DBLV: 1st Quarter 2022 Portfolio Review
“Economic medicine that was previously meted out by the cupful has more recently been dispensed by the barrel. These once unthinkable dosages will almost certainly bring on unwelcome after-effects. Their precise nature is anyone’s guess, though one likely consequence is an onslaught of inflation.”
– Warren Buffett
“I do not think it is an exaggeration to say history is largely a history of inflation, usually inflations engineered by governments for the gain of governments.”
– Friedrich August von Hayek
“The first panacea for a mismanaged nation is inflation of the currency; the second is war. Both bring a temporary prosperity; both bring a permanent ruin. But both are the refuge of political and economic opportunists.
– Ernest Hemingway
The U.S. equity market started 2022 rather poorly, recording its first down quarter after seven consecutive quarters of positive performance. Overall, the S&P 500 Index was down 4.6% during the period, while the Russell 1000 Value Index fell 0.7%, but greatly outperformed its growth counterpart, which was down 9.0%. Against this backdrop, the AdvisorShares DoubleLine Value Equity ETF (DBLV) returned -0.6% and outperformed its benchmark, the Russell 1000 Value, by 0.1%.
The relative outperformance of the Russell 1000 Value Index in the most recent quarter aligns with our past commentaries, which noted the higher growth prospects and lower valuation multiples of value names, and which cautioned of the risks of holding richer-multiple growth names in the face of rising rates. We see this dynamic continuing even now, as we progress farther through the economic and business cycles, and our preference remains on later-cycle names balanced against those defensive stocks that can better weather the rising risks we see emerging on the horizon.
Indeed, economic data points became still more mixed during the first quarter, with continued indications of economic strength and sustained post-pandemic recovery increasingly offset by worrying signs of rapidly rising inflation. The CPI print (given on March 10) of 7.9% continued a problematic trend of rising prices seen since the start of the year. Import and export price hikes for February (reported in mid-March) were still higher, at 10.9% and 16.6%, respectively, perhaps indicating where the true rate of cost increases lie before hedonic adjustments. Meanwhile, the 5-year breakeven inflation rate, which reflects forward expectations over a longer time horizon, has moved up to 3.3% at the end of the first quarter from 2.9% at the end of last year, suggesting that long-run inflation expectations have perhaps shifted permanently higher.
One key development during the quarter was the broadening of inflationary pressures. It appears that Covid-related supply chain challenges (e.g., the chip shortages), which are obviously transitory in nature, are no longer the only driver of rising inflation. The aggressive increases in money supply from the fiscal stimulus amidst the pandemic lockdowns are now (belatedly) finding their way into the real economy as money velocity recovers. Meanwhile, labor scarcity and accelerating nominal wage growth are threatening a potential wage-price spiral. Moreover, surging real estate values are now translating into higher rental costs that will only add to the need for higher labor compensation. Energy prices, which have been rising for about a year now, reflect still another tax on consumers, either directly via gas prices or indirectly through food and other energy-intensive products. Critically, the outbreak of war in Ukraine only exacerbates inflationary pressures given the interruptions to key, meaningful supplies of commodities (e.g., energy, fertilizer, agricultural products, strategic metals and industrial gases, et. al.) from both Russia and Ukraine. Finally, China has recently locked down its most important trading city, Shanghai, and more recently declared that lockdown indefinite, thereby exacerbating the supply of key inputs and finished goods. All of these inflationary pressures—supply chain, monetary, structural and geostrategic—are raising the risk that growth might burn itself out amidst an economy running too hot.
