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The
philosophy for our managed equity portfolios is based upon a combination of preferred sector investing,
contrarian stock selection, and quadrant box investing.
The
investment strategy for our domestic funds is based on empirical
research undertaken by the firm’s founder Timothy McIntosh, whilst
he was working on his Phd. This
research has two facets; sector investing and contrarian investor
behavior. His findings
concurred with better well-known research namely papers published by
Jeremy Seigel of the University of Pennsylvania & Richard Thaler
of the University of Chicago. In examining
the firm’s sector investment philosophy, studies were completed
that concluded that only 4 sectors consistently produced superior
performance over the long-term and that there are predictable cycles
in the price movements of equities.
This data was compiled from Lipper Mutual Fund Data.
An examination of the Lipper Mutual Fund Data over a
twenty-seven year time frame from 1980 to 2007 found that only four
sectors, healthcare, energy, technology, and financials, produced
superior returns over that of the benchmark S&P 500 stock index.
All other sector had returns below that of the index.
This return data was supported by larger well known research
completed in the past ten years.
The most notable was a study performed by Jeremy Seigel of
the
University
of
Pennsylvania
. In
March 2005, Dr. Siegel published a book titled The
Future for Investors: Why the Tried and the True Triumph Over the
Bold and the New. In
the publication, Dr. Siegel found five sectors have outperformed the
S&P 500 during a period from 1957-2003.
These five sectors were healthcare, energy, consumer staples,
technology, and financials.
Dr. Siegel’s work confirmed our own internal study.
However, our
investment strategy does not incorporate consumer staples as feel
the healthcare sector provides enough “defensive capability”
within our own internal investment strategy.
Furthermore, the consumer staples sector has not performed as
well since 1980 (according to the Lipper data) as it had in the two
previous decades.
The
attributes of our four favored sectors are not just limited to
performance. Healthcare stocks offer a strong defensive
characteristic and have historically held up well during period of
market turmoil. Energy stocks provide an excellent choice
based upon their low correlation to the other three sectors. Energy
stocks also provide a portfolio hedge against inflation. Inflation
has an adverse impact on the stock market. In the last two periods
of high inflation (1974, 1979), stocks performed very poorly. One
advantage of investing in our four recommended sectors are the low
historical correlations that these four sectors possess. The highest
correlated sectors are the healthcare and financials; with a 0.64
correlation. This is considered moderately high. However, all other
correlations within the four sectors are at a 0.45 or less. Some
relationships are exceptionally low. Healthcare and technology have
a minuscule 0.07 correlation. Energy and healthcare have a
diminutive 0.19 correlation. These low correlations indicate these
sectors offer high performance, but do so at different times.
In light
of this, SIPCO’s portfolios focus on the four sectors highlighted.
Approximately 75% of our portfolios are invested in these
four sectors. This compares with equivalent weighting as of 09/30/08
of the major indices of 58% for the Russell 1000 Value Index, 56%
Russell 1000 Growth Index & 58% for the S&P 500 Index. A
major positive attribute of focusing on these four sectors is the
production of excellent risk-adjusted returns. The correlations
amongst the sectors are low and hence the overall result is a
reduced risk profile.
The
second part of our investment strategy is devoted to “fallen
angels”. This is
based upon the academic argument known as the overreaction
hypothesis. The
overreaction hypothesis states that investors are inclined to digest
information irrationally and have a disposition of placing too much
weight on more current events. In
other words, investors ordinarily interpret new information, be it
available or unavailable, in a systematically biased manner. They
tend to be either over-optimistic or over-pessimistic, with no room
in between. Under such a scenario, equity prices are not equitably
determined by the “true” forces of market supply/demand and are
not in equilibrium all of the time, especially when new information
or extreme events arrive. This
theory was tested most notably by Professors Werner
F. M. DeBondt and Richard H. Thaler of the
University
of
Chicago
. Their study
tested stock market overreaction and subsequent price action.
De
Bondt and Thaler ranked two sets of stocks; past winners and past
losers over a preceding 12 months.
The study then followed these two groups over a 36-month and
60-month period. They
found the loser stocks outperform past winners by a significant
margin over both periods. The
longer the period, the more dramatic the outperformance.
DeBondt and Thaler concluded
investors tend to overreact to some unexpected sensationalized news
events regardless of whether the events are positive or negative,
and that the overreaction tends to negatively affect short-term
stock prices. This short
term irrationality causes the stock to trade at a level below
normalized value, and thus subsequent long-term returns are above
average. We define these
loser firms as “fallen angels” and incorporate this contrarian
investment method as a primary basis for stock selection
Investment Process Selection: Quadrant Box Investing
Investment ideas are generated through a screening process. First,
our firm screens our four primary sectors according to historical
relative value. The primary screening methods are historical
price/sales, price/book, and price/earnings ratios. We divide each
sector into four quadrants.
 
 
The
first quadrant possesses those securities that maintain the lowest
price/sales and price/earnings ratios compared to their own
historical range. Within this sector, several "fallen
angel" candidates will appear. The fourth quadrant contains those that have the
highest price/sales and price/earnings ratios compared with their
own historical range. Our investment choices will come from each
sector’s quadrant one selections. Once these candidates have been
identified, we then explore each company in detail to access
potential. We utilize both internal and external research sources.
Wall Street research from the major brokerage houses is utilized for
an overview of outside opinions and market expectations. Our own
internal research then is initiated beginning with an in-depth
10k/10q review. Assessments are made in regard to the quality of the
company, management, and financial capabilities. Earnings and
revenue projections are made, and stock valuation appraised.
All stocks within the quadrant one fields are placed on a watch
list. We will set our target buy price for each of these
"fallen angel" securities.
If the stock meets our target price, then it is a potential buy
candidate. It will only be purchased, however, if several other
parameters are met. One, the sector of the buy candidate is viewed
favorably by our firm. Second, the sector is not fully weighted
(i.e. healthcare at 30%). Third, there is ample cash for purchase,
or another stock is to be sold in the portfolio. Stocks are sold out
of the portfolio generally for the following reasons; One, stock met
target price. Second, stock valuation enters the third or fourth
quadrant of screening within its sector. Third, any accounting
irregularities. Fourth, a major change of leadership or strategy at
the company.
Our two portfolio managers and one equity analyst are the primary
decision makers for each portfolio. Ideas are generated through the
screening process and discussed and analyzed during investment
committee meetings. The actual decision to buy or sell in each
portfolio is authorized by the lead manager.
Additional Comments
Our equity portfolios; U.S. Growth Leaders and U.S. Value
Leaders, are typically invested in 30-40 stocks. The
portfolios are large-cap offerings that follow a GARP style
with our unique "fallen angel" and quadrant box investing approach. Portfolios are
constructed by sector weights, then stock selection. Guidelines to
our preferred sector weights are as follows; Healthcare (15-30%
range), Energy (10-25%), Technology (10-25%), Financials (10-25%), .
Other sectors account for 25% of the portfolios weight. Within this
25%, not more than 10% can be devoted to any one sector. Minimum
market capitalization is $10 billion for any potential equity
selection. Cash will not exceed 10% of portfolio. Turnover averages
less than 25% per year.
Timothy
J. McIntosh, CIO
June
2, 2008
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1-800-805-5309
