Sandhill has had a very, very solid year so far with our equity accounts as measured by the CEA Composite up 28.8% through 9/30/13 vs. 17.9% for the S&P 500 Index.

While we are thrilled to deliver this much excess return to our clients, the question really becomes what to do with these gains.

As we have expressed to many of you, the timing of the gains that accrue in the equity markets in general and good equity managers in particular are very unpredictable. This is why timing the market is fool’s gold.

Case in point: Sandhill was up 12.9% through 6/30/13 vs. 12.6% for the S&P 500 Index. Essentially, Sandhill and the indices were even in the first half of 2013. Then the third quarter. Sandhill was up 15.9% vs. 5.3% for the S&P 500 Index. The driver of this dramatic excess return in just three months was earnings season (when our companies report operating results). Our companies reported, and the results were pretty good across the board. It is very difficult to predict when these bursts of good performance will come.

So, we have been getting a number of calls (with good reason) about what to do in light of the mess and dysfunction in Washington. While I am really unclear how this all ends, one thing I do know is that six months from now this will seem like a distant memory. If the time horizon for owning our companies is three to five years and possibly longer, we are reluctant to make investment decisions based on the daily nonsense coming out of Washington.

The backdrop

 Without choosing sides in this bungled mess, we remain very respectful and wary of the damage the gridlock and funding problems can do both short term and longer term. A nation’s ability to pay its bills should never be put in question (shame on you Republicans) and a nation should not spend more than it takes in unless the circumstances are extraordinary (shame on you Democrats).

When considering the fallout from this dithering and posturing, the really scary part has nothing to do with the stock market. It is the global credit (bond) markets which are the financial engine of the world’s economy that most concern me. First of all, the bond market is far larger than the stock market. In addition, if we push all the way back to the dark days of the fall of 2008, it was the freezing of the short term bond markets that really struck the blow to the equity markets and the global economy. When short term credit markets lock up, watch out, that is when the word “default” starts coming into play.

So all those phone calls to us are good calls, smart calls. Yes, it makes sense to raise a little cash or maybe change the asset allocation a touch. However, at the end of the day, we invest in companies and cash flows, and the building of value in these companies takes years, so we will continue to invest through all environments. One of the things that we are most proud of at Sandhill is that since inception (3/1/2004), our CEA equity accounts are up 109.6% net of fees vs. 46.9% for the S&P 500 Index – far outpacing the market and providing a strong real (after inflation) return to our clients. We have achieved these results through many different market environments and at times a lot of volatility.

Distribution of returns

As mentioned, not only has Sandhill been pleased with the return that it is providing its clients, but we are pleased with how we are making the return. One of the more subtle but important aspects of our equity returns is that the return of our equity portfolios is well distributed across our holdings. Gains that are well distributed across an equity portfolio are far healthier than large gains that are stacked in one or two stocks.

Of the 15 stocks that are in the CEA portfolio and were owned at the beginning of the year, 9 of those stocks have gains of more than 20% year to date. In addition, of the 7 stocks that we have purchased since the beginning of the year, 5 have gains of more than 20% since they were purchased. These metrics are signals of good and highly consistent stock picking.

The bond market

I think it is going to end badly in the bond market. We saw the first taste of that in the second quarter when Federal Reserve chairman Ben Bernanke hinted that the Fed may start “tapering” and lessening its monthly bond purchases. Interest rates shot up dramatically – especially in the five to ten year maturity where the yield curve is the steepest.

Sensing the possible stalemate in Washington, I give Bernanke great credit for backing off his “tapering” comments and saying that he would not slow bond purchases for the time being. He correctly sensed that a hard slide in the bond market combined with the current budget mess might spook markets. So he once again committed to use the Treasury firepower (the printing press) to artificially suppress interest rates. He succeeded and the stock and bond markets remain calm for the moment.

Make no mistake about it – this is a temporary measure and when the Fed backs off buying treasury and mortgage bonds in massive quantities, it will be painful for bond holders. Again, we don’t know when, but the time is coming.

We are very comfortable with our bond portfolio positioning. Our maturities are short and in solid corporate paper. Our bond portfolios are approximately breakeven to up a little for the year which is a good result given the rise in interest rates. If rates do spike over the next few years, we will have money rolling off the bond books that we can reinvest at higher rates.
Referrals

Sandhill has grown to over $450 million in assets under management. Our growth over the last two years has been very strong.

We hope that we have earned the right to ask our existing client base for referrals. It helps us and it helps you. As Sandhill’s cash flows grow, we are able to invest more money in research and technology that helps us invest your capital. I really think referrals help both client and asset manager as long as we continue to deliver on the investment side.

Comings and goings

 Since our last newsletter, we have added Mark Larry as an equity research analyst, Joe Foy as a research intern, Steve Garvin as a vice president of business development, Mary Hosler as a vice president of business development, Tina Allsop as an operations officer, and Chris Mainard as a portfolio administrator. We are intent on adding personnel where we can find highly skilled employees who fit our current needs.

Gary Stott will be retiring although he will remain affiliated with the firm. Gary had a great five years and was an important contributor in building what we have done to date. We will miss his smile and enthusiasm on a daily basis but know we will see plenty of him.

I hope everyone has enjoyed our beautiful fall and I look forward to speaking with many of you over the months to come.

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

Performance Disclosures: Sandhill Investment Management (“Sandhill”) is a registered investment advisor that is not affiliated with any parent company. The performance statistics disclosed above are calculated on the rates of return from accounts managed by Sandhill, as defined below.
These accounts are managed by Sandhill on a discretionary basis. There are no non-fee paying accounts included in the composites. The U.S. dollar is the currency used to express performance. The Concentrated Equity Alpha, Large Cap Yield, and Corporate Bond composites include 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.
Sandhill claims compliance with the Global Investment Performance Standards (GIPS®). To request a complete list and description of firm composites and/or a full performance presentation that adheres to GIPS® Standards, please contact Shant Goubrial at (716) 852‐0279 x 305 or sgoubrial@sandhillim.wpengine.com‐im.com or visit the firm’s website at sandhill‐im.com.
i The information in this report has been obtained from sources believed to be accurate; however, Sandhill Investment Management makes no guarantee as to the accuracy or completeness of the information. Past performance is not a guarantee of future results. Investing involves risk, including the possible loss of principal. There is no guarantee that the CEA, Large Cap Yield, and Corporate Bond composites will achieve their investment objectives or that they are suitable for all investors.
ii For a full list of all composite recommendations for the preceding year, please contact Sandhill’s Chief Compliance Officer, Ryan Myers, at (716) 852-0279 Ext. 307 or email your request to rmyers@sandhillim.wpengine.com-im.com.