DBLV: 3rd Quarter 2021 Portfolio Manager Review
And all at once, summer collapsed into fall. — Oscar Wilde
It is not the strongest species that survive, nor the most intelligent, but the most responsive to change. — Charles Darwin
One doesn’t accept bad challenges. Part of it is always the risk-taking without seeing that the risks are rational and the rewards are commensurate…are more than commensurate…with the risks. — Sumner Redstone
The third quarter of 2021 saw continued upward momentum in the equity market, with growth stocks outpacing value shares for much of the period, until all at once the market corrected in September just ahead of the autumnal solstice. Throughout most of the quarter, the markets had been edging higher on continued easy liquidity from the Fed, as well as indications that delta-variant covid cases had peaked, thus reducing worries about a faltering recovery despite disappointing economic data. However, the equity market experienced a pullback on a sudden surge in interest rates apparently driven by growing fears over the Fed’s upcoming taper plans, as well as by expanding evidence that inflation is not proving transitory, rising doubts about the economic recovery and growing worries surrounding corporate earnings disappointments during the upcoming reporting season. As a result, the market from the early September peak to quarter’s end corrected by more than 5%.
Even with the pullback, the S&P 500 index still ended the quarter with a modest gain of 0.58%. During the correction there was a rotation back into value stocks, but growth nonetheless outperformed value during the full third quarter. The Russell 1000 Growth index rose 1.16%, while the Russell 1000 Value index decreased 0.78%. The AdvisorShares DoubleLine Value Equity ETF (DLBV) returned -2.28%, underperforming its benchmark, the Russell 1000 Value, by 150 basis points. The cause of this relative underperformance was broad-based, with financials, health care and materials impacting performance the most. During the quarter, we had responded to rising stagflationary risks by shifting moderately to a more balanced exposure between reflationary financial names and defensive technology and communications services stocks. Yet this positioning did not offset the negative performance attribution from individual holdings within these sectors. That said, we continue to maintain these positions since we expect them to show positive relative returns in the future, and because we believe our more balanced portfolio exposures are prudent amidst the risks we see in the current environment.
After a robust economic start to the year, following the onset of the global re-opening, the recovery’s progress has appeared to decelerate on the emergence of several headwinds. This slowdown has coincided with the emergence of delta-variant covid case count spikes, as well as the rolling off of government stimulus, which together have raised concerns surrounding the pace and durability of the economic rebound. Ongoing supply chain disruptions, whose resolution now appears further out than previously believed, is another key and growing drag, as are the related rising risks concerning energy and electricity supplies across the globe. Delays in the passage of a US infrastructure bill, as well as concerns over the inability to resolve in Congress the debt ceiling, have raised further concerns about the ability to promote growth—indeed, one could argue that many of the governmental policies to address the pandemic (e.g., vaccine mandates and passports, etc.) implemented in several countries have created further challenges to a full reopening. Finally, concerns about a slowdown in economic growth and easy credit in China’s economy, traditionally a key locomotive of global growth, have justifiably increased, driven by the government’s recent and seemingly anti-capitalist regulatory crackdowns across multiple sectors, as well as by its tighter control over loan growth amidst a potential brewing liquidity crisis in the important property sector.
Because the dynamics of the current economic recovery are so unconventional, driven by unique challenges of a global pandemic, as well as the unprecedented governmental interventions to address it, it is harder than usual to determine our location in the business cycle. Ordinarily, during the course of a cycle, the economy slows as investments fueled by excess liquidity turn sour, or consumer spending slows due to tightening credit conditions late in the cycle, and this typically causes labor markets to soften as well. However, the dynamics in the U.S. economy are undeniably different this time—although we recognize the dangers of writing those three words—since the decline in economic activity seems to be more related to continued interruptions in supply and rising inflationary pressures overwhelming the ability of consumers to pay, than it is a function of exhausted credit or issues with underlying consumer demand for goods and services.
Indeed, we believe that the recent slowdown in the U.S. economic recovery more likely reflects a delay in the full re-opening of activity, rather than the start of a more enduring downturn or a recession. First, we think the worst of the anti-growth aspects of the pandemic and governmental response to it are likely behind us. Although the pace of vaccinations has slowed, the delta-variant covid case counts have peaked, and it is likely that increasing numbers of individuals will begin to view Covid-19 as an endemic infection that we will have to live with; hence, even in the event of further case count spikes, we would expect the most draconian governmental pandemic measures will soften in the future in order to further the goal of promoting higher levels of employment and reaccelerated rates of economic growth, thereby resolving over time supply chain disruptions, relieving many ongoing price pressures, supporting consumer demand and returning more fully to normalcy. Of course, if the government continues to promote stricter policies (i.e., zero tolerance) even as SARS-COV2 goes endemic, then this more sanguine growth scenario would be threatened, especially in the event of a severe fall or winter spike in covid cases from a new variant.