All eyes are on the consumer, whose health remains strong on conventional measures, but whose future activity could be far weaker amidst the advent of 40-year high inflation. U.S. employment growth remains solid, with the March report showing job gains totaling 431,000—the 11th consecutive month of employment gains exceeding 400,000. Meanwhile, wages continue to rise in nominal terms, as average hourly earnings on nonfarm payrolls increased 5.6% year-over-year. Finally, American consumers still appear to have healthy private balance sheets, as about $2.5 trillion in excess savings were accumulated since the start of the pandemic, largely due to stimulus support from the federal government. Of course, wage gains exceeding 5% are still not keeping up with inflation, so real wages actually are falling and thus supportive of less consumption than a year ago. Perhaps reflecting this, consumer spending slowed during the quarter, as February spending rose a scant 0.2% on a seasonally adjusted basis, versus the revised 2.7% growth seen in January—prompting many economists to project a negative print for March. Meanwhile, measures of consumer confidence have continued to lose momentum since recovering from pandemic troughs, although these tend to be backward-looking; specifically, the most recent readings in March were down month-over-month both the Conference Board and University of Michigan surveys, with the latter showing particular weakness. Finally, with Biden’s signature Build Back Better bill apparently stalled by Senators Joe Manchin and Kirsten Sinema, another $1.7 trillion in stimulus is still delayed, and with it, any hopes for further governmental support for consumer spending.
Beyond inflation, the other key risk undoubtedly remains the actions from the Federal Reserve to contain it. Unsurprisingly, the Fed became much more vocal in its hawkishness during the first quarter, and initiated a new rate-hiking cycle by lifting off the zero bound. No longer viewing inflation as transitory, the Fed has signaled the possibility for one or more 50 basis point rates, while the bond market is projecting a greater than 50% probability of at least ten quarter-point rate hikes by the end of this year. Time will tell if the Fed will be able to sustain such a rate lift-off, given the recent, high dependency of global economic growth on loose fiscal and monetary conditions, the high levels of public debt and continued deficit spending requiring low rates, and historically high asset valuations that appear vulnerable to corrections on such an aggressive rate-hiking cycle. In addition, and perhaps more importantly, the Fed is also guiding to a faster-than-expected reduction in the size of its balance sheet, which is the quantitative tightening (QT) efforts to undo prior quantitative easing (QE) policies employed in record amounts during the pandemic lockdowns; such tightening implies additional constricting of financial conditions beyond the rate hikes. This profoundly more hawkish stance of the Fed will raise concerns about an adverse hit to the economy, putting it on the clock for an eventual recession if history is any guide. Importantly, Fed actions also raise key risks for the equity market in terms of slowing growth, further valuation multiple pressure and less supportive liquidity. The last piece is an important consideration: because the creation of enormous liquidity via QE was highly correlated with the tremendous stock market returns seen over the last two years, and really over the last twelve years (see nearby chart), the reversal of such excess liquidity should be properly viewed with great wariness by all equity investors.
Now, history shows that stocks typically rise after the initial liftoff in rates and a brief bout of elevated equity volatility, especially in the minority of cases in which a rate-hiking cycle does not cause a recession (i.e., 3 of the last 11 cases in the post-WWII period). In fact, equities have posted double-digit returns on average in the 12 months following the initial rate lift-off. Moreover, given that real yields are still negative, incentives to hold equities remain compelling. However, most of the historical record involves interest rate liftoffs that occur before inflation has reached such heady levels, and also that usually were launched with stock valuation levels sitting lower than where they currently are. And while negative real yields might incent investors into risky assets, they are likely to eschew those same assets if stock prices begin to fall, to avoid the insult of capital losses on top of the injury of inflationary erosion. Critically, the risks of a Fed policy error leading to a market correction and/or a recession have likely increased, given that the Fed appears behind the curve, stock valuations are at elevated levels and the dependence of the economy on deficit spending and debt for growth remains high. As noted in previous letters, we see the high valuations of many stocks as particularly vulnerable to downward rerating amidst interest rate normalization and quantitative tightening, and our view has not changed as those rate hikes are now upon us. What is new, however, is the growing concerns over growth of the economy and of corporate profits and cash flow, and this would seem to imply a greater need for quality and resilience in one’s equity portfolio.
