DBLV: 2nd Quarter 2021 Portfolio Manager Review
There will always be rocks in the road ahead of us. They will be stumbling blocks or stepping stones; it depends on how you use them.
— Friedrich Nietzsche
A bend in the road is not the end of the road… Unless you fail to make the turn.
— Helen Keller
Step with care and great tact, and remember that life’s a great balancing act.
— Dr. Seuss
In the second quarter of 2021, the growth-to-value rotation partially reversed on wavering investor confidence about the economy and its status on the road to a post-pandemic recovery. Such rising uncertainty about the pace and sustainability of economic growth, and with it, prospects for continued progress on corporate earnings, prompted investors to shift portfolio exposures toward idiosyncratic secular growers perceived as safer bets with lower dependence on a post-pandemic rebound. As a result, growth stocks outperformed value shares even as the major indexes achieved new peaks yet again, all buoyed by the continued flood of liquidity into the financial system. During the quarter, the Russell 1000 Value Index returned 5.21% while the Russell 1000 Growth Index gained 11.90% and the S&P 500 Index rose 8.60%. The AdvisorShares DoubleLine Value Equity ETF (DLBV) increased by 6.21% (NAV), outperforming its benchmark, the Russell 1000 Value Index, by 100 basis points.
We always expected the path to a recovery from last year’s crisis would be unconventional and unpredictable, given how unprecedented the pandemic and the world’s response to it both were. The collapse and recovery in the current cycle are very different from both normal downturns and also severe recessions or depressions. The pandemic stopped or hampered much economic activity via lengthy and never-before-seen lockdowns in ways that even the most severe prior crises had failed to do—witness, for example, the unprecedented 90%+ fall-off of air travel. Moreover, the governments’ responses around the world, with coordinated fiscal and monetary stimulus dwarfed anything previously seen. And just as the dynamics of the pandemic are unique versus historical precedent, so are the characteristics of the recovery. As a result, it is difficult to predict with high confidence the puts and takes behind the global reopening, although we continue to endeavor to respond rationally to the changing facts that we are observing.
The market anticipated a strong and rapid recovery and, over the trailing twelve months or so, posted dramatically positive returns on that outlook coming to fruition. However, in the quarter just completed, it appears that market commentators have begun to temper what were perhaps overly optimistic expectations about the pace and extent of that recovery. This had given rise to some concerns that the rate of earnings beats among cyclical companies may already have peaked. Moreover, certain aspects of a “normal” recovery or reflation phase have been hindered by the unique aspects of this crisis. For example, we have witnessed supply chain bottlenecks or misalignment of interests between reopening businesses and a labor force willing to collect paycheck protection dollars rather than return to work. These unique aspects of the reopening have led to a dramatic increase in inflationary pressures that may or may not prove transitory. Finally, the response of the Federal Reserve (Fed) becomes a key question, given the wide disconnect between where policy rates lie and where inflation is boiling over. While Jerome Powell continues to focus on the mandate of full employment, arguing for staying the course with accommodation rather than tapering, concerns surrounding price stability raise the risk of a policy mistake. While we continue to maintain our portfolio positioning for further gains in reflationary names, these unconventional characteristics of an investing environment, moving as it is beyond the pandemic, raise critical market risks worth exploring further.
Inflation has become a major worry of the market. Recently, inflation spiked more than expected, raising concerns that the economy could be running hot. Persistently high inflation could cause the Fed to tighten monetary policy sooner than expected and limit additional fiscal stimulus. In May, the consumer price index (CPI) jumped to 5% year-over-year, above economist expectation of 4.7%. Annualized based on the month-over-month change, CPI was even higher at 8% in May. Core CPI (excluding food and energy) increased 3.8% year-over-year, the fastest rate since 1992. Core PCE (personal consumption expenditures) (excluding food and energy), the Fed’s preferred inflation measure, was also up 3.4% year-over-year. While some of the sharp rise in inflation is attributable to the base effect which reflects the lapsing of depressed economic activity at the start of the pandemic in 2020, the higher than anticipated CPI seems to also reflect general inflationary pressures from strong demand in addition to shortages in supplies and labor. Some investors are increasingly concerned that the economy is starting to overheat and that the Fed may be too slow in heading off high inflation. Even within the Federal Reserve, there is growing concern about higher inflation. According to the latest dot-plot projections in the June FOMC meeting, 11 Fed officials compared to six in March now expect at least two rate hikes in 2023, implying inflation expectations have increased. Also, Federal Reserve Chairman Jerome Powell acknowledged that some inflation pressures were stronger and could persist longer than he had anticipated.
