DBLV: 3rd Quarter 2020 Portfolio Manager Review
Performance data quoted represents past performance and is no guarantee of future results. Current performance may be lower or higher than the performance data quoted. Investment return and principal value will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than original cost. Returns less than one year are not annualized. For the fund’s most recent standardized and month-end performance, please click www.advisorshares.com/etfs/dblv.
“Bäume wachsen nicht in den Himmel.”
— Old German proverb
“Multa renascentur quae iam cecidere,
cadentque quae nunc sunt in honore…”
— “Ars Poetica,” Horace
During the third quarter, record monetary and fiscal stimulus continued to propel the U.S. equity market, pushing the S&P 500 to a new record high in early September, notwithstanding the fact that the prospects for a full economic recovery remain very uncertain and highly challenged. Even against a still weak economic backdrop, the S&P 500 rose 8.9% to a new peak in early September, before pulling back slightly. The Russell 1000 Growth Index soared 13.2%, far outpacing the Russell 1000 Value Index’s return of 5.6%. The AdvisorShares DoubleLine Value Equity ETF (DBLV) posted a return of 4.6%, lagging its benchmark, the Russell 1000 Value Index, by about 1%.
From the trough in late March, the stock market rebound has been mostly led by large cap growth stocks, which perhaps should not be very surprising. These businesses have shown resilient or even improving business fundamentals despite the pandemic-induced recession, and they have delivered solid earnings reports and superior market returns as a result. Meanwhile, value stocks and smaller cap names, which are more dependent on a re-acceleration in earnings during economic recoveries, have not yet seen sufficient investor confidence in a cyclical upswing to participate equally in the equity market’s rebound. Hence, the market conditions that have supported and sustained the unprecedented relative outperformance of growth stocks during the last decade or more—low interest rates, scarcity of growth, ongoing tech disruption, the rise of ESG investing, relative balance sheet strength and earnings resiliency of growth companies, et. al.—remained in place during the third quarter.
This continued outperformance of growth stocks has stretched to unprecedented extremes the relative valuation of growth stocks over their value counterparts. Indeed, value stocks today trade at a steeper discount to growth stocks than they did during the late stages of the tech bubble seen in late 1999 and early 2000. On a price-to-book valuation basis, the bottom half of the S&P 500 Index’s constituent companies now trades at a 9.0x multiple-point discount to the top half, much greater than even the discount experienced during the height of the ’99-’00 tech bubble (4.7x). This remarkable differential currently observed is more than two standard deviations greater than the historical average. Based on consensus-estimated 2021 price-to-earnings (P/E) multiples, the Russell 1000 Growth Index traded at about 29x at the end of the third quarter, which is almost twice the multiple of the Russell 1000 Value Index (about 16x). Clearly, growth is more expensive than ever compared to value.
More concerning, the most recent surge in the growth premium has not been driven by sturdy distinguishing characteristics of such stocks. Specifically, while the rise in growth company share prices had previously been accompanied by strong earnings growth and continued posting of superior returns on equity, it is important to note that the recent move has been driven much more so by mere multiple expansion. In fact, during the last six months this growth company multiple expansion was so large that it increased the overall S&P 500 earnings multiple by more than 9x multiple turns, the largest such expansion in post-war history.
One can debate whether such a dramatic multiple expansion is related to rising speculation and animal spirits amidst easy money, defensive positioning in proven large-cap technology winners or the mathematical relationship of higher-valuation multiples to longer-duration earnings amidst ultra-low rates. Valuations have increased substantially for some companies with limited operating and profit history, as seen in recent IPO and SPAC (special purpose acquisition company) deals involving early-stage high-fliers or the apparent proliferation of retail investor participation in highly speculative momentum stocks—including those randomly pulled out of a hat (or was it a bag?) by blogging star and investing neophyte David Portnoy. Yet valuation multiples and analyst price targets of proven technology winners, like Amazon and Microsoft, have also continued to push higher on further institutional investor bets regarding company earnings and lower-for-longer rates. Indeed, analysts can justify higher valuation targets when the assumed interest rates inputted into their discounted cash flow models are lowered for the next decade amidst the rate regime of an interventionist Federal Reserve. Yet the important observation remains: namely, that the cost being incurred by investors for those incremental growth companies’ earnings have never come at higher valuations.
