Dividend Growth Portfolio 2017 Year-End Letter to Investors

For the full-year 2017, the Dividend Growth portfolio returned 8.5%, trailing the S&P 500’s 19.4% by a wide margin [returns figures calculated by Interactive Brokers; past performance no guarantee of future results]. While I probably shouldn’t consider an 8.5% annual return a “failure,” it’s certainly frustrating to me to trail my benchmark like this. So, we’re going to take a long, hard look at what went right and what went wrong in 2017. To start, it’s important to remember that, by design, my returns will deviate from the indexes. In my view, an active manager whose return closely mirrors that of the S&P 500 (or any benchmark) is a closet indexer that isn’t offering much in the way of value. If a manager is too timid to deviate from the S&P 500, then frankly, the client would be better served by firing the manager and opting for a cheaper index fund. An actively manager should be truly active. This means that, if they are doing their jobs, there will be years where they beat the pants off of the S&P 500, but there will also be years when they don’t. Over time, an active managers’ returns should be as good or better than their benchmark index’s returns. But just as importantly, their returns should not be highly correlated. And here, I can confidently say that my returns are not highly correlated to those to the S&P 500. The Dividend Growth portfolio consistently produces an R-Squared of 0.5 to 0.6. In plain English, this means that only about half of the portfolio’s returns are explained by the S&P 500. The rest is explained by stock picking. That is exceptionally high diversification for a long-only stock portfolio. In 2016, the Dividend Growth portfolio beat the S&P 500 by a wide margin, 26.0% vs. 9.5%. Last year, it underperformed, 8.5% vs. 19.4%. That is the nature of a truly actively-managed portfolio. There will be years of outperformance, and there will be years of underperformance.

Growth vs. Value

While the Dividend Growth portfolio has “growth” in its name, this refers to dividend growth and distinctly not “growth investing.” My mandate is to find undervalued stocks that are raising their dividend payouts. I am, by temperament, a value investor. You will never see me chasing hot, faddish stocks in this portfolio. Well, 2017 was a year that favored glitzy growth investing over sober value investing. The S&P 500 Value index returned 11.5% last year, whereas the S&P 500 Growth index returned an eye-popping 24.4%, reminiscent of the go-go days of the late 1990s. No style of investing works best in every single year, but over time value investing with a focus on dividends has proven to be a winning strategy. In the late 1990s, growth stocks left value stocks in the dust. But from 2000-2008, it was the value sectors that outperformed. And while I cannot guarantee a similar shift to value outperformance is imminent, I believe that day is getting close. As I write this, the S&P 500 sports a cyclically-adjusted price/earnings ratio (“CAPE” or “Shiller P/E”) of nearly 34. That puts current valuations on par with late 1997, as dot-com mania was entering its final blow-off stages. And as was the case in the late 1990s, we’re starting to see the excesses you see near a major top, particularly in cryptocurrencies like Bitcoin and in stocks purporting to be using blockchain technology. Again, this doesn’t mean the market is topping today, tomorrow, or even next month. As we saw in the 1990s, an expensive, bubbly market can get a lot more expensive and bubbly before reaching its ultimate top. But I very emphatically believe that staying the course with an income and value strategy makes sense at this stage.

Where We Are Investing in 2018

Our largest exposures as of this writing are in midstream oil and gas pipelines, automakers, alternative asset managers and REITs. After a mixed year in 2017, pipeline stocks, automakers and alternative asset managers have all enjoyed a very strong start to 2018. I expect these sectors to be very strong drivers of our returns this year. REITs, however, have had a rough start this year. And while it’s impossible to ever truly know “why” a sector falls out of favor, it appears that worries over rising bond yields is what is depressing REITs at the moment. Rising bond yields affect REITs in two ways. To start, REITs tend to borrow a lot of money, so every additional dollar paid out in interest due to rising yields is a dollar that comes out of profit. But secondly, REITs, as high-yield investments, are also priced relative to bonds. So, rising bond yields (and falling bond prices) mean rising REIT yields (and falling REIT prices), all else equal. With U.S. economic growth picking up, there is widespread belief that inflation is just around the corner. And higher inflation, were it to happen, would almost certainly mean higher yields. I’m not convinced that higher inflation rates are imminent, however. Inflation remains very subdued globally, and this is reinforced by the aging of the baby boomers and by technology trends. All else equal, older consumers borrow and spend less than younger consumers. So, the aging of the baby boomers creates a deflationary anchor that should keep inflation rates low for a long time to come. Furthermore, the wage inflation that has been so hard to come by over the past 10 years isn’t likely to come roaring back, even with a strong economy. In virtually every customer facing industry, kiosks and smartphone apps have effectively replaced human labor. As soon as higher labor costs start to cut into profits, companies react by replacing expendable labor with cheaper technology. And while this trend has been with us since the dawn of human history, today it is accelerating at the fasted rate since the Industrial Revolution. So again, inflation is not something I’m particularly concerned about, and I believe that the current spike in yields will recede within a few months. I may prune our REIT portfolio slightly in the first quarter, but I believe the overall bearishness towards the sector is unwarranted, and I continue to view the sector as a  good “fishing pond” for stable, dividend-paying stocks. That’s going to wrap it up for this month. Looking forward to a strong 2018, Charles Lewis Sizemore, CFA This article first appeared on Sizemore Insights as Dividend Growth Portfolio 2017 Year-End Letter to Investors

