To Our Investors,
2011 was a year for the history books. This was a year that saw an earthquake, tsunami and nuclear disaster cripple Japan, the third-largest economy in the world. It witnessed the “Arab Spring,” the biggest upheaval in Middle Eastern politics in more than three decades. Closer to home, it saw the United States lose its coveted AAA credit rating. And of course, 2011 was the year of the slow-motion European sovereign debt crisis that, at time of writing, is still far from resolved.
Through it all, investors experienced some of the most volatile market moves since the meltdown year of 2008. This was the year of “risk on / risk off.” Virtually all risky asset classes moved in lockstep in response to macro events. When it appeared that Europe might avoid meltdown, stocks, commodities, real estate, non-Treasury bonds, and even alternative investments like fine art soared as risk appetites returned. But at the first whiff of bad news, all of these disparate assets classes crashed together.
Allocating capital under these conditions is a little like walking through a minefield. You’re generally quite satisfied to make it through in one piece. Quite a few investors—including household names like George Soros, John Paulson, and Bill Gross—saw their reputations tarnished in 2011 (see “Even the Greats Make Mistakes” for our write-up on some of these high-profile flameouts). We are pleased to say that all Sizemore Capital strategies saw positive returns in 2011.
Portfolio Review
SCM Tactical ETF Portfolio
For the year ended 12/31/2011, Sizemore Capital’s Tactical ETF Portfolio returned 2.5 percent vs. 1.9 percent for the S&P 500 Total Return Index.
While we were pleased to see that the Tactical ETF Portfolio beat its benchmark, the S&P 500, 2011 was nonetheless a frustrating year. Our decision to build the portfolio around a core of high-quality, dividend-focused stocks was vindicated, as quality dividend payers performed well relative to their lower-quality and non-dividend-paying peers. Our tactical investment in the healthcare sector also performed as expected. Our investments in emerging markets and in Europe did not perform as expected, however, and negatively impacted returns. We continue to see value in these sectors, however, and expect them to do well in 2012.
Perhaps most frustrating was our tactical gold short. We correctly identified that gold was in a bubble and predicted that its price would crash (see “Is the Gold Bubble Reaching its Climax?”). Yet despite being correct about the gold bubble, our implementation of the gold short was ineffective. Rather than being a significant driver of portfolio gains, our two attempts at shorting gold resulted in small portfolio losses. Such was 2011; you could be “right” and still lose money.
Still, we shouldn’t complain. By keeping the core of the portfolio invested in high-quality dividend payers, we prevented small unsuccessful tactical trades from inflicting large losses on the portfolio as a whole.
Looking forward, I am confident that the strategies being employed in the Tactical ETF Portfolio will serve us well in 2012. We added one new tactical position at the end of December, the iShares MSCI Germany ETF (NYSE:EWG), which complements our existing tactical position in Spanish equities. We expect the European bond markets to stabilize in the first half of 2012, and as a result we expect European equities to be among the best performing of all asset classes. The core of the portfolio, however, remains invested in high-quality, dividend-paying stocks. So, should capital market conditions remain volatile longer than we anticipate, the core of our portfolio should remain relatively stable.
SCM Strategic Allocations
In 2011 the SCM Strategic Allocations enjoyed the following returns:
| Preservation of Capital | 3.83% |
| Conservative Income | 8.20% |
| Growth and Income | 6.62% |
| Growth | 4.13% |
| Aggressive | 2.13% |
All Sizemore Capital Strategic Allocations outperformed the S&P 500, which had a total return (capital gains and dividends) of 1.9 percent. The superior returns were largely the result of Sizemore Capital’s focus on income. The S&P 500 was flat for 2011—starting and finishing the year at 1,257—meaning that the 1.9 percent total return is due entirely to dividends. The higher returns enjoyed by Sizemore Capital’s Strategic Allocations relative to the S&P 500 are almost entirely due to the higher yields paid on the Allocations’ portfolio holdings.
Looking forward, we expect to see a greater percentage of the Allocations’ returns coming from stock dividends. With growth options somewhat limited, many companies have opted to increase their dividends in recent years. Dividend payout ratios, however, remain quite low, suggesting that there is plenty of room for additional dividend hikes.
Notably, we do not expect the bond holdings of the Strategic Allocations to be meaningful contributors to portfolio returns in coming years. With bond yields as low as they currently are, it is not realistic to expect future returns to be as high as the returns of recent years. That said, we do believe that bonds continue to play a valuable role as a portfolio “shock absorber” and that, when utilized with an effective rebalancing strategy, reduce portfolio risk.
Looking Ahead
Last quarter, we wrote that “The remarkable thing about the volatility that has dominated the markets for the past several months is that none of the issues driving it are new.” And as this letter is going to press, little has changed. Europe remains the key. When it appears that Europe’s leaders have reached a political solution to alleviate the debt crisis, the capital markets shift into “risk on” mode; when the political solution inevitably falls short of expectations, they shift instead into “risk off” mode.
We expect a workable solution in the first quarter of 2012, but we also expect a lot of volatility in the meantime. In 2011 taught us anything it is to expect the unexpected. And our preferred way to prepare for the unexpected in this environment is to err on the side of quality. Given the attractive pricing and negative sentiment in most world markets, we believe that putting capital at risk makes sense. We view the “risk” in today’s market as that of short-term volatility; but the risk of permanent or long-term loss would seem remote.
Looking forward to a profitable 2012,
Charles Lewis Sizemore, CFA
Chief Investment Officer, Sizemore Capital Management, LLC
