Our weakness remains our short term equity performance in our flagship CEA equity product. We like our portfolio and will remain patient. That said, it is very bothersome to deliver substandard results.

As most of you know, we are long term. The CEA composite has delivered an average annualized return of 16.7% per annum over the last five years.

For the first nine months of the year (1/1/21 – 9/30/21), our flagship Concentrated Equity Alpha (CEA) composite returned +10.0% net of fees.

For the first nine months of the year, our Large Cap Yield (LCY) composite returned +11.7% net of fees.

For the first nine months of the year, our Corporate Bond (CB) composite returned +1.0% net of fees. The current yield on the CB composite is 4.4% and the yield to maturity is 2.3%.

For the first nine months of the year, our private REIT composite returned 6.1% net of fees with most of the return being tax deferred.

Three of our four products are doing very well. We need to pick it up with the CEA product.

With each of our products, we think not only about the return that we want to generate, but the risk that we take to generate the return. I thought it would be helpful to highlight the risks that we take in each of our products.

In the equity market, we address four kinds of risk. They are competitive risk, operational risk, balance sheet risk, and valuation risk.

Competitive risk – This centers around our portfolio companies’ ability to compete. Do they have a novel technology? Are they innovative? Are they leaders in their industry? Has the company achieved scale? Does the company have a strong brand? Is the industry healthy? We feel all our companies meet this litmus test. That said, all companies are subject to competitive risk and this is a major source of risk in holding an equity portfolio.

Operational risk – Are our portfolio companies well run? Is management shrewd and forward thinking? Does the company allocate capital well? Do people want to work for the company? Most if not all of our portfolio companies are run by very smart people and operate very well. Very little risk here.

Balance sheet risk – One of the good things about Sandhill’s CEA portfolio is that we take very little balance sheet risk with our companies. Of the twenty-nine companies that we own, only one has leverage (debt) that is very high (the company is Clarivate). While debt is a very cheap source of capital in this low interest rate era, companies with large debt loads still owe the money to their banks and bondholders. If the company goes through a rough earnings patch, they can quickly get in trouble. This can result in large capital losses that happen very quickly. Very little risk here.

Valuation risk – This is where Sandhill takes the most risk. In this twelve year bull market and low interest rate era, equity valuations are high. Many prominent Wall Street strategists have called for serious market corrections over the last five years – they have all been dead wrong. Many of these bear case scenarios have been based on valuation. Why have so many smart people been so wrong? What it comes down to is the world is changing rapidly and the stock market anticipates where the world is going – not where it has been. The high valuation of many companies is a reflection of the paradigm shift in which companies are innovating and will benefit from the new ways we are living.

The stock market’s price to earnings multiple is 20 times 2022 earnings estimates for the S&P 500. The CEA’s price to earnings multiple is 36 times 2022 earnings estimates.

Where we end up on all of this is fascinating. Sandhill is paying a higher than market multiple for our portfolio stocks because we are buying the “corporate leaders of tomorrow” to generate return better than the market averages.

So….at the end of the day, we are taking valuation and competitive risk to own the winners of tomorrow. We mitigate that risk by minimizing balance sheet and operational risk.

We take three kinds of risk with our corporate bond product – credit risk, duration risk, and diversification risk.

Credit risk – This is the big one. Credit problems will kill a bond portfolio. In the twelve years that we have run our corporate bond portfolios, we have had one credit problem. A remarkable record. We manage credit risk very well.

Duration risk – Duration is effectively the maturity length of your bond portfolio. As a rule, the longer the duration of a bond portfolio, the more interest rate risk you have (the investor is vulnerable to rising interest rates). The current duration of our Corporate Bond composite is 3.5 years – very short. We take very little duration risk.

Diversification risk – Given that corporate bonds offer finite return, it does not pay to concentrate your holdings. Having a highly diversified bond portfolio is another way of reducing credit risk. However, in this low interest rate era, it is very difficult to buy good corporate bonds that have high enough yields to maturity to make them worth buying.

At Sandhill, we are very good at gauging credit quality. As such, we have made the decision that we are willing to concentrate (have bigger position sizes) in our bond portfolios because it is hard to find good credit bonds that have a decent yield to maturity.

We will now go up to a 4% position size in a bond portfolio which is higher than in the past. Long story short, our bond portfolios are subject to increased concentration risk but we are more than comfortable with that due to our credit expertise.

We take on four kinds of risk with the private industrial REIT that we offer. The risks are asset quality risk, economic risk, interest rate risk, and liquidity risk.

