Sizemore Capital Management 3rd Quarter 2010 Letter to Investors

The following is Sizemore Capital Management LLC's Third Quarter 2010 Letter to Investors, reproduced with permission.

To Our Investors,

The third quarter of 2010 ended on a high note with the S&P 500 posting its strongest September in 71 years.  Against this backdrop, our actively-managed Tactical Portfolio returned 9.0% for the year through the third quarter, compared to 3.9% for the S&P 500 Total Return.

Our returns for 2010 year-to-date on our Strategic Portfolio Allocation models were the following:

• Preservation of Capital……..3.61%
• Conservative Income………. 7.44%
• Growth and Income………….7.81%
• Growth…………………………8.06%
• Aggressive…………………….7.86%

Portfolio Review

SCM Strategic Portfolios

Given that the Strategic Portfolios are long term in nature, it is rare for Sizemore Capital to make allocation changes. We rebalance annually, of course, but the core positions do not often change. The only change made prior to the third quarter of 2010 was the replacement of the defunct Bear Stearns MLP ETN (BSR) with a substantially identical security, the JP Morgan Alerian MLP Index ETN (AMJ).

In the third quarter, we decided that another change was appropriate. We replaced our emerging markets position, the iShares MSCI Emerging Markets ETF (EEM) with the EG Shares Emerging Markets Consumer ETF (ECON).

This is a change we would have loved to have made sooner had it been possible. We were never satisfied with EEM as an emerging markets position, but we kept it for lack of better alternative. EEM was never truly an “emerging market” play but instead a “global macro” play, as the fund was comprised almost entirely of banks, oil companies, and export-oriented companies with very little exposure to emerging market consumers themselves.

ECON is the first ETF to specifically target the emerging market consumer sector. This ETF was a long time coming, and kudos to Emerging Global Shares for being the first to bring it to market.

For an expanded explanation of our investment rationale with respect to ECON, see the two articles we penned for Seeking Alpha in September:

ECON: Investing in the Emerging Market the Right Way
Just One ETF: The New Fund Aimed at Local Goods for Emerging Consumers

SCM Tactical Portfolio

We made several significant changes to the Tactical Portfolio during the quarter, selling four long-time holdings in infrastructure, municipal bonds, and luxury goods and replacing them with two new positions that focus of dividend income.

In a July 16, 2010 internal trade memo, we wrote:

Given the recent correction in the equity markets and our belief that high-dividend stocks offer better value than bonds at current prices, we felt the time was right to liquidate our position in municipal bonds (VKQ) and to reallocate the funds to high-dividend stocks via an ETF, the WisdomTree LargeCap Dividend Fund (DLN).

DLN is the ideal position for our current strategy. Many of the companies we have recommended in The Sizemore Investment Letter are among the fund's top holding, including AT&T (T), Johnson & Johnson (JNJ), Microsoft (MSFT), Philip Morris International (PM) and Procter & Gamble (PG). In DLN we get a cash yield comparable to a ladder of Treasury securities, but unlike bond interest—which does not increase over the life of the bond—the dividends of DLN's equity holdings should rise in the quarters ahead.

The market's currently elevated level of volatility shows no sign of abating, and a general market selloff, were it to occur, could send DLN's price lower in the short term. But given the attractive pricing of DLN, we would consider any such volatility to be little more than short-term noise. We consider this a low-risk and potentially high-return allocation for the Sizemore Capital Management Tactical Portfolio.

On July 26, 2010, we increased the Tactical Portfolio allocation to DLN from 10% to 20%. Reaffirming our investment rationale, we wrote:

Given our view that non-financial, blue-chip equities are currently the most attractive asset subclass, we have increased our allocation to the WisdomTree Large Cap Dividend ETF DLN to 20% of the SCM Tactical Portfolio. This is not a short-term trade; we consider this a major change in investment strategy with a time horizon of 1-5 years.

Our belief in the attractiveness of non-financial blue-chip equities is multifaceted. Firstly, we want to emphasize how cheaply many of America's premier companies are currently priced relative to their historical averages. As we outlined in the July issue of The Sizemore Investment Letter, Johnson & Johnson, Procter & Gamble, and Microsoft (among many others) are trading at P/E ratios not seen in multiple decades. According to financial theory, large and stable companies should trade at a premium to the broader market. By buying at higher prices, investors are generally willing to accept lower returns on blue chips in exchange for the perceived safety. But today, the opposite is true. Many blue chips actually trade at a discount to the S&P 500. The 2009 rally was primarily a rally in lower-quality “junk.” And while we do not necessarily forecast that the broader stock indices like the S&P 500 will see poor returns going forward, we do expect higher-quality stocks to outperform given current pricing. So on a valuation basis, a large overweighting in DLN makes sense.