Looking at the prospects for corporate earnings just ahead of the release of quarterly reports, the picture at first glance appears healthy both in terms of growth and reasonableness of analyst expectations. Wall Street consensus projections for S&P 500 company profit margins, at 12.1%, reflects the third sequential decline from the 13.1% peak in the second quarter of 2021; however, such profitability would remain above the 11.2% 5-year average level, implying quite healthy margins despite many sources of input cost inflation. Similarly, the assumed earnings growth of 4.5% over the prior year, incorporating as it does tougher year-over-year comparisons and one-off impacts in certain sectors (i.e., mostly the Financials sector) reflects both a normalization of growth rates and a reasonable level versus the 5-year median level. The assumption held by Wall Street analysts appears to be that U.S. companies retain pricing power, and the current level of inflation has been well managed in the quarter just completed. The critical determination, of course, lies in the forward guidance, particularly since the sales and earnings estimates for the second half of 2022 have actually increased over the course of 1Q22 even as the inflationary pressures and threats to growth have appeared to rise. This would imply that investors have not incorporated into their expectations as of yet, but actually have so far further discounted, the growth and profitability risks for companies in a high inflation environment. Given what we see as a disconnect between those consensus expectations and inflationary risks, we believe that the upcoming earnings season—especially the forward-looking commentary of management teams—will be particularly important for determining the true rate of revenue growth, margin development and earnings and cash flow relative to those still-sanguine Street expectations.
Notwithstanding the cloudier backdrop confronting investors at the end of the first quarter, we believe investment managers (and their clients) are best positioned to create lasting value by seizing upon opportunities created by that short-term volatility, while keeping their focus primarily on the long-term fundamentals of each portfolio name. As the investing environment becomes choppier, we continue to believe that active investment management will increasingly shine, particularly if the rising uncertainties lead to greater dispersion in the valuations and price performances of individual stocks within broader sectors, styles or factors.
In terms of positioning, we continue to favor value over growth. Historically, value stocks have tended to outperform in periods of economic expansion and manageable levels of inflation, and the superior earnings prospects of value names remains in the current cycle as well. Moreover, the large valuation discount of value versus growth has created a particularly long runway of opportunity for relative value outperformance during the current cycle, especially since lower-multiple shares should face less pressures from the ongoing downward rerating of equity multiples. Additionally, U.S. value stocks, on average, pay a higher dividend yield than the broader market, with many names showing good dividend growth as well. Hence, we still believe this combination of favorable relative valuation, along with superior earnings prospects, continue to support the ongoing growth-to-value rotation.
That said, we also view the current cycle as one now in its later innings. Hence, we increasingly prefer high-quality, late-cycle value stocks (i.e., cyclical stocks, such as energy, materials and industrials names), which are better poised to benefit even amidst the moderating economic growth and rising input costs. Many of these names can pass along input cost inflation and actually benefit from higher levels of inflation to obtain such pricing. Moreover, the continued recovery from the pandemic, particularly in non-U.S. markets, provide additional support to such names. Even if the U.S. economy is now on the clock for an eventual recession, late cycle shares often continue to rise for several months leading up to such a downturn, so we remain constructive on these areas within the portfolio.
Recognizing that many value stocks are more sensitive to economic and business cycles, we also now prefer defensive names within the portfolio, including consumer staples, health care and certain communication services and information technology shares. The rising risks to growth highlighted earlier suggest that it is increasingly important to maintain healthy weights to those companies with superior pricing power, more stable sales profiles (even in recession), higher margins and more resilient earnings and cash flow. These sector exposures constitute a complementary ballast in the portfolio, thereby providing balance and support should economic growth decelerate faster than expected.
As always, we continue to follow our differentiated fundamental value investment strategy, seeking attractive long-term investment ideas and maintaining a prudently positioned portfolio, which strikes reasonable balances between those investment ideas offering safety in increasingly uncertainty times and those holdings representing compelling long-term value.
