The following is an excerpt from a Sizemore Capital Management internal investment memo, reproduced with permission.
Given our view that non-financial, blue-chip equities are currently the most attractive asset subclass, we have increased our allocation to the WisdomTree Large Cap Dividend ETF (NYSE: DLN) to 20% of the SCM Tactical Portfolio. This is not a short-term trade; we consider this a major change in investment strategy with a time horizon of 1-5 years.
Our belief in the attractiveness of non-financial blue-chip equities is multifaceted. Firstly, we want to emphasize how cheaply many of America’s premier companies are currently priced relative to their historical averages. As we outlined in the July issue of the Sizemore Investment Letter, Johnson & Johnson (NYSE: JNJ), Procter & Gamble (NYSE: PG), and Microsoft (Nasdaq: MSFT) (among many others) are trading at P/E ratios not seen in multiple decades.
According to financial theory, large and stable companies should trade at a premium to the broader market. By buying at higher prices, investors are generally willing to accept lower returns on blue chips in exchange for the perceived safety.
But today, the opposite is true. Many blue chips actually trade at a discount to the S&P 500.
The 2009 rally was primarily a rally in lower-quality “junk.” And while we do not necessarily forecast that the broader stock indices like the S&P 500 will see poor returns going forward (on this point we are agnostic), we do expect higher-quality stocks to outperform given current pricing. So on a valuation basis, a large overweighting in DLN makes sense.
Secondly, the competing investment alternatives are sparse. Bonds represent a remarkably poor investment given current yields. The 10-year Treasury note yields less than 3 percent—and less than the dividend yield of many of the blue-chip stocks in DLN.
There is a fair amount of overlap in our current allocation. For example, Johnson & Johnson is a major component of both DLN and IYH, and AT&T (NYSE: T) is a major component of both DLN and IXP. Under more normal pricing, we might view this as a risk. But in this situation, we consider the overlap a source of strength.
A major broad-market sell-off, were one to occur, would punish all stocks, including the high-quality names in DLN. But we consider the risk of any such sell-off to be remote enough to justify our bullish allocation.
Jeremy Grantham Appears to Share Our View
We were delighted to see that GMO’s legendary Jeremy Grantham—an investor we respect very much—appears to agree with our assessment of non-financial, blue-chip equities. In his July 2010 letter to investors, Grantham laid out his seven-year forecast for various asset classes. At the top of his list were what Grantham calls “US High Quality Stocks,” defined as those companies with high and stable profitability and low debt. Grantham sees high-quality stocks returning 7.3% per year vs. 2.9% for U.S. large cap equities in general.
While Mr. Grantham’s comments would certainly not be sufficient to persuade us to invest in the sector, we do find it encouraging that our favorite asset class is shared by an investor of his stature. We would certainly prefer to bet with Mr. Grantham than against him.
Disclosure: Author is long every stock mentioned.