After the Concentrated Equity Alpha (CEA) product delivered a return of 38% net of fees in 2013, it has been a quiet beginning to 2014.
Sandhill added a lot of “excess return” for its clients in 2013 as the S&P 500 Index was up 29.6%.
The “digestion period” in the first quarter of 2014 was expected. If you will, the market has reached a period of “stasis” or relative equilibrium.
The backdrop to this “stasis” is that stocks are no longer the bargain they once were. The ability to buy high quality companies at less than ten times earnings does not happen very often. It did in 2009. Sandhill bought world class assets at eight, nine, and ten times earnings in 2009. Equities remained cheap in 2010 and continued to be bought over the next few years as investors got more comfortable that the economy and capital markets were returning to normal.
U.S. equities are no longer cheap. The S&P 500 Index currently trades at a multiple of 16 times 2014 earnings. The average price to earnings multiple for the U.S. stock market over the last 100 years is 14.5 times earnings…….so we are a touch expensive on a price to earnings basis.
The counterbalance in this “stasis” is that the economy continues to improve and strengthen, corporate capital spending looks better, unemployment is down, and the federal budget deficit is shrinking due to higher tax receipts. Add to this continued low interest rates (makes future cash flows more valuable) and a “dovish” Federal Reserve (continued low interest rates) and the backdrop for equities remains constructive.
So……..a fully valued market vs. a constructive investment environment. A stand-off. No wonder things have been quiet.
Where do we go from here?
As we walk forward in this “stasis” and wait for the weather to warm (in the north), the question is, “Where do we go from here?”. When the equity markets get very quiet, I pay close attention.
This is going to unfold in one of two ways, and it is difficult to tell which way it will go.
The bull case is that the market is resting. A brutal winter slowed first quarter GDP a bit, and things will get rolling once we get into the summer. Europe is growing (although slowly) again, Asia is mixed but still has very high GDP growth relative to the rest of the world, and there is a massive part of the world’s population that is moving into a consumptive phase that will drive worldwide economic expansion for years to come. (It has been well documented that when a family in an emerging economy has annual household income of more than $3000, members of the household become consumers as opposed to subsistent. Further research has shown that as families reach $10,000 in annual income, they become far more consumptive).
The bear case is that valuations are full, and because global GDP is growing slowly due to structural problems, meaningful revenue growth for corporations will be difficult to generate. U.S. corporations have already done a superb job cutting costs and eliminating waste. There is not much more profit to be gained from cost cutting. The final steps in the bear case are that revenue stalls, demographic challenges in the western world kick in, China’s asset bubble comes undone (China is now the second largest economy in the world), confidence wanes, and employment gains start to stall. With revenue growth gone and no further room to cut interest rates, asset prices deflate and the consumer gets defensive.
It really comes down to whether there will be a “mid cycle” reacceleration of the global economy and different geographies start to grow in synch and feed off each other.
Said another way, the U.S. equity market has enjoyed quite a run because earnings have grown nicely and price earnings multiples have expanded. I don’t see much more multiple expansion so it is up to earnings to drive the market higher. An increase in earnings will only come with meaningful revenue growth for corporate America and the rest of the world.
Does it matter?
We spend a lot of time telling our clients that thinking about market direction is a waste of time. To try and buy and sell in synch with economic cycles is fool’s gold. Yes, there will be obvious (but scary) moments when the market is super cheap and you put every penny on the table (2009). There are other times the market is clearly in an asset bubble and you want out (2000, 2007). However, no one is good enough to continually time the market through numerous cycles.
The proof that long term investing wins is compelling. There are only two ten year rolling periods that the U.S. stock market declined in the twentieth century. So, out of ninety-one possible periods (1900-1909, 1901-1910 etc.), there were just two ten year periods when the stock market had a negative rate of return. Both of these down periods include the heart of the Great Depression. This is an incredible record when one considers that the twentieth century included two World Wars, the Korean War, the Vietnam War, the Cold War, the grinding and cruel market sell-off of the 1970s, runaway inflation, price controls, and numerous recessions – some severe.
As the very astute investor Ron Baron said, we are in the business of compounding. The issue is simply at what rate you compound your capital.
Sandhill now has a 10 year GIPS compliant track record. From 3/1/04 – 3/31/14, Sandhill’s CEA product (which almost all of our clients own) has a cumulative return of 125.5% vs. 63.5% for the S&P 500 Index.
Would we have done better had we tried to enter and exit the market? I doubt it. One must also consider the cost of paying capital gains taxes and transaction costs when trying to time the market. It takes time to build value, and Sandhill needs to give the management teams of the companies that our clients own time to build value.
Having now done this for a fairly long time, I have found that people or institutions who do not meet their desired goals fail for one of two reasons:
- They cannot leave the money alone. Constant invasion of principal.
- They pick an active manager that underperforms (sometimes dramatically) the indices over time.
If I could impart any wisdom to a prospective investor, it would be find a good active manager and give them capital you won’t need for a long time and leave it alone. Check in with the manager every six months and judge them first and foremost on their long term record relative to the broader market. And finally, the United States still remains the best and most transparent economy and capital market in which to invest over the long term.
The natural inflator
It took me many years to learn this, but I don’t think that investors give the stock market enough credit for capturing inflation which preserves purchasing power and wealth. Good companies with healthy businesses increase prices every year. Good schools increase tuition. Sports teams increase season ticket prices. The cost of food has risen dramatically. The bottom line is that the cost of living increases every year except in exceptional circumstances.
If you are a long term investor and own good companies that make good products, the cost of those products will go up over time. Simply, there is a strong enough demand for the products so that prices can be increased. Assuming that the companies maintain a stable (or better yet increasing) operating margin and have stable (or better yet increasing) unit volumes, the companies’ earnings by definition will increase. Good companies naturally capture inflation, will earn more, and this will be reflected in the stock price.
So……this is why Sandhill looks for companies with sustainable structural advantage. Companies with sustainable structural advantage have pricing power and naturally capture inflation and earn more.
What we are doing now
We are scouring the landscape for good investments – but it is tough given that most assets are fully valued. We look for companies with sustainable structural advantage, strong free cash flows, and high return on invested capital. The beauty of what we do is that it is a dynamic, not static, pond that we fish in so there are always opportunities…….it’s just that sometimes there are less opportunities than others. We are looking high and low, but we have also learned patience. Sometimes, it’s best to be quiet.
Sandhill is very pleased to announce the hiring of Jon Amoia. Jon will be a Director of Sandhill and joins the asset gathering team. Jon enjoyed an extremely successful run at Citibank and now wants to apply his skill, knowledge, and energy in a more entrepreneurial setting. It took me many months to convince Jon to join Sandhill and we are thrilled to have him.
I am pleased to announce that at the end of March, Sandhill’s assets under management exceeded $500 million. We view this as a confirmation of our efforts and it only incents us to work harder given the trust and support our clients have given us. If we continue to grow, I can assure you that my primary duty and concern will be that Sandhill keeps doing a good job on the investment side. We are particular, we are granular, and it is very important to our whole team and to you that we continue to deliver returns over time that beat the benchmark. We also will continue to exercise sound judgment, prudence, and do our best to minimize risk. Asset quality remains paramount.
My best to you all for the summer.
Edwin M. “Tim” Johnston III
Founder | Managing Partner