportunistically purchased in November as a fifth industry name after a drastic drop around a missed earnings report as well as concerns around pharmaceutical distribution price competition. There has been a fair dispersion in the performance of the underlying names since industry purchase, with ABC up over 20%*, MCK up about 17%* since November, OMI down just under 3%* with CAH and PDCO up mid- to high single digits*. To us, this performance dispersion is currently somewhat irrelevant because of the attractive industry valuation in our modeling and our price targets on these names showing an average of 42% upside.
Our Retail discount stores holdings, currently about 11% of the portfolio, are another example of a contrarian play. At present, extremely negative sentiment is baked into retail prices more broadly. Interestingly, since our purchase of the discount stores industry in October, we are actually down only very modestly (<1%*) despite the struggles of holdings like Target (TGT) and Kohl's (KSS). With deeply discounted valuations (based on our proprietary modeling as well as more traditional fundamental measures), we view the present opportunity as significant even in the face of the transformation going on in bricks and mortar retail. There is no question that Amazon (AMZN) and e-commerce have changed the rules of the game, but leaving it at that is an oversimplification. For example, AMZN's market capitalization is now larger than Walmart (WMT), Target (TGT) and Home Depot (HD) combined. But Amazon only generates about one-fifth of the revenue of WMT, TGT and HD. Furthermore, Amazon is far less profitable than either WMT, TGT or HD and has significantly lower profit margins. In other words, with Amazon, an investor is buying one-fifth of the sales of those three discount stores and lower profitability. Eventually, these incongruities will revert as investors realize the opportunities in WMT, TGT and HD, even in the face of stiffer e-commerce competition. We would also note that WMT, TGT and HD still produce billions in free cash flow annually. Another retail holding, the unloved name of Kohl's (KSS), at current valuations, has meaningful upside based on our process. Importantly, KSS is supported by a free cash flow yield of more than 20%, the highest in company history. Kohl's has a healthy balance sheet and, in our view, will be one of the winners.
Our analysis is centered on repeatable cycles (yield and price) for a given industry to uncover opportunities that fit our criteria and pass our stringent screens. We've seen, and prevailed, over many different cycles since 2002. As part of our discipline, our responsibility is to consistently monitor and evaluate all of our assumptions to make sure we have a deep understanding of what is going on beneath the surface. But it is also important to know that we use an array of risk management tools for the portfolio. For example, while we seek to buy industries and names at trough (low) valuations, we employ a sophisticated stop loss strategy that will force a sale, without emotion, if we are wrong. As a function of what we do, this happens sometimes. We have shown over the past fifteen years that, even with the occasional forced sale, we can still generate outperformance with lower risk.
While we believe our modeling is a differentiating factor in our approach, the fundamental screening has to be thorough for the process to work. This screening comes into play in creating the relevant, well-vetted universe of eligible industries/names and in evaluating buy/sell/hold candidates. This translates into owning healthy industries with the underlying buy names showing meaningful long-term free cash flow generation, a healthy balance sheet with plenty of liquidity, and shareholder-friendly management that has shown a long-term commitment to dividend consistency.
We believe strongly that our current portfolio is well positioned to both weather any storm and realize absolute returns. The industries and names we own give us confidence that the process we have followed over the last fifteen years will continue to serve us well.
As always, if you have any questions or would like further details, please feel free to contact us.
- Robert Herman
- Donald L. Hagan, CFA
- Jeffrey Palmer
- Arthur S. Day
PDF COPY OF ARTICLE: Day Hagan Logix Tactical Dividend Strategy Update, April 5, 2017 (pdf)
Note: 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: *Note that individual's percentage gains relative to those mentioned in this report may differ slightly due to portfolio size and other factors. The data and analysis contained herein are provided "as is" and without warranty of any kind, either expressed or implied. Day Hagan Logix (DH Logix), 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 DH Logix 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. DH Logix, accounts that DH Logix 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. DH Logix 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 DH Logix recommendations or DH Logix performance rankings, one should also consider that DH Logix 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 DH Logix'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.