Obviously, it is the continued crowding into growth stocks—which necessarily entails further neglect of value names—that is driving the dramatic valuation dispersions seen in the equity market. According to Bank of America’s analysis of stock ownership data, long-only positions of most active managers are concentrated in growth stocks rather than value stocks, with over-weights in growth sectors, like technology and internet services, while those managers are maintaining under-weights in value sectors, such as financials and industrials. While this portfolio allocation strategy has worked during the stock market rebound seen since late March, just as it has for most of the last decade or more of growth outperforming value generally, the reality is that this state of affairs cannot continue indefinitely. Trees do not grow to the sky, as the Germans like to say. Rather, they are typically felled by lightning or other threats, or alternatively, at least halted by old age.
The giant sequoias of the market, which are the well-known large cap growth names, face many challenges even as their current nose-bleed valuations would imply the opposite. Not only do they now require much larger incremental addressable markets to move the needle on what are much larger operations—the problematic law of large numbers—but they also face greater government scrutiny in terms of antitrust inquiry and regulatory oversight of their use of customer data. There is growing (albeit admittedly still low) risk that these dominant technology platforms oligopolies will eventually be broken up or, more likely, otherwise hindered by regulation and taxation. We believe that investor positioning in growth stocks has become thoroughly overcrowded, even as the valuations for many growth stocks have moved ahead of what their underlying business fundamentals can support—thus raising the risk of a price correction in such names. Given their size and power, we do not expect competition or government action to take down these fantastic businesses anytime soon; however, we think that their strength and resilience is so well known that there is little room for them to grow sufficiently faster than market expectation to be a source of alpha, and so we would expect their valuations to recede in the future from recent peaks. This is true not only of the so-called FANG or FANGMAN names, but also of other high-flying technology companies sporting high-altitude valuations, like Zoom or Tesla. Like the redwood forests located nearby Silicon Valley, these many technology giants may indeed stand tall for many years to come, but their stock prices simply cannot continue to be driven by the sort of multiple re-ratings or earnings surprises that we have seen in recent quarters. Trees don’t grow to heaven.
This observation, we believe, potentially sets the stage for a meaningful rotation out of richly-priced growth and into reasonably-priced value. Indeed, September saw a modest rotation into value stocks that could be attributed to rising valuation concerns surrounding growth stocks, coupled with abating fears surrounding more cyclically-sensitive value names. We believe that a shift to value will become more durable than the tentative, ephemeral moves seen in the last ten years when the market can reliably discount a broad economic recovery and concomitant widespread cyclical rebound in earnings. Historically, value stocks have outperformed growth stocks when the business cycle turns up. As noted in a study recently conducted by Bank of America, value stocks have outperformed growth stocks in 15 out of 17 prior corporate profit recovery periods, measured trough-to-peak from 1944 to 2018. Moreover, value stocks have outperformed the broader S&P 500 Index for at least a quarter and usually for far longer, following the trough of every single recession or depression since 1929. While recognizing that a sustained economic recovery is far from assured at this point in the current pandemic and recession, we nonetheless see ahead of us an emerging opportunity to position one’s portfolio for the expected rising relative attractiveness of value stocks over their growth counterparts.
It is widely understood that corporate earnings for value stocks have been hit disproportionately harder by the pandemic, while many growth companies have seen their competitive positioning improved during the crisis. This has caused investor to assume a worsening of the long-extant secular challenges facing many slower-growth industries. However, the reality is that the majority of the earnings declines for value companies has been almost wholly driven by cyclical pressures from weak overall demand related to the current recession. This means that the pressures of the business downturn should abate as the economy demonstrates a durable recovery. Currently, consensus expectations are for S&P 500 earnings to rebound significantly in 2021, with value sectors expected to contribute most to the overall earnings growth expected next year. Specifically, for the Russell 1000 Value Index, earnings are expected to rise by about 33% yoy in 2021, while earnings for the Russell 1000 Growth Index are expected to increase by about 20% yoy. If these earnings forecasts are shown to be correct, or even understate the relative size of future earnings rebounds between growth and value stocks, then we would expect any rotation into value, likely occurring in anticipation of such superior earnings, to prove durable. Future earnings still matter to equity prices.
