Sandhill had a very solid fourth quarter with the Concentrated Equity Alpha (CEA) composite up 6.3% (net of fees) vs. the S&P 500 Index return of 4.4%.
Many asset classes had difficulty in the fourth quarter with the collapse of oil prices being the big news.
The year of 2014 was difficult for active managers. Barron’s recently reported that only 21% of actively managed funds beat their benchmark. In a year in which many asset classes struggled, Sandhill once again delivered solid results.
Here is where we finished the year of 2014:
Sandhill CEA composite +10.5%
S&P 500 Index +11.4%
Russell 3000 Index +10.5%
iShares China Large Cap (FXI) + 8.5%
S&P 500 Midcap Index + 8.2%
BOA Merrill 5-7 Yr Aggregate (bond) + 5.2%
S&P Smallcap 600 Index + 4.4%
iShares Gold Trust – 2.1%
S&P Emerging Markets – 2.8%
MSCI EAFE Index (mostly Europe) – 9.3%
United States Oil (UAD) – 42.4%
The year of 2014 was a difficult one for active managers as there was nowhere to “hide”. Oil got hammered. So did natural gas. Emerging markets fell under the weight of lower commodity prices and a perceived global economic slowdown, Europe did terribly against the very real fear of deflation (and very serious structural problems with taxation). Finally, the Saudis decision to drastically lower oil prices has caused considerable dislocation and pain (and more to come) in the global energy complex. Countries such as Russia have been severely hurt – they generate almost 50% of their national government revenue from their domestic energy complex.
The domestic equity and bond markets were also hard to get a read on. The U.S. stock market – after a stable first half – was volatile with few trends through the second half of the year. Interest rates were supposed to go up and they went down. Put this all together, and it made for a very tricky environment. A lot of noise and a lot of rapidly changing asset prices.
I have commented to people internally that I thought this was one of our better years. After an up 38% (net of fees) year in 2013, we followed up with another 10.5% increase in 2014. We had to work hard and grind to achieve that return in 2014. Compounded – the CEA composite is up 52.2% in two years. More importantly, our consistency in philosophy and execution combined with our ability to purchase quality assets in public markets once again served us well. In some years, the wind is at your back as an asset manager – 2014 was not one of them.
There is one more subtle footnote to our performance. Almost 75% of the CEA composite’s assets are comprised of mid and small cap stocks. If one considers that our CEA composite was up 10.5% while the S&P Midcap Index was +8.2% and the S&P Smallcap 600 Index was +4.4%, our performance looks even better.
The question is then, “Why so much of the composite’s assets in mid and small cap stocks?”. For our first time readers, the answer is that Sandhill’s job is to find the best public assets (in the form of corporations) which have structural and sustainable economic advantages in healthy industries regardless of market capitalization. Finally, over long periods of time, small and mid-cap stocks have outperformed large cap stocks by a wide margin.
Through the collapse of the oil patch, we have watched as interested observers. The most commonly held theory for the collapse in oil prices is that the Saudis purposely did not cut production and cut the price of oil in half in order to slow U.S. fracking, put the brakes on global energy capital spending and exploration, make $80 oil uneconomic, and damage the economies of Russia, Iran, and Iraq. I agree with all of the above.
I also believe there is a longer agenda here. I think the Saudis want to retard the development of the electric car. Specifically, they want to slow Elon Musk down. At $4.00 plus for a gallon of gas, electric cars start to look economic and more capital flows to their development. At $2.20 for a gallon of gas, electrically powered cars are unattractive unless it’s a lifestyle choice.
The Saudis changed the game and cut the price of oil in half in six months. Small oil companies will go broke, Hedge funds will go broke. It will probably be years before we see $100 oil again.
We love this kind of dislocation. Marginal producers fall by the wayside, rig count drops, energy stocks are sold, capital spending takes a drastic fall, and operating earnings in the energy complex start to deteriorate rapidly. Investors forget that the pain isn’t over until the last shoe drops.
In times such as this, an astute investor in the energy markets needs four things: Patience to let the last shoe drop, the ability to identify companies with production growth, the ability to identify companies with low cost and long lived oil deposits, and the ability to identify companies with rock solid balance sheets that will be there at the end of the day.
We have been underweight energy until December of 2014. In the last month, we have added more Cimarex (XEC) at around $99.75 per share. The XEC position now constitutes approximately 4% of the CEA composite.
We originally bought XEC 2/19/13 at $66.62 per share. The price of West Texas Intermediate crude on 2/19/13 was $96.09 per barrel. At the close of business on 1/6/15, XEC’s price per share was $99.33 per share – an increase of 49.2%. At mid-day on 1/6/15, West Texas Intermediate crude was $48.14 per barrel – a decrease of 49.9%. The point here is that XEC’s stock is up almost 50% while the commodity is down almost 50% – the quality of the asset far outweighed the movement in the underlying commodity.
Here is what makes Cimarex interesting: XEC has a low cost asset position in the prolific Permian basin in Texas, XEC’s estimated production growth for 2015 is 21% for its oil business, XEC has a bullet proof balance sheet with $4.4 billion in equity and only $1.5 billion in debt, and XEC has $564 million in cash on its balance sheet. XEC will be standing when this is all over and will be in a better competitive position than it is today.
So…..we have moved to a slight overweight in energy relative to the S&P 500 and will get more aggressive if the energy stocks continue to decline (they have already been battered with many energy stocks down 50%). We will buy more XEC if the stock declines significantly from here. We are patiently building a position.
The year ahead
I have been asked a fair bit where the market is headed in 2015. I don’t know.
With that said, I do not think that the “party” is over. It is both a tricky and, at times, dangerous environment, but this also creates opportunity. While I certainly have a healthy respect for economic cycles and asset values, bull markets don’t often end on a sour note. There is great strength in the U.S. economy right now and I think there is more to come. Without a doubt, the collapse in the price of oil creates the greatest danger to the health of the U.S. economy.
The prices of U.S. equities has moved from very “cheap” in 2009 to a touch overvalued at the beginning of 2015. From here, a rising (or moderately rising) tide will not lift all boats. The quality (and valuation) of the assets that you hold in your portfolio will be the determinant of future success or failure. Because the world is dynamic, there will always be money to be made, it just won’t be as easy over the next few years.
Sandhill’s revenue rose 32.6% in 2014. Thank you to all of our customers. I believe very much in the holistic power that weds our client’s faith and support with our desire and ability to produce consistent, quality returns on capital over full market cycles.
In the most recent edition of Business First, Sandhill was ranked as the 20th largest asset manager in Western New York (this includes Merrill, Morgan etc.). While we take nothing for granted, not bad for a company that was incorporated a little over a decade ago.
Our growth allows me to invest in the firm and hopefully increase the abilities, products, and resources available to our clients.
My best to everyone for a happy and healthy 2015.
With warm regards,
Edwin M. “Tim” Johnston III
Founder | Managing Partner