CWS: 3rd Quarter 2023 Portfolio Review

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The third quarter of 2023 was largely a tale of two markets: a bullish one through July and a bearish once after July. Near the end of the quarter, the S&P 500 Index dropped to its lowest close since June 7. As the quarter wore on, investors became far more pessimistic.

For the quarter, the S&P 500 lost 3.65%. With dividends, the index fell 3.27%. The AdvisorShares Focused Equity ETF (CWS) saw its NAV fall 3.00% and traded shares declined 3.03%.

One of the major concerns for investors was rising interest rates. In September, the yield on the 10-year U.S. Treasury bond closed at a 16-year high of 5.61%. In six months, the yield increased by 130 basis points. Apparently, the market believes that despite cooling off some, inflation is not going away. That may be right.

Before the quarter ended, the price for oil broke above $95 per barrel. That’s the highest price in more than a year. During Q2 2023, oil was going for less than $70 per barrel. This is important because higher gasoline acts like a regressive tax. It siphons money out of consumers’ pockets, and it’s hardest on the poor.

Consumers were also worried about higher mortgage rates and an uncertain outlook for the economy. The rate on a 30-year fixed mortgage reached 7.41%. That’s a three-year high. Including all the costs, housing is the least affordable it’s been in decades.

On top of that, investors had fears of a government shutdown and several labor issues. Many conservative stocks were particularly weak and so were many high-yielding utility stocks. The stock market’s famous “Magnificent Seven” (Microsoft, Meta, Apple, Amazon, Alphabet, Tesla and Nvidia), which powered the market higher this year, floundered during Q3.

Higher Yields Are Holding Stocks Back.  First, I need to put this into context. The stock market isn’t crashing. It’s really giving back some of the impressive gains it made over the spring and summer. My guess is that the selloff startled investors who had grown complacent. They thought that steady gains were the rule.

The truly surprising aspect of this recent drop has been the consistent rise in U.S. Treasury yields. The increase has been most pronounced at the long end of the curve (maturities longer than five years out). Lately, it seems that investors are both nervous and running towards risk!

Another surprise is closely related. We’re seeing an inversion of the typical rule of risk and return. When the market was rising in July, value stocks did better than growth stocks. That’s not what usually happens. Similarly, once the market started retreating in August, growth stocks held up better than value. Again, scared investors are chasing risk?

There’s also a lot of concern about the state of the economy. Unfortunately, the outlook is murky at best. The government reported that the economy grew in real annualized terms at a 2.1% rate for Q2 2023. That’s unchanged from the previous report, but Q2 is already old news.

At the end of October, the government will release its initial report on growth for Q3 2023. This is being hotly debated on Wall Street right now. The Atlanta Fed (Federal Reserve Bank of Atlanta) thinks Q3 had growth of 4.9%. That’s a very strong number. Honestly, I think that’s too optimistic. I’m cheering for a high number, but we need to be realistic. Most of Wall Street expects something closer to 3%.

Regarding higher interest rates, we’re also watching real interest rates (after-inflation rates) go up as well. Looking at the finances of the United States, Uncle Sam will have to issue lots more debt to keep the ship running. Lots and lots more debt. That was easy when the globe was on lockdown, but now investors are demanding a greater cut.

This is a major change in investor sentiment. Eighteen months ago, the 30-year TIPS (Treasury Inflation-Protected Securities) yield was negative. In other words, investors desired safe Treasury debt so much that they were willing to lose money after inflation. That’s no longer the case. The 30-year TIPS yield recently closed at 2.29%

Let’s look at some of the stocks that drove our performance during Q3.

On September 21, FactSet (FDS) reported fiscal-Q4 earnings of $2.93 per share. That was well below Wall Street’s consensus of $3.50 per share, but some explanation is needed. Last quarter, FactSet had a tax charge of 68 cents per share. Looking past that charge, FactSet did quite well. Wall Street’s initial reaction was negative, but once cooler heads emerged, shares of FDS rallied.

For Q4, FactSet’s revenues increased 7.2% to $535.2 million. For the year, FactSet’s revenues rose 13.1% to $2.086 billion. This was the company’s 43rd year in a row of higher revenues. A key stat to watch is FactSet’s Annual Subscription Value, or ASV. For Q4, the company’s organic ASV increased 7.1% to $2.175 billion. I like to keep an eye on FactSet’s operating margin. That’s usually a good sign of business health. For Q4, FactSet’s adjusted operating margin increased 210 basis points to 33.6%. For the whole year, FactSet’s adjusted operating margin increased 230 basis points to 36.2%

Linda Huber, FactSet’s CFO, said, “FactSet made good progress on expense management. Looking ahead, we will maintain our focus on sustainable growth and profitability to fuel innovation.” This was the 27th year in a row that FactSet grew its earnings.

FactSet provided guidance for FY 2024. The company expects ASV growth of 6% to 8% and revenue growth of 6% to 7%. FactSet sees 2024 earnings ranging between $15.65 and $16.15 per share. Earlier this year, FactSet raised its dividend for the 24th year in a row. During the year, the company returned $315 million to shareholders in dividends and share repurchases. In 2023, FactSet’s client count increased by 5.1%, and users grew by 5.6%. I was very pleased with this report and FactSet’s guidance.