Separately, the macro environment also might soon turn more favorable for value stocks. While academic research shows at best only a weak correlation between interest rates and relative performance of value versus growth, there appears a stronger connection between central banks’ balance sheets and the relative fortunes of value and growth investment styles. Specifically, value stocks have tended to outperform in periods of shrinking central bank balance sheets. Therefore, it will become significant if quantitative easing has peaked and the economic recovery continues to gather strength. While we may not be out of the woods yet with regard to risks of a double-dip recession, we can say that as the economy recovers, the Fed balance sheet shrinks and corporate earnings improve, the valuation gap between value and growth stocks should begin to narrow to more normal levels from the current extremes.
Recognizing that value investor underperformance often comes from being too early, market participants will not want to miss the great rotation that is potentially now imminently before us. Indeed, famed investor Benjamin Graham included in the preface to his revered book, Security Analysis, the immortal quote by the Roman poet Horace (i.e., “many shall be restored that are now fallen, and many shall fall that are now in honor…”) to caution investors of the dramatic reversals of fortune that invariably occur in this world, including the unforgiving, mean-reverting rotations within our capital markets.
How are we positioned given this potential for a great rotation? We are continuing to shift gradually our portfolio holdings from higher-multiple defensive names with more reliable growth and margin profiles to lower-priced value stocks that are expected to show outsized earnings growth as the economic recovery gathers strength. And we are carefully monitoring the economy and changes in corporate earnings prospects to determine the rate at which we should effect this transition.
That picture of future economic activity and corporate earnings results currently remains mixed at best. First, it goes without saying that we are not yet through the pandemic, which caused the economic crisis in the first place, and without the advent of still-unproven vaccines or hard-to-determine herd immunity, a full economic recovery is highly challenged. At the moment, the economy continues to benefit from the past fiscal and monetary stimulus, as well as other government actions, such as forbearance and deferrals; and this support has boosted the personal savings rate and has provided an added income buffer for those who are unemployed. Because the benefit from the fiscal and monetary stimulus, which has been greater than expected, is largely temporary, the market will need to anticipate the advent of an economic recovery not reliant upon government support in order to justify further gains, especially in those value names that are more sensitive to business cycles.
Of course, the economy, which remains mired in a deep recession even with the anticipated third quarter bounce, does not appear ready to be taken off of life support for a host of reasons. First, meaningful gains in employment will likely be a challenge, as certain industries, such as travel and leisure, struggle to resume normal activity without an effective vaccine or herd immunity. Second, state and local governments, which employ about 20 million people, or about 13% of the total U.S. workforce, are facing mounting fiscal pressures, as budget shortfalls are expected to approach $1tn, according to Barron’s, and may be forced to cut expenses by laying off workers without federal government aid. Third, the lingering benefits from past stimulus seem to be waning, causing a stall in new hiring. Meanwhile, within the most vulnerable industries, lay-offs have started to increase again, while business bankruptcies have been on the rise. With the pace of economic activity appearing to slow, there seems to be a greater need for further stimulus at this stage of the recovery.
Fourth, hopes for additional stimulus continue to be dashed, as negotiations have become increasingly politicized. There appears to be a deep divide between the Democrats and Republicans regarding the size of a new stimulus package and how it should be deployed. Also, with major market indices rebounding so thoroughly and employment trends improving off the nadir, the sense of urgency in Congress to pass another stimulus package has diminished. Additionally, the upcoming Presidential election adds perverse partisan calculations to the stimulus negotiations, amplifying the risk that further stimulus will come too late or in insufficient amounts, thereby triggering a major slowdown in the economy and a correction in the equity markets.
Lastly, the federal deficit is expected to reach a record high as a percentage of GDP over the next couple of years, which could have long-term negative ramifications on economic growth, interest rates, and possibly inflation depending on how future deficits are funded. Prior to the pandemic, the US economy had already struggled to achieve targeted levels of growth due to unfavorable demographics and adverse debt loads. It would not seem likely that such challenges to secular economic growth will be lessened in the post-pandemic years ahead, even before we consider the impossibly complicated question of how our society has been permanently changed by COVID-19.