Second, and more importantly, key supports for a sustained economic recovery are in place, which make a renewal of economic recovery our base case assumption at the present time. U.S. household balance sheets remain in good shape. Indeed, despite the ending of some government stimulus programs, consumer spending could remain strong, as Americans have accumulated about $2.5B in excess savings since February 2020, based on our internal estimates. Meanwhile, according to J.P. Morgan, inventories are at 25-year lows since supply chain constraints have impeded inventory replenishments. While companies have been cautious about ramping up capital investments despite being flush with liquidity amidst the still-elevated uncertainties arising from the pandemic and supply-chain shortages, we think this postponement of capital investment and inventory replenishment will soon end, leading to a period of robust catch-up investment. With ample job openings that actually greatly outnumber unemployment counts, we expect employment to further recover—especially as in-person schooling allows more parents to return to work and paycheck protection payments have ended. Moreover, more fiscal stimulus should still be on its way, with the delayed but popular $1 trillion bipartisan infrastructure bill awaiting approval by the House of Representatives, and another $2 trillion to $3.5 trillion “human infrastructure” bill currently being negotiated. Lastly, credit conditions among consumers and businesses remain healthy.
Inventory-to-Sales at All Time Low
Source: J.P. Morgan Global Equity and Quantitative Strategy, Haver Analytics
Capital Expenditure (CapEx) Cycle in Early Stages of a Recovery
Source: J.P. Morgan Global Equity and Quantitative Strategy
As COVID-19 eases, Capex for Epicenter/Recovery Stocks Likely to Increase
Source: J.P. Morgan Global Equity and Quantitative Strategy
This constructive view of the economy, if correct, would be supportive of healthy corporate earnings, even as the near-term slowdown in economic growth prompted analysts to temper their earnings estimates in September, with projections for Q3 being tweaked negatively last month after months of strong upward revisions. However, third quarter earnings for this year are nonetheless expected to rise by about 28% year-over-year, which would mark the third-best earnings growth seen in the last decade—behind only the two preceding quarters. And while the rate of growth is expected to decelerate substantially from the record annualized earnings growth rate seen in the second quarter of this year, the growth rate should remain rather healthy. In light of this, we should still see positive earnings surprises and upward revisions (albeit at more normalized frequency) given what are still favorable year-over-year comparisons, and because certain companies could actually benefit from the current dynamics. Specifically, cyclical company earnings can benefit from the higher inflation and rising interest rates, since the inflation creates an opportunity for firms with pricing power to obtain price hikes, while rising rates would likely portend rising economic demand for the goods and services of those cyclical firms. Separately, companies with reasonable valuation multiples engaged in accelerated stock repurchases would also enjoy a boost to earnings, thereby posting incrementally higher earnings per share on a smaller outstanding share base.
Source: FactSet and DoubleLine
As is widely understood, inflation continues to run relatively hot. The consumer price index (“CPI”), in August, rose 5.3% from a year earlier and was up 4% yoy, excluding food and energy. The personal consumption expenditures (“PCE”) deflator, which is the Fed’s preferred measure of inflation, increased 4.3% yoy and 4.9% month-over-month annualized in August. These rates of inflation are well above anything experienced in the last several years, and also are above central bankers’ targets. Given that many of the underlying drivers of inflation (e.g., labor shortages, supply chain disruption, lingering covid-related issues, etc.) are proving more difficult to resolve, central bankers, including members of the Fed, are starting to concede that these pressures may last longer than they initially expected. Hence, the definition of “transitory” is itself proving transitory.
Still, many investors seem to agree for now that the inflationary pressures, while more long-lived than originally thought, will, in time, abate. Apparently, this too shall pass… Indeed, according to the most recent BofA Global Fund Managers Survey, 69% of equity investors (still) believe inflation is transitory. At quarter end, the 1-year and 3-year TIPS breakeven inflation rates were 2.54% and 2.51%, respectively, while the 5-year TIPS breakeven inflation rate was also 2.51%, implying that bond investors—arguably more sensitized to inflationary pressures than equity investors—currently expect inflation to recede to 2.5% over the next few quarters and years.
Our view remains that inflation will stabilize below current levels, but stay meaningfully above the Fed’s 2% target, as we expect some portion of the inflation to endure. In particular, we think shelter and wage inflation, which carry a significant weight in the CPI calculation, are likely to be somewhat sticky and could rise further. Overall rent contributed 33% to CPI, with owner’s equivalent rent (“OER”) portion carrying a 24% weight. Home prices have risen considerably, and rent increases have accelerated, so rent is likely to have a bigger impact on CPI going forward. Also, wages carry a significant weight of 25% in the overall index, and are also on the rise. Meanwhile, food (14% weight) and energy (7% weight) prices could stay elevated longer than expected, especially given that soaring energy prices have already created a crisis in Europe and Asia.
Interest rates are rising again, apparently due to the inflationary pressures, as well as on the anticipation that the Fed’s QE program may be approaching an end, the recognition that we are past the peak for delta-variant cases and so more draconian shutdowns are less likely in the near term, and the abating worries that China’s trouble property market will trigger a deflationary contagion. Whatever the exact causes, the 10-year Treasury yield jumped 21 bps from 1.33% to 1.54% over a 5 day period, which was a highly unusual move. While interest rates remain relatively low, and historically, their rise has not necessarily led to a market downturn, the all-important question is whether rates are rising along with broadening growth in a strengthening economy, or whether rates are merely reflecting the eroding purchasing power of the dollar in a stagnant economy (i.e., stagflation).
