October has seen the return of significant, negative market volatility. While those of us who have been around this business long enough know that periods of market weakness are inevitable, after Wednesday afternoon’s precipitous drop, many valid questions arise about what comes next.
The Day Hagan Logix Tactical Dividend Strategy (DHLTD) has consistently protected client portfolios during difficult market conditions since our 2002 inception; this includes years like 2002 and 2008, but also shorter periods of weakness as well. For the month of October to date, DHLTD has outperformed the Russell 1000 Value by over 200 basis points* and the broader-based S&P by over 350 basis points* (numbers are total return, gross of fees and considered estimates until month-end reconciliation). In our recent monthly letters and webinars, we have continued to emphasize risk management as a central, foundational tenet of all that we do. That not only translates into sufficient upside capture during positive markets but modest, long-term downside capture of just over 50% versus our benchmark Russell 1000 Value. The result of our focus on upside and downside capture has led to meaningful outperformance with nearly 40% lower volatility risk than our primary benchmark since inception.
As many of you already know, the current DHLTD portfolio is holding a defensive cash position. This is because, based on our disciplined valuation methodology, there simply haven’t been industries and underlying stocks that meet our evaluation criteria. We do not “bend the rules” to include holdings that don’t meet our criteria, preferring to hold cash rather than a stock that has more risk than reward. However, what we do currently hold in the portfolio clearly meets our valuation criteria and strict fundamental screening.
While outperforming our benchmark, we are holding a cash position as part of our portfolio risk management process. Our goal is to be fully invested. However, if a sufficient number of appropriate opportunities are not available based on our objective discipline, we are comfortable holding cash to mitigate downside until we see compelling risk-return present itself in new holdings. We’re often asked, “Would it take a correction for you to be fully invested?” The answer historically—and we confidently expect in the future—is “no.” One of the compelling characteristics of our stock selection methodology involves sectors, industries and individual holdings that may have different drivers than the broader market. Our deep value focus means we may see an opportunity in a specific industry grouping or name based on price movement that has very little (or nothing) to do with the direction of the broad markets. What we can say currently is that our broader universe of screened, eligible industries and names is significantly overvalued based on our measures (by about 26% as we write this) while the names we hold in the portfolio are undervalued by about 50%. This spread is as wide as we’ve seen it in our 16+ year history, and it has us excited about the portfolio’s upside potential as we continue to navigate risk carefully.
Another question we frequently get from clients relates to our stop-loss paradigm. Risk management is critical to our successful, 16+ year track record, and individualized stop-loss levels are a component of this. Occasionally, a portfolio holding will trigger a stop-loss, forcing a sale, which we view as an expected part of our process in managing downside capture and overall performance. Consistent with history, we have a few names currently that are on a watch list related to the stop-loss discipline. While we believe strongly in those particular names and their future risk-return dynamic, we follow an objective, unemotional process in making stop-loss decisions. Our stop-loss discipline is multifaceted and based on four primary pillars: 1) Current return on cost, 2) absolute 1- and 3-month price performance, 3) relative (to benchmark) 1- and 3-month performance, and 4) a stock-specific intrinsic value calculation that determines potential “floor value” that a stock price may reach in a worst-case scenario. If you’d like to understand our stop-loss discipline in further detail, we have a two-page FAQ piece available upon request.
Even prior to the latest market decline, we have been performing a due diligence review of three industries and their underlying holdings, which are very close to a buy range. Given the month-to-date decline across sectors, our eligible screened universe of several hundred stocks has moved into a more reasonable valuation range. With that as a backdrop, we do expect to find compelling risk-return opportunities to put cash to work moving forward.
While we have significantly outperformed our primary benchmark during this recent weakness, we continue to view our invested portfolio with optimism. As a deep value player that has successfully navigated a growth stock environment for several years, we view the road ahead as playing to our strengths. Regardless of whether growth or value is favored, our historical performance (absolute and risk-adjusted) shows that our strict focus on identifying attractive valuations and fundamentally sound companies with healthy balance sheets provides rational returns while managing risk.
Our energy exposure provides a good illustration of this point. Our modeling process identified a small number of vastly undervalued stocks with attractive upside, putting them into a potential buy category. In-depth fundamental work identified an even shorter list of eligible stocks with reasonable leverage, significant cash and attractive free cash flow characteristics, to name a very few of the characteristics we review on a daily, dynamic basis. In other words, these equities have healthy, sustainable balance sheets over the long term. In conjunction with our scenario analysis related to oil supply or demand shocks impacting pricing, Permian Basin pipeline bottlenecks, or any number of negative outcomes, we believe that the risk-return dynamic for our holdings is attractive regardless of near-term noise or macro market performance.
Similar to energy, any industry holdings in our invested portfolio must meet disciplined, methodical and objective valuation and fundamental screens. Our track record since early 2002 shows that downside protection in difficult market conditions, alongside healthy upside capture in positive markets, leads to outperformance. We would be happy to discuss the current market environment as it relates to our strategy anytime.
As always, we sincerely appreciate your support and welcome questions and comments.
Donald L. Hagan, CFA
Arthur S. Day
PDF copy of the article: Day Hagan Logix Tactical Dividend Strategy Update October 25, 2018 (PDF)
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. 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. Net return for the strategy year to date through 9/30/2018 is +5.63%; last twelve months net return is +12.70%.
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. The S&P 500® Index is a broad-based unmanaged index of 500 stocks, which is widely recognized as representative of the equity market in general.
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 express 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. 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.