Given these elevated uncertainties, we remain cautious and believe it is prudent to maintain a defensive posture with continued exposure to quality companies with more resilient balance sheets and more reliable earnings growth profiles, even as we continue adding gradually to our weightings in more cyclical stocks that are riskier in the current environment but also more attractively priced relative to longer-term earnings prospects. This balance in the portfolio reflects our view that, while value stocks are generally more vulnerable to economic weakness, especially if the current nascent recovery proves uneven, growth stocks are not without risks either, especially after the recent, dramatic outperformance period in which their valuations have risen so much. As the relative attractiveness of value stocks’ risk-reward profile increases in the days and weeks ahead, we would expect to adjust further this balance in our portfolio weightings in response to future developments. In short, we will continue to seek sound, long-term investment ideas and to strike reasonable balances within our portfolio among those investment ideas offering safety in uncertain times and those holdings that represent compelling long-term value once a broader recovery is underway.
More fundamentally, we will continue to search, as always, for companies with compelling products and services, leadership positions in their markets and prudent management teams, as these are the types of businesses most likely to gain share, achieve above-consensus growth, strong or even expanding margins and superior returns. We would expect that holding a collection of such businesses will allow the portfolio comprised of them to post superior risk-adjusted rewards over time. As we have previously noted, it is our differentiated fundamental value investment philosophy, which informs our selection of such businesses, that allows us to cast the widest possible net in our search for such opportunities, and thus helps our efforts to achieve solid relative, risk-adjusted investment returns.
In terms of the current portfolio positions, relative to the Russell 1000 Value Index, DBLV is overweight consumer discretionary, consumer staples, health care, and information technology, and underweight industrials, materials, real estate, communication services, and utilities. DBLV is about equal weight energy and financials. The portfolio’s largest stock holdings, by absolute and relative sector weights, are found in the accompanying charts:
As of 9.30.2020.
While we have taken some profits following strong momentum in information technology, we remain overweight the sector. Given the still-uncertain economic environment, we continue to favor companies that can sustain idiosyncratic growth due to their value-creating innovation and/or ability to automate and reduce costs. These disruptors have demonstrated clearly a benefit from the acceleration in digital transformation adoption, and thus have been able to grow earnings and cash flow even in a depressed economic environment. That said, we have shifted some exposure to underappreciated quality technology companies that are more cyclical in nature, like Flex and KBR, which have not participated as much in the rally and which trade at more modest valuation multiples.
In the consumer discretionary sector, we reduced our portfolio weights in some of our winners, such as Amazon and Target. Yet we have retained a healthy exposure to defensive retailers, like Dollar General and Target, which are providing essential services during the pandemic while successfully competing with major e-commerce disruptors.
We have also remained overweight the consumer staples sector, given our concerns about the frothiness of certain portions of the broader equity market. We continue to hold companies with strong established brands that are not overly rich in valuation yet still provide exposure to earnings which are more resilient to economic weakness, like Mondelez and PepsiCo.
In health care, we are moderately overweight to the sector, with most of that exposure centered among healthcare service providers (e.g., Anthem) and pharmaceutical companies (e.g., Sanofi). While the health care industry faces increasing regulatory risks that are amplified in an election year, we believe that, ultimately, the likely regulatory impact upon the service providers’ business models will be less adverse than feared, and that private insurance will remain an option for many millions of Americans, regardless of who wins the election. Consequently, we expect the stocks of health care service providers to rebound from currently depressed levels once it becomes more apparent that the strong earnings of these companies are indeed sustainable. Meanwhile, our pharmaceutical holdings are in companies with superior mid- and long-term earnings prospects given their advantaged development pipelines and benign loss-of-exclusivity patent portfolio profiles.
In financials, we are about equal-weight the sector, but the portfolio carries a higher mix of asset-sensitive financials (i.e., those stocks that should outperform in a rising rate environment) relative to that of the benchmark. In particular, we favor the banks (e.g., Bank of America), especially those with diversified revenue streams and a strong capital position, such that they can weather through a bumpy recovery. We believe that investors’ fears of significant credit losses over the last few months have driven down the relative valuations of bank stocks to near-historic lows. However, credit delinquencies and defaults have actually been relatively low to date, due largely to the ongoing monetary and fiscal support from the government. Meanwhile, banks’ reserves already were raised to levels that seem to reflect more than sufficiently the credit losses typically seen in prior severe recessions during which the government stimulus response was not nearly as aggressive. Given this, we believe bank stocks represent potential coiled springs that can bounce significantly with positive developments in the likely event of an economic recovery.
