The third quarter was not Sandhill’s finest. For the first time in three and a half years, we did not execute at our desired level and performance suffered. We had problems with four of our companies – an unusually high number for us.
That said, our equity performance for 2019 remains ahead of the S&P 500 Total Return Index and our bond performance is superb.
For first nine months of 2019 (1/1/19 – 9/30/19), our Concentrated Equity Alpha (CEA) composite returned 22.6% net of fees vs. a return of 20.6% for the S&P Total Return Index. We are pleased that we continue to outperform our benchmark even though our positive spread narrowed in the third quarter.
For the first nine months of 2019 (1/1/19 – 9/30/19), our Corporate Bond composite returned 7.40% vs. 7.95% for the Bank of America Merrill Lynch 3-5 Year Corporate Bond Index. Our return was really good given the duration (effective maturity) of the Corporate Bond composite is only 2.8 years – less than our benchmark.
What Spooked the Market
Over the last two weeks, the stock market has had a tough go. Between September 19th and October 3rd, the S&P 500 Index dropped 3.2%. The market felt shaky. Impeachment, trade wars, and geopolitical uncertainty have been blamed.
The real reason the market came a touch unglued was the Institute for Supply Management’s (ISM) factory index slipped to 47.8% in September. A reading of over 50% is healthy and indicates growth and a reading below 50% signals contraction in our industrial economy. The ISM factory index is a closely watched economic indicator. This was the worst reading since June 2009 – the depths of the Great Recession.
Even more troubling was this was the second month in a row the reading has been below 50%. The investment community will be tracking future ISM readings to see whether these recessionary readings turn into a trend.
Industrial output is only 11% of the United States’ Gross Domestic Product (GDP) – but our industrial backbone remains a very accurate indicator of our country’s economic health.
Other Troubling Issues
Capital markets like stability. I am often asked if I think the current political climate is playing a role in dragging the market down. My answer has always been that I ascribe 0% importance to the political landscape when thinking about the behavior of the stock market. Two thoughts bring me to this conclusion:
First, Microsoft (MSFT) did not create hundreds of billions of dollars of wealth for its shareholders because of any political climate. MSFT created this wealth because two computer science geniuses dropped out of Harvard and formed a company that allowed people to look at multiple documents at the same time on a PC with enhanced productivity tools. Same goes for DuPont, Merck, and Johnson and Johnson.
Second, presidents come and go but the capital markets will still be here. The point is that our capital markets function openly, honestly, and transparently so that individuals and institutions can invest with confidence.
So that said, I have changed my opinion and am now assigning politics a 10% input factor as to how the capital markets behave. A small percentage, but now a factor. Impeachment, trade wars, the executive branch trying to influence the Federal Reserve – these are not good developments.
Finally, our country is spending money like a drunken sailor. Onerous debt levels have retarded the growth of Europe and Japan over the past two decades because they let their deficits get out of control. Once you are too “in debt” (person, company, or country) – it is hard to get out of debt (or return it to a manageable place). Our national debt is now about 100% of our GDP, and if we push our debt significantly higher, it will be a problem.
Investing Through the Cycle
It is not my intention to paint a dark picture here – but I think it is important to be realistic about the landscape we are playing in. To ignore the backdrop serves no purpose.
That said (and I have said this a hundred times), I believe more than ever that successful investing is won and lost at the individual company level. Owning great assets will always trump what the stock market is doing. This is why I think it is important to invest through the cycle and remain committed to long term stories of success. It takes a long time to build value – but when it arrives – the payoff can be large. The reason that one stays invested through the cycle is that one does not know exactly when those successes will happen. Timing the arrival of value, success, and significant wealth generation is fool’s gold.
Bonds Are King (for the moment)
This is a bit of a show stopper: Over the last twelve months (10/1/18 – 9/30/19), the short-term corporate bond market has significantly outperformed the stock market. Over the past twelve months, the Bank of America Merrill Lynch 3-5 Year Corporate Bond Index returned 8.8% vs. an increase of 4.3% for the S&P 500 Total Return Index. Good for all you bondholders!
The Bond Market
The bond market is now a lousy deal. Big time. Who in their right mind would want to buy a 30-year Treasury Bond and get 2% per year? The ten-year Treasury Bond yields 1.52%. Terrible deal. You are losing money to inflation and diminishing your wealth in real terms.
The common chain of thought is that with such low interest rates money gets pushed into the stock market because investors want meaningful return (this is true). Be careful of that. Low interest rates nurture deflation, penalize savings, and are indicative of a weak economy. The capital that is forced into the stock market is not “permanent” investment capital and can get spooked out of the market quickly with nasty short-term dislocations.
It is in all our best interests to have real interest rates that reward savers and create real and meaningful barriers for those who want to borrow money. Much healthier in the long run.
Sandhill’s Bond Portfolio
Sandhill’s corporate bond portfolios are in great shape. Credit wise – we cleaned house of any questionable credits (not that there were many) over the summer. Our fixed income portfolios are “clean” on the credit side, are delivering good return, and showing their usual price stability.
As of 9/30/19, our Corporate Bond composite has a duration of 2.8 years and a yield to maturity of 3.28%. The three-year Treasury currently yields 1.36% so our bond composite has a 1.92% positive spread over the three-year Treasury. A big positive spread for such short-term bond portfolios. Good stuff.
As bond prices have increased and yields have declined, I have shortened the duration of the bond portfolios because the current bond market is not attractive for investors. Given the short duration of our bond portfolios, we will have the flexibility to recycle the capital in the near term – hopefully at higher rates.
If interest rates increase, I will lengthen the duration of our bond portfolios.
As I have highlighted, this is a tricky time. There are a lot of cross winds. We have preached conservatism to our clients over the past two years, and for those that made their asset allocation more conservative – good for you – you have reaped the rewards over the past year.
The important thing is that Sandhill continues to manage money in the same consistent way that we have for the past fifteen years. We are a growth manager looking for companies that have high revenue growth potential, strong free cash flows, good balance sheets, are well managed by smart and intuitive people, and generate an adequate return on the capital deployed. We want companies that can grow the top line (revenue) while expanding operating margins and creating structural economic advantage that can be exploited for long periods of time. These companies are few and far between, and when we find them, our intention is to own them for a long time.
Growth stocks are currently out of favor. We will not change our strategy and bend to the flavor of the day. Without revenue growth, it is very hard to drive margin and expand your business. So….while growth is out of favor and the market rerates the earnings multiple of growth stocks (in many cases fully warranted), we will look to take advantage of this “rerating” window.
We like market volatility at Sandhill – both to the upside and to the downside. Simply put, downward volatility creates buying opportunities and upward volatility allows us to (occasionally) sell our holdings at inflated values. The rest of the time we hold our companies and let the managers of those companies build value over time.
Finally, we need to clean up our mistakes and tighten up the ship a bit. We don’t like to disappoint. Execution and adding real value for our clients is and remains at the core of our mission.
Hope everyone is well.
Edwin M. 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 advisor 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 S&P 500 TR Index is a float-adjusted market cap-weighted index of 500 of the largest US common stocks. The S&P 500 TR Index performance includes the reinvestment of dividends, interest and capital gains; but not the deduction of management fees. 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. Prior to May 1st, 2018 these composites held both wrap and non-wrap clients. This is reflected in the historical performance. For a full performance presentation and/or the Firm’s list of composite descriptions, please call 716-852-0279.