Diamond Hill Investment Group (DHIL) is a value-based investment management firm that has a superb track record of beating the market. Its large-cap strategy has outperformed since it began in 2001, even though 92.3% of large-cap investment managers have failed to beat their respective benchmark over the last 15 years. Diamond Hill’s small-cap and small-mid-cap strategies have outperformed since they were started in 2000 and 2005. Yet, most mid-cap managers – 94.8% – and small-cap managers – 95.7% – have failed the same test.
These results have led to significant asset growth – one of the most important metrics for an investment firm – from just over $500 million in 2004 to over $22 billion in 2018 – a 33.5% compound annual growth rate (CAGR).
While Diamond Hill has continued to grow its asset base, many other active investment managers have seen assets decline because of poor results. The table below shows the capital outflows – money clients take away from the investment manager – for publicly-traded asset managers of similar size to DHIL.
|Company||AUM @ 1/1/15 (bil)||Inflow (Outflow)||Change|
|Cohen & Steers, Inc||$ 53.1||$ 13.2||25%|
|Waddell & Reed Financial, Inc||$ 123.7||$ (50.5)||-41%|
|Virtus Investment Partners||$ 56.7||$ (11.2)||-20%|
|Pzena Investment Management, Inc||$ 27.7||$ 0.9||3%|
|GAMCO Investors, Inc||$ 46.6||$ (11.2)||-24%|
|Westwood Holdings Group, Inc||$ 20.8||$ (1.8)||-9%|
|Manning & Napier, Inc.||$ 47.8||$ (30.2)||-63%|
|Total||$ 376.4||$ (90.8)||-24%|
|Diamond Hill Investment Group, Inc.||$ 15.7||$ 2.1||13%|
The seven asset managers in the table above, not including Diamond Hill, had almost a quarter of their AUM pulled out by clients since the beginning of 2015, and that includes a large inflow of capital for Cohen & Steers. Where are the assets going?
For the longest time, there was little choice for investors other than mutual funds or individual stocks, leading most investors that didn’t have the ability, confidence or time to pick their own stocks to either avoid the market or live with the consistently poor results turned in by most active managers. More recently, the power has been shifted to investors because index funds and ETFs are easy to access, cost less, and for the most part, have better returns.
This shift from active management to passive management has created an industry headwind that has crushed the stock prices of publicly-traded investment management firms – and in many cases rightfully so. It has also pulled down the prices of stronger firms – DHIL being one of them – presenting an opportunity to purchase a high-quality investment management firm at a significant discount to my estimate of intrinsic value.
Diamond Hill takes a long-term, patient, value-based approach to investment mainly in U.S. equities, but more recently has begun to focus on fixed income and global equities. Value investing is a proven approach that has worked over multiple market cycles for DHIL and for many other value investors as well.
The paradox with value investing is that it does work because it doesn’t always work. Value investing does not perform well when markets continue to make new highs and prices are above their long-term average in relation to earnings – the past few years for Diamond Hill and other value managers being a shining example.
For a lot of investment managers, short-term underperformance is unacceptable and typically causes an exodus of capital. DHIL, on the other hand, has done a great job of explaining the benefits of a long-term investing mindset. In the 2010 annual letter, retired CEO and current chairman, Ric Dillon, said:
We suggest that investment results be measured over at least a five-year period, which is the minimum period of time for statistical significance. While longer periods would be even better, few investors have the patience for anything longer than five years. We also know that some investors will not wait even five years, but such lack of patience does not influence our belief regarding what is necessary for us to fulfill our fiduciary duty.
It seems that – based on capital flows from clients – DHIL has attracted clients who share this long-term mentality and have stuck with the company. Management’s long-term track record and commitment to its proven investment philosophy give me confidence that relative results will improve when the market shifts its focus from growth to value.
Even with its recent poor relative performance, DHIL’s long-term track record is still intact. The table below shows nine Diamond Hill funds, six of which have been operating since 2005. Five of those six have outperformed their respective benchmarks since inception. The sixth – the Diamond Hill All Cap Select Fund – has underperformed by 0.09% per year, a roughly 1.1% difference in total return over the 12-year life of the fund.
Tables from 2018 Annual Shareholder Meeting. Data through March 31, 2018. Results are net of fees.
Why does management continue to stick with the value investing philosophy even in the face of poor recent performance? They’re focused on the long term and understand that value investing will perform poorly from time to time. If management and DHIL’s employees didn’t have so much of their own money invested in DHIL stock and their investment strategies, I would be more concerned with management capitulating and chasing what’s hot in the market.
Management and employees own 20.5% of the company worth roughly $123 million. Direct investments in DHIL’s strategies by employees are worth more than $150 million, totaling inside investment in the company and its strategies of $273 million for its 118 employees.
Source: DHIL Form ADV Part 2A, filed February 28, 2018
The issue with Diamond Hill is that its estimated runway for growth in U.S. equities is relatively small. DHIL currently has ~$21 million in AUM in these strategies and management estimates capacity of only $25 billion to $30 billion. Management, however, has already begun to focus on fixed-income and global strategies to continue growth, with an estimated capacity in fixed-income of $40 billion and less than $1.4 billion in AUM currently.