In communication services, we reduced our underweight and have shifted modestly towards a more cyclical posture by raising our exposure to more advertising sensitive earnings with the addition of Comcast.
We are underweight the utilities and REITs sectors, because we see greater value in other defensive areas, like consumer staples (e.g., Reynolds Consumer Products) and communication services companies (e.g., Verizon), as well as in other areas like software (e.g., Microsoft). We believe these defensive names are to be preferred because they possess more compelling business models, durable earnings and resilient balance sheets, and which will likely emerge stronger from the current crisis. The traditional defensive names within the utilities and REITs sectors possess fewer growth opportunities, higher underappreciated risks and relatively richer valuations.
While we are collectively modestly underweight the industrials, materials and energy sectors, we have been shifting more weight towards the more cyclical, lower multiple names within these sectors (e.g., Norfolk Southern), since we see such names thriving in an eventual recovery.
Finally, we continue to hold elevated levels of cash to maintain some dry powder for opportunities that we think will arise as we continue through what will likely be a very bumpy road to recovery.
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 L.P. do inform secondarily these sector weightings.
In terms of the portfolio’s sector attribution, quarterly performance for DBLV was driven by positive contributions from communication services, consumer discretionary, consumer staples, financials, industrials, information technology, materials, and utilities, offset by adverse results within energy, health care, and real estate. On a relative basis, DBLV was helped by communication services, consumer discretionary, financials, information technology, materials, and utilities, offset by adverse results within consumer staples, energy, health care, industrials and real estate. Cash had a negative impact on relative performance in a rising market.
As of 9.30.2020.
The top-three positive contributors to third quarter performance were Taiwan Semiconductor (TSM), Target (TGT), and Norfolk Southern (NSC):
- TSM (information technology) is the world’s leading semiconductor fab, supplying semi’s at the smallest geometries and fastest speeds to its customers. The company’s technology leadership, which has become more apparent following news of Intel’s delays in reaching equivalent geometric nodes, has allowed it to continue gaining share. Moreover, the company revealed July and August interim sales results that were ahead of normal seasonality and expectation. While continued trade friction between the US and China have created a headwind and raised uncertainty—TSMC can no longer ship chips to Huawei and must find replacement demand—the company appears increasingly likely to gain further share with the largest handset makers, like Apple, which are ramping 5G phones manufacturing for imminent launches. As a result, investor sentiment around the name improved during the month of September. We continue to see TSMC as the franchise supplier of semiconductor products requiring the most advanced manufacturing nodes, such as logic, and expect the company to be a key beneficiary of growing demand for its products on continued proliferation of more advanced communications technologies, faster data centers and digital content both among consumers and in the enterprise. Importantly, we do not yet believe that the current stock price fully captures the full potential still in front of the company.
- TGT (consumer discretionary) is one of the largest brick-and-mortar, general merchandise retailers in the United States. The stock appreciated by 31.3% in Q3, driven by an exceptional Q2 earnings result that demonstrated strong market share gains and a pronounced rebound in margins. After Q1’s margins were pressured by COVID-related expenses and an adverse mix shift toward grocery items, investors remained cautious on the amount of bottom-line flow-through that the elevated sales levels would bring. When it came down to it, Q2 spending on higher margin discretionary items bounced back to a surprising extent, and Target maintained a level of sales momentum that competitors like Walmart were unable to match. The investments that Target has made over the past few years on store renovations, private label brand refreshes, and digital order fulfillment capabilities appear to have been fortunately timed and, therefore, are paying off in a big way even as the COVID-19 pandemic has reduced competition from non-essential businesses and thus driven more customers through their doors, thereby placing a premium on the one-stop convenience that multiline retailers like Target can deliver. Following the earnings release, we have reduced our position in TGT to lock in a portion of the outperformance and to manage the size of our exposure.