Secondly, the competing investment alternatives are sparse. Bonds represent a remarkably poor investment given current yields. The 10-year Treasury note yields less than 3 percent—and less than the dividend yield of many of the blue-chip stocks in DLN.

There is a fair amount of overlap in our current allocation. For example, Johnson & Johnson is a major component of both DLN and IYH, and AT&T is a major component of both DLN and IXP. Under more normal pricing, we might view this as a risk. But in this situation, we consider the overlap a source of strength.

In order to free up capital for the new allocation, we are having to part with two long-time portfolio holding, FMO and MFD. While we remain bullish on both, neither had a long-term place in the Tactical Portfolio. When we initially purchases FMO, it was one of the few options available for investing in the MLP sector. But today, options are plentiful. Were we to re-enter the MLP asset class in the Tactical Portfolio, we would do so using a different investment vehicle. The same is true of MFD. While we consider infrastructure and utilities to be attractive—and continue to have exposure to the sector via XLU—we no longer see MFD as a potential long-term holding.

We were delighted to see that GMO's legendary Jeremy Grantham—an investor we respect very much—appears to agree with our assessment of non-financial, blue-chip equities. In his July 2010 letter to investors, Grantham laid out his seven-year forecast for various asset classes. At the top of his list were what Grantham calls “US High Quality Stocks,” defined as those companies with high and stable profitability and low debt.

While Mr. Grantham's comments would certainly not be sufficient to persuade us to invest in the sector, we do find it encouraging that our favorite asset class is shared by an investor of his stature. We would certainly prefer to bet with Mr. Grantham than against him.

Finally, we regrettably had to close our position in the global luxury goods sector, or rather it was closed for us. In a September 29 internal trade memo we wrote:

This is a trade that we would have unfortunately preferred not to make. We were very satisfied with the investment performance of the Claymore / Robb Report Global Luxury ETF (ROB). It was the only pure play in existence for one of favorite investment themes for the next decade: the rise of the new rich in the developing world. In addition to the long-term growth story, the individual stocks that comprise the ETF remain undervalued in our view. This is an investment we would have liked to have let run for at least another several months, if not longer.

Unfortunately, the fund sponsor had other plans. Given the sheer volume of ETFs on the market, there was simply not enough investor demand for a niche ETF like ROB. The fund was never able to gather enough assets or generate sufficient trading volume to stay viable. So, in late September the fund was liquidated and the cash proceeds were returned to investors. Not wanting to sell into an illiquid market, we opted to hold the shares until the liquidation date.

While we were not ready to let this position go, we do believe we have found a suitable replacement. ROB was a unique way to play a niche sector, and it was one of our favorite ways to get access to emerging market growth without having to take positions in volatile emerging market stocks. Given that no other funds exist that fill that role, we have opted to pursue a different investment theme altogether.

The Powershares International Dividend Achievers ETF (PID) is an ideal position for the Tactical Portfolio. In the current environment of economic uncertainty, we are focusing heavily on quality, as we explained in our investment rationale for the Wisdom Tree Large Cap Dividend Fund (DLN) in July. At current market prices, there is no premium for quality. Some of the world's finest companies are also among the cheapest. This is a condition that should normally never exist, yet it does today. When the market gives us gifts like these, we gladly take them.

The International Dividend Achievers index is as close to a pure play on non-US quality as we have seen. To become eligible for inclusion, a company must be incorporated outside of the United States. The companies must be have an American Depository Receipt or common stock trading on NYSE or NASDAQ. Most importantly, companies must have paid increasing regular annual dividends for five or more consecutive years.

A company that could raise its dividend over the past five years—years that included the worst credit crisis in 100 years and the worst recession since the Great Depression—is a company that is clearly worth owning at the right price. And in PID, we get an entire portfolio of them trading at a trailing P/E ratio of only 12. As an aside, several companies that have been highlighted in The Sizemore Investment Letter are currently in the index, including AmBev (ABV), Turkcell (TKC) and Telefonica (TEF).

We consider PID to be an excellent position at current prices.

Looking Ahead

With the third quarter finishing as strongly as it did, we expect a more muted finish to 2010. We do not necessarily expect a crash or significant correction, but at the same time we do not expect the strong momentum to continue throughout the fourth quarter.

Given our ambivalent view towards the potential for capital gains, we believe that our current emphasis on high income will be a major plus over the next 3-9 months. 40% of the Tactical Portfolio is allocated to dividend-centric stocks and high-yield bonds, while another 30% is allocated to sectors that have payouts higher than the market averages. We also have zero exposure to the sectors we feel are most at risk of collapse—gold and commodities—and zero exposure to low-yielding US Treasuries.

Here's looking forward to a strong finish to 2010,

Charles Lewis Sizemore, CFA

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