The stock market continues to roll on fueled by cheap money, low interest rates, very good corporate earnings, a low corporate tax rate, a very strong jobs report on April 1st, and acceleration of the national vaccine rollout. Given the vast amount of money being infused into the economy by the federal government, there is a wall of money behind the stock market. Think of it as just getting up on your surfboard with a big wave behind you……
For the first quarter of 2021, Sandhill’s Concentrated Equity Alpha (CEA) composite returned +4.2% net of fees vs. a return of +6.4% for the Russell 3000 Total Return Index.
For the first quarter of 2021, Sandhill’s Corporate Bond composite was down -0.3% vs. a return of -1.1% for the Bank of America Merrill Lynch 3-5 Year Corporate Bond Index. Very good performance.
Our equity returns
Sandhill’s CEA composite is up 21.9% net of fees over the last nine months (7/1/20-3/31/21). Over the same period, the Russell 3000 Total Return Index is up 33.2%. The CEA composite has meaningfully underperformed for the most recent nine-month period. The liquidation of two large accounts at the bottom of and early in the COVID recovery era cost the composite approximately 2.5% in performance. Most CEA accounts did better than the 21.9% return (some significantly better) over the last nine months.
Sandhill’s CEA composite outperformed the Russell 3000 Total Return Index in 2016, 2017, 2018, matched the index in 2019, and outperformed the index in the first half of 2020. Over this four-and-a-half-year period (1/1/16 – 6/30/20), Sandhill’s CEA composite was up 93.2% vs. a return of 63.6% for the Russell 3000 Total Return Index. Really good performance.
What this discussion casts a light on is our underperformance for the last nine months.
Good money managers will underperform from time to time if they stick to their process and discipline. The important take away is that the underperformance does not become long term.
We were very careful as we navigated through the COVID recovery era. We give great consideration to both our returns and the preservation of our client capital. Although we cannot control the volatility of the stock market, we are very wary of handing our clients permanent capital loss.
We understand that it is our job to figure out where the world is going and to invest across those ideas/themes, but we are not willing to pay 20-30 times revenue (yes revenue, not earnings) for companies that we don’t think will come close to validating the investment.
Since the beginning of Sandhill’s track record (March 1, 2004), the CEA composite is up 471.7% net of fees and has beaten the Russell 3000 Total Return Index by 62.8%.
The market and the economy
The biggest worries for the current equity market are massive budget deficits and artificially cheap money. The combination of these two dynamics creates bubbles – and we have to be very careful to make sure that our clients own a proper combination of growth, value, stability and safety in their portfolios. Paying any price for growth is a strategy that will not end well – of that I am sure.
Modern Monetary Theory (MMT) suggests that if a nation has a reserve currency, the nation can issue as much debt as it wants because it does not have to pay back the debt. In essence, the power of being a reserve currency is that the nation can “print” money. Want to avoid a recession? Print money. Want to juice the economy? Print money. Want to stave of the effects of a pandemic? Print money. Politicians on both sides of the aisle no longer have the will or discipline to go through a normal business cycle (which might include a recession).
What is “printing” money? Investors have images of massive printing presses running 24/7 under the Federal Reserve Building. This is not the case. “Printing” money is the Federal Reserve and U.S. Government selling U.S. government bonds to raise capital to fund our deficits. Well, that’s fine as long as U.S. citizens, foreign citizens, and foreign entities and governments will buy our bonds. As the United States issues more and more debt, this debt becomes less attractive because there is more supply. In order to sell more debt, investors demand a higher interest rate to buy the debt. This is what is happening right now.
Over the last six months, the yield on the ten-year U.S. Treasury bond has increased from .68% to 1.74%.
To my surprise, the value of the U.S. dollar against a basket of global currencies has remained constant over the last six months.
To my surprise as well, the U.S. dollar as a percent of the world’s reserve currency has remained constant at approximately 59% over the last twenty-five years.