To what degree is this inflation transitory is still up for debate. Our view on inflation remains nuanced, as we see the potential for some sources of pricing pressure to resolve as supply chain bottlenecks or government-driven misaligned incentives are reversed in the months ahead. That said, we recognize that some portions of the price increases will prove sticky and difficult to return to pre-pandemic levels. For example, some of the material input or commodity costs that have skyrocketed, such as lumber, have already substantially reversed in recent weeks. On the other hand, Rents, Owners’ Equivalent Rent (n.b., ROER is a proxy for home owners cost) have been rising, and these increases are unlikely to reverse.
To us, the largest inflation-related risk to corporate earnings is that labor costs will largely prove sticky. Even though the economy remains 6.8 million jobs below pre-pandemic levels, many small business owners have reported difficulty in filling job openings because many workers would prefer to collect government support rather than return to the workforce or because school closures and a lack of available child-care options have prevented such a return. This has undoubtedly slowed the pace of recovery for labor participation rates. In April, non-farm payroll increased by only 266,000 well short of the 1 million addition expected while the unemployment rate rose to 6.1% versus an expectation of 5.8%. In the near-term, the labor shortage not only slows the progress on re-opening but also contributing to inflationary pressures. Many businesses, such was Amazon, Walmart, Chipotle and Under Amour, have already increased wages to attract workers. According to the Bureau of Labor Statistics, average hourly earnings increased by 3.6% year-over-year in June, above its historical average. While it is true that changes in labor mix can have an impact on the averages, distorting real changes in wages, at an industry level, there are ample signs that wages may be increasing at a faster rate than expected. For the leisure and hospitality industry, wages increased 11.2% year-over-year in June after lagging other industries in the prior year.
Some believe that the current labor shortage could be temporary, since the enhanced federal unemployment benefits are scheduled to expire on September 6, including the $300 weekly benefit and the Pandemic Unemployment Assistance (PUA) program, and because most schools and child-care suppliers plan to re-open this coming fall. Perhaps guided by this belief in temporary wage pressures, some businesses are trying to limit or avert instituting more permanent labor cost increases, preferring instead to offer special bonuses or other perks as incentives. However, even if the supply of labor improves later in the year, we would expect wages to normalize at higher rates even if ongoing labor cost pressures begin to moderate. The reason for this is the observation that wages have proven sticky in past cycles during much of the middle of the 20th century. Because those wage hikes and other incentives will likely prove sticky, we would expect wage-related inflation levels to run higher than what we have observed in the many years preceding the pandemic.
In short, we would expect broad inflation indicators to decline from the current, highly elevated levels as the base effect diminishes, demand normalizes and many of the shortages and bottlenecks are resolved. However, we expect inflation to settle out above pre-pandemic levels as we expect some of the inflation, particularly surrounding rents and labor, to prove sticky. So as the economic recovery progresses, we expect inflation to continue to rise to a new normalized level above the 2.2% rate of increase seen in 2019. This viewpoint would appear differentiated from both the bond market, which seems to believe that the bulk of the recent inflation is transitory—the implied breakeven inflation rate based on 5 year Treasury Inflation-Protected securities (TIPs) have moderated after peaking in May, ending the quarter below the current inflation rate at 2.47%—and the Fed, whose Chairman maintains the view that the current inflation is mostly transitory. Importantly, modest or moderate inflation has been favorable for equities generally and value stocks in particular as a historical matter, as it has generally signaled the economy was growing and healthy.