In terms of the current portfolio’s positioning by sector, relative to the Russell 1000 Value Index, DBLV is overweight consumer discretionary, financials, industrials, materials, and communication services. It is underweight health care, information technology, real estate, and utilities. It is broadly equal-weight consumer staples and energy. 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 event that grow slows materially 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 03.31.2022.
In information technology, we remain underweight relative to the benchmark for the sector, as much of the sector carries above-market valuation multiples that continue to come under disproportionate pressure in the face of further interest rate increases. Moreover, we already have reduced portfolio exposures in those companies that are more cyclical in nature—and thus more likely to post negative returns during a growth scare or in a recessionary environment—such as semiconductor or semi-cap names. That said, we continue to like those cyclical names that trade at reasonable valuation multiples, such that they are mainly shielded from downward multiple rerating, and that also have strong enough franchises to achieve growth targets even as overall economic growth moderates (e.g., Flex Ltd., KBR Inc.). 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 financials, we are overweight the sector with a modest tilt towards banks (e.g. Wells Fargo, Citizens Financial, and Citigroup), consumer finance (e.g. Capital One) and life insurance (e.g. Prudential Financial) companies, that typically benefit from higher interest rates and healthy economic growth. During the quarter, we replaced our position in Bank of America with Citigroup, which is undergoing a major transformation under new leadership that has the potential to unlock significant value in the company. Currently, we expect banks and consumer finance companies to benefit from an improvement in loan growth, an increase in interest rates and a still benign credit loss environment. That said, with inflation persisting and rising, potential headwinds to future economic growth have increased. As we move further along the Fed hiking cycle, there is increased risk that monetary conditions become restrictive causing economic growth to deteriorate and credit losses to rise. As such, we plan to adjust our exposure to these asset sensitive financials if we expect economic conditions to significantly worsen, potentially leading to a recession. Balancing out these exposures, we own quality commercial P&C insurers (e. g. Chubb and Markel) that continue to benefit from strong commercial insurance pricing tailwinds and an exchange (e.g. Intercontinental Exchange) that has a high mix of stable recurring revenue and is well positioned to benefit from secular growth. Earnings for these companies tend to be relatively resilient in a weak economy. Overall, most of our financial holdings continue to trade at a higher discount to the overall market relative to their historical averages.
In health care, we exited the quarter modestly underweight, but our current positioning is neutral in the sector. Despite the near term headwinds from rising interest rates, potential US regulatory pressures on drug pricing, and uncertainties around an inconsistent FDA, we added to our Biopharma exposure (Sanofi and Biomarin) during the quarter at attractive valuations and ahead of potentially positive catalysts. Given the aforementioned risks, we are still modestly underweight the group, but our exposure has increased with the relative attractiveness of the sector, particularly in an inflationary environment, given the pricing power and high profit margins companies in the industry currently enjoy. We continue to maintain an underweight exposure to the life science tools providers given the sub-sector’s elevated valuations and more mixed near-term earnings growth outlook, which is clouded by macroeconomic uncertainties in addition to the headwinds from 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 still trade at significant discounts to the broader sector and overall market, while offering greater earnings visibility in the current environment. We continue to maintain a favorable view of and overweight toward physician preference medical device manufacturers, as they are gaining share from new product launches (e.g., Medtronic and Alcon), and because they should benefit from the reversion of global procedure volumes to normal pre-pandemic levels.
As of quarter’s end, we are slightly overweight the consumer discretionary sector, while our exposure to the consumer staples sector is broadly in-line relative to the benchmark. That said, we continue to maintain across the two consumer sectors a bias toward higher quality, defensive names, given the mounting macroeconomic pressure on consumers. Our staples positioning over-indexes to brands with the pricing power needed to navigate the inflationary cost environment (e.g., Philip Morris, Mondelez, and PepsiCo) with as little margin contraction as possible. Our positions in US Foods, Advance Auto Parts, and TJX Companies provide us with exposure to the gradual reopening of the U.S. economy following multiple years of mobility restrictions. Given record margin performances in 2021 and ongoing cost inflation, we expect many names in the consumer sectors to see margin contraction and EPS pressure this year, putting full year guidance metrics in jeopardy. Our mix of market share gainers, quality compounders and select bets on the reopening is designed to mitigate risks to consumer activity from inflationary headwinds and tighter financial conditions.
