After the volatile month of February, the Day Hagan Logix Tactical Dividend strategy is now -1.57 percent* year to date, gross of fees, versus the Russell 1000 Value benchmark at -1.09 percent (for comparison purposes, the S&P 500 Value is -1.56 percent); all numbers are total return. For the trading week prior to the February 9th low, the Day Hagan Logix strategy was effective in mitigating downside, outperforming its benchmark Russell 1000 Value benchmark (and the S&P 500) by over 300 basis points.
The stock market’s swift decline from January 26 through the February 9 low provided us with an opportunity to add to existing positions. On February 9, we increased our holdings in Archer Daniels Midland (ADM), Tyson Foods (TSN), Cardinal Health (CAH), and Schlumberger (SLB), raising our overall equity allocation by 7.5 percent. All of these companies are attractively rated and reside within attractively rated industries using our proprietary dividend yield-based methodology. Additionally, each company meets our company-specific criteria regarding solid balance sheets and fundamental strength.
Although we opportunistically increased our equity exposure, our cash levels remain meaningfully high. The reasons are straightforward: 1) our work shows that the broad market remains significantly overvalued, and 2) fewer industries and stocks meet our standards for purchase. Given this backdrop, we will continue to cultivate a diversified portfolio of companies trading at discounts to fair value that are supported by positive operating fundamentals, but we will not reach for returns at the expense of taking on undue risk.
Currently, our portfolio is invested in 26 companies among six industry groups, with average fair value targets more than 52 percent above today’s prices. As described in earlier monthly updates, our target prices reflect each company’s ability to achieve normal operating returns. To be clear: We are not modeling extraordinary company performance in an effort to justify price.
Early in February, the S&P 500 ended its longest streak on record without a 3 percent correction and had the first 5 percent decline since Brexit, which was the second-longest period on record going back to 1928. (Source: NDR) As there hadn’t been a 3 percent decline since November 7, 2016, volatility and measures of market anxiety surged higher as risk aversion swelled from extreme levels of complacency. It is within this environment that stocks with the unfortunate timing of delivering earnings announcements following the market’s peak on January 26 were often negatively dealt with, almost without regard for the quality and any positive messaging that the earnings updates provided.
Cisco (CSCO), one of our technology-related holdings, bucked the trend as the stock price jumped higher following an earnings announcement. Their report illustrated a return to revenue growth, confirmation that their transition to a recurring revenue model was meeting goals, and future guidance that came in ahead of expectations (not to mention a 14 percent dividend increase).
McKesson (MCK) also reported, with earnings and revenues well ahead of expectations, while also providing future guidance that was meaningfully ahead of consensus expectations. In fact, each of McKesson’s operating segments reported positive year-over-year results. These are all good things. However, the stock price moved lower as jittery investors, in our view, misinterpreted headline and media-fostered negative sentiment around medical distributors as an industry. While we use a proprietary valuation methodology, here are some of the more common traditional metrics for the company: At current levels, MCK stock is trading at just 14.6 times free cash flow and has a forward P/E of just 11.3x. Operating margins have expanded over the past year, and the Price/Book ratio is close to a 5-year low. In our view, MCK is trading at a tremendous discount to fair value, and the negativity around the industry group is overdone. How long it will take investors to recognize the value and join us as buyers is unknowable. However, we have bought and sold MCK successfully in the past, including most recently between November 2016 (we purchased the stock just after the price dropped over 20 percent on a poorly received earnings report, providing us an attractive entry point) and June 2017, for a return of nearly 27 percent*. Our history shows that value, as we measure it, is eventually recognized.
Tractor Supply (TSCO) was another February example of a company reporting a strong quarter followed by weak price performance. Earnings per share and revenues were ahead of expectations, and forward guidance was also a positive. Same-store sales were up +4 percent year over year, and based on tax reform, the company expects their tax rate to decline from 36.7 percent in 2017 to about 23 percent in 2018. Proceeds are expected to go towards driving growth via high-potential new stores. We continue to view TSCO prospects as strong.