The federal deficit in fiscal 2020 was $3.1 trillion or 15% of U.S. GDP. The estimated federal budget deficit for fiscal 2021 before the pending infrastructure deal is $2.3 trillion. The United States had and will have massive budget deficits in fiscal 2020 and 2021 that are multi trillions per year. These budget deficits are the highest as a percentage of our GDP since the end of World War II. Complete lack of discipline.
So maybe, just maybe, the “printing” of money will have a day of reckoning. The rise in interest rates is giving us a peek behind the curtain.
How this plays out
The spark that lit the fire in the first quarter of 2021 (when the stock market sold off sharply and went into negative territory) was a seven-year U.S. treasury note auction that did not go well. Soft demand. As noted, interest rates went up sharply and tech stocks sold off. The rise in interest rates stood ready to prick the tech bubble.
The market found its legs and closed strongly for the quarter. The swift but meaningful selloff in the first quarter was either a temporary blip or a harbinger of things to come.
If interest rates rise further, the stock market will get hit. The tech trade will unwind. The Federal Reserve is able to hold down short-term interest rates (by setting overnight lending rates) but does not have absolute control over the movement of intermediate and long-term interest rates. The bond market is simply too big.
The construction of your portfolio is always important, and if we do hit a bumpy patch based on massive budget deficits, rising interest rates, and the unwind of the tech trade, the quality and valuation of our portfolio companies will be the determinant of long term outcomes.
Our bond portfolios are in great shape. Of interest, 29% of client bond holdings mature or have a call in 2022.
The average duration of our Corporate Bond composite is 2.97 years with a yield to maturity of 2.25%. We have no credit problems.
The three-year Treasury note yielded .34% at the end of the first quarter – so our Corporate Bond composite yields 1.91% better than the three-year Treasury note.
As the bond market became less attractive over the last couple of years, we bought shorter and shorter duration bonds because we did not want to get locked into low rates of return for a long period. Thus, we have the short duration of 2.97 years.
We have switched our strategy and are now buying longer duration bonds as seven-year interest rates have increased substantially and we want to capture the increase in yield. Equally important, the yield curve is the steepest at seven years – and buying the steepest part of the yield curve is generally an effective strategy.
Bond yields are not yet high enough to give stocks any real competition.
Private REIT offering
The private REIT that Sandhill began offering in August of 2020 is off to a great start. The REIT share value in August of 2020 was $56 per share and over the last seven months the stock price per share has increased twice to $60 per share. In addition, the dividend has been increased twice and now stands $3.93 per share for a net of fee yield to our clients of 6.1%. The dividends for 2020 were 69% tax deferred which makes this a very attractive investment.
The private REIT that we offer is an industrial REIT and is a space that we like very much. As with any stock that we own, we have one dedicated analyst that follows the REIT. Sandhill is in close contact with the REIT’s management in order to stay current on their operations and the credit quality of its industrial portfolio.
The return for the first year for the REIT (starting August 2020) is tracking at roughly 13.5% net of fees with most of the return tax deferred. We like the REIT investment for accredited investors who want income, tax deferral, and asset class diversification.
Please talk to your investment advisor if you are interested.
Assets under management
Sandhill ended the first quarter of 2021 with $2.06 billion in assets under management. Assets under management increased $64.7 million in the first quarter of 2021 on a combination of new business and performance.
After hunkering down during the COVID era, we are coming out of our shell. We have two job searches in the works as we continue to invest in the capabilities of the firm.
Our web site is being overhauled. You will find a great fact sheet done by Bryan Burdick under the Institutional tab on our web site and we will also be adding a Podcast tab that will start with a recent podcast that I did and think is worth sharing. Others from our firm will be doing podcasts on different subjects as we look to drive relevant and useful content to our clients.
We are always thinking about and looking for new products that are differentiated and add value while being mindful on staying focused on the tasks at hand.
As the weather warms and the world opens up, I hope this letter finds everyone safe and well.