Alternative Investments Gone Wrong: The Story Of The Dallas Police Pension Plan


Alternative investments can both reduce risk and boost returns in a well-constructed portfolio, particularly at a time when traditional investments like stocks and bonds are expensive and priced to deliver disappointing returns.

But the key word here is can. Alternative investments can deliver that holy grail of higher risk-adjusted returns if chosen carefully and in prudent allocations. But if done poorly, alternative investments can just as easily take a wrecking ball to a portfolio and destroy years’ worth of gains.

As a case in point, consider the story of the Dallas Police & Fire Pension System (DPFP).

Dallas cops are in a dangerous line of work, a point that was made clear by the sniper attack this summer that tragically claimed the lives of five officers. But in exchange for the risks they take in keeping the rest of us safe, cops get certain perks, such as retirement at age 55 with a traditional pension plan. Well, today, those benefits are under serious threat.

After making a series of questionable investments during the go-go years of the real estate bubble, the DPFP took massive losses that effectively bankrupted the plan that over 9,000 current and former police officers, firefighters and their families depend on. Before the dust settles, Dallas taxpayers will probably have to shell out $600 million or more to keep the plan afloat, and the police and firefighters may be forced to work longer or accept benefit cuts. No matter what the final deal looks like, it will likely be a raw one for the police and firefighters… and for the taxpayers they serve and protect. And all of this is due to the incompetence of an investment manager.

What Happened?

Well, it made sense at the time…

Following the 1990s tech bubble and bust, the plan’s managers wanted to diversify outside of the risky stock market. But in order to make the targeted 8.5% return, bonds weren’t going to cut it. So the fund diversified into the wild, wild west of alternatives.

Hey, I get it. What was true in the early 2000s is even more true today. Stocks are expensive and looking wobbly, and bonds yield so little as to be unworthy of consideration for many investors. But what the fund’s managers did next is remarkable for its lack of basic prudence and common sense.

At one point, the fund had over half of its investments in alternatives. Now, in a vacuum, that’s not necessarily a bad thing. The Harvard University endowment fund has famously kept about half of its portfolio in alternatives for years. It’s the particular choices of assets that the DPFP held that should have been a major red flag. Among other questionable assets, the fund owned interests in the American Idol production company, luxury homes in Hawaii, a Napa vineyard and Uruguayan timberland.

I think there might have been some oceanfront property in Arizona in the mix too.

Not All Alternative Investments Are Created Equal

Apart from sheer strangeness (Uruguayan timber?), the alternative investments owned by the Dallas police pension had some other aspects in common. To start, all were extremely illiquid. Now, illiquidity is not necessarily a deal breaker. I’m comfortable with an asset being somewhat hard to sell so long as it is relatively safe and throws off consistent income. For example, the Dallas police would have probably been perfectly fine owning a diversified portfolio of rent-producing apartments or warehouses… but instead their managers bought them glitzy luxury properties and raw land held for speculation.

Along the same lines, the assets they owned, in general, did not have observable prices. Now, again, that is not necessarily a deal breaker by itself. It’s silly and cost prohibitive to get real estate appraised every month, and appraisals might not be accurate in the absence of reliable comps. And investments in private equity or private individual businesses also lack observable prices. But this is why you keep investments like these as a small piece of your portfolio and, again, make sure that they throw off a reliable stream of current income.

Doing It Better

So, how can we avoid falling into the same traps that ensnared the Dallas police and firefighters? After all, with stock and bond prices still very elevated, the case for alternatives is stronger than ever. So how can we avoid investing in alternatives that blow up?