As noted, risk of a misstep by the Federal Reserve is another key concern for market participants, and while we continue to monitor statements from the U.S. central bank for clues on the timing of tapering plans, we do not expect a premature shift toward monetary tightening. Recall that the Fed has supplied an unprecedented amount of stimulus to support the economy during the pandemic. Through its quantitative easing program, assets at the Fed have doubled to $8 trillion since February 2020, allowing the central bank to inject trillions of dollars into the system. For the moment, the Fed remains committed to purchasing $120 billion per month of Treasuries and mortgage-back securities, expanding further its balance sheet. Concurrently, the fed funds rate has been reduced to near-zero, facilitating material credit expansion. In addition, the government (via Congress) has spent trillions through its fiscal stimulus programs. Reversing quantitative easing, increasing the fed funds rate or implementing tight fiscal policies—such as increasing taxes or cutting government spending—would reduce liquidity, potentially undermining economic growth and thus creating headwinds for the equity market.
Despite market jitters about potential rate hikes, Fed officials do not expect to raise rates until late 2022 at the earliest. Furthermore, the Fed has made a significant change to its policy in this cycle, noting that “substantial further progress” towards maximum employment and stable inflation that averages 2% over time needs to occur before the withdrawal of monetary accommodations. Of course, it plans to provide notice well in advance of taking any policy actions. We think this shift in monetary policy to an average inflation target could prolong economic growth, along with the reflation trade as the policy shift increases the odds that Fed will allow monetary conditions to remain accommodative for longer. Additionally, in the prior three rate hiking cycles, rising short-term interest rates due to the Fed may have caused a temporary pullback in the market, but did not spark an extended downturn in the market initially. Rather, the market trended higher and did not begin to falter until further rate hikes eventually caused the yield curve to invert. That said, we are in uncharted territory as it relates to record quantitative easing, fiscal stimulus and government debt levels so the economy today could be more sensitive to any reduction in fiscal or monetary accommodations.
Meanwhile, additional fiscal stimulus could provide a further boost in the near term to economic growth. Currently, a new stimulus program focused on “hard” infrastructure projects, such as highways, bridges, ports and broadband investments, appears to be gaining traction in Congress. The total program could be over $1 trillion while corporate or individual tax hikes are not expected to be part of the bill. Moreover, a portion of the recently passed $1.9 trillion stimulus is likely still flowing through to the economy. Personal savings remain high implying not all the money received from the stimulus payments have been spent so there are some potential for pent-up demand among consumers to translate into more spending activity. Finally, a large, incremental stimulus program focused on “human” infrastructure is also being considered, although we see that initiative as less likely to make its way through Congress even remotely at the currently proposed size of $3.5 trillion due to the inability of Democrats to win enough votes to support the requisite tax hikes to support such a large initiative. In other words, we do not see the Fed or Congress running the risk of undermining economic growth by prematurely removing either monetary or fiscal support in the near or medium term.
It is worth noting that the economy continues to recover, even as we observe some rather unique bumps in the road this time around. With most states fully re-opened now thanks to the durability of the vaccine in keeping individuals out of the hospital, and with fiscal and monetary support still in place, economic growth should continue to sustain as the labor and supply chain issues are resolved. Consumer spending has been on the rise with spending on services, in particular, rebounding robustly. Although it may take some time for business activities to fully return to normal levels, businesses expect to increase capital investments again, and this is a positive indicator of future growth. In sum, while there are continuing risks that the economy eventually overheats on supply-chain disruptions or labor shortages, we believe the recovery will remain intact and actually still has some ways to go.