In the past, markets have performed well when rising rates were accompanied by rising expectations of continued healthy economic growth, but they have performed rather poorly when those rising interest rates reflected merely higher inflation expectations amidst slowing or stagnant growth prospects. The latter stagflationary scenario could emerge not only due to persistent and high inflationary pressures caused by supply chain disruptions and labor and input shortages that prove difficult to resolve, but also due to technical factors; specifically, lower demand for Treasuries (by investors, as well as a tapering Fed) amidst ongoing or accelerating increases in Treasuries issuance needed to fund our still-widening fiscal deficits, could cause rates to jump. It is important to understand that stagflation, while rare, can occur when the market’s ability to course-correct is substantially blocked—as we saw during the lengthy and challenging process of overcoming a foreign-supplied energy crisis that adversely impacted a manufacturing-centric U.S. economy during the 1970s. If it turns out that the challenges to addressing today’s underlying drivers of inflation, such as the growth-slowing government policies intended to address the pandemic, the deterrents and disincentives for workers to return to the labor market, the issues causing protracted supply-chain snafus, or the continued dependence on excessive deficit spending to sustain growth, all prove exceedingly protracted, then it could be possible to see inflation persist even in the absence of solid economic growth. And because such stagflation has historically proven harmful to most asset classes, including equities, this is a risk that we are watching closely even though such stagflation is not our base case assumption.
This risk of worsening inflation—stagflationary or otherwise—remains top-of-mind for us, particularly since we expect monetary conditions to remain accommodative for the time being, even as the Fed’s formal announcement of tapering plans looms. The Fed has said that such an announcement could come as early as November, with actual tapering commencing in December. However, such a taper would reduce bond purchases only by $15 billion per month, meaning that the U.S. central bank would still be injecting about $660 billion of additional liquidity, with about $315 billion occurring in 2022, into the monetary system. This is because the Fed is not technically tightening during the taper, but rather, merely reducing the amount of stimulus. More importantly, the reality is that the Fed might already be behind the curve given the significant inflationary pressures already baked into the economy, as well as the fact that a true lift-off in rates would likely only occur after the taper ends by mid-2022 or even the beginning of 2023. Such a delayed and perhaps muted rate lift-off may not fully quell the rising inflation over the longer term. We think we will see higher rates, but a heavily indebted nation will be reticent to raise those rates too high, given the adverse impact on debt servicing costs.
Not all parts of the market will be impacted in the same way by the prospects of rising interest rates and perhaps permanently higher inflation levels. The stocks of cyclical companies tend to do well in an inflationary environment in which economic growth is increasing along with the rising prices. With the recent, sudden rise in interest rates, value stocks started to outperform growth stocks again. This likely reflects the ability of cyclical companies to obtain pricing and enjoy operating leverage in their business models. Moreover, it also reflects the relative benefit that lower-multiple value stocks enjoy versus their growth stock counterparts in an environment in which higher rates pressure down elevated stock multiples. This is especially true given that the valuation spread between growth and value stocks is still among the widest in history. Growth stocks, which bested value shares in performance in Q3, after a very extended period of outperformance, may not prove such reliable outperformers if we enter a new stage of higher inflation and interest rates. Assuming such a regime change, we likely would be on the cusp of a more sustained growth-to-value rotation, assuming some modicum of growth.
Of course, tightening monetary conditions could pose a challenge to equity market valuations more generally. Market valuations have become even more elevated on the overabundance of liquidity in the financial system. Stocks, bonds, commodities and home prices all have climbed higher. The rise in prices across major asset classes has occurred even while the expansion in GDP, consumer spending and profit margins appears to have peaked. Over the past 20 years, major asset classes have become much more correlated, as Bank of America has noted, with the median correlation among major asset classes increasing to 47% from just 7% two decades ago. We view the rising correlations as a reflection of liquidity expansion perhaps superseding fundamentals as the driving force behind valuations. Hence, we think that a contraction in liquidity could conversely become a headwind for asset prices. For now, given the fragility of the recovery and the Fed’s shift to average inflation targeting, we expect in the near term relatively accommodative conditions to continue even on rising risks of higher inflation. That said, with the Fed pivoting to less accommodation and, eventually, to tightening conditions, there certainly is increased and rising risk further down the road of a Fed misstep, such that liquidity will dry up too quickly, causing valuations to deflate for most asset classes.
Correlations among major asset classes have jumped over the past 20 years
Median 3-yr correlations between major asset classes as of today vs. 20 years ago
Source: BofA US Equity & Quant Strategy, FactSet
3-yr correlations among major asset classes as of today vs. 20 years ago
Source: FactSet, BofA US Equity & Quant Strategy
Separately, the pandemic has exposed the vulnerability of global supply chains, threatening to stall, or even worse, reverse the long-standing globalization trend that has contributed to strong earnings growth for many years, as noted by a recent Bank of America study of the past 2 decades. Labor and tax arbitrage, along with supply chain efficiencies, have contributed to lower production costs and taxes. Margins for all sectors, except energy, have improved, with technology, materials, and consumer discretionary among the sectors seeing the most meaningful expansion. Yet margins may be approaching a secular peak as the tailwinds from globalization abates and cost pressures from higher wages and input cost inflation increases. A switch to reshoring or near-shoring would likely result in higher labor and other costs, and would require additional capital investments, and these impacts are likely to pressure margins. Furthermore, the incremental demand for labor required could exacerbate the current labor shortage. To the extent that supply remains tight relative to demand, companies may have the ability to increase prices to offset higher cost and protect margins. However, as the business cycle matures and policy rates rise causing demand to soften as supply improves, corporate margins across a variety of sectors are more likely to compress.
