Sizemore Capital 4th Quarter 2015 Letter to Investors

I wasn’t sad to see 2015 end. It was called “the year that nothing worked.” And while that’s not entirely true – if you happened to be long the “FANG” stocks Facebook, Amazon, Netflix and Google, you did quite well – it was certainly true for my Dividend Growth portfolio. The strategy had a poor second half to the year, erasing the gains of the first half and leaving it with a loss of 11.3% for the full year net of fees.

And the volatility didn’t end on December 31; it spilled over into January. As I’m writing this letter, the maximum drawdown from the April 2015 highs to the mid-January lows was a gut wrenching 27.6%.

That might be tolerable if I were running an aggressive growth portfolio full of speculative names. But I distinctly built my Dividend Growth model with low volatility in mind. The portfolio entered the year with a beta of 80%. In layman’s terms, that means that the Dividend Growth portfolio was about 20% less volatile than the broader market. And with an R-squared that generally stays in the 60s or 70s, the portfolio’s correlation to the broader market has historically been low. This is a portfolio designed to march to the beat of its own drum, regardless of the direction of the market.

So, what happened? And more importantly, what is the outlook for 2016?

I’ll address each of those questions. The short answer is that we got bogged down in a credit crunch and that the portfolio should enjoy a nice recovery once credit conditions return to “normal.” Now let’s get into the details.

What Went Right in 2015

Let’s take a moment to review the Dividend Growth portfolio’s mandate. Its primary objective is to provide a high and growing stream of income. And on this count, the portfolio delivered. The portfolio started 2015 with a trailing dividend yield of 4.8%, more than double the dividend yield of the S&P 500. And we achieved very respectable dividend growth: Total cash received from dividends in 2015 was up 8.7% over 2014.

We had two stocks – Kinder Morgan (KMI) and Teekay (TK) – take us by surprise with dividend cuts. But portfolio wide, the theme was one of growing dividend payouts.

I’m willing to stomach quite a bit of market volatility if I’m confident that the stocks I own will continue to deliver a reliable dividend stream to my investors. Providing income in retirement or dividend compounding at younger ages are my primary objectives, after all. But it’s hard to enjoy that income when you see the value of your portfolio grinding lower every day.

What Went Wrong in 2015

Where do I start. REITs started to come under pressure in the first quarter due to fears that (eventual) Fed tightening would raise their cost of capital. REITs started to stabilize…right about the time that oil took a major leg down and dragged the entire MLP sector with it. Then China started to buckle, and several of my standard divided-paying stocks started to sell off due to their exposure to China. And all throughout the year, there was nearly continuous selling of mortgage REITs, business development companies and closed-end bond funds, mostly due to fear of Fed tightening.

But what really hurt my returns was the implosion of the MLP sector in the last two months of the year. MLPs depend on stock and bond sales to fund growth. During the boom years, the bond market all but tripped over itself giving cheap financing to the midstream pipeline MLPs. But when the bond vigilantes sobered up and noticed the junk bond market’s exposure to oil and gas exploration companies, yields began to rise and credit ratings came under scrutiny…even for the quality names in our portfolio. And I should emphasize here again that the MLPs we owned throughout 2015 were the blue chips of the midstream segment.

Kinder Morgan faced a choice: Either they kept the dividend intact and sacrificed growth…or they cut the dividend and used the saved cash to “self-fund” their growth projects for the future. Kinder opted to cut the dividend, sending the entire sector reeling. (Teekay faced a similar issue. They worried that, in the current credit market, one of their subsidiaries wouldn’t be able to roll over a large maturing bond issue. So they opted to conserve cash and avoid the capital markets altogether.)

To show how quickly things change, as recently as the summer both Kinder Morgan and Teekay raised their dividends and gave every indication that more dividend growth was coming. My, what a difference a couple months can make.

If there is an underlying theme here, it is credit. The sectors of my portfolio that got hit the hardest – MLPs, small and mid-cap REITs, business development companies and mortgage REITs – were the sectors most dependent on financing. We had a slow-motion crisis throughout 2015 that effectively took a wrecking ball to all of these sectors indiscriminately.