Within the industrials sector, we are maintaining cyclical exposure in the transportation sub-sector (Norfolk Southern), where supply chain friction has temporarily disrupted the recovery. We have later cycle exposure in electrical equipment (nVent), where electrification and connectivity infrastructure investments should drive improving fundamentals. We have later cycle exposure in commercial aerospace (Raytheon Technologies and Boeing) and construction equipment with the addition of Herc Holdings, Inc (HRI), as we see such names thriving amidst a recovery in the end markets of these sub-sectors. Due to our view of the underlying businesses of Vontier Corp., which spun out of an industrial company (Fortive Corp.), we view our overall portfolio positioning in the industrials sector as modestly overweight relative to the benchmark.
In communication services, we remain overweight the sector, with a mix of defensive holdings that can generate cash flow through the cycle given their ability to obtain pricing fairly reliably because of relative competitive strengths and business model quality (Verizon, Comcast), of reasonably-priced growth plays that also can post superior earnings through a down-cycle (Alphabet, Facebook), and of 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 a transformation opportunity with semi-conductor, electronics, and water 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 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 recyclable beverage packaging. We are equal weight in the energy sector, with 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 reflationary environment.
We are underweight real estate stocks, as these companies tend to operate with significant debt and could face some headwinds from higher interest rates. Currently, we are relatively balanced in this sector 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 outperformed its benchmark, the Russell 1000 Value index, by 11 basis points in the most recently completed quarter. In terms of the sectoral attribution for the portfolio’s relative Q1 outperformance, quarterly results were helped by consumer discretionary, financials, health care, industrials, and real estate, offset by adverse results within communication services, consumer staples, energy, information technology, materials, and utilities. Cash holdings had minimal impacts on relative performance. As of 03.31.2022. Portfolio = DBLV; Russell 1000V = Russell 1000 Value.
Up until the start of the Russia invasion of Ukraine, cyclical value stocks outperformed the market as bond yields rose. The increase in interest rates led to a decline in higher multiple growth names, particularly in information technology, communication services and consumer discretionary sectors. However, the conflict in Ukraine created great risk of supply shocks that exacerbate already significant inflationary pressures and, in turn, increase the headwinds for continued economic growth. Such rising stagflationary risks prompted further outperformance of the resource-centric energy and materials sectors, while also causing the outperformance of highly defensive sectors like utilities. Other defensive sectors also hung in well amidst a challenging overall market, such as health care and consumer staples. Meanwhile, less defensive sectors with high valuation multiples, such as technology and consumer discretionary, underperformed amidst the downward rerating of those multiples caused by rising inflation and interest rates. Finally, despite reasonable valuation levels, financials declined on rising growth concerns.
Our outperformance versus the benchmark was driven by holdings within healthcare and industrials, offset by negative relative attribution within materials, utilities, communication services and information technology. Within healthcare, we benefitted from our managed care and pharma positions, which outperformed the benchmark, even with the modest sector underweight. Industrials benefited from solid stock-picking and the moderate overweight in the sector. On the negative side, the negative contribution from materials related to the underexposure to resource-centric names within the sector, while our lack of exposure to utilities was also a headwind. Within the communications services and information technology sectors, stock specific issues surrounding future revenue growth detracted from quarterly contribution to relative portfolio returns.
Looking at attribution by individual stocks, the top five positive contributors to first quarter performance were AstraZeneca (AZN), KBR (KBR), Raytheon Technologies (RTX), Markel (MKL), and Prudential Financial (PRU).