Another strong report came from Science Applications International (SAIC). The company said that its fiscal-Q2 earnings increased by 17% to $2.05 per share. That was well ahead of Wall Street’s consensus for $1.62 per share. This is the third quarter in row in which SAIC has beaten the Street by more than 17%. I really like SAIC, and it continues to do very well. Quarterly revenues fell 3% to $1.784 billion, but after adjusting for the impact of divestitures, organic revenues increased by 8.3%.

SAIC’s operating income increased 7% to $134 million. Operating margin widened by 70 basis points to 7.5%. Q2 EBITDA increased by 5% to $174 million, and EBITDA margin was 9.8%. Free cash flow was $143 million. These are solid results.

SAIC’s CEO Nazzic Keene said, “I am proud of the financial performance we delivered in the quarter with both strong organic-revenue growth and margin expansion. We remain on track to achieve our three-year financial targets and are off to a strong start.” One impressive stat is that SAIC reduced its number of outstanding shares. For Q2, SAIC’s number of shares decreased from 55.9 million to 53.9 million. During the quarter, SAIC used $100 million to buy back shares and paid out $20 million in dividends.

SAIC raised its outlook for the rest of this year. The company now sees revenues ranging between $7.2 billion and $7.25 billion. The previous range was $7.125 billion to $7.225 billion. SAIC also sees full-year earnings coming in between $7.20 and $7.40 per share. That’s an increase of 20 cents to both ends of the previous guidance. Wall Street had been expecting $7.16 per share. This is the second time this fiscal year that SAIC has increased its full-year guidance. The previous increase was also by 20 cents per share at both ends. Shares of SAIC had a very nice run earlier this summer, but it’s been somewhat weak lately. There’s nothing to worry about. This is a sound company.

After the closing bell on August 2, FICO (FICO) beat earnings and raised guidance. The shares continued their impressive run. This is such an impressive company. For its fiscal Q3, Fico made $5.66 per share. That’s a 26% increase over last year, and it’s 41 cents more than Wall Street had been expecting.

CEO Will Lansing said, “We delivered another excellent quarter, with record-setting results throughout the business.” Net revenues increased 14% to 398.7 million. Scores revenue increased 13% to $201.8 million, and Software revenue was up 16% to $196.9 million. Thanks to these results, Fico raised its full-year guidance. The company now sees 2023 revenues of $1.5 billion. That’s an increase of $20 million. Fico also sees full-year earnings of $19.70 per share. That’s an increase of 25 cents per share. Since Fico has already made $14.70 per share for the first three quarters of its fiscal year, the new guidance implies Q4 earnings of $5 per share. FICO closed 4% higher during Thursday’s trading. FICO has been an outstanding stock for us this year.

Ticker	Security Description	Portfolio Weight %
MLR	MILLER INDUSTRIES INC/TENN	5.41%
TREX	TREX COMPANY INC	5.33%
FICO	FAIR ISAAC CORP	5.10%
CARR	CARRIER GLOBAL CORP	4.84%
BR	BROADRIDGE FINANCIAL SOLUTIO	4.81%
INTU	INTUIT INC	4.72%
CE	CELANESE CORP	4.38%
MCO	MOODY’S CORP	4.14%
FI	FISERV INC	4.12%
SYK	STRYKER CORP	4.10%

As of 09.30.2023.

Many folks on Wall Street have been expecting a recession. In fact, a lot of well-paid forecasters were certain that the U.S. economy would be flat on its back by Q3 of 2023. That hasn’t happened yet, but it will come at some point.

The good news is that the inflation numbers have improved somewhat, but we’re still a long way from declaring victory. The Federal Reserve has aggressively raised interest rates. That’s worked to some extent, but it’s also weakened the economy, and the potential for future growth.

The housing market, for example, is slowing down. That’s a concern because housing affects so many other sectors. In two FOMC meetings so far, the Fed has decided not to forego raising rates. If the economy continues to flash warning signs, the Fed may start lowering interest rates sometime in 2024.

If any damage comes to the stock market, conservative stocks will fare much better. This is good news for the AdvisorShares Focused Equity ETF (CWS). I see our strategy continuing to lead the market.

I remain very optimistic for the stocks in our fund and our overall strategy. We beat the market handsomely in last year, and I foresee these trends lasting for the rest of 2023 and into next year.

In a first for the ETF industry, the portfolio strategist of CWS has “skin in the game.” The strategist’s compensation is directly tied to portfolio’s performance. Using the trailing 12-month returns of CWS vs. its S&P 500 Index benchmark, stronger outperformance is rewarded with a larger management fee while weaker underperformance is penalized with a smaller management fee. The CWS fulcrum fee was 0.85% during July, August, and September 2023. After the Fund’s September performance, the CWS fulcrum fee will remain at 0.85% in October 2023.

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