- NSC (industrials) is a dominant East Coast railroad and one of the cheapest among the publicly traded North American Rails stocks. Through fundamental, self-help actions, the company is implementing a so-called Precision Scheduling Rail (PSR) service, which management expects will generate 60% operating ratios (i.e., an industry specific cost measure), down from the mid-60s by 2021, thereby improving margins, earnings and returns. We believe the company can achieve this goal, but we also had assumed it would happen later than 2021, given the pandemic. During the most recent quarterly earnings report, the management team reiterated its goal of achieving 60% operating ratios by 2021 notwithstanding the pandemic, as the company continues to materially reduce operating expenses. Meanwhile, weekly volumes (i.e., carloads) continued improving on a sequential and annualized basis. The management team also disclosed that operating ratios would be better in Q3 2020 versus those posted in Q3 2019, which positively surprised the market given that volumes are still down materially from 2019 due to the current economic recession. We trimmed the position on the outperformance, but we believe that NSC should remain a core portfolio holding with attractive upside given that the company continues to improve operational performance, operating ratios and future earnings prospects.
The top-three detractors from quarterly performance were Reynolds Consumer Products (REYN), CVS Health (CVS) and Cigna (CI):
- REYN (consumer staples) is a manufacturer of branded and private-label consumer products focused on cooking, baking, storage and waste disposal. The company holds a dominant position in their eponymously named aluminum foil and plastic wraps, as well as a strong share in waste and food storage bags under the Hefty brand. REYN’s Q3 underperformance is mainly attributable to a disappointing earnings announcement on August 5th, which caused the stock to decline 8.7% in one day. Market expectations for the newly-public company were elevated ahead of the earnings update thanks to third-party data sources that showed very strong consumer takeaway trends for Reynolds branded products. What those third-party data sources failed to capture is Reynolds’ significant private label portfolio, as well as its sales into foodservice end markets. Sales to foodservice end markets faced a major headwind from restaurant closures. Additionally, private label sales lagged branded product sales as consumers turned to brands they trust, and the company put more of a focus on keeping the higher margin, branded products in-stock. Because of these dynamics, REYN’s reported Q2 sales growth that fell short of the market’s expectations and caused many shorter term, post-IPO investors to sell out of their positions. Despite the revenue shortfall, the performance of branded products did allow Reynolds to beat consensus expectations for profit metrics. Reynolds’ management team has committed to intra-quarter updates on sales trends in an effort to avoid similar surprises in the future. In the wake of the earnings release, we opportunistically added to our position in REYN, realizing that the Q3 stumble reflected more of a misunderstanding on the part of Reynolds’ investor base than a sign of fundamental weakness in the business or the company’s brand strength. We remain pleased with the underlying sales momentum in Reynolds’ product categories and believe its current valuation (15.6x 2021 P/E multiple, 13.0x 2021 EV/EBITDA multiple) leaves headroom for multiple expansion.
- CVS (health care) is the largest retail pharmacy and pharmacy benefits manager (PBM) in the US and is also a leading managed care provider through Aetna. During the quarter, CVS declined in sympathy with its pharmacy peer Walgreens Boots Alliance (WBA), which provided a disappointing near-term outlook. While CVS has also experienced some weakness in its pharmacy segment (about 35-40% of total profits) due to the ongoing covid-19 pandemic, in contrast to WBA, the significantly more diversified CVS continues to be on-track to meet or exceed its near and medium financial targets, with outperformance in the managed care segment, continued strength in the PBM, and further execution on merger synergies, anticipated cost savings, and strategic transformation initiatives that include the conversion of physical stores into HealthHUBs (i.e., a new, lower-cost means of delivering primary care). We believe the CVS comparisons to WBA are misguided, as CVS is not just another physical pharmacy, but rather a scaled, multi-channel healthcare services provider aligned with reducing overall healthcare system costs similar to United Healthcare, that will deliver market share gains and accelerating EPS growth over time. As CVS continues to deliver additional proof points of this differentiated strategy and further distinguishes itself from WBA and other healthcare service providers, we expect the stock to re-rate materially higher from its current near-all-time low multiple of less than 8x 2021 earnings.