Asset quality risk – My “line” with regard to the private REIT is that you can have all the Amazon.com’s in the world you want, but someone still has to make the product. Good industrial space that is well located will never go out of style. I have personally visited seven of the private REIT’s industrial holdings – and they were all top notch. We are taking modest asset quality risk with the private REIT. Further evidence of the asset quality integrity of the private REIT is that in a mere five months after the pandemic hit in March of 2020, the private REIT had 100% of their industrial tenants paying rent on time.

Economic risk – The industrial sector is subject to and hardest hit by recession. That said, the average lease is seven to eight years which is far longer than any recession will last. Some but not too much risk here.

Interest rate risk – As the private REIT is a tax deferred income investment, the value of the private REIT is subject to interest rate risk (rising interest rates are bad for REIT investors). Higher interest rates are harmful because the industrial buildings the private REIT owns and the long term leases granted to the private REIT’s tenants are long lived assets. So…as opposed to our Corporate Bond product that has very little interest rate risk, the private REIT does have some sensitivity to rising rates.

Liquidity risk – Investors can not get their money back for one year if they invest in the private REIT. For the next four years, the investors get 95% of the private REIT share price upon redemption. After five years, the redemption price is 100% of the share price. In addition, only 4% of the private REIT’s shares are available for redemption each year (this has never happened). To date, the private REIT has had terrific return, but liquidity risk is by far the biggest risk.

In thinking about all of our products, we take different risks to achieve certain returns. We feel that each Sandhill product offers a good risk profile relative to the anticipated return – that we generate return with sound risk guidelines and go a long way to manage risk such that our clients do not experience permanent capital loss over the long term.

We continue to work on the multi asset class income product. I have acknowledged that we have a gap in our product line up. We would really like a product that takes more risk than our Corporate Bond product and yields in the 3.60% – 4.25% range net of fees.

We have done a lot of modeling and back testing. We can get to a 4% yield but feel that we are taking too much risk to get there. We will not force it.

We will continue to work on this product until we can get to a risk/return profile that works and we have confidence in the product.

As of 9/30/21, client assets under management were $2.2 billion. Assets under management have increased $184 million since the beginning of the year. The increase in assets under management is a combination of new business and performance.

We are beginning the transition of sending the newsletter electronically next quarter. Clients will be receiving an email that will ask whether they want to receive the newsletter in hard copy or electronically.

Sandhill continues to invest in our firm infrastructure to better serve our clients.

Dave Dennett joins our sales team. Dave most recently worked at Viking Capital. Dave is a 28-year industry veteran with experience in sales, asset allocation, and risk management.

Amanda Theriot joins our operations team. Amanda will be working in the AR/AP, vendor management, and human resources area. Amanda was most recently with Sodexo as a Unit Controller. Amanda also served in the U.S. Army as an Information Systems Operator Analyst.

Julianna Kraft joins our client service team. Julianna will be working to support our advisors in meeting our clients’ needs in a responsive and timely manner. Julianna was most recently the personal assistant for the lead actress in the Cabrini film that was shot in Buffalo over the summer.

We continue to build at Sandhill. New products, talent acquisition, and innovation will continue to drive the firm. CEA performance is our central focus right now. The remainder of the firm is operating at a very high level.

With regards,

Edwin M. “Tim” Johnston III
Founder, Managing Partner

Annualized Performance Summary (Net of Fees) As of 9/30/2021

CEA (Master): 1 Year: 22.1% | 3 Year: 11.8% | 5 Year: 16.7% | 10 Year: 10.8%

Russell 3000 TR: 1 Year: 31.9% | 3 Year: 16.0% | 5 Year: 16.9% | 10 Year: 10.2%

Corp. Bond: 1 Year: 1.4% | 3 Year: 3.1% | 5 Year: 2.5% | 10 Year: 3.5%

B of A ML 3-5 Year: 1 Year: 1.8% | 3 Year: 5.7% | 5 Year: 3.7% | 10 Year: 3.9%

Large Cap Yield: 1 Year: 25.2% | 3 Year: 9.7% | 5 Year: 10.2% | Since Inception: 9.8%

DJIA: 1 Year: 21.9% | 3 Year: 8.6% | 5 Year: 13.1% | Since Inception: 10.7%

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 S&P 500 TR Index is a float-adjusted market cap-weighted index of 500 of the largest US common stocks. The Large Cap Yield Composite consists of all discretionary non-wrap fee accounts invested in U.S. common stocks, American Depositary Receipts (A.D.R.’s), domestic ETF’s, sector ETF’s, and cash in solely large capitalization companies. 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. 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.