Globalization has been a big contributor to S&P 500 net margin expansion since 2004
2021 YTD margin expansion waterfall
Source: BofA US Equity & Quant Strategy, FactSet
Source: FactSet and DoubleLine
Higher taxes are also a key risk that may not be fully reflected in stock prices or earnings. In the latest “human infrastructure” bill, the Democrats are looking to fund a portion of the infrastructure spending with higher taxes from an increase in the corporate tax rate and a reduction in tax loopholes. President Biden’s latest proposal calls for $2 trillion in spending partially offset by a hike in corporate tax rate to 28% from 21% and includes measures to prevent companies to move profits offshore. Higher taxes, if passed, are likely to have a more immediate impact on corporate earnings and would almost certainly cause an adjustment to stock prices.
As noted, the last key market risk to highlight surrounds ongoing monetary policy. The Fed is currently entering a delicate stage of the monetary policy cycle, which could have major ramifications on the direction of the economy and the market, thus warranting investor caution. With inflation still above 2% and employment gradually improving, the path ahead for the Fed seems clearly to be the withdrawal of monetary stimulus. Yet, coordinating the pace of removing liquidity to sync with the timing of a recovery is very challenging, especially given the feedback loop between stimulus and economic growth. We’ve only had one major tapering and quantitative tightening event over the last 50 years, so the Fed has limited experience reversing quantitative easing (“QE”). During that previous tapering, market volatility increased early on, but then the markets trended higher as GDP increased, and it was not until after multiple rate hikes had caused the yield curve to flatten and then invert that monetary conditions became overly tight, adversely impacting the economy and equity market. However, that past experience may not be predictive. As we shift to a period of less accommodation, the markets and economy might be more susceptible to Fed policy errors this time around, given the larger size of the stimulus involved, the higher rates of inflation we are currently experiencing, and the higher valuations prevailing in the market. The only certainty is that the timing and speed of the liquidity withdrawal will have significant implications on the economy as well as the equity market, so the Fed will have to walk a narrow, dangerous path between overheating and stifling a growing economy, either of which could trigger a market pullback.
While recognizing these important market risks, we currently expect further recovery in the U.S. and globally, resulting in higher but manageable inflation and interest rates, which should be favorable for value stocks, which still trade attractively relative to growth stocks on a valuation basis—indeed, the difference in multiples between growth and value stocks is still near historic highs. We believe that this combination of benign reflation and attractive value stock multiples could lead to a more sustained growth-to-value rotation, providing attractive potential upside to value stocks. Separately, as we have noted in the past, we also believe that active management will show its importance in the present investing environment, as salient differences in relative company positioning reemerge and become more important that liquidity or macroeconomic considerations.
We will continue to seek sound, long-term investment ideas and strike reasonable balances within our portfolio among those investment ideas offering safety in uncertain times and those holdings representing compelling long-term value once a broader recovery is underway. Our differentiated fundamental value investment philosophy allows us to capture both of these opportunity scenarios in our ongoing effort to seek out solid relative returns.
In terms of the current portfolio’s positioning, relative to the Russell 1000 Value Index, DBLV is overweight consumer discretionary, consumer staples, financials, materials, and communication services. It is underweight health care, information technology, real estate, and utilities. It is broadly equal weight energy and industrials. These portfolio exposures reflect a healthy exposure to reflationary stocks that will benefit from the continued expansion of the economy and movement of capital into names exposed to that expansion, as well as to more defensive names that can continue to post earnings growth even in the even that further hiccups to full economic reopening and recovery occur in the months ahead. We see such a balanced set of portfolio exposures as the most prudent positioning amidst the elevated set of market risks we have identified.
The portfolio’s sector weights, both in absolute terms and also relative to the benchmark, are found in the following charts:
As of 09.30.2021.
In information technology, we increased and added some exposures to more defensive names in the sector (e.g., Fidelity National Information Services, Microsoft) but still remain underweight relative to the benchmark for the sector, as much of the sector carries above-market valuation multiples that are likely to come under disproportionate pressure in the event of continue interest rate increases. Hence, we continue to seek portfolio exposures in underappreciated technology companies that are more cyclical in nature—and thus more likely to post better returns in a reflationary environment—and which also trade at more modest valuation multiples that shield them relatively to the multiple pressure that could come in a rising rate environment (e.g., Flex Ltd., KBR Inc., and Lam Research Corp.). One should also note that one of our technology holdings, Vontier Corp., really is an industrial company, so we would exclude this name from the sector and highlight that our unofficial weighting in the IT sector is even lighter (relative to the RLV benchmark) than would otherwise appear.
