Our primary goal for our managed equity portfolios is superior risk adjusted returns.  We strive to build portfolios that can withstand the worst of stock markets.  Our ability to protect capital is based upon quadrant box investing and superior sector selection.  When selecting equities for our managed portfolios,  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.  

Investment Committee

January 2, 2010