Adding these new strategies isn’t just a quick pivot to continue growth either. Management has been very methodical and patient about adding new strategies. They’ve managed a fixed-income strategy since 2002 but didn’t start to focus on growing the asset base until 2014. The global-equities story is similar.
In the 2009 annual letter, Ric Dillon said:
We will continue to investigate the possible addition of a global or international
capability, because we believe the importance of understanding and following non-U.S. companies is essential to making us better investors.
Three years later, in the 2012 annual letter, he again mentioned global equities:
Our research is primarily focused on U.S. companies; however, we have been expanding our focus to include international companies with the objective of being better investors through a deeper understanding of non-U.S. based companies in this time of increasing globalization. It is possible that these additional international research capabilities may lead us to establish global and international strategies in the future; however, there are no active plans for a new global or international strategy at this time.
Finally, in 2018, they were ready to launch a global strategy that currently has just $19 million in assets. Management understands that they must add value for clients with new strategies and they waited until they were sure they had the capabilities to launch a global fund.
While both of these strategies offer significant potential for growth, the fixed-income strategy will have lower fees than equity strategies, driving down the overall fee as a percentage of AUM as fixed-income becomes a larger portion of total AUM. Unfortunately, that’s not the only headwind that DHIL faces when it comes to fees.
Passive management has put pressure on active manager fees across the board. Even though DHIL has a record of outperformance, they’ve seen their fees shrink from 0.76% of AUM in 2009 to 0.64% in 2017. I expect the pressures on fees to continue, especially in the face of some index funds charging no fees.
Even with strong industry headwinds, Diamond Hill has performed well and I expect it to continue to grow. But the quality of the business, opportunities for growth, and dynamics of the industry are only the first part of the equation. The opportunity lies in the second part of the equation – the valuation.
The best way to value diamond hill is by separately valuing the operating business that earns fees on AUM and the net cash and investments on the balance sheet. This requires some adjustments to earnings because investment income earned on those assets is included in net income.
|Balance Sheet (as of 6/30/18)||Value (mil)|
|Cash on balance sheet||$ 78.2|
|Total Investments||$ 205.2|
|Less noncontrolling interests and deferred comp||$ 87.1|
|Total investments attributable to shareholders||$ 118.1|
|Total cash and investments||$ 196.3|
|Diluted share count (6/30/18)||3.52|
|Cash and investments per share||$ 55.77|
|Income Statement (as of 12/31/17)||Value (mil)|
|Operating Income||$ 67.0|
|Taxes (25%)||$ 16.8|
|Owner earnings||$ 50.3|
|Diluted share count (6/30/18)||3.52|
|Owner earnings per share||$ 14.28|
|Current share price||$ 170.00|
|Current share price less cash and investments||$ 114.23|
|Current P/E ratio (ex-cash)||8.0|
|Share price based on 12x P/E ratio (ex-cash)||$ 227.07|
|Share price based on 20x P/E ratio (ex-cash)||$ 341.28|
DHIL is selling at an extremely low valuation, despite strong performance from the underlying business and its future growth prospects. A reasonable valuation – although still low by my estimate – of 12x P/E ratio (ex-cash) results in over 33% upside. A More realistic valuation – taking into account DHIL’s past growth and future prospects – takes me to a 20x P/E ratio (ex-cash) and a price that’s roughly double the current price.
My discounted cash flow analysis yields similar results. I conservatively estimated 6% earnings growth over the next ten years, with 2.6% growth into perpetuity – a terminal growth rate I use as an estimate of long-term GDP growth. At a 9% discount rate, the business is worth just over $340 per share including cash and investments.
To put this in perspective, after five years of 6% after-tax earnings growth – a very conservative assumption – owner earnings would be $67.2 million. Assuming a $340 share price and share count is still 3.52 million, the business would be worth $1.2 billion – a P/E ratio of 17.9x, not including anything for net cash and investments. If net cash and investments stayed the same as they are today at $196.3 million, the P/E ratio (ex-cash) would be 14.9x. Change the growth to 10% per year and the P/E ratio (ex-cash) is 12.4x.
This means that DHIL is selling for 50% of my conservative estimate of intrinsic value, without taking into consideration DHIL’s recent buyback announcement or growth of the investments on the balance sheet.
Chris Bingaman – CEO of DHIL since 2016 – stated in the 2017 annual letter:
Importantly, we will only engage in share repurchases if we believe it to be accretive
to the intrinsic value of the Company’s shares.
In other words, they’re buying if they think the shares are selling for less than they’re worth. Shares were trading around $210 when the annual letter was issued in mid-March. By late September, shares had reached down below $163/share. On September 25, 2018, the company announced a share repurchase program of $50 million – roughly 8.3% of outstanding shares at current prices – indicating that management believes the shares are significantly undervalued as well.
Brian Binder is the portfolio manager for Stonebridge Value Capital, LLC, an investment management firm that focuses on investing in high-quality businesses for the long term.
Myself and my clients currently have a material investment in DHIL. This position may be increased or decreased at any time without prior notice. This post should not be considered investment advise nor a recommendation to buy or sell a security. It’s imperative that each person do their own research.
If you’re interested in discussing Stonebridge Value Capital, LLC managing a portion of your capital, please contact me at firstname.lastname@example.org.