- 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 reporting two positive pipeline updates for medicines that will transform the standard of care in prostate and breast cancer, while adding multiple billions of dollars to AZN future revenue estimates. Additionally, AZN reported Q1 earnings that exceeded expectations and management subsequently offered positive commentary on growth targets beyond 2025 that should continue to position AZN as one of the leading growers in the industry. These updates support our continued expectation for AZN to post industry leading revenue and earnings growth through the decade, which we do not believe is fully reflected in the current valuation of ~15x 2024 P/E.
- 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 first quarter, on the back of another solid quarterly report. Near-term visibility of the companies orders, sales and earnings continue to improve, while the solid set of long-term growth drivers, in areas like sustainability, space and cybersecurity, are becoming ever more apparent to investors. Also helping sentiment around the name is a growing recognition that KBR has multiple, higher-growth sustainability opportunities that help it win favor among ESG investors.
- RTX (industrials) is a leading manufacturer and supplier of aerospace and defense systems for commercial, military and government customers. During the quarter the conflict in Ukraine drove many governments to consider increasing defense budgets. As a leader in missiles, Raytheon’s defense business should benefit from increased defense spending. Simultaneously, commercial aerospace traffic continued to recover as concerns from the Omicron virus declined. As air traffic increases airlines need to provision more aftermarket supplies and take delivery of new more fuel-efficient planes which drives the company’s commercial business. Raytheon will return $18-20 billion in share repurchase and dividends while it targets $10 billion in annual free cash flow by 2025. With commercial aerospace still recovering, defensive attributes in a world of geopolitical tensions and solid capital returns, RTX remains an attractive holding.
- MKL (financials) is a well-run specialty commercial insurance company with a good track record of underwriting insurance for complex risks at structured terms and for a higher premium. Through its subsidiary, Markel Ventures, the company also owns a diverse portfolio of businesses from different industries. During the quarter, MKL stock reacted positively to continued momentum in insurance rate increases in Q1 along with favorable commercial P&C pricing commentary at the Association of Insurance and Financial Analysts conference in early March. Markel should continue to see strong underwriting profits as the insurance rate environment is expected to remain favorable in 2022 given rising CPI and social inflation trends, and loss fatigue in cat-exposed lines of businesses.
- PRU (financials) is a well-managed life insurance and retirement services company with a top-tier asset management business and a disciplined approach to allocating capital. Its stock rallied during the quarter in response to rising interest rates and an improving pricing environment for life insurance. PRU, along with its peers such as Metlife, Unum Group and Hartford Financial, have been repricing their life insurance products higher as contracts come up for renewal. We would expect the increase in interest rates to contribute to higher investment income and the pricing momentum to lead to better underwriting margins. Meanwhile, the company has made further progress on its strategic initiatives, divesting slower growth market and rate-sensitive businesses while growing its asset management business and expanding its operations in emerging markets. Even with the recent rally, PRU stock remains attractively valued at 0.7x P/B and 8.9x 2023 P/E.
The top five detractors from quarterly performance were Meta Platforms (FB), Citigroup (C), Arconic (ARNC), DuPont de Nemours (DD), and International Flavors (IFF).
- FB (communication services) is a dominant provider of social media services that allow people to connect, share, discover and communicate with each other via its core Facebook, Instagram, Messenger and WhatsApp platforms; it also owns Oculus, a suite of virtual reality solutions. FB stock underperformed in the second quarter of 2020, largely due to a poor quarterly report in which the company missed on platform engagement and top-line growth expectations. Moreover, the CEO lamented how the company had fallen behind competitor TikTok in the arena of video sharing, which is an extremely popular segment among the most valuable youth segment. We view the competitive issue as limited to the video sharing arena, so the established franchises should maintain their profitability even if growth has now slowed. Moreover, we think that the stock price reaction was overdone and thus makes the company’s current valuation less challenging even after considering the downward pressure on multiples from the current rate hiking cycle that is widely impacting growth equities.