Similarly, over concerns around future capital expenditures (more trucks, airplanes and distribution hubs) related to serving additional capacity, United Parcel Service’s (UPS) stock price moved lower despite beating analyst consensus expectations for the quarter and providing guidance that meaningfully increased the high end of the expected range of the coming year’s results. Interestingly, the capacity issue stemmed from demand that significantly exceeded forecasts for last year’s holiday season. Longer term, spending money (capital expenditures) to increase capacity to increase profits makes sense.
UPS also dealt with Amazon’s (AMZN) announcement over the past few weeks that it is planning to test a delivery service for businesses later this year (mind you, in only one zip code in Los Angeles). Nevertheless, any hint of AMZN’s interest in a given industry seems to drive existing players’ market capitalizations south no matter how sparse the detail. While the kneejerk reaction was negative, more careful examination would suggest an adverse impact over the next decade on larger, existing shipping networks is unlikely. E-commerce more broadly is increasing the overall demand equation. Furthermore, AMZN would not seem to be trying to undercut on price with Prime memberships and costs to merchants increasing. With the big picture in mind, we believe that the scale of players like UPS and FDX provides an enormous, sustainable competitive advantage.
Another byproduct of AMZN’s actions (and potential actions) is that Merger and Acquisition chatter and activity is increasing. AMZN’s influence clearly demands a rethinking of how certain industries can consolidate market power vertically and horizontally. While much of it is noise at this point, we do think our portfolio holdings will be positively impacted. We posit that the Day Hagan Logix strategy has always had a fair bit of M&A potential (most recently, QCOM). This is not all that surprising since we purchase good businesses at prices we calculate to be meaningfully undervalued (trough valuations). These are, in our view, the types of companies that are natural takeover candidates.
For example, in relation to AMZN and healthcare, Walgreens Boots initiated the first steps toward a takeover of AmerisourceBergen (ABC), a holding in our portfolio, in mid-February. This caused AmerisourceBergen stock’s price to initially spike. According to subsequent press reports, those talks have since cooled, but we would not be surprised to see one or more deals happening in that space. While we do not factor that into our valuation analysis, we expect the portfolio to realize positive, deal-related impact over a market cycle.
Although we have paid an inordinate amount of attention to Amazon in our letters of late, we view any negative impact on our holdings as being primarily short-term in the context of our disciplined, methodical and objective valuation approach. Day Hagan Logix is a “weight-of-the-evidence,” rules-based portfolio approach that uses sophisticated dividend yield-based valuation modeling and a fundamental screening overlay focused on balance sheet strength and long-term free cash flow generation.
During the month, we entered one new position, Cabot Oil & Gas (COG), which modestly increased our energy exposure. Our modeling shows significant upside potential for COG, which in many ways is a similar story to our other energy industry holdings. The company’s cost structure continues to be meaningfully reduced within an already efficient company. Production growth is driving significant free cash flow generation. The sale of non-core assets provides for enormous levels of cash and balance sheet flexibility, as well as further focus on high return opportunity Marcellus shale (a projected $2.5 billion of free cash flow for the company from 2018-2020). In other words, given the attractive entry point, it is the kind of opportunity our strategy seeks.
As we expect further volatility ahead in 2018, please know that we are receptive to your questions and engaging with you. We wish you a happy and productive March.
- Robert Herman
- Donald L. Hagan, CFA
- Jeffrey Palmer
- Arthur S. Day
PDF copy of the article: Day Hagan Logix Tactical Dividend Strategy Update March 2018 (PDF)
Note: Day Hagan Logix Tactical Dividend YTD net return through 2/28/2018 = -1.67 percent. S&P 500 Total Return = 1.72 percent.
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 individuals’ 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.
Day Hagan Logix 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 Logix claims compliance with the Global Investment Performance Standards (GIPS®) and has prepared and presented this report in compliance with the GIPS standards. Day Hagan Logix has been independently verified for the periods April 30, 2002 through December 31, 2016. A copy of the verification report is available upon request. Verification assesses whether (1) the firm has complied with all the composite construction requirements of the GIPS standards on a firm-wide basis and (2) the firm’s policies and procedures are designed to calculate and present performance in compliance with the GIPS standards. Verification does not ensure the accuracy of any specific composite presentation. 2 Calculation Methodology: Pure gross of fees returns are calculated gross of management, custodial fees and transaction costs and are shown as supplemental information. Net of fees returns are calculated net of actual management fees, transaction costs 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.