Source: FactSet, DoubleLine; Capital Expenditures (Capex) Year-over-Year Growth
While some market participants have expressed concerns over peak earnings growth and positive earnings surprises, we expect cyclical value companies to continue posting superior growth amidst the ongoing recovery, thereby supporting a return of the reflation trade. In Q2 2021, earnings for cyclical sectors saw the greatest upward revisions, reflecting a rebound in the economy from state re-openings broadening as a growing proportion of the population got vaccinated. Within the S&P 500, upward earnings revision was strongest for cyclical sectors with Energy, Materials and Financials seeing the greatest positive revisions. On average, the bottom-up Q2 earnings per share (EPS) estimates for Energy, Materials and Financials were revised up by 36.6%, 16.8%, and 9.3% from March 21 to June 30, respectively. This compares to an average upward revision of 7.3% for the S&P 500. Full year 2021 EPS estimates for Energy, Materials and Financials, were also revised up by 32.2%, 19.2% and 16.2%, respectively. The improved earnings outlook coincided with stronger expectations for economic growth. During the quarter, Q2 real GDP year-over-year growth expectation increased to 13.1% by the end of Q2 from 11.7% at the start of the quarter. For calendar year 2021, the estimated real GDP growth rate increased to 6.5% from 5.8% on March 31. Value stocks could see further upward revision as the economy strengthens further.
Importantly, value stocks continue to trade at a historically large discount to growth stocks. The valuation differential between growth and value stocks widened further this quarter and remain near or at historic highs across a broad set of valuation metrics. On 2021 price-to-earnings multiples, the valuation spread between the Russell 1000 Value and the Russell 1000 Growth indexes increased due to relative earnings revisions as well as price performance. Despite rising stock prices, the Russell 1000 Value 2021 price-to-earnings multiple declined in Q2 as increases in earnings revisions exceeded stock price appreciations. In contrast, the Russell 1000 Growth 2021 price-to-earnings expanded even as earnings were revised higher. As discussed in our recently-published white paper (i.e., “Value Investing is Dead? No, Long Live Value!”), the valuation spread does not appear to be fundamentally driven. Based on our analysis, the wide valuation disparity is not likely to be attributable to a select group of companies that have developed sustainable superior business models or adverse divergences in profitability or return on assets of value stocks relative to growth stocks. Therefore, we would expect this disparity to converge towards historical norms over time. We continue to see value stock as offering an attractive valuation with improving growth prospects while also paying a higher dividend yield than the broad market.
Source: Factset, DoubleLine
P/B = price to book value ratio
Source: Factset, DoubleLine.
R1000 Growth = Russell 1000 Growth Index
With markets reaching all-time highs, fueled by strong equity flows, overall valuations have increased even further from already-elevated levels, and the S&P 500 now stands well above historical averages, as shown in the table below. This creates a challenge for further multiple expansion for the broad market indexes.
Source: Factset, DoubleLine. Note: Valuations are from 1/31/1996 to 6/30/2021.
P/E LTM = price to earnings ratio for the previous 12 months
That said, we believe the relative value of value stocks means that we could see a renewed rotation into value stocks from those growth stocks with challenging valuation multiples. Indeed, value stocks currently carry earnings multiples that are considerably lower than those of growth shares. Moreover, we believe value shares could offer superior earnings growth with the potential for positive surprise over the next two to three years, meaning that value stocks would appear to be the new growth names.
Source: Factset, DoubleLine.
R1000 Value = Russell 1000 Value Index
Of course, this sanguine view on value stocks presupposes that economic growth can be sustained. If the bear case (which we view as less-likely) emerges, and it turns out that growth abates, then value stocks may lag, given that many value stocks are more sensitive to the economy. Moreover, because value shares typically carry higher betas, they tend to decline more than the broad market during a market correction, reflecting investor fears that a fall in their profits will more than offset the benefit of their lower valuation multiples. While value stocks continue to trade at much larger-than-normal discounts to the lofty-multiple growth stocks, it is true that the valuation multiples of value stocks have also increased over time and are currently above their long-term historical averages. So while we continue to see relative value in value stocks, we would not expect such names to emerge unscathed in the event of a reversal in the recovery, whether such a setback is prompted by a dangerous coronavirus variant, a misstep by the Fed, a sudden loss of confidence in the U.S. dollar or some other unanticipated exogenous shock to the system.
