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].

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

Dividend Growth Portfolio November 2017 Letter to Investors

If it ain’t broke, don’t fix it.

That was the approach I took this past month. Apart from some modest rebalancing, I made no major portfolio changes. And barring any expected new opportunities, I’m not expecting to make many major changes between now and year end. Frankly, we are already well allocated to the sectors that I consider the most attractive on a valuation basis. And if investors continue to rotate out of growth names and into value names – a trend that has been in effect in the first few trading days of December – we should enjoy a very strong finish to the year.

After all fees and expenses, the Dividend Growth portfolio returned 0.4% in November and 7.6% year to date. While a respectable performance, it is has significantly trailed the S&P 500’s year-to-date return of just over 20%.

When you run a strategy that has a low correlation to the broader market, periods of underperformance like this are part of the game. It’s fun when your strategy is performing well, as it did last year. In 2016, Dividend Growth returned 26% after all fees and expenses vs. a 12% return for the S&P 500. Of course, it’s less fun when you’re lagging as we are today.

My advice here is to keep the faith. My strategy is a patient one: I buy stocks I consider undervalued and collect a growing stream of dividends while I wait for the market to recognize the value. If I’m slightly early in a trade, that’s perfectly ok. I’m generally being paid quite handsomely to wait.

Over the past month, our performance was dragged down by our MLP and alternative asset manager holdings. In particular, Energy Transfer Equity (ETE) and Oaktree Capital (OAK) had the biggest negative impact. Skilled nursing REIT Omega Healthcare Investors (OHI) also had negative month, as did most of its peers in the skilled nursing space.

Our biggest winners for the quarter were deep-value play Prospect Capital (PSEC) and our play on a recovering Europe, Northstar Realty Europe (NRE).

With tax-loss selling now likely having run its course, I expect to see very strong performance from our MLP investments. I believe strongly enough in this to have made Enterprise Products Partners (EPD) my pick in InvestorPlace’s Best Stocks for 2018 contest, the annual stock picking contest I enter every year.

For what it is worth, my 2017 submission – General Motors (GM) – has been a strong performer, up 27% for the year.

That’s going to wrap it up for this month. Here’s looking for a strong finish to 2017,

Charles Lewis Sizemore, CFA

October 2017 Letter to Investors

October was a reminder for us of why it’s important to diversify. Apple (AAPL) had a fantastic quarter on expectations of strong iPhone sales, and as I write this, the company is within striking distance of being the first trillion-dollar company by market cap.

I’ve been expecting this for a long time, and it’s nice to see an investment thesis executed as expected.

General Motors (GM), also had a great month though it ended on a sour note with negative comments from Goldman Sachs prompting investors to take profits.

But these successes notwithstanding, October was a difficult month for many of my favorite sectors. Our MLPs, REITs and alternative investment managers such as Blackstone (BX) and KKR (KKR) didn’t react well to certain aspects of President Trump’s tax reform proposals. Specifically, companies that routinely use a lot of debt in their capital structures – and MLPs, REITs and private equity firms all most certainly do – might see their ability to write off interest expense curtailed.

Weakness in these sectors dragged down the Dividend Growth portfolio’s performance in October, and we finished the month down 0.4% after all fees and trading costs.

I’m not particularly concerned about the proposed tax reforms. To start, these are proposed reforms, and there is still a lot of deal making left to be done. And while our government has a long history of making very poor decisions, I don’t think they are dumb enough to pass a tax reform law that will do serious damage to the real estate market, as a cap on interest expense write offs most certainly would.

In fact, I expect that tax reform will actually help most of these companies, which was one of the reasons I overweighted them in the portfolio this year.

I’m not alone in that belief. Writing for Barron’s, Crystal Kim quoted Credit Suisse analyst Craig Siegenthaler as saying it was probable that tax reform incentivizes Blackstone, KKR and other alternative managers to ditch their complex partnership structures and reorganize themselves as C-corporations. This, in turn, would likely lead to significantly higher valuations, as institutional investors would then be more likely to embrace the sector.

Even if tax reform doesn’t happen or if it fails to compel the alt managers to reorganize, these are still very attractive companies to own at this stage of the cycle. Due to the back-ended nature of private equity returns, we should see very healthy earnings and dividend growth for several quarters to come.

Interestingly, Barron’s – which is usually quite critical of MLPs – also had very flattering things to say about Enterprise Products Partners (EPD) late last month, saying that at current prices, EPD offered both growth and income.

I would vigorously agree.

Enterprise had a disappointing quarterly earnings release and raised its distribution by less than what investors expected, leading the shares to sell off. I’m viewing this as a buying opportunity. Frankly, I know of few places you can get a 6.7% yield without taking vastly more risk.

The Barron’s article noted that the ownership structure of MLPs is changing, getting more institutional. That’s unambiguously a good thing, as the MLP sector was notorious for its gun-slinging cowboy culture of aggressive growth via debt issues and equity dilution.

November marks the beginning of the seasonally most-favorable time of the year. As bond yields continue to ease, I’m expecting a very solid end to 2017.

Until next month,

Charles Lewis Sizemore, CFA

September 2017 Letter to Investors

September was a solid month for the Dividend Growth portfolio, as it retuned 1.02% for the month. This underperformed the 1.93% return for the S&P 500, but the portfolio also started the month with a larger-than-usual allocation to cash.

The portfolio remains moderately cash heavy, with 10% allocated to cash as of month end. But as we enter the seasonally strong November to April period, I will look to get fully invested over the course of the next month, market conditions allowing.

