By any measure, Sandhill did not have a good third quarter.
The Concentrated Equity Alpha (our flagship) product had a return of -2.61% net of fees vs. the S&P 500 Index’s return of +0.6%. So, we underperformed by 3.2% in the quarter.
First of all, I would like to be clear that we are not pleased with this performance. We were especially hard hit in September and had our worst quarter relative to the market in a long time.
We also take our performance in context. We do not get overexcited or overly disappointed by any ninety day period – that would be a mistake. If we became perennial underperformers, I certainly would be bothered by that and we would lose business. We are nowhere near that situation.
The reason for our bad quarter is fourfold. First, our Concentrated Equity Alpha (CEA) product had a return of 47.2% net of fees from January 1, 2013 to June 30, 2014. Quite a run. The CEA outperformed the market by 9.8% over that time frame. A lot of our holdings had strong runs. Frankly, our portfolio got a little “tired” as many of our positions became fully valued to overvalued in the near term.
Make no mistake – we could have done some trimming and “refreshed” the portfolio a bit. However, this is the tension for good long term investors who find businesses that will create great wealth over time vs. the constant pressure to produce return each quarter. Good long term investors will have periods of underperformance.
The second reason for the weak quarter was two of our tech holdings had meaningful declines. Adobe (ADBE) was -4.4% and CTRIP (CTRP) was -11.6% in the third quarter. We originally bought ADBE at $27.26 on 11/18/11 and it closed the quarter at $69.19. We more than doubled our money from initial purchase and still think there are plenty of legs left in the story. We originally bought CTRP at $19.53 on 12/12/12 and it closed the quarter at $56.76. Again, we have almost tripled our money from initial purchase and think there are legs left in the story.
The third reason for the weak quarter was the start of the correction in the energy market. Oil prices have collapsed as demand is stagnant and supply continues to increase on the back of the U.S. oil shale boom. Libya reentered the international export market, and Saudi Arabia, Iran, and Iraq declared there will be no production cuts. The final shoe was the declaration of price cuts by Saudi Arabia and Iraq to maintain market share. The near term outlook for oil is challenged.
Cimarex (XEC), our sole oil position, was -11.8% in the quarter. XEC is a $2.5 billion revenue company with one of the best, low cost reserve positions in the Permian Basin in Texas. Further, XEC has a rock solid balance sheet with debt at just 25% of capital. If the correction gets sharp enough, we will buy more. We originally bought XEC at $66.62 on 2/19/13 and it closed the third quarter at $126.53.
Range Resources (RRC), our sole natural gas position, was -22.0% in the quarter. The glut of natural gas in the eastern Marcellus Shale region (western Pennsylvania) has caused significant (negative) price differentials with NYMEX natural gas prices. Part of the problem is that there is insufficient pipeline capacity out of the Marcellus and that has hurt pricing badly in that basin. We originally bought RRC at $63.77 on 12/19/12 and it closed the quarter at $67.81. We bought more RRC on the correction at $75 and think there is very good potential return. Gas storage in the ground at the beginning of the heating season is less than the five year average. We spoke with the company and the price differentials are expected to be gone by 2016 given increased transport capacity out of the region by that time.
The fourth and final reason for our underperformance is that the CEA is multi capitalization portfolio with large, mid, and small capitalization equities. At the end of the third quarter, 65.3% of the stocks in our CEA portfolios were mid and small cap. For the third quarter, mid cap stocks were -4.4% and small cap stocks were -6.9%. So, we took a hit on our asset class exposure. Again, we are more concerned with buying great companies that have growing revenues and solid cash flows than worrying about what market cap box the company fits into. Our long term outperformance is partially due to our ability to “go anywhere” with regard to market capitalization.
I think this correction has legs, but I don’t think that it is the beginning of a bear market. In fact, it is probably healthy to shake some of the “frothy” money out of the market. Fear has started to creep in, and another way to interpret that fear is a healthy respect for asset values and the danger of overpaying for those assets.
While I take this correction seriously, I remain comfortable with our positioning and the quality of our asset base. At the end of the day, it is the quality of our asset base combined with our proven ability to outperform over time that sets us apart.
Despite a bad third quarter, our CEA equity portfolios were +3.9% year to date ended 9/30/14. Portfolio values have continued to decline in the fourth quarter but our relative performance to the benchmarks is improving.
We will remain patient but vigilant for opportunity.
My best to everyone.
Edwin M. “Tim” Johnston III
Founder | Managing Partner