One longer-term risk over which we are particularly concerned is the potential for some unintended consequences associated with the record stimulus and corresponding, sharp rise in government debt. Government spending will continue to outpace revenues again in 2021, and the Congressional Budget Office (CBO) estimates that the budget deficit will be about $2.3 trillion in 2021 even before accounting for the spending associated with the $1.9 trillion stimulus passed in March 2021. Meanwhile, Congress is discussing additional stimulus that together could exceed another $3 trillion. Consequently, federal debt held by the public is projected to reach $22.5 trillion, or 102% of GDP, at the end of 2021, up from $16.8 trillion, or 79.2% of GDP, at the end of 2019. Although we have not experienced any meaningful repercussions from this rapid rise in government debt that is funding the huge deficit spending, we worry that the impact will occur sometime in the future, following a loss of confidence in the U.S. dollar and our country’s monetary system.
That said, we think the apparent market concerns over the economic reopening and recovery are likely overdone, and so we would expect the reflation trade—which should benefit value stocks—will resume going forward. Given the stark difference in valuation multiples between growth and value stocks, we believe that a rotation to value stocks from growth stocks will be rewarded given the better earnings prospects and superior valuation setup for value names. 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 emerge and become increasingly important.
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, industrials, materials, and communication services. It is underweight health care, information technology, real estate, and utilities. It is broadly equal weight energy.
The portfolio’s sector weights, both in absolute terms and also relative to the benchmark, are found in the following charts:
As of 06.30.2021.
In information technology, we remain underweight the sector as we wait for more attractive entry points, especially among the technology disruptors which continue to benefit from the acceleration in digital transformation adoption. These companies can sustain idiosyncratic growth via value-creating innovation, and automating and reducing costs, increasing their attractiveness when there is economic uncertainty. For the moment, we continue to maintain exposures in underappreciated technology companies that are more cyclical in nature and which trade at more modest valuation multiples (e.g., KBR Inc., Lam Research Corp.). Moreover, we view Vontier Corp. as an industrial company, making our unofficial weighting in the IT sector even lighter relative to the RLV benchmark excluding this name.
In Q2, we reduce our financials weight after the sector’s strong year-to-date performance and given the potential of a temporary economic slowdown due to materials shortages and supply chain constraints that could cause loan growth to be delayed. During the quarter, we took some profit in JPMorgan Chase given expectations of less relative upside than our other bank holdings, potential near-term risks for the group, and possible capital return limitations due to its supplementary leverage ratio approaching the maximum regulatory level allowed. That said, we continue to remain overweight financials, and banks in particular, as we are still constructive about the long-term prospects of the sector. Bank earnings were strong in Q1 while earnings for Q2 have been revised up significantly, mostly reflecting favorable credit trends. Given relatively low actual incurred credit losses, many banks are reversing reserves for credit losses. In the near-term, though, loan growth remains tepid and interest rates have partially pulled back on concerns that growth may slow. We believe many of the supply shortages and bottlenecks hampering growth will be resolved, clearing the way for economic growth to resume. With most states fully re-opened now, consumer spending is ramping and companies are expecting to increase capital investments. We expect loan growth to improve and interest rates to rise as the economy strengthens. Meanwhile, financials still trade at a higher discount to the overall market relative to history. Yet, banks have emerged from the current downturn with solid balance sheets and substantial excess capital. Many banks have announce dividend increases starting in Q3 when the Fed’s restrictions are lifted. Also, we expect banks to ramp buybacks going forward.
In health care, we are now moderately underweight the sector after the recent benchmark rebalance that added significant weight to the sector. We continue to have overweight exposure to the healthcare service providers (e.g., Anthem, Cigna, and CVS Health), which continue to trade at significant discounts to the 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. In contrast, we believe there is relatively more regulatory risk to Biopharmaceutical companies, with bipartisan efforts to lower drug prices. As such, we continue to be underweight this part of the sector, with our pharmaceutical holdings in companies with relatively less US exposure, while having superior mid- and long-term earnings prospects, given their advantaged development pipelines and benign loss-of-exclusivity patent portfolio profiles (e.g., Sanofi and AstraZeneca). Additionally, we initiated a position in Biomarin, a rare disease Biotech with a promising pipeline and leading gene therapy technology platform. We continue to have a favorable view of physician preference Medical Device manufacturers (e.g., Medtronic and Alcon), which should benefit as procedure volumes continue to return to normal pre-pandemic levels globally with the continued COVID-19 vaccine rollout and maintain an overweight to the sub-sector. We maintain an underweight exposure to the Life Science Tools and Diagnostics providers given the sub-sector’s lofty valuations and a more mixed near term earnings growth outlook with lower COVID-19 testing volumes.
