DUSA ETF Has Hit Its Stride, But Concerns Remain (BATS:DUSA)

Today I would like to present a quarterly sentiment update on the Davis Select U.S. Equity ETF (BATS:DUSA), an actively managed vehicle offering exposure to an equity portfolio calibrated using sophisticated methods based on the Davis Investment Discipline, which, as we know from the research methodology,

… seeks durable, well-managed businesses at value prices that can be held for the long term to allow the power of compounding to work.

I have been covering DUSA since July 2023, with all three articles presented to date having a more skeptical tone and concluding with the Hold ratings. My essential concerns encompassed DUSA’s consistent underperformance since its inception, fairly burdensome fees, and a few factor nuances. However, last year, DUSA finally hit its stride, beating the iShares Core S&P 500 ETF (IVV) with ease. This year, as momentum has not decelerated, DUSA has notched a three-month winning streak against IVV, solidly outperforming the S&P 500 index since my January article.

This might once again raise a question about whether the ETF should be upgraded to a Buy. In this regard, I would like to offer a fresh view on its advantages and vulnerabilities to explain why a more cautious rating is warranted.

DUSA in April 2024: minor changes, improvements on the growth front

Since my January 2024 article, the ETF has added just one stock, Humana (HUM), while refraining from deletions, so the portfolio composition has almost not changed, with 22 equity holdings as of April 9 and the key five accounting for around 44.8% of the net assets.

Since there were no significant additions or deletions, DUSA’s sector mix remained almost completely the same.

DUSA still ignores the consumer staples, energy, real estate, and utilities sectors. In my view, no defensive sector exposure (except for healthcare) does not look like a serious issue as the economy is on a firm footing. Contrarily, no oil and gas industry exposure will be more of a drag assuming the commodities are back in vogue, with geopolitics pushing Brent and WTI prices higher, together with the E&P players and the like, as can be illustrated by the Energy Select Sector SPDR Fund ETF’s (XLE) performance.

Also, it is worth highlighting that despite the Street enamored with the tech sector, DUSA has not rotated toward IT, though maintaining a meaningful footprint in communication.

Besides, DUSA is still keeping overseas exposure at a minimum, in stark contrast with its predominantly optimistic view on international equities that was prevailing in 2023. It is worth reminding that in October 2023, which I discussed in the respective article, DUSA had exposure to Canada, China, Denmark, Korea, the Netherlands, Singapore, and South Africa. In the current iteration, there is just one Canadian company in its portfolio, NYSE-quoted Teck Resources (TECK), a copper and zinc mining heavyweight, accounting for 1.9%. I should note that radically reduced international exposure has likely minimized numerous macro and FX risks, thus allowing the ETF to deliver stronger gains this year. Among other things, the removal of JD.com (JD) was obviously timely. Despite a recovery staged in March, this Chinese consumer discretionary sector player is still down by about 7.7% YTD. DUSA had JD in its portfolio in October 2023 but not in January or April 2024.

DUSA maintains a profound tilt toward financials, with a key holding from the sector being Capital One Financial Corporation (COF), with a 10% weight. Will it pay off in 2024? This is an excellent question. Earlier this year, it mostly worked, as out of 8 financial sector stocks it had exposure to both in the January and April versions of the portfolio that I have analyzed, only USB has surprised to the downside, while four have outperformed the S&P 500 ETF, even despite the market anticipating an interest rate cut this year, which does not look fully supportive of the sector.

Even though the portfolio composition has seen just cosmetic changes, notable developments can be observed in the factor mix, mostly on the growth front.

Growth factor

My calculations show that DUSA’s weighted-average forward revenue growth rate is approaching 7%, the highest level since I started covering the ETF. Besides, there is a massive improvement in the forward EPS growth rate to 9.4%, as 13 holdings have seen their growth prospects upgraded, with Alphabet (GOOG) and Markel Group (MKL) among the contributors.

Quality

I still consider DUSA a high-quality portfolio. Though I believe a 7% weighted-average Return on Assets is insufficient, I acknowledge that other metrics illustrate the overall resilience of this mix, especially assuming all the holdings have a B+ Quant Profitability rating or better. The only stock that had a B- rating in January was TECK, but its profile has improved since then.

Value

As a predominantly mega-cap play with a WA market cap of almost $550 billion, DUSA has an adequate share of holdings with a B- Quant Valuation rating or higher. We see that the earnings yield has compressed since the previous coverage, yet it is nonetheless healthy, primarily because of financials that tend to trade with low P/E ratios. For context, the median EY for DUSA’s holdings in the sector is 8%.

What are the vulnerabilities and risks?

Despite DUSA now looking more appealing from a factor mix perspective, I am still mostly skeptical about this vehicle owing to a few disadvantages to be detailed below.

Long-term returns still look weak

There is no denying that DUSA had a few spectacular periods in the past, especially in August 2020–April 2021, when it recorded its longest, 9-month winning streak against IVV. And in 2023, it had a solid run lasting into 2024. Nevertheless, its annualized total returns since inception still look fairly soft compared to IVV’s.

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Data from Portfolio Visualizer. The period is February 2017–March 2024

Volatility and drawdowns

While investors might riposte here that the ETF might easily improve the CAGR going forward if the current momentum is maintained, I should highlight other vulnerabilities: elevated volatility and deep maximum drawdowns, which are more likely the consequence of its minimalist portfolio, encompassing just 22 equities at the moment. Importantly, as I have already emphasized in the past, while DUSA was less capable of benefiting from bullish market sentiment than IVV, it captured much more downside during the bearish phases on the Street:

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Data from Portfolio Visualizer. The period is February 2017–March 2024

Conclusion

DUSA did an excellent job this year, outperforming the S&P 500 index consistently in January–March, capitalizing on last year’s momentum.

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Calculated using data from Portfolio Visualizer

It seems the ETF may have finally hit its stride, so a rating upgrade might be necessary. However, while not being bearish, I would prefer to maintain a more neutral view on DUSA. I appreciate its high-conviction approach and long-term horizon. Yet there are a few reasons, including its steep maximum drawdowns in the past, which I believe are directly connected to its too-lean portfolio (which also translates into higher volatility). It also goes without saying that DUSA is hardly an ideal choice for investors seeking more diverse, market-like sector representation. Finally, the expense ratio of 61 bps is not to be forgotten.