The good news here is that the underlying business fundamentals haven’t changed. The midstream MLPs continue to build out their highly-profitable empires. The small and mid-cap REITs continue to collect their rent checks and pass them along to investors as dividends. Defaults remain very low in our one business development company, Prospect Capital (PSEC). And the mortgage REIT and closed-end bond fund sectors continue to throw off a ton of cash while trading at some of the deepest discounts in history.

Credit conditions will normalize in 2016. And when they do, investors will rush back into these high-income sectors for lack of a better place to park their funds. Nature hates a vacuum, and high dividend yields will not remain unnoticed for long, particularly when the 10-year Treasury is yielding a pitiful 2.1% at time of writing.

I don’t know how long this will take. But I do know that we’re being paid handsomely to wait.

Potential Surprises

Despite the Dividend Growth portfolio’s conservative nature, we have several positions that I believe have the potential to double or more in the coming year. Prospect Capital trades for an almost pitiful 60% of book value. A narrowing of this discount combined with the ridiculous 17% dividend yield can get us to 100% profits very quickly. Could Prospect slash its dividend? Perhaps. But as of its last earnings release, it was comfortably covering its dividend, so I don’t see this as being likely over the next several quarters.

Likewise, Energy Transfer Equity (ETE) is down by more than 70% at time of writing and now yields a ridiculous 12%. As ETE struggles to complete its takeover, a reduction of the dividend can’t be completely ruled out. But we really need to consider the big picture here. The new post-merger ETE will be the biggest pipeline empire in the world and will be a cash-flow-generating powerhouse. Any reduction of the dividend would be a temporary means to an end to make the merger happen.

When ETE traded at $35, I believed that it could be worth $70 per share within a few years. While that might sound a little aggressive right now given that the stock trades for less than $10, I still consider it reasonable, at least by the end of this decade. From today’s prices, that would represent a more than 600% return.

Similarly, Teekay is down nearly 90% from its all-time highs. (I added it to the portfolio after it had already dropped by nearly a third.)

When Teekay traded at $35 per share, I believed that it would be worth upwards of $70 per share by 2020. That figure might not be attainable at this point given that the deleveraged Teekay will be raising its dividend at a much more modest rate. But considering that Teekay trades at a 25% discount to its tangible book value, it’s hard to see this stock doing poorly starting at these prices. The stock could safely triple from current prices even at the reduced dividend payout. Once Teekay’s subsidiary MLPs restart their distribution growth, I expect Teekay Corp to jump like a coiled spring.

Even Apple (AAPL) has the potential to jump by 50% or more over the next 12-18 months. Apple stock has sold off aggressively on fears that iPhone sales growth is sagging.

Well, yes. iPhone growth will slow. We all knew this. The iPhone 6 windfall was a one-time event, as it was the first large-screen iPhone that could compete with some of the larger Android handsets. No one in their right mind expected that kind of growth to continue.

But the thing is, Apple’s stock was never priced with that assumption. When you strip out Apple’s gargantuan cash position, the stock trades at a mid-single-digit price/earnings ratio. That is ludicrous pricing. Carl Icahn believes that Apple is worth more than $200 per share. I agree, though I don’t expect a stock as large as Apple by market cap to get there overnight. But over the next 2-3 years, I consider that not only possible but extremely likely.

Parting Thoughts

I don’t know what 2016 will bring. When I look at the broader market, I don’t like what I see. Stocks are expensive relative to their cyclically adjusted price/earnings ratios, and this is looking to be a disappointing year on the earnings front.

But in looking at the Dividend Growth portfolio, I’m far less concerned. Portfolio wide, we have a strong collection of dividend payers that I expect to significantly boost their payouts over the course of the year.

While I don’t particularly like volatility, I don’t fear it. I prefer to view risk the way Benjamin Graham and Warren Buffett do: Not as volatility but as the potential for permanent or long-term loss. At today’s prices, I see very little of this risk in the Dividend Growth portfolio.

To earning a solid return in 2016,

Charles Lewis Sizemore, CFA

This article first appeared on Sizemore Insights as Sizemore Capital 4th Quarter 2015 Letter to Investors

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