In the consumer discretionary sector, our overweight increased as we established a new position in Advance Auto Part, while the benchmark sector weight declined from the recent rebalancing. Advance Auto Parts is a top tier automotive aftermarket parts retailer that should benefit from increase mobility as the economy recovers. We also retain healthy exposure to retailers with a proven ability to compound value throughout the full economic cycle, like Dollar General, Target and TJX Companies, leaving aside some of the riskier, short term beneficiaries of the earliest stages of the cycle.
Meanwhile, we reduced our exposure to more defensive names in consumer staples by exiting our Reynolds Consumer Products position and decreasing our weight in Pepsi. We remain slightly overweight consumer staples as we continue to hold companies such as Mondelez and Phillip Morris with brand strength and the ability to increase prices in the event inflationary pressures build up.
We are modestly overweight the industrials sector according to GICS. We are maintaining cyclical exposure with lower multiple names in Transportation (Norfolk Southern), Machinery (Parker Hannifin) and Commercial Aerospace (Raytheon Technologies, Honeywell and Boeing) as well as downstream Oil & Gas exposure (Honeywell) as we see such names thriving in an eventual recovery. Due to our view of the underlying businesses of Vontier Corp., which spun out of an industrial company (Fortive Corp.), we view our positioning in the industrials sector as modestly overweight.
In communication services, we are modestly overweight, as we continued to add to our Discovery Communication position. We initiated the position late in Q1, following the sell-off of the stock driven by forced liquidation of Archegos’ position. Discovery should benefit from an upturn in advertising spending as the economy strengthens. Its direct-to-consumer strategy appears to be gaining traction, positioning it for better aggregate sub growth.
We are modestly overweight in the materials sector. Our position in Dupont provides cyclical, infrastructure and semi-conductor exposure. Our position in International Flavors & Fragrances provides modest reopening economic exposure combined with a significant turnaround opportunity. Our Arconic position provides exposure to a recovery in automobile, aerospace and beverage can manufacturing. It also provides exposure to the growth in Electric Vehicles, which need 20% more aluminum than traditional vehicles and sustainability in packaging.
We are equal weight in the energy sector. We are underweight real estate, preferring financials at this stage of the cycle given our expectation that economic growth will lead to higher interest rates. Within real estate, our position is relatively balanced with a defensive secular growth position (American Tower) and a cyclical position (BXP Properties).
Finally, with markets hitting new highs, we took profits on some of our investments, adding to our cash holdings. At the moment, we are evaluating several opportunities and waiting for better entry points to redeploy the cash. We expect the further re-openings to provide a tailwind to the economy and the growth-to-value rotation to resume when investor confidence regarding the economy improves.
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.
In terms of the portfolio’s attribution by sector, quarterly performance for DBLV was driven by consumer discretionary, consumer staples, energy, financials, health care, industrials, information technology, materials, real estate and utilities, offset by adverse results in communication services. On a relative basis, DBLV was helped by consumer discretionary, consumer staples, financials, health care, information technology, materials, real estate and utilities, offset by adverse results within communication services, energy and industrials. Cash had a negative impact on relative performance in a rising market.
As of 06.30.2021.
The top five positive contributors to second quarter performance were Capital One Financial (COF), Arconic (ARNC), Target (TGT), AstraZeneca (AZN), and Alphabet (GOOGL).
- 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. During Q2, COF stock continued to trend higher after a big Q1 beat. COF has managed credit exceptionally well during this downturn, resulting in very low incurred credit losses. Although loan balances have yet to grow due to high payment rates, credit card spending has rebounded significantly with the economy re-opening. We expect further economic growth to lead to loan growth as payment rates normalize. Meanwhile, COF is in a very strong capital position with substantial excess capital. We expect COF to ramp share repurchases starting in Q3 when the Fed capital return restriction is lifted.