In Q3, we reduced our overweight in financials on concerns of a near-term slowdown in economic growth given the rapid spread of the delta variant, as well as the production headwinds associated with supply chain challenges and a labor shortage that could weigh on the sector. During the quarter, we took some profits in some of our bank holdings (e.g., Fifth Third, PNC Financial, and JPMorgan) while increasing our exposure to property and casualty (P&C) insurance names (e.g. Chubb and Markel), since the P&C market continues to harden (i.e., achieve better pricing), and yet the group has lagged the broader financials sector this year. That said, we remain constructive on the banks and consumer finance companies and remain slightly overweight relative to the benchmark. Although loan growth remains tepid, we expect that many of the supply shortages and bottlenecks that currently are hampering growth will be resolved over time, thus clearing the way for a reacceleration of economic growth and a resumption of more solid loan growth from the banks and consumer credit companies that we own. We also continue to see higher interest rates, which would come with such a reacceleration in economic growth, as a potential benefit to these portfolio holdings. Given that their balance sheets and credit positions remain healthy, and their ability to deploy excess capital toward earnings-enhancing stock repurchases is still growing, these financial names remain core holdings in the portfolio, especially since they continue to trade at a higher discount to the overall market relative to historical averages.
In health care, we are modestly underweight the sector, driven by our underweight in pharmaceuticals and biotech, which continue to face near term headwinds from rising interest rates, likely US legislative pressures on drug pricing, and uncertainties around regulatory decisions by the FDA. We continue to direct our biopharma exposures to companies that have relatively less exposure to these risks, with superior mid- and long-term earnings prospects, given their advantaged development pipelines and benign loss-of-exclusivity patent portfolio profiles (e.g., AstraZeneca, Sanofi, and Biomarin). We maintain an underweight exposure to the life science tools and diagnostics providers given the sub-sector’s lofty valuations and more mixed near-term earnings growth outlook, which is clouded by the prospect of lower COVID-19 testing volumes and vaccine bio-processing revenue. Conversely, we continue to maintain an overweight exposure to the healthcare service providers (e.g., Anthem, Cigna, and CVS Health), which continue to trade at significant discounts to the broader health care sector and overall market. While the health care industry faces increasing regulatory risks under Democratic leadership, we believe that, ultimately, the likely regulatory impact upon the service providers’ business models will be minimal. We continue to maintain a favorable view of and overweight toward physician preference medical device manufacturers that are gaining share from new product launches (e.g., Medtronic and Alcon), as they should benefit from the reversion of procedure volumes to normal pre-pandemic levels globally.
In the consumer discretionary sector, our overweight relative to the benchmark decreased materially as we exited our position in Target. Target is operating as well as it has in years, but the company will likely see fading benefits from COVID-related disruptions that hampered smaller retailing competitors, and the stock had reached trading levels that fully priced in the improved performance of the business, thereby justifying the profit-taking. To wit, from the time of our first purchase on 4/25/2019 to our final sale on 8/27/2021, Target’s stock tripled (and provided an incremental 17% from dividends) while the Russell 1000 Value index offered a total return just under 37%. Partially offsetting this sale were small additions to Advance Auto Parts, as we built up the position size from its initial entry in Q2. Within the sector, we continue to hold high quality, compounding retailers such as Dollar General and TJX Companies, preferring them over lower quality retailers in the face of a currently slowing macroeconomic growth environment, as well as an uncertain cost environment.
Changes to our exposures within consumer staples were minimal during Q3, consisting solely of small trims to Philip Morris, as it displayed relative outperformance. Our consumer staples exposures remain over-indexed to brands that enjoy higher-than-sector-average growth prospects and also superior pricing power (e.g., PepsiCo and Mondelez). We believe these attributes will allow our portfolio companies to better navigate than the broader consumer staples universe the rising inflationary cost pressures we are currently seeing.
We are modestly overweight the industrials sector (n.b., due to our view of the underlying businesses of Vontier Corp., which spun out of an industrial company (Fortive Corp.), we include that name within the industrials sector). We are maintaining cyclical exposures within industrials via the transportation sub-sector (Norfolk Southern), where supply chain friction has temporarily disrupted the recovery but longer-term prospects remain healthy. We also maintain later-cycle exposures via the electrical equipment sub-sector (nVent), where electrification and connectivity should drive improving fundamentals over the long term. We also have later-cycle exposure within commercial aerospace (Raytheon Technologies, Honeywell and Boeing), as well as through downstream oil & gas exposure (Honeywell), and we see these names thriving in an eventual recovery.
In communication services, we are overweight, with a mix of exposures to defensive holdings that can generate cash flow through the cycle and also can obtain pricing fairly reliably given their relative competitive strength and business model quality (Verizon, Comcast), to reasonably-priced growth plays that also can post superior earnings through a down-cycle (Alphabet, Facebook), and to more cyclical names that should benefit from continued improvement in the economy (Discovery Communication).