- C (financials) is a global diversified bank servicing institutional and consumer clients. It has a large international operation, serving many of the largest multinational companies. During the quarter, Citigroup stock pulled back due to concerns that sanctions on Russia would cause significant asset impairments as well as expectations for slower progress on its turnaround efforts. During its investor day, Citigroup provided outlook that imply progress towards achieving its long-term 11-12% ROTCE target would take longer than investors had expected. We believe the financial impact on Citigroup from sanctions on Russia and the Ukraine war will be relatively small. Citigroup estimates its exposure to Russia is less than 0.5% of total assets. Meanwhile, Citigroup has made significant progress in divesting low return, non-core assets, enabling it to redirect resources towards higher return businesses. We believe Citigroup has a strong competitive position in its core businesses – Treasury and Trade Solutions business, credit card franchise and capital markets operations. With its stock trading about 0.6x book value and 7x FY 2023 P/E, the market appears to be undervaluing those franchises in our opinion.
- ARNC (materials) is a leading manufacturer of aluminum sheet, plate and extrusions. During the quarter the sanctions against Russia weighted heavily on the company as 11.5% of total company EBITDA is generated in Russia. The sanctions also created supply concerns for Aluminum sending prices higher. While earnings are not impacted by aluminum costs, free cash flow is due to increases in working capital. As aluminum appreciated, Arconic’s free cash flow guidance became questionable. Concerns regarding the recovery of automobiles and commercial aerospace continue to weigh on the stock. However, auto and aerospace production rates are currently at recessionary levels having never recovered. Excluding the Russian earnings, Arconic still trades at a discount to peers and has 40% upside to fair value.
- DD (materials) is a leading developer of specialty materials and chemicals for the electronics, industrials, water and protection end markets. During the quarter, increasing input costs weighed on DD. Raw material costs were improving until sanctions were implemented against Russia causing supply concerns in the energy markets. Dupont disclosed that raw material costs were increasing again, and new price increases will be required to offset rising natural gas costs at manufacturing plants in Europe. The market is valuing Dupont like the mobility & materials business that will be sold by year end. However, with the acquisition of Rogers, Dupont is transforming into a less cyclical, higher margin, higher growth, net cash company in semiconductor manufacturing, advanced electronic solutions, and water, yet it trades at a 29% discount to future peers.
- IFF (materials) is a leading manufacturer and supplier of flavors and fragrances used in food, beverage, personal care, and household products. During the quarter inflationary pressure on input costs weighed on IFF. There was concern about these costs negatively impacting margins which would cause IFF to report disappointing results and guidance. Although results were better than feared, it was not enough to offset concerns that arose after Russia was sanctioned by several countries creating new concerns of commodity supply shocks. Although IFF has implemented company-wide price increases there is a lag effect. Costs will have to stabilize, but with new management IFF should be able to cut costs and close the margin and valuation gap with its peers, with which it currently trades at a ~30% discount.
During the most recent quarter, we introduced Citigroup (C) as a new holding. We made net additions to our positions in EOG Resources (EOG), Herc Holdings (HRI), Norfolk Southern (NSC), Fidelity Natl Info Svcs (FIS), Boeing (BA), Valero Energy (VLO), BioMarin Pharmaceutical (BMRN), International Flavors (IFF), Sanofi (SNY), Verizon Communications (VZ), and Arconic (ARNC). We made net reductions to our positions in KBR (KBR), Raytheon Technologies (RTX), Microchip Technology (MCHP), Chevron (CVX), Meta Platforms (FB), Microsoft (MSFT), KLA (KLAC), and Alphabet (GOOGL). We eliminated our holding in Bank of America (BAC).
The top 10 portfolio holdings, by weight and active weight, as of month’s end, can be seen in the following tables: As of 03.31.2022.
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 previously noted, 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 2022 consensus estimates for DBLV of 14.6x, versus the Russell Large Value at 15.9x and the S&P 500 at 20.2x.
We thank you for your continued interest in DBLV.
AdvisorShares DoubleLine Value Equity ETF (DBLV) Co-Portfolio Manager
Past Manager Commentary