- CI (health care) is an integrated managed care provider and PBM whose stock declined during the quarter on continued concerns of the negative impacts to commercial membership from rising unemployment and growing investor fears in an election year of potential, adverse regulatory changes to the PBM industry. On commercial membership, CI continues to outperform consensus expectations of declines given its under-indexing to those industries hardest hit by the COVID-19 pandemic, and because employers continue to retain health benefits while navigating a return to more normal economic activity. In the PBM, a recent Executive Order by the Trump Administration on drug rebates is unlikely to result in any material regulatory changes given the legal requirement of budget neutrality. However, even if additional bi-partisan legislation is eventually pursued to change the structure and economics of drug rebates, we believe any change will prove manageable, since retained rebates are less than 5% of CI’s overall earnings. Despite these two ongoing “headline risks,” Cigna continues to meet or exceed its financial targets and commitments post the Express Scripts (ESRX) acquisition, including continued mid-to-high single digit percentage growth in PBM profits. We continue to believe that PBM’s represent the most efficient and scaled vehicle to drive lower drug prices, and as CI continues to prove out its integrated model, we would expect the stock to re-rate significantly higher from its current circa 8.5x 2021 price-to-earnings multiple.
During the most recent quarter, we introduced Comcast (CMCSA), Honeywell International (HON) and Raytheon Technologies (RTX), as new holdings.
We made net additions to our positions in Ameren (AEE), Alcon (ALC), Bank Of America (BAC), Boeing (BA), DuPont De Nemours (DD), Flex Ltd. (FLEX), Intercontinental Exchange (ICE), IHS Markit (INFO), KBR Inc. (KBR), Medtronic (MDT), Reynolds Consumer Products (REYN), Roche Holding (RHHBY), TJX Companies (TJX), and Willis Towers Watson (WLTW).
We made net reductions to our positions in Amazon (AMZN), Air Products & Chemicals (APD), AstraZeneca (AZN), Citizens Financial Group (CFG), Capital One Financial (COF), Alphabet (GOOGL), JPMorgan Chase (JPM), KLA Corp. (KLAC), Lam Research (LRCX), Microchip Technology (MCHP), Mondelez International (MDLZ), Microsoft Corp. (MSFT), Norfolk Southern Corp. (NSC), Parker-Hannifin Corp. (PH), Target Corp. (TGT), Taiwan Semiconductor Manufacturing (TSM), and Verizon Communications (VZ).
We eliminated our portfolio holdings in Chubb (CB), M&T Bank (MTB).
The top ten portfolio holdings, by weight and active weight, as of month’s end, can be seen in the following tables:
As of 9.30.2020.
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.
In summary, we believe continued caution is warranted given that the economic recovery remains fragile and valuations appear to have moved ahead of fundamentals, particularly for growth stocks. That said, we also think that market conditions are shifting such that we could see a meaningful growth-to-value rotation in US equities. Specifically, we believe investor positioning within growth stocks has become sufficiently overcrowded and consequently, valuations for many growth stocks have become stretched to unsustainable levels—just as the profit cycle is beginning to turn more favorable for value stocks. Although value stocks remain disproportionately susceptible to cyclical weakness and uneven economic recovery, we believe that the risk-reward for value stocks has vastly improved relative to growth stocks, given the improving future prospects of value names, as well as the current, extreme valuation disparities between value and growth stocks. Therefore, we would expect value stocks to outperform their growth counterparts as the market anticipates a durable improvement in economic conditions, and our shifting portfolio exposures to more cyclical stocks reflects that expectation.
As we have noted previously, we believe that the fundamental value strategy informing our management of DBLV is well suited to navigate through the current environment of evolving risks and opportunities, since it affords balanced exposure both to low-multiple value names tied to rising expected returns in a cyclical upswing, as well as to high quality, less economically sensitive stocks trading at reasonable prices. At quarter’s end, this balanced exposure carried a price-to-earnings multiple on 2020 consensus estimates for DBLV was 18.0x, versus the Russell 1000 Value Index at 18.5x, and the S&P 500 at 24.0x.
We thank you for your continued interest in DBLV.
AdvisorShares DoubleLine Value Equity ETF (DBLV) Co-Portfolio Manager
Past Manager Commentary