We are modestly overweight in the materials sector. Our position in Dupont provides cyclical, auto, construction, and semi-conductor exposure. Our position in International Flavors & Fragrances provides modest reopening economic exposure combined with a significant turnaround and cost cutting opportunity. Our Arconic position provides exposure to a recovery in aerospace, as well as exposure to the expected proliferation of electric vehicles, which need 20% more aluminum than traditional vehicles, and to the increasing demand for sustainable, recyclable beverage packaging.
We are equal weight in the energy sector. We have a balanced exposure to the integrated oil and gas segment, and to the independent exploration and production and refining sub industries. We expect energy companies to hold up in value in an inflationary environment. That said, energy prices are also predicated on OPEC+ managing supply and U.S. oil shale companies maintaining capital discipline. As energy prices increase meaningfully above oil breakeven prices for the marginal producer, there is increased risk that energy companies lose their capital discipline and revert back to their old ways. We are underweight real estate stocks, preferring financials names at this stage of the cycle, given our expectation that economic growth will lead to higher interest rates that tend to undermine this bond-proxy sector. Within real estate, our position is relatively balanced with a defensive secular growth position (American Tower) and a cyclical position (BXP Properties).
As always, the DBLV portfolio’s sector exposures primarily reflect the DoubleLine Equities Team’s bottom-up investment process, which places an emphasis on individual stock selection. However, the macroeconomic views of DoubleLine Capital LP do secondarily inform these sector weightings.
As noted, DBLV lagged its benchmark, the Russell 1000 Value index, by 1.5% or 150 basis points in the most recently completed quarter. In terms of the sectoral attribution for the portfolio’s relative Q3 underperformance, quarterly results were helped by consumer discretionary, industrials and information technology, offset by adverse results within consumer staples, energy, financials, health care, materials, real estate and utilities. Cash and communication services holdings had minimal impacts on relative performance.
As of 09.30.2021. Portfolio = DBLV; Russell 1000V = Russell 1000 Value.
The relative underperformance during 3Q was driven by multiple sectors, with financials, health care and materials impacting performance the most. Financials rallied late in the quarter on a spike in rates, outperforming the benchmark for the quarter, but our portfolio holdings within financials were up less than those within the broader index. Our relative performance within financials was adversely effected by company specific news that we view as temporary, and was also impacted by our reduction in the portfolio’s relative overweight in asset-sensitive financials to reflect a more balanced exposure to recovery and reflation. Meanwhile, in health care, although the sector outperformed our overall benchmark, our portfolio names, on average, trailed the sector during Q3 for company specific reasons. Finally, in materials, our sector holdings lagged the benchmark on average due to a more balanced portfolio exposure to economic reopening and reflation, as well as particular exposures to the delayed reopening of certain industries and end markets, such as airlines and autos, and to sensitivities to rising input costs. Importantly, we continue to see long-term value in the individual stock holdings within these three sectors, notwithstanding the lagging performance posted in Q3.
Looking at attribution by individual stocks, the top five positive contributors to third quarter performance were Alphabet (GOOGL), Alcon (ALC), KBR (KBR), Vontier (VNT) and Capital One Financial (COF).
- GOOGL (information technology) is a dominant global supplier of online advertising services and related technology in digital content, cloud services, enabling hardware devices and other products and services. Alphabet stock outperformed for much of the third quarter of this year, along with many of the technology platform giants, on the continued reversal of the reflationary trade; this reversal has coincided with rising concerns about the reopening amidst news of coronavirus variants and breakthrough infections among the vaccinated, providing a boost to demand for defensive large cap technology stocks amidst the rising uncertainty. Given the company’s competitively advantaged business model and cash-rich balance sheet, as well as the incremental opportunities represented by YouTube, Waymo, Google Cloud Platform, et. al., Google should continue to see above-average long-term earnings growth that is not fully priced into the shares’ current valuation. Hence, it remains a core holding at the present time.
- ALC (healthcare) is the largest global eye care manufacturer, with leading market share positions in Surgical and Vision Care products. The stock outperformed during the quarter after posting strong beat and raise Q2 results underpinned by continued product launch driven share gains in both the Implantables and Contact Lens franchises. We believe ALC can continue to grow Revenue +MSD to +HSD and expand operating margins from the high teens today closer to its peers in the mid-to-high 20s, driving top tier mid-teens EBITDA and >20% FCF growth over the next 5 years. Based on peer valuations, the market continues to give management very little credit for margin improvement, and we continue to see significant upside potential in the stock.
- KBR (industrials) provides technology, engineering and professional services solutions across its Government Solutions, Technology Solutions and Energy Solutions divisions. Services include R&D, test, automation and integration, as well as operational, logistics, security and training support. KBR made multiple acquisitions to transition from its highly volatile legacy, energy-focused engineering and consulting (E&C) business to the more stable government and technology consulting services operations, which reduce the lumpiness of its activities and improve its profitability. Given that the transition is largely behind the company, that its remaining exposure to commodity-driven operations is now rather small and largely de-risked, and that its valuation remains unchallenging, we believe KBR stock offers an attractive risk-reward currently. KBR shares outperformed during the third quarter, as the near-term visibility of the companies orders, sales and earnings improved, against a backdrop of solid long-term growth drivers in areas like sustainability, space and cybersecurity. Also helping sentiment around the name was a growing recognition that the budget environment, which drives many company orders, is becoming more predictable and sustainable. KBR trades in-line with many larger peers, despite having superior secular drivers and a less leveraged balance sheet. We currently see it as a core holding.
