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Our
primary goal for our managed equity and bond portfolios
is
capital preservation. We strive to build portfolios that can
withstand the worst of stock and bond markets. Our ability to
protect capital is based upon quadrant box investing, sector
selection, and hedge utilization. When selecting equities for
our clients, we seek out stocks that meet our criteria for
solid relative value (Quadrant Box) and low beta (risk) based upon
low historical P/E, P/S, and P/CF ratios. When choosing among
the various sectors of the economy, our firm focuses on three
specific criteria;
1.
Superior historical investment returns
2. Low correlations
3. Defensive capabilities
The
investment strategy for our equity portfolios is based on empirical
research undertaken by the firm’s founder Timothy McIntosh. 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-three year time frame from 1986 to 2009 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 equities are invested in these four sectors. This
compares with equivalent weighting as of 03/31/09 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 are typically invested in 30-50 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 (15-35% range), Energy (10-25%), Technology
(10-25%), Financials (5-20%). Other sectors generally 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 20% per year. Our
bond portfolios are comprised of laddered high grade corporate bonds
and treasuries.
Investment
Committee
January
2, 2010
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