With warm regards,
Edwin M. “Tim” Johnston III
Founder, Managing Partner
This report has been prepared for informational purposes only and is neither a solicitation to buy or sell securities. Third-party information in this report has been obtained from sources believed to be accurate; however, Sandhill makes no guarantee as to the accuracy or completeness of the information. Sandhill Investment Management (“Sandhill”) is a registered investment adviser with the Securities and Exchange Commission that is not affiliated with any parent company. Individual results may vary. Investments may not be suitable for all investors. Performance may be materially affected by market and economic conditions. Investment strategies have the potential for profit or loss. The performance statistics disclosed above are calculated on the rates of return from accounts managed by Sandhill, as defined by the following. The U.S. dollar is the currency used to express performance. Composites includes discretionary accounts under management from the first full month at which the account’s capital is fully invested by Sandhill. Closed accounts are included in the composites through the completion of the last full month under management and are not removed from the historical rates of return. Performance presented net-of-fees is reduced by investment management fees, trading expenses, and administrative fees. Interest, dividends and capital gains in these Composites are not immediately reinvested. The Concentrated Equity Alpha Composite includes all discretionary non-wrap fee paying accounts in the all-cap core strategy which may hold large, mid, and small capitalization U.S. common stocks, American Depositary Receipts (A.D.R.’s), domestic ETF’s, sector ETF’s, and cash. Accounts with securities that are not part of the all-cap core strategy are not included in the composite. The Russell 3000 TR Index is a market cap-weighted index of 3000 of the largest US common stocks which represents 98% of the US equity market. The Russell 3000 TR Index performance includes the reinvestment of dividends, interest and capital gains. The Corporate Bond Composite consists of all discretionary non-wrap fee paying accounts invested solely in individual Corporate Bonds and cash equivalents. The Corporate Bonds will generally be rated single B to single A and will have maturities of three to nine years. The Bank of America Merrill Lynch 3-5 year Corporate Bond Index is a subset of the Bank of America Merrill Lynch US Corporate Master Index tracking the performance of US dollar denominated investment grade rated corporate debt publicly issued in the US domestic market. Referenced benchmarks are not available for direct investment. For a full performance presentation and/or the Firm’s list of composite descriptions, please call 716-852-0279.
Private REIT Disclosure: Accredited investors only: Non-Traded Private REIT is only offered and sold to individual investors and certain entities which are “accredited investors” under the Securities Act and the rules of the SEC, and who provide us with information we require to verify their status as accredited investors. Individuals are accredited investors only if they meet certain minimum net worth or sustained annual income thresholds. Entities are accredited investors only if they hold sufficient assets or are completely owned by accredited investors. Limited Liquidity: Investors may need to hold their shares for an indefinite period of time. Royal Oak’s share redemption program is limited in amount, may be terminated or suspended from time to time, and is only available after shares have been held for a required period of time, except upon death. In addition, Royal Oak’s ability to redeem its shares may be limited. Determined Share Value set by Royal Oak’s Independent Directors Committee: The Determined Share Value (DSV) is the price at which Royal Oak sells its common stock and is set by the members of the Independent Directors Committee of Royal Oak’s Board of Directors In setting the determined share value, the Independent Directors Committee considers, among other factors, annual valuations by an independent valuation firm, real estate appraisals and the purchase prices of recently acquired properties and tenant compliance with leases. There may be variations from time to time in how Royal Oak’s independent directors apply or weigh the criteria in setting the “determined share value” or stock price. Royal Oak is not required by law to follow any particular methodology in setting the stock price. Timing or amount of distributions not guaranteed: Distributions with respect to Royal Oak’s common stock are only made if and when declared by the Board of Directors, and are subject to state law limitations on sources of funds and Royal Oak’s ability to pay distributions and certain contractual commitments, including financial covenants. Royal Oak’s past practice of distributions does not guaranty the timing or amount of future distributions. Royal Oak’s dividend is comprised of ordinary income (taxable) and return of capital (tax deferred). For income tax reporting via form 1099, real estate investments benefit from certain non-cash tax deductible expenses (i.e. depreciation). Not investment, financial, legal, or tax advice: Information presented in connection with this offering of common stock is not investment, financial, legal, or tax advice. You should obtain financial and tax advice and conduct diligent investigation of information material to you before making any investment decision. Information about performance or any of the properties is historical, and past performance does not guarantee future performance.