- VNT (information technology) is a leader in mobility technology such as retail fueling infrastructure, c-store payment systems and auto aftermarket diagnostics and repair solutions. During calendar Q3, the company reported solid Q2 results, but the most important information coming out of earnings was the guidance for 2021 and 2022. The company lowered its EMV (Electronic Mastercard Visa) headwind guidance in 2021 with similar guidance for 2022. Combined with the recent acquisition of DRB Systems which should provide offsetting accretion to declining EMV sales, the implied EPS for 2022 was $3.00. Additionally, it seems the EMV headwinds could be bottoming in 2022. This news combined with an undemanding valuation of 11.3x earnings and 8% free cash flow yield drove the stock’s performance during calendar Q3. Vontier remains one of the most undervalued multi-industry companies trading at a 45% discount to the market. Multi-industry companies with similar free cash flow margins in the high teens trade at a 20% premium to the market. As a result, we see material upside in Vontier and it remains a core holding.
- COF (financials) is a leading credit card and auto finance company. The company has a strong understanding of consumer risks and has been good at underwriting subprime credit by leveraging technology and statistical data. Over the last few years, COF has migrated its portfolio mix towards higher quality credit, by growing its prime credit card business and lowering its exposure to high balanced revolvers. Although its stock faced some headwinds during the quarter on concerns of slowing growth due the spike in Delta Variant cases, COF stock trended higher on strong consumer credit card spending along with the surge in interest rates late in Q3. COF has managed credit exceptionally well during this downturn, resulting in very low incurred credit losses. Although high payment rates continue to be a headwind for loan growth, we expect economic growth along with a normalization of payment rates to translate to loan growth. Meanwhile, COF has substantial excess capital to repurchase shares, which remains attractively valued at 1.2x P/BV.
The top five detractors from quarterly performance were Cigna (CI), Sanofi (SNY), Discovery (DISCA), Intercontinental Exchange (ICE) and State Street (STT).
- CI(healthcare) is an integrated managed care provider and PBM that declined during the quarter after posting a weaker Q2 earnings report in the managed care business from a higher than expected medical loss ratio (MLR), driven by greater than expected COVID-19 treatment costs and a faster acceleration in non-COVID-19 utilization. Meanwhile, the Evernorth (primarily PBM) segment continues to outperform expectations and grew +13% Y/Y. While the higher MLR is an unwelcome development and could disappoint again in Q3, we expect management to re-price these short-tailed insurance products to current medical cost trends, and continue to drive overall annual EPS growth of +10-13% in 2022 and beyond. As CI continues to prove out its integrated model with leading assets in managed care, PBM, and site of care services including Telehealth, we expect the stock to re-rate significantly higher from its current ~9x 2022 P/E valuation.
- SNY (healthcare) is a France based pharmaceutical manufacturer with a variety of therapeutic focus areas including immunology, rare diseases, oncology, and hematology, with leading businesses in vaccines and consumer health. During the quarter, SNY underperformed the Pharmaceutical peer group, as the market continues to wait for stronger signals of an R&D turnaround with the new management team; meanwhile, SNY’s exposure to COVID-19 vaccines, therapeutics, and testing, which drove better performance in certain peers during the quarter, is currently limited as its recombinant protein vaccine is still in Phase 3 trials and will not report results until late-2021. SNY remains one of the cheapest pharmaceutical stocks at ~11-12x 2022 P/E, with the least exposure to branded patent expiries in the industry over the next decade and a valuable embedded call option on its pipeline, which we believe continues to be under-appreciated by the market, but could drive significant stock upside over the next 12-18 months as multiple later stage pipeline datasets read out.
- DISCA (communication services) is an international media company that owns a substantial library of reality television shows, as well as growing news and sports assets in Europe. We initiated the position late in Q1, following the sell-off of the stock driven by forced liquidation of Archegos’ position. During 2Q, the company announced its intention to merge with WarnerMedia, which is being spun out of AT&T, in a deal still to clear regulatory hurdles. The enlarged media company—to be called Warner Bros. Discovery—will be better positioned to compete in direct-to-consumer (DTC) streaming with such larger players as Disney and Netflix, by marrying complementary Discovery assets with the key properties of WarnerMedia, including Warner Brothers, HBO, DC Comics and CNN. The stock again underperformed during Q3, as the announced and still-pending merger has created an overhang on the name. Moreover, the key DTC business appeared to be decelerating somewhat in the last quarterly report, which also has given some investors pause. We continue to take a longer-term viewpoint on the business, which will be larger and more competitively differentiated post the merger, even as it continues to trade at a discount to other leading media companies. We also believe the company should benefit from an upturn in advertising spending as the economy strengthens, and we believe its DTC strategy will continue to gain traction, especially following the planned merger since it greatly increases the content available for online delivery thereby positioning the company well for accelerated aggregate sub growth. In short, we would expect the stock multiple to rerate once certainty around the merger and its lasting synergies are disclosed.
