Sizemore Capital Management 2010 4th Quarter Letter to Investors

The following is an excerpt from Sizemore Capital Management LLC's 2010 Year End Investment Outlook and Commentary, reproduced with permission.

I am proud to announce that Sizemore Capital Management has logged another successful year. Our actively-managed Tactical Portfolio returned 15.7% for the year 2010, essentially matching the 15.1% for the S&P 500 Total Return Index but with less volatility.

We made no major changes to the Tactical Portfolio during the fourth quarter of 2010, maintaining our strong focus on income and our contrarian value positions in the health care, utilities, and global telecom sectors—all of which we see doing exceptionally well in 2011. In the first week of January 2011, we reinvested the 5% of the portfolio that was formerly in cash in the PowerShares International Dividend Achievers ETF PID, raising our allocation to 15%. This brings our total allocation to dividend-focused investments to 35% of the portfolio. Our sector positions in health care, utilities, and telecom make up a combined 30%. The remainder of the portfolio lies in our core position in the S&P 500 (25%) and our tactical position in high-yield bonds (10%).

This is an optimal allocation for the economic environment I see materializing in 2011. Though I do not anticipate a return to the crisis conditions of recent years, I do see risk aversion making a comeback and would expect investors to rotate out of cyclical sectors—which are beginning to look extended—and into value sectors. I view the energy and materials sectors as being particularly at risk. These sectors were among the best performing in 2010 (see Figure 1), while our contrarian investments in health care, utilities, and telecom were laggards. I see this trend reversing in 2011, as investors take profits in the cyclical sectors and look for bargains among the currently out-of-favor sectors. Valuations in our contrarian sector positions—as measured by price/earnings ratio and dividend yield—are highly favorable relative to the broader S&P 500.

Furthermore, I believe that the recent spike in interest rates is already nearing its end. Interest rates may never again fall to the lows seen earlier in the year, but the absence of inflation should guarantee that they stay low by historical standards. This should benefit our dividend-focused investments. (For a more detailed explanation of SCM's views on interest rates, please see: “Is There a Bubble in Bonds?” and “There is NOT a Bond Bubble—at Least Not Yet.”)

A rising interest rate environment is generally bad for all sectors of the stock market, but sectors that receive a high percentage of their total return in the form of dividends are particularly at risk. After all, investors have no need to accept the volatility of equities if they can get comparable yields in the bond market. Expectations of a continued rise in rates caused the Tactical Portfolio's positions to underperform in the 4th quarter of 2010, losing some of the relative outperformance from the 3rd quarter.

In a more normal environment, rising rates would also punish cyclical industries such as industrials, basic materials, and energy. Of course, we are not at all living in normal times; we are living through an extended liquidity-driven “reflation” of the capital markets after the worst credit crisis in a hundred years. As the angst that gripped investors during the second and third quarters began to lift, money poured into the most volatile and economically-sensitive sectors and into emerging markets. Commodities and energy have been in a bull market for roughly a decade now, and these sectors are becoming increasingly trendy. It is my belief that the prices of many physical commodities are now firmly in bubble territory and driven almost entirely by speculators in the plethora of new commodity-themed ETFs and mutual funds. While we cannot know with certainty when this bubble will burst, I feel that it is prudent to avoid commodities and to underweight materials and energy equities. It is unrealistic to believe that commodities and energy will continue to rise in an extreme low-inflation environment. Furthermore, a major bust in China—which I consider a question of “when” rather than “if”—would put extreme pressure on commodities and energy prices. (See “More Evidence of a Chinese Investment Bubble” for an expanded analysis of the China bubble).

Betting Against the Herd

In November, I published an article that discussed the extreme negative sentiment toward the utilities sector based on a survey published on November 1 by Barron's (see “Avoid the Herd: Buy Utilities”)

On December 22, Barron's published the results of a similar survey. Despite the passing of nearly two months and the selection of a new panel of professionals, the results were nearly identical (See Figure 2).

The utilities and health care sectors are absolutely despised by the “Big Money” interviewed by Barron's. Fully half of the investors surveyed were bearish on the two. Utilities got not a single bullish vote, and health care got only one. The figures for telecom were little better.

Meanwhile, fully half of those surveyed were bullish on energy (and none bearish), and a whopping two thirds were bullish on technology.

As a contrarian value investor, this is exactly what I like to see. The sectors that have performed the most poorly over the past several years in Figure 1 are the very same sectors that investors are shunning in Figure 2. What this tells us is that these sectors are under-owned and that the selling has largely already been done. While not an exact science, I consider this to be an excellent rule of thumb for evaluating sectors.

At the very least, what this tells us is that the downside should be limited in these sectors relative to the others. If I am right about the coming sector rotation and about inflation being benign, then we should earn market-beating returns in the quarters ahead. But if I am wrong, the cheap valuations and high yields mean that our downside should be limited.

Looking Ahead

2010 was a great year at Sizemore Capital Management. Here's to making 2011 even better.

Respectfully,

Charles Lewis Sizemore, CFA

For the complete letter, see: Sizemore Capital Management 2010 4th Quarter Letter to Investors

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