To start, use the same common sense you would use in a traditional stock portfolio and keep your position sizes reasonable. What is “reasonable” may be subjective, of course, but common sense applies. Putting 10%-20% of your portfolio in a single alternative fund may be completely reasonable if that fund is itself very well diversified and liquid. Putting 10%-20% of your portfolio into a single property or into an operating business in which you are a passive investor with no operational control is probably not reasonable.

When I put together an alternative portfolio, I generally like to see four conditions in place:

  1. The alternative investments should be uncorrelated to both the stock market and to the other alternative investments in the portfolio.
  2. The returns should be consistent and, ideally, have a current yield component.
  3. The assets should be relatively liquid. I don’t have to have 24-hour instant liquidity, but I need to know that my clients can get their money out in a month or two if they need it.
  4. The investment should have observable prices or, at the very least, accurate financial statements that give me an indication of financial health.

In the interests of full disclosure, I co-manage a liquid alternative robo advisor specializing in risk parity strategies. So, I’m obviously a believer in alternative investments and make them a major part of my practice.

The pension crisis has led many Dallas police officers to retire early and request a full distribution of their pension out of legitimate fear that the plan will fail. If you’re one of those officers, give my office a call to see if our liquid alternatives might be the answer for your portfolio.

Charles Sizemore is the principal of Sizemore Capital Management, a registered investment advisor based in Dallas.

This piece first appeared on Forbes.

This article first appeared on Sizemore Insights as Alternative Investments Gone Wrong: The Story Of The Dallas Police Pension Plan

In Defense of Hedge Funds…


Photo credit: Sean Davis

Hedge funds don’t get a lot of love these days. They’ve underperformed for years, and their fees — the standard is 2% of assets and 20% of profits — make them a pariah in the age of indexing and low-cost robo advisors.

Hey, I get it. The high fees and lousy performance of competing hedge funds was a major reason that I started a liquid alternative robo advisor with my partner, Dr. Phillip Guerra. We run a suite of risk parity portfolios that hold their own against comparable hedge funds… and we do it at a fraction of their fees.

Yet let’s not throw out the baby with the bathwater. While many — perhaps most — hedge funds add no real value and certainly don’t justify their fees, there are plenty of hedge funds that absolutely do add value and deserve every last cent. But how do you separate the wheat from the chaff?

Ask yourself the following questions:

Does the fund do something unique that realistically cannot be replicated in a cheaper and more transparent vehicle, such as an ETF, mutual fund or managed account?

Really dig deep here. If the fund is a long-only large cap fund, you should be skeptical as to whether the hedge fund structure is necessary. If the fund employs sophisticated hedges that would be hard to implement in a smaller managed account, then the hedge fund structure is probably justified.

Does the fund deal in illiquid securities that would justify the lack of liquidity of the fund itself?

Years ago, a hedge fund in the DFW area made a fortune buying idled planes from the major airlines. Needless to say, that sort of thing would be impossible to replicate in a mutual fund, ETF or managed account. It’s virtually impossible (or at least impractical) to securitize an airplane. On a similar note, in the past I have placed accredited investor clients in a fund that finances medical accounts receivable that might take two years or more to pay off. It’s hard to see a strategy like that working in a mutual fund that promises daily liquidity.

Does the fund have a strategy that would be fundamentally undermined by investor redemptions?

Think about corporate raiders like Daniel Loeb or Carl Icahn. These guys are known for amassing massive stakes in companies and then using their clout to force change, including booting out management that is underperforming. That only works if you have a stable pool of capital. Imagine Loeb attempting to take over a company and then having to back away with his tail tucked between his legs because he had a wave of shareholder redemptions.

When your advisor pitches you a hedge fund, you shouldn’t necessarily recoil in horror. I regularly incorporate hedge funds into the portfolios of my accredited investor clients when they fill a specific niche I’m trying to fill. And to date (knock on wood), I have yet to have a major disappointment on this front. I’ve lost plenty of money for myself and clients in low-cost ETFs and mutual funds, though I’ve never lost money (again, knock on wood) investing in a good alternative manager or hedge fund. I probably will at some point. You know the drill, past performance is no guarantee of future results. But I can credibly say that it hasn’t happened yet.

Before you invest a single red cent in a hedge fund, ask yourself the questions above. Hedge funds are certainly not for everyone, but if utilized correctly they can reduce portfolio volatility without sacrificing returns.

Charles Lewis Sizemore, CFA is the principal of Sizemore Capital, an investments firm in Dallas, Texas.

This article first appeared on Sizemore Insights as In Defense of Hedge Funds…