- ARNC (materials) outperformed in Q2 primarily on the results and announcements of Q1 2021. Q1 results were better than expected and guidance was revised higher for 2021 on strength in ground transportation, industrial and packaging end markets. The company announced a $300 million buy back over a two-year period. With aggressive moves to offload pension obligations and pension reform that was part of a stimulus bill, the company materially lowered its unfunded pension obligation. Arconic also announced contract wins of $2 billion in aerospace and a packaging contract with attractive margins that will utilize latent capacity. The position size peaked in early May to 1.6% of the fund. Since the positive announcements we have harvested gains by trimming the position to 1.16%.
- TGT (consumer discretionary) is one of the largest brick-and-mortar, general merchandise retailers in the United States. The stock returned 22.5% in Q2, driven by a strong earnings result that led to a confident increase in full year earnings guidance. As wallet share among consumers has started to shift away from grocery and household essentials back toward apparel and more discretionary categories, Target is seeing a greater than anticipated benefit to margins thanks to its strength in apparel and its stable of high quality, owned brands. The company has done an outstanding job of acquiring and delighting customers throughout the pandemic with one of the best drive-up fulfillment executions in the industry. As consumers increasingly shop more for social occasions and the upcoming back-to-school season, Target should continue to see margin accretive share gains.
- AZN (health care) is a UK-based pharmaceutical manufacturer with leading franchises in oncology, cardio-metabolic, respiratory, and immunology. The stock outperformed during the quarter after posting strong Q1 results, in contrast to many of its Pharma peers. AZN’s key oncology drug launches continue to perform well, with recent clinical and regulatory successes for additional indications and geographic expansion supporting continued strength. Additionally, we believe the market’s greater appreciation for the financial merits of the pending Alexion acquisition contributed to the stock’s outperformance. We continue to expect AZN to post the best revenue and earnings growth in the space over the next five years, which we do not believe is fully reflected in the current valuation.
- 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 in the second quarter of this year, along with many of the technology platform giants, on a reversal of the reflationary trade occurring over the last two months; this reversal has coincided with rising concerns about the reopening amidst news of coronavirus variants and breakthrough infections among the vaccinated, and during a period in which the yield curve has begun flattening—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.
The top five detractors from quarterly performance were Discovery (DISCA), Fifth Third Bancorp (FITB), Cigna (CI), Chevron (CVX), and Verizon Communications (VZ).
- DISCA (communication services) is the legacy media company that owns a substantial library of reality television shows, as well as growing news and sports assets in Europe. During the second quarter, 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 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 underperformed during the quarter, as legacy DISCA investors likely were disappointed that the recent period of investment that had depressed earnings would yield higher returns next year, since the merger is likely to delay those returns still further into the future, given the need to integrate the companies and further invest in the DTC streaming opportunity. We continue to take a longer-term viewpoint on the business, which is now more competitive than it was when the name was added to the portfolio following the large price correction occurring in the aftermath of the Archegos unravelling, even as it continues to trade at a discount to other leading media companies.
- FITB (financials) is well-managed regional bank with a solid competitive position in the Midwest. The company has a strong commercial and industrial loan business, driven by its long-term relationship with companies. It maintains a healthy loan book with primary exposures to commercial and industrial loans, residential mortgages, auto loans and commercial real estate mortgages. Also, the company has prudently managed costs, initiating a new cost reduction program late in 2020. Despite reporting solid Q1 results, FITB stock, along with other regional banks, underperformed in Q2, as a decline in interest rates sparked by concerns about a slowdown in economic growth caused the reflation trade to partially reverse. We believe any slowdown in growth from material and labor shortages as well as supply chain bottlenecks will likely be temporary, especially as most states are fully re-opened now. We expect FITB’s loan growth to improve, interest rates to move higher and the reflation trade to resume when economy growth picks up again. Meanwhile, its credit trend remains favorable and capital returns are expected to increase. We see further upside to FITB’s earnings and stock price.
