In the many years (fourteen) that I have run Sandhill, the second half of 2015 was one of the most difficult times for our firm.
In an intensely competitive business where only one in five active managers beats the market over time, we have prided ourselves on delivering good, if not great, results. We did not in the second half of 2015.
For the first six month of 2015, Sandhill’s core equity product (Concentrated Equity Alpha) was up 4.0% and the S&P 500 Index was up 0.2%. Things were tracking well.
For the full year 2015, Sandhill’s Concentrated Equity Alpha (CEA) product was down 2.7% vs. a decline for the S&P 500 Index of 0.7%.
For the full year 2015, Sandhill’s CEA product underperformed the S&P 500 Index by 2% (net of fees) – not a disaster but below our standards.
But when you look at the second half of 2015 alone, we underperformed significantly and that bears some examination.
After some time and thought, it is clear that we had our portfolios incorrectly positioned for the second half of the year. Sandhill always owns quality companies and most do well in time. However, we had exposure (and stuck by that exposure) to sectors of the market that were hit hard.
Our specific exposures that hurt us were energy and industrials. Of interest, China helped our performance in 2015.
Let’s start with China. We have two direct holdings and two other companies that have significant revenue exposure to China. China is currently the world’s second largest economy and is projected to be the world’s largest economy in ten to fifteen years – so our exposure is on purpose and well thought out. We have also made a lot of money in China.
Our two direct holdings are Ctrip (CTRP) and Baidu (BIDU) – respectively the Priceline and Google of China. Both companies are solely listed on the New York Stock Exchange as American Depository Receipts (ADRs) and are not listed in China. Both companies encompass the theme that China wants to move from an industrialized economy to a more consumer driven economy like the United States (that is, less cyclical). CTRP and Baidu (we think) are the best way to play this theme of an expanding consumer economy with 1.3 billion consumers (the most of any country in the world). Since initial purchase, we have made substantial money for our clients with Ctrip and Baidu.
Ctrip was up 104% in 2015 and Baidu was down 17.1% in 2015. So “netting it out” these companies provided +2.54% of performance for the CEA portfolio in 2015. Due to our concerns regarding the short term economic health of China, these two positions have been cut back to two of our smallest positions (each is approximately 3% of the CEA portfolio). Finally, Baidu will have $10 billion in revenue in 2015 and Ctrip will have $1.6 billion in revenue in 2015 – both are substantial companies with great business models, good profitability, and healthy balance sheets.
The story with China does not end there. Our CEA portfolio owns mead Johnson (baby and infant formula – $4 billion in revenue) and Las Vegas Sands (gambling, lodging, retail, and entertainment – $12 billion in revenue). Both companies are extremely profitable. Mead Johnson derives approximately 40% of its revenue from China. Las Vegas Sands derives 57% of its revenue from China. Mead Johnson was down 21.5% in 2015 and Las Vegas Sands was down 24.6% in 2015. Together they cost us 1.41% in performance. Both companies are involved in markets where the Chinese government exerted influence that was not helpful to their near term business prospects.
When you take the aggregate performance of Baidu, Ctrip, Mead Johnson, and Las Vegas Sands, they provided +1.13% of performance for the CEA portfolio in 2015 and outperformed both our portfolio and the S&P 500 Index.
The energy story has been much documented and discussed. Long story short, this is the largest energy bust since the mid-1980s – a very dire and draconian environment for energy companies to operate. The energy markets are suffering from oversupply of oil (globally) and natural gas (domestically). The price of oil declined 31% in 2015 and the price of natural gas declined 19% in 2015. The respective price declines followed even bigger percentage drops in 2014.
We were (correctly) under exposed to energy markets going into 2015 and began to increase our energy holdings as the energy complex started to collapse in the first half of 2015. We were a touch early but it is hard to pick an exact bottom. It is one of our favorite plays to buy high quality assets in distressed environments. However, when you do that, one must be patient to let the industry self-correct and rebalance supply and demand.
Our first energy holding is Cimarex (XEC) – an oil and gas producer we have owned for years. It is run by one of the smartest buys in the business (Tom Jorden) and has a set of low cost, world-class assets in the Permian Basin in Texas. Most importantly, it has a highly conservative balance sheet and will survive and prosper through all this turmoil. Cimarex was down 15.7% in 2015. Cimarex cost us 0.6% in performance.
Our second energy holding is Now Inc. (DNOW) – the largest distributor of equipment for oil and natural gas drilling rigs in North America. DNOW came public around $32 per share in the summer of 2014. We passed on the Initial Public Offering (IPO). DNOW initially did well on optimism in the energy complex (imagine that!). After peaking in June of 2014 at $37.65, DNOW has declined dramatically over the last year and a half. DNOW currently trades at $13.80 per share.
We jumped early. We made our initial purchase at $22.74. We have made additional purchases down to $17.20. We have been hurt by this holding. DNOW cost us 1.53% in performance in 2015. That said, DNOW has minimal debt and a 60% market share in North America. Competitors will go broke and DNOW will not. DNOW will have about $3 billion in revenue this year. It is acquiring smaller companies that add either increased geographic reach or new drilling technologies. We think the company will come out of the bottom of the cycle in great shape – we just wish we had been a little more patient with our purchase.
The final area where our CEA portfolio struggled is in the industrial area. There has been a noticeable slowdown in our domestic industrial economy over the second half of 2015 as evidenced by the Purchasing Managers Manufacturing Index falling below 50 (this means a contracting industrial sector) for the first time since 2009. Add to this the collapse of commodity prices and you have a very difficult environment for many parts of America’s industrial backbone. This bears watching (no pun intended).
We own Genesee & Wyoming (GWR) and have followed the company for years. It is the largest short haul railroad in the United States and has an effective monopoly in the markets that it serves. GWR takes off loaded cargo from the national rail lines (Union Pacific, CSX, Burlington Northern, etc.) and delivers this cargo locally via short haul rail to manufacturing plants, power generation plants, and large distribution centers. In effect, GWR has a monopoly in the markets it serves because no one builds two short haul railroad tracks to one factory. We initially bought GWR on June 5th, 2014 at $84.71. GWR is currently at $48.01 per share. Obviously, GWR has hurt performance. GWR cost us 1.5% in performance in 2015. The miss here is we did not appreciate how quickly the energy and industrial cycle would deteriorate in the second half of 2015.
In this discussion, I have focused mostly on what did not work in our portfolio. I have really spent no time on what did work. However, as a money manager, you have to understand and learn from your misses in order to walk the road of awareness and continuous improvement.
Our mistake was not the quality of the companies that we own or their long term business prospects; rather, we bought some companies too early and before asset prices had really and truly corrected and bottomed. In essence, we suffered from the “catch a falling knife” syndrome in our excitement to grab good assets for our clients. I always preach patience, but we were not patient enough.
Being long term is NOT an excuse for bad performance. That said, our performance over the last three years has been +38% in 2013, +10.5% in 2014, and -2.7% in 2015. Sandhill’s cumulative performance over that time period (net of fees) is 48.4% vs. 43.3% for the S&P 500 Index.
The year of 2016 will be an important one for Sandhill. After a substandard year in 2015, it is important that we deliver good results. There is no guarantee on this – but I can assure you it is my number one business goal for 2016. I believe in what we own and I believe in our research. The rest of the story will take care of itself one way or another.
I think the investment path through 2016 will be volatile and tricky. I further believe that, as always, the quality of the assets that one owns will rule the day.
I want to thank all of you for your trust and patience and wish you a happy and healthy 2016.
Edwin M. “Tim” Johnston III
Founder | Managing Partner