Newsletter
January 19, 2010
Dear client & prospective client:
The year of 2009 was stunning for Sandhill, our company delivered exceptional equity and fixed performance, managed risk very well, attracted important new accounts, and more than doubled in asset size. As we complete our seventh year, Sandhill has started to mature as an investment manager and settle into our role as a primary fiduciary for families, corporations, and non profits.
Performance 1
Our equity return for 2009 was exceptional:
| Sandhill Investment Management | + 52.3% |
| S&P 500 Index | + 26.5% |
To outperform our benchmark by 26% is really something, and I think we should take a little time and examine why we did. As I understand it, these are the reasons:
- Through the very difficult stock market crash of late 2008 and early 2009, our clients owned quality assets with clean balance sheets that would survive and even prosper in the event of a serious and prolonged recession.
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As an investment manager, Sandhill understands how to value securities. This is an often overlooked aspect of investment management. When the market was making its low in the spring of 2009, institutions and individuals were selling assets at prices that did not make sense. I have always said that regardless of the macro environment, asset prices sometimes reach certain levels that are so compelling on an absolute basis that one should purchase regardless of how bad the economy is.
There are two things that usually prevent investors from doing this. First is fear. Sandhill actually relishes sharply declining and disruptive markets because it creates opportunity. Second, investors normally donÕt have cash available because they are locked into purchases at higher (and incorrect) prices.
SoÉ. At Sandhill, we had the benefit of having plenty of capital at a time when assets were being given away.
- Our disciplines put us in the right position. While constantly scouring the markets for quality assets that are cheap, we canÕt always find them. And when we canÕt, that is a signal (among others) that markets will correct because investors are paying too much for assets and cash flows and will not earn a high enough rate of return. When we could not find much to buy in the second half of 2008, we started to stockpile cash as we sold certain positions and did not reinvest the capital. By March of 2009, we had exactly the opposite situation where quality assets were being offered at six, seven, and eight times earnings. We could not buy enough.
Long term performance 1
The proper measure of any investment manager is of course its long term performance. Approximately 20% of investment managers outperform their benchmarks over timeÉ..so an investment manager that outperforms over long periods of time is valuable. SandhillÕs equity performance since inception:
For the period 1/1/03 Ð 12/31/09
| Cumulative | |
|---|---|
| Sandhill Investment Management | +70.3% |
| S&P 500 Index | +45.7% |
| Annualized | |
| Sandhill Investment Management | +7.9% |
| S&P 500 Index | +5.5% |
A couple of points on performance. First, Sandhill has outperformed the S&P 500 by on an average annual basis by 2.4%. While this may not seem like one in any one year, by looking at the cumulative number above one can see that 2.4% of outperformance per year over seven years adds up to and extra 25% of return. That is a big deal!
To those of you reading this letter, it should also alert you to how damaging underperformance over a long period of time can be. For every $1 million in capital that Sandhill received at inception, we have added an extra $250,000 in additional gain beyond what the stock market returned. This can make a big difference in lifestyle, funding educations, and saving for retirement.
Fixed Income
In a year where we did many things right, I am pleased with our execution in the fixed income markets. The normal spread over treasuries (that is, the extra interest rate you get for taking the risk of lending money to a corporation as opposed to the government) for a five to ten year investment grade corporate bond is 1.2%. Not much. In the credit crisis of late 2008 and early 2009, the spread over treasuries ballooned to 6%. What a gift. Everybody was panicking that corporations would not be able to repay their IOUs (bonds). Investors stop discriminating between solvent and insolvent corporations. There was a wholesale dumping of fixed income assets that created bond prices that delivered equity like returns with much less risk.
In the first quarter of 2009, Sandhill started purchasing three to eight year investment grade corporate bonds with yields to maturity up to 9%. As we are inflationists (due to massive budget deficits), we kept the duration (maturity) of the bonds short. We bought investment grade bonds with big, fat coupons at anywhere from 82 to 95 cents on the dollar. Almost all of the bonds now trade north of par, and we have not had one credit problem. In a low rate environment, our clients will enjoy healthy cash flows from their fixed income holdings and hopefully be able to reinvest the capital at higher rates of return in five years time when the U.S. economy is much stronger.
Our corporate bond fixed income performance in 2009:
Corporate bond performance 1/1/09-12/31/091
| Sandhill Investment Management | +14.4% |
| Barclays US Treasury Intermediate Term Index | - 1.5% |
Hard Asset Portfolio
The third leg of investment strategy in 2009 was to build portfolios that were built with companies that produced hard assets. Think oil, natural gas, copper, silver gold, fertilizer, coal, uranium, iron ore, steel, titanium, and molybdenum.