- ICE (financials) operates multiple financial exchanges and securities clearing houses, enjoying strong competitive advantages from network effects and scale economies. It also has a solid fixed income and data subscription business and mortgage technology business. Despite delivering solid operating results across all is business segment in Q2, ICE lagged the sector in Q3 on concerns that slowing mortgage originations would hamper growth in its Mortgage Technology business. Currently, Mortgage Technology revenue is expected to decline about 6% sequentially in Q3. Although this could be headwind in the near-term, ICE is well positioned to grow revenue over time, by capturing share of a growing addressable market from automating the mortgage market and sharing the efficiency gains with network participants. It has a relatively high mix of predictable recurring revenues that continue to grow steadily. The company has a history of leveraging its unique core assets to deliver incremental value and remains a core holding.
- STT (financials) is a leading global trust and custody services provider. The company operates a scalable investment servicing platform that generates durable recurring fee revenue. During the quarter, STT stock initially pulled back on news that it plans to acquire Brown Brothers Harrison’s Investor Services business for $3.5B in cash and suspend its buyback program until 2022Q2. Its shares also came under pressure after rumors resurfaced that STT was in discussion with Invesco about forming a joint venture with its asset management business. We believe the transaction with Brown Brothers makes strategic and financial sense as it enhances scale, extends STT’s international reach and is expected to accretive to value. Post the deal, STT would become the largest global custodian by AUC. For the moment, it is still too early to assess the impact of a potential JV with Invesco. Although some may view an outright sale of the asset management business as somewhat more desirable than a JV as it reduces conflict of interest with clients, we believe a JV could still be value enhancing as it would add substantial scale to the business and improve its cost structure. Meanwhile, STT’s core custody business remains healthy. STT has invested technology to expand the range of data and analytical applications to its clients to drive growth, as well as to improve efficiency and to reduce risks. Also, STT’s earnings should benefit considerably from rise in short-term rates. STT remains an underappreciated asset at 1.25x P/BV and 10.1x FY2022 P/E.
During the most recent quarter, we introduced Chubb (CB), Facebook (FB), Fidelity National Information Services (FIS), Markel (MKL), Microsoft (MSFT), nVent Electric (NVT), and State Street (STT) as new holdings.
We made net additions to our positions in Alphabet (GOOGL), International Flavors (IFF), Cigna (CI), DuPont de Nemours (DD), Advance Auto Parts (AAP), Sanofi (SNY), Flex Ltd (FLEX), Wells Fargo (WFC), BioMarin Pharmaceutical (BMRN), Discovery (DISCA), AstraZeneca (AZN), and Intercontinental Exchange (ICE).
We made net reductions to our positions in Bank of America (BAC), Citizens Financial Group (CFG), Capital One Financial (COF), Raytheon Technologies (RTX), Honeywell International (HON), Philip Morris (PM) and Norfolk Southern (NSC).
We eliminated our holdings in Fifth Third Bancorp (FITB), JPMorgan Chase (JPM), Lam Research (LRCX), Parker-Hannifin (PH), PNC Financial Services Group (PNC) and Target (TGT).
The top 10 portfolio holdings, by weight and active weight, as of month’s end, can be seen in the following tables:
As of 09.30.2021.
Active weight refers to the difference in allocation of an individual security or portfolio segment between a portfolio and its benchmark. For example, if a portfolio allocates 15% within the energy sector, and the benchmark’s allocation in energy is 10%, then the active weight of the energy segment of the portfolio is +5%. Active weight can also be referred to as relative weight.
As we have noted many times previously, the fundamental value strategy informing our management of DBLV is well suited to navigate through the myriad environments of evolving risks and opportunities. Recall that our differentiated strategy facilitates the construction of a portfolio with potentially higher prospective risk-adjusted returns by allowing us to seek compelling investments within low-multiple value names tied to rising expected returns in a cyclical upswing as well as among high-quality, less economically sensitive stocks trading at reasonable prices. To wit, at quarter’s end, this balanced exposure carried a price-to-earnings multiple on 2021 consensus estimates for DBLV of 16.6x, versus the RLV at 17.0x and the S&P 500 at 21.8x.
We maintain that continued caution is warranted on the broad equity market, given that the economic recovery remains vulnerable, and valuations are not only still highly elevated versus historical averages but also in many instances appear to be ahead of underlying fundamentals. Moreover, there is increased risk of rising inflation and interest rates which could become a headwind for valuation multiples. That said, value stocks, particularly cyclicals, tend to be better equipped to maintain or raise margins in an inflationary environment. Meanwhile, the risk-reward for value stocks remain compelling as the earnings prospects for values stock have been improving, yet their valuation discount to growth stocks is still at or near historic highs. We believe that the potential shift in environment towards higher inflation and interest rates, when supported by durable economic recovery and growth, could lead to a more sustained growth-to-value rotation. We continue to observe further opportunities for active equity managers to capitalize on this growth-to-value rotation in U.S. equities.
We thank you for your continued interest in DBLV.
AdvisorShares DoubleLine Value Equity ETF (DBLV) Co-Portfolio Manager
Past Manager Commentary