A top investment manager on the wealth gap, national debt, and his stock picks

  • By Leslie P. Norton,
  • Barron's
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One of the best stock-picking teams in the U.S. makes its home in the quiet city of Buffalo, N.Y. The $1.4 billion Sandhill Investment Management has quietly churned out market-beating numbers since its 2004 beginning. Its founder, Edwin “Tim” Johnston III, is an avid hunter who named Sandhill after a crane that flew over a duck blind where Johnston was hiding. Johnston, 58, is also an exceptionally skilled hunter of stocks. The firm’s Concentrated Equity Alpha portfolio owns just 25 to 30 stocks chosen by a four-person team led by Johnston. It has returned 330% since its inception through the end of March, versus 148% for the S&P 500 index (.SPX).

We asked Johnston to share his views about stocks, what’s keeping him up at night, and for some names that he finds exceptionally promising today. Read the edited excerpt for more.

Q: You were rightly concerned about the stock market last year. How about now?

A: We sold quite a bit of stock last summer because it was very clear that valuation levels were not sustainable. The fourth quarter brought valuations back into line. It was blamed on the economy slowing down a notch. The gospel for us is speaking to the companies: We talk to a lot of CEOs personally, to chief financial officers, to the investor-relations departments, numerous analysts on the Street. For the companies that we talk to, the economy remains very healthy. It’s a little harder to squeeze out more margin, but revenue growth remains healthy, so we remain constructive.

But we’re 10 years into an economic expansion. The average economic cycle is seven years. At some point, we will have a meaningful correction.

Q: You’re optimistic

A: Chinese tariffs, Brexit, interest rates, and the [border] wall garner constant headlines, but we don’t think they will have a long-term impact on the market.

Q: You must be worried about something

A: There are two big worries that could cause severe dislocation in the capital markets. The biggest is the social divide and the wealth gap. One-tenth of 1% [0.1%] of the U.S. population accounts for 12% of our national wealth. The last time that happened was in the 1920s. And the discourse is getting divisive: We’ve forgotten that we’re all on the same team. The U.S. capital markets are the best functioning, most efficient, and most transparent in the world. Our politicians take that for granted. For the country to prosper, our capital markets require relative social stability, absolute transparency, and sound but not onerous regulation by independent institutions. We’re politicizing things that shouldn’t be politicized.

The second thing that keeps me up at night is the total federal deficit. It’s now just shy of $22 trillion, or 107% of gross domestic product. Japan got over 200%, but look at what their stock market has done. We’ve gotten lazy with regard to our debt. Most politicians think we can run structurally increasing deficits because we are a reserve currency. But in 1977, we were 85% of global reserves, and today we’re 62%. Is there a tipping point where the bids at a Treasury auction become much thinner? I’ve seen this play out in Corporate America many times, when companies get very levered—then there is a dislocating event, like a bad quarter, or the loss of a big client, or a CEO leaves. Suddenly, the bankers get nervous, and there are no buyers for the bonds.

Q: Your fund is pretty concentrated. How do you choose what to own?

A: The average domestic mutual fund holds 91 stocks. If you’re going to hold 91 equities, just go buy a SPDR and save yourself a fee. Thirty stocks is plenty of diversification.

We look for companies with structural competitive advantages that can be exploited over a long period. For example, Vail Resorts (MTN) has 10- to 40-year leases with the Department of Agriculture for premier ski locations in North America. Adobe (ADBE) is ubiquitous: Over 90% of the world’s creative professionals use Photoshop, and over 110 million Creative Cloud apps have been downloaded. We bought Adobe in 2011, and Vail, in 2012. Adobe is up tenfold; Vail 4½-fold. We still own them because they’re terrific franchises that will be worth a fair bit more down the road.

Q: What’s the thesis for Fiserv, which merged with First Data?

A: I have taglines for each of our stocks. Fiserv (FISV) is Houdini, the great escape.

