Sheets Smith Investment Management
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Absolute Return Balanced Portfolio

Absolute Return Balanced Portfolio

Balanced Investment Philosophy

The investment objective of this product is to produce competitive returns while having Preservation of Capital of prime importance.  Our process is highly quantitative.  In addition, our process will raise substantial cash positions in a volatile market if the assets we own no longer meet our investment criteria.

There are two parts to this process.  First, the tactical asset allocation model used for the Absolute Return Balanced accounts was originally developed by William F. Sharpe.  We have modified this approach from the original by using an expected return for stocks based on projected earnings rather than historical returns.  As earnings estimates change with the economic cycle and as the price of stock market changes, the expected return of the stock market also changes.  This expected return is then evaluated with the more stable investments of bonds and cash equivalent investments.  The model calculates the optimal mix during the economic cycle based on this expected return, current interest rates and the trailing 60-month volatility of the capital markets.  As these changes occur, the portfolio manager must adjust the portfolio mix in an objective, quantitative manner, moving assets from relatively overvalued assets to ones with better risk adjusted returns.

Once the optimal, or maximum, mix is determined, assets must be selected to fill the allocation.  A proprietary analysis we use has shown us that about 65% to 70% of the time, stocks with above average earnings growth outperform the market. We, therefore, look for companies with exceptional earnings growth in the future.  These can be economically cyclical companies as well.  There are numerous other fundamental and technical criteria that are also required for inclusion in our portfolios.

The inception date of this product is 10/1/1999.  Although the asset allocation model has a much longer history, the stock selection process used in this product began on this date. On a cumulative basis since inception, the Absolute Return Balanced Portfolio has outperformed the S&P 500 with about 35% less volatility.

Investment Decision Making Process

The decision-making process begins with the asset allocation process.  This decision as well as the stock selection process is highly quantitative.  The expected returns of stocks is derived from estimates of future earnings.  This number along with the level of interest rates and the statistical measures of risk and covariances are input into the optimization model which calculates the maximum asset allocation to be used at a given time.  This process is calculated at least monthly.  The Absolute Return Balanced product, we believe, is the optimal balance between risk and return.  The firm can and does manage accounts somewhat more aggressively, but there is a corresponding increase in risk.  Conversely, the same is true for more conservative accounts.  The difference between accounts with different risk tolerances is managed through the asset allocation process, not through stock selection.  Stocks are selected for inclusion by passing several quantitative screens, the most important of these being the growth rate of earnings and the strength of earnings revisions.  Various valuation and technical measures are then evaluated.  The stocks having the best measured characteristics are included in a portfolio.

Portfolio Construction

We believe the Absolute Return Balanced product is an ideal balance between risk and return. The asset mix has averaged about 60% stocks, 30% bonds and 10% cash over many years.  However, there have been periods of time when the portfolio has been as much as 100% stocks and as little as 20% stocks.  The change in the mix is usually gradual over time, but changes in the asset mix are a primary driver of the performance of this product.  The frequency of rebalancing depends on the relative performance of stocks and changes in the level of interest rates. The Tactical Allocation model primarily drives changes in the mix but falling stock prices may also change the mix when the markets are under duress.  The decision to make changes in the mix is determined at least once per month or when significant changes occur in the capital markets.  Once the percentage of stocks is determined for the portfolio, stocks are selected by passing a screening process based on fundamentals, primarily earnings growth, earnings revisions, relative valuation measures, and various technical measures. The portfolio is highly diversified usually consisting of about 75 to 125 stocks of all capitalizations and many industry sectors.  The screening factors determine sector emphasis.  The asset classes used in these portfolios consist of stocks publicly traded in the United States, including ADR's.  Fixed income securities are generally of intermediate maturities and may consist of Government, Agency and Corporate paper and ETFs.  When appropriate, municipal bonds will be used, but those accounts are not included in the composite shown here.  Longer term and short-term maturities will be utilized depending on anticipated changes in interest rates.

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