- CI (health care) is an integrated managed care provider and PBM that marginally declined during the quarter after significant outperformance in the prior quarter. CI posted a strong beat and raise Q1 with positive incremental commentary on 2022 prospects. As such, we believe the stock’s underperformance during the quarter was primarily a result of some mean reversion in value names across the sector as well as some concerns of the potential impact of rising utilization in the 2H21 with the post-pandemic re-opening and surprise FDA approval of an Alzheimer’s drug in June. However, we do not expect either of these two dynamics to have a material negative impact on CI’s financial results. We continue to believe as CI continues to prove out its integrated model with leading assets in managed care and PBM, we expect the stock to re-rate significantly higher from its current valuation (i.e., a 2022 price-to-earnings multiple of about 10x).
- CVX (energy) is an integrated oil company with an attractive global asset base, a strong position in the Permian Basin and a solid downstream business. The company has a vast inventory of high quality/low cost resources, enabling it to generate top tier cash margins. It also has one of the healthiest balance sheet in the industry. During the quarter, pure play E&P companies and levered energy companies rallied significantly on the backs of higher oil and natural gas prices, while CVX lagged the group given its diverse business mix, low financial leverage, strong relative performance through the pandemic. CVX is a solid efficient operator who continues to demonstrate good capital discipline. We expect its earnings and cash flow, along with capital returns to increase with the higher commodity prices.
- VZ (communication services) is a leading communications provider to consumers, businesses and governments, supplying wireless, broadband and video connections, as well as related solutions, to hundreds of thousands of businesses and public entities. Verizon is expected to benefit from the launch and rollout of 5G wireless services. VZ stock underperformed last quarter as the safe-haven stock lagged the broader index in the second quarter, as investors moved into more growth-oriented areas. Given the importance of wireline and broadband connectivity, Verizon retains utility-like qualities and yet also sports a multiple that is lower than regulated utility companies. We continue to own the stock as a defensive name expected to better weather risk-off market environments.
During the most recent quarter, we introduced Advance Auto Parts (AAP), Arconic (ARNC), and BioMarin Pharmaceutical (BMRN) as new holdings.
We made net additions to our positions in Cigna (CI), Anthem (ANTM), Medtronic (MDT), Alcon (ALC), Boeing (BA), AstraZeneca (AZN), Sanofi (SNY) and Discovery (DISCA).
We made net reductions to our positions in JPMorgan Chase (JPM), International Flavors & Fragrances (IFF), Raytheon Technologies (RTX) and PepsiCo (PEP).
We eliminated our holdings in Ameren (AEE), IHS Markit (INFO), Reynolds Consumer Products (REYN) and Roche Holding (RHHBY).
The top 10 portfolio holdings, by weight and active weight, as of month’s end, can be seen in the following tables:
As of 06.30.2021.
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, we believe that 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. We think the current environment presents a growing opportunity to capitalize on a sustained outperformance of cyclical and value stocks over their growth counterparts.
Continued caution is warranted on the broad equity market in general, 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. However, we do continue to observe clear opportunities for active equity managers who can selectively capitalize on a continuing growth-to-value rotation in U.S. equities, driven by a strengthening economic recovery and an improving earnings outlook for value names. We see this value rotation equally supported by the historically large value spread that creates opportunities to find relatively cheaper investments amongst value stocks. To wit, at quarter’s end, this balanced exposure carried a price-to-earnings multiple on 2021 consensus estimates for DBLV of 16.1x, versus the RLV at 18.2x and the S&P 500 at 22.9x. Because value stocks appear to be the new growth stocks for at least the next year or two, and given their lower valuation multiples, we continue to maintain our exposures within the DBLV portfolio toward more cyclical and value stocks in order to capitalize upon these opportunities.
We thank you for your continued interest in DBLV.
AdvisorShares DoubleLine Value Equity ETF (DBLV) Co-Portfolio Manager
Past Manager Commentary