The thesis for this investment was twofold. First, commodities had corrected sharply as the world economies slowed in synch. Commodity inventories exploded. For example, Oil peaked at $145 in July of 2008 and fell to $30 in December of 2008. As is the case in normal economic cycles, we expected inventories to build, production to be cut, the eventual recovery of the worldÕs economies, and increased pricing based on stronger demand and less production.
The second leg of the thesis is built on American budget deficits. With the massive (and reckless) trillion dollar plus deficits being run by the Obama administration coupled with deep trade deficits, the United States was over borrowing (big time) and exporting capital abroad (mostly to China). The only way for this to end would be a weaker dollar. When you borrow more than you can afford, it lessens your credit and makes your currency less valuable.
Most commodities are denominated in dollars. The dollar has been losing value relative to other currencies. Therefore, it will take more dollars to purchase these commodities.
SoÉ.an upside storm has been brewing for commodities and is now playing out. The backdrop of increased demand, lower production, and increasing prices because of a weaker dollar have set a positive backdrop for this investment.
The performance of our hard asset portfolio since inception:
Hard asset performance 5/7/09 Ð 12/31/09 1
| Equities in hard asset portfolio | + 36.1% |
| CRB Index | + 18.3% |
| S&P 500 Index | + 23.0% |
Lessons learned
Sandhill learned in 2009 that investing in todayÕs capital markets requires patience and discipline. You only get good opportunities for outsized returns on capital every so often, and you have to be ready to act. Our ability to value assets allows us to maintain the discipline that is necessary to be in a position to act when opportunities arrive. As I have said to clients, it is also very important to do nothing when there is nothing to do.
Outlook
We view the U.S. equity market as fairly to slightly overvalued. Not too much to do. We view the U.S. bond market as overvalued Ð especially on the long end. The end result is that we are fairly quiet right now. But then again, we donÕt know when or where the next opportunity will present itself. We remain moderately cautious and currently carry higher than normal levels of cash.
Where the U.S. economy goes from here is anyoneÕs guess. The bulls point to a cyclical upturn in global consumer demand, the passing of the financial crisis, the restocking of corporate inventories, and corporate capital spending beginning to normalize (rebound). The bears say that the economy is still rotten at the core, the banking system is still close to default, commercial real estate is in trouble, and this is a false recovery that will not end well.
At Sandhill, we have learned to respect and try and understand cycles Ð both on a macro level and within industries. And while things certainly are better, there is still rot at the core. You can not run $1.8 trillion deficits without consequence. You cannot simply replace private sector GDP with public sector GDP to create the illusion of growth. It is the private sector, kept honest by the mantle of competition, which provides the innovation and efficiency that make America so competitive. While badly run stimulus programs and massive entitlement programs might make us feel good in the short term, it is unacceptable to run the printing presses of this country to fund such projects.
Having lived almost half a century and through some serious shocks to our country, I never cease to be amazed by the strength and resiliency of this country. But I remain a touch hesitant about our prospects until some fiscal discipline is brought to our national treasury.
Sandhill had an incredible year in 2009. I continue to work diligently to scale our operations, increase our competencies, and stay true to our capabilities and discipline that allowed us to get here.
Regards,
Edwin M. Johnston III
Managing Partner
Sandhill Investment Management
(1)The composite used to generate the equity and corporate bond returns includes all discretionary Sandhill Investment Management accounts.Ê The equity return excludes International Exchange Traded Funds (ETFs) and Mutual Funds.Ê The returns are asset weighted and time weighted.Ê Total return (includes cash, bonds, ETFs, mutual funds, and preferred stock) was 14.2% in 2003, 9.8% in 2004, 1.3% in 2005, 8.7% in 2006, 12.0% in 2007, -33.32% in 2008, and 19.9% thru 12/31/2009.Ê At period end, the composite consisted of 244 accounts and $148 million in assets.Ê Equities represented 44% of total composite assets.Ê Any equity not on SandhillÕs buy list and more than 1% of total equity assets in composite is not included in performance.Ê The composite used to generate the hard asset return consisted of 1 account and $9.5 million in assets. The returns of the comparative indices are total return.Ê On 3/1/04, O'Keefe Shaw Investment Advisers was spun out of O'Keefe Shaw & Co., Inc. to become Sandhill Capital Partners LLC.Ê Sandhill Capital Partners LLC changed its name to Sandhill Investment Management in June 2007.Ê Past performance is not indicative of future performance.Ê As with any investment vehicle, there is always a potential for profit as well as the possibility of loss.Ê Sandhill Investment Management is a registered investment adviser with the Securities & Exchange Commission.Ê