Fiserv provides mission-critical back-end systems for banks. They provide core banking for one out of every three banks in the U.S. [First Data] is the No. 1 global merchant acquirer and the No. 1 credit-card issuer processor. (KKR) bought FDC in a leveraged buyout [in which the buyer borrows the money to acquire the company, using the target’s assets as collateral]. In 2015, they were overleveraged and not particularly well managed. Enter Fiserv, which bought it for a relatively modest multiple, and is combining a company with mission-critical banking systems with a merchant acquirer. They have cited a $900 million run rate of synergies based on duplicate overhead, $500 million in revenue synergies, and the ability to recapitalize the firm as a whole and pay off the debt quickly. We estimate that the ratio of combined debt to earnings before interest, taxes, depreciation, and amortization will be 3.7 by the end of 2019, down from seven times in 2015. And they can delever to less than three in the very near future.

Financial technology is a hot area right now. Consumer demand is causing banks to update their systems to compete more efficiently. This is basically an oligopoly. Fiserv is a very consistent compounder, growing earnings at 10% or more for 34 years, which is rather incredible. They have 85% recurring revenue and very sticky, long-term contracts of three to five years with thousands of customers.

Q: What’s the tagline for Dentsply Sirona (XRAY), which has stumbled since the 2016 merger?

A: It’s putting Humpty Dumpty together again. We make very few errors: This is one. But we’re still on board. Dentsply is a leader in consumables, a powerhouse in North America. Sirona, a European company, is a powerhouse in hardware and technology, far and away the leader in chairside dentistry. On paper, it looked great: $3.8 billion in revenue, 70% consumables, 30% equipment, revenue synergies, cost savings.

Pretty much anything that could go wrong did. The CEO was living in Greenwich, Conn, the chairman in York, Pa., and the CFO spent most of his time in Europe. They had 10 or 11 business units, and multiple salespeople calling on the same dentists. They brought in a new interim CEO whom we liked, but everybody lost confidence in the story. Then Don Casey, who ran Cardinal Health’s medical segment, came aboard in January 2018.

We called Don and said, “You moved from San Francisco to take over this company. What is your motivation for doing this?” Don said, “Well, I’ve always wanted to live in York, Pa.”

Q: Yet you were confident

A: Well, then he said, “This company is a mess. It needs to be realigned, reinvigorated. We need to strengthen and turn over a lot of the management bench. There’s a tremendous opportunity in an industry with incredible tailwinds, the main one being people living longer and needing more dentistry. I’m looking forward to running this company.” In the third quarter, they announced they could bring back organic sales growth, and a 50% increase in margins, in four years. The fourth quarter was the first time they’ve raised guidance in a few years. We said that if we didn’t see progress after one year, we would throw in the towel.

Casey plans to make the supply chain a single unit and prioritize research and development. He’s investing in Latin America and China; he has shrunk the company from 10 business units to four and will lay off 6% to 8% of the workforce. He has moved his office to Charlotte, N.C. At a low multiple of 22, the stock could be at $60 by the end of 2020, or a 20% return.

Q: Tell me about Bloom Energy (BE)

A: The game-changer: This is the most interesting and speculative of the stories. Normally, when I hear the term fuel cell, I run the other way. Bloom makes energy servers, or boxes that use oxygen and natural gas, without combusting the natural gas, to create electricity. The servers provide energy to commercial buildings for as low as 11.4 cents per kilowatt hour, versus 18 cents in Connecticut, 16 cents in California, and 14 cents in New York.

The CEO, K.R. Sridhar, was director of the space technologies laboratory at the University of Arizona. He received $400 million from venture capitalists, including John Doerr, to develop the Bloom server. You can find Bloom servers on top of Morgan Stanley’s (MS) trading headquarters in Times Square, and on the Staples Center in Los Angeles, and at the eBay/ PayPal (PYPL) data center in Utah.

We’re seeing Moore’s Law at play. As they manufacture more servers, the cost per kilowatt hour comes down; [this could become] the cheapest source of energy in the world. Each new generation, which happens every five years, reduces the cost per kilowatt hour of energy by 30% to 35%. This is a massive market. We bought 1.5 million shares, so we’re committed. It’s 2.6% of our portfolio.

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