The true standout performers in September were our two automakers, General Motors (GM) and Ford (F), which were up 11.6% and 8.6%, respectively, in September and which have continued to push higher in the first week of October.

All I can say is that it’s about time. I’ve been writing for all of 2017 that auto stocks were one of the few true pockets of value remaining in an otherwise expensive market. Furthermore, while sales were on pace to underperform 2016, I believed that any cyclical weakness would be minor. Frankly, the existing stock of automobiles on American roads is old and in need of being replaced. (The average age of an American car is now 12 years).

Furthermore, the threats posed by ride sharing services like Uber and by driverless cars – while real – are very long-term in nature and more than priced in at current levels. And finally, automakers are in their best financial shape in years and more than capable of powering through any industry downturn.

All of this was as true in January as it is today. But what forced Mr. Market to sit up and pay attention was Hurricane Harvey.

We may never know the exact figures, but as many as a million cars were estimated to have been severely damaged by Hurricane Harvey. As those cars are replaced, the buying will essentially mop up the excess inventory that has been worrying investors.

I’m far less interested in the “Harvey story” and far more interested by the fact that both General Motors and Ford are cheap stocks that pay safe, above-market dividends. But I’ll gladly take the portfolio returns, no matter where they might come from.

Unfortunately, it wasn’t all sunshine and roses last month. Bond yields climbed throughout the month, which rattled the REIT sector and some of our REIT holdings; STORE Capital (STOR), VEREIT (VER) and WP Carey (WPC) all lost ground in September and were a drag on performance.

My view of the REIT sector remains unchanged. So long as long-term bond yields remain range-bound, REITs offer an attractive income alternative. And retail REITs in particular offer value that is harder to come by in other subsectors of the REIT market.

I intend to opportunistically add new money to our REIT holdings on any further weakness, as I consider all to be very attractive at current prices.

Disclosures: Long GM, F, STOR, VER, WPC

Dividend Growth Portfolio August 2017 Performance and Outlook

August was an unusual month. We had escalating nuclear tensions with North Korea, and a storm – Hurricane Harvey – that will likely go down in history as the costliest natural disaster in U.S. history once the damages are tallied.

Yet perhaps shockingly, the stock market remained surprisingly quiet. Volatility ticked up modestly from its summer doldrums, but the S&P 500 managed to finish the month flat, up 0.1%.

The Dividend Growth portfolio finished the month down slightly, giving up 0.28% after fees and expenses. Year to date, the Dividend Growth portfolio was up 6.7% compared to 10.4% for the S&P 500 [Note: All returns data calculated by Interactive Brokers as of 8/31/2017; past performance no guarantee of future results].

I made several portfolio moves in August to better position the portfolio for the remainder of 2017.

To start, I took partial profits in oil and gas tanker operator Teekay Corporation (TK). Teekay’s stock price has been volatile in 2017 (along with energy prices), and I have been adding to the position when it reaches the lower end of its wide trading range and taking partial profits when it reaches the upper end of that range. While I expect Teekay to go much higher from current levels, I also intend to continue opportunistically trading the shares as conditions allow.

Following the announcement of a major dividend hike, I added shares of Citigroup (C) in August. The financial sector stands to benefit from several very favorable trends in the coming years. To start, while I don’t expect the Federal Reserve to be particularly aggressive in raising short-term interest rates, I do expect rates to go at least modestly higher. All else equal, higher interest rates and stronger economic growth mean higher profits for banks.

But beyond this, the large banks are one of the few true remaining pockets of value in a market that seems to get more expensive by the day. Citi trades for just 90% of book value and at a modest 11 times expected 2017 earnings.

Citi doubled its dividend last month after passing the Fed’s stress test. But even after the hike, Citi only pays out about 25% of its profits as dividends, so there is plenty of room to grow the dividend further.

Additionally, I sold three positions – Prospect Capital (PSEC), Main Street Capital (MAIN) and GameStop Corp (GME) – and have decided to keep the proceeds in cash for now.  While I do not believe a major stock-market correction is imminent, we are entering the September – October window when the market tends to be a little more volatile, and I felt it prudent to keep a little more cash on hand than usual. Assuming no unexpected developments, I will look to redeploy the capital within the next two months.

Prospect Capital’s performance has been below expectations for the past two quarters and, expecting a dividend cut, I decided it made sense to sell the shares. Prospect Capital did ultimately cut its dividend, vindicating my decision to sell.

After the post-dividend-cut selling, Prospect now sits at a very attractive 28% discount to book value, meaning the company is worth more dead than alive. I’m evaluating Prospect for re-entry and expect to make a decision in the coming weeks.

My decision to sell Main Street was based less on fear and more on opportunity cost. Main Street trades at a large premium to its peers in the business development company space, and at current prices, I don’t see a lot of upside left in Main Street, so it made since to sell and keep a little extra cash on hand to take advantage of any buying opportunities in September and October.

And finally, I believe that GameStop’s recent subpar performance is mostly due to negative sentiment towards brick-and-mortar retailers – negative sentiment that I consider extreme and overdone. Nevertheless, I see no immediate catalyst to send the stock higher. So, for now, I’m comfortable selling the stock and reevaluating it a few months from now.

That’s going to wrap it up for this month.

Thanks, as always, for trusting me with your hard-earned capital.

Charles Lewis Sizemore, CFA

Disclosures: Long TK, C