Q: What is the investment philosophy behind the fund?
All of our strategies, including the Select portfolio, are based on the philosophy of intrinsic value. We aim to purchase stocks for significantly less than our estimate of their intrinsic value. Then we hold them for the long term until price and value converge with each other.
Over the last three years, since we began managing the fund, we have concentrated on the companies that provide us with the highest degree of confidence in their ability to grow their intrinsic value over time.
We do not purely focus on the current discount to intrinsic value, but also consider the quality of the company, the growth potential of the industry, and the competitive advantages that would lead to compounding capital over time. We believe that the large winners tend to be companies which provide return not just from the convergence of value and price, but also from growth in per share value over time.
Q: How has your investment strategy evolved?
Diamond Hill was founded as an investment manager in 2000, when Ric Dillon, the CEO of the firm, was given a mandate by the board to start the company. The Select strategy was one of the first strategies offered at Diamond Hill. It has evolved over the years, but its goal has always been to find the best ideas, as defined by our investment team, within a broad stock universe.
Initially, the fund was more focused on larger-cap companies. That changed in the last three years, when we started to manage the fund. At present, we are considering the entire market cap spectrum. We do not necessarily look for a certain weight in small-cap or mid-cap companies; we are open to all opportunities, regardless of where we on the market cap spectrum we find them.
Another change is that the fund has become more concentrated. We now own about 30 companies, compared to 40 previously. The rationale behind the concentration is that we want our best ideas to have an outsized impact on the portfolio. By focusing on a smaller number of companies, we can develop a deeper understanding of the companies we own. Also, that deeper understanding helps with allocating capital between the holdings and managing risk.
These two characteristics, the all-cap nature and the concentration, differentiate us from the vast majority of funds on the market.
Q: What is the structure of the research organization that you rely on?
Initially, the firm used a portfolio manager-centric model. Since there were only a few people at the firm’s inception, they tended to generate all the ideas. Over the last decade, however, we have heavily invested in the research team. Currently, we have 28 research analysts and associates.
Our research function is organized into sector teams. An analyst focuses on a specific industry and, over time, he or she becomes a real expert in that industry. We do not have career paths for analysts that eventually lead to portfolio management, so the analysts follow their industries for many years and are likely career analysts.
Q: How do you define opportunities and look for investments?
We don’t use any predefined filters or screens. The analysts take a broad view of the universe and evaluate the long and short potential of every investment. Our goal is to identify companies, accurately value them, and then recommend them to the appropriate portfolio manager.
Typically, the analyst decides if something looks interesting and focuses on building a model for that company. Detailed models will typically include assumptions about business segments, returns on capital, and cash flow distributions over time. Those assumptions are translated into high-level core assumptions, which provide the inputs into the Diamond Hill Investment Model, our proprietary web-based model used by the entire investment team. The inputs include metrics such as revenue growth, margins, tax rates, multiples, and discount rates, and the output is the estimate of intrinsic value. We model the companies using a five-year time horizon and a discounted cash-flow type of analysis.
The analysts write a very detailed recommendation, including assumptions on their estimate of intrinsic value. After a dialogue with the portfolio managers about risk, it is ultimately up to the conviction level of the portfolio manager whether a company goes in the portfolio or not.
Q: Could you illustrate your research process with the help of an example?
Willis Group Holdings, an insurance broker and one of the largest positions in our portfolio, would be a good example. We first became involved with the company in 2013. It caught our interest because the stock had underperformed for a long period of time, but operates in a very attractive industry with excellent long-term economics.
We believed that Willis’ shortfalls were self-inflicted and could be corrected over time. With the right management, it could focus on structural cost-saving measures that the other large players, notably Marsh & McLennan and Aon, had taken over the last decade with excellent results.
A management change at Willis in 2012 prompted us to take a closer look at the company. The new CEO laid out a detailed plan to implement structural changes, to move back-office support to offshore locations, and to reduce the real estate footprint. Overall, his ideas were in-line with the best practices of modern professional firms.
It is important to understand that this is a concentrated industry with significant pricing power. About 80% of the large-company brokerage activity goes through the top three brokers. The barriers to entry are significant as large investments in technology and industry know-how are required to service large multinational clients.
The cost of switching insurance brokerage is very high and the retention rate tends to be about 95 percent. Brokers deliver the largest tangible benefit of your insurance program, which is advice and market access, but they represent a minor portion of the insurance cost.
Overall, the attractive industry, the management change, and the history of the competitors, who implemented similar practices, provided us with a lot of confidence that the changes at Willis would ultimately pay off in terms of earnings growth.
Q: How is the story of Willis unfolding currently? Are the changes already providing the desired results?
After several disappointing quarters, there have been two quarters of cost reductions and improving margins. We believe that Willis has turned a corner, but there is still a long way to go. We have not changed our estimate of intrinsic value during that period of time. We continue to believe that the company will generate huge amounts of cash flow, although the market is still skeptical.
In terms of organic growth, Willis has been superior to its two largest competitors over the past several years, because of its strategy to target specific markets, where it has real expertise. It has been extremely successful internationally, including in faster growing geographies. The international organic growth of Willis in the last two years has been in the high single digits, which is well above the rates of the market.
We think this is sustainable over the long term, because developing markets are a major source of growth. Once the GDP per capita of a country reaches around $10,000, the insurance market tends to grow rapidly as insurance penetration increases significantly. With the emerging markets representing 15% to 20% of Willis’ business, the company is well positioned to benefit from the growth trend.
Q: Would you quote another example?
LifePoint Health, Inc. owns and manages a network of rural hospitals in 21 states. On first blush, an obvious negative of the rural market is that the customer base is somewhat challenged in terms of employment and wage trends; however, a less obvious offset is that LifePoint usually runs the only hospital in the area, which gives it leverage against a consolidating pool of insurers. Other tailwinds for hospitals, in general, are the increase in the number of insured patients brought about by the Affordable Care Act and Medicaid expansion, the latter of which has thus far taken place in only 9 of the 21 states in which LifePoint operates.
If Medicaid expansion spreads to the remaining LifePoint states, as management expects that it will, it could mean a 15% uplift in operating income. As operators, LifePoint has a record of effectively controlling costs while at the same time increasing services and delivering high quality of care and safety.
At the end of the day, though, this leaves shareholders with a slow organic growth business, somewhat insulated from the broad trend in payer consolidation, and some medium term upside in margins from further Medicaid expansion that possibly reverses in the longer term due to demographic challenges.
And, with an enterprise value that is 15 times 2016 net operating profit after tax, the equity seems to be priced for just this. What’s missed, though, is the value being created through acquisitions. 80% of hospitals in the U.S. are still run as non-profits, but it is becoming increasingly difficult for these operators, especially the smaller ones, to remain viable in the face of increases in regulatory and technology complexity as well as capital intensity.
This has created an attractive opportunity for shareholder owned hospital networks to acquire non-profits at highly attractive prices. When non-profits sell, their motivation isn’t to maximize the sale price; it is to insure that quality of care will improve and be sustained for the community, and this makes LifePoint a preferred acquirer given their strong quality and safety record as well as the added credibility derived from a partnership it shares with Duke University.
In 2014 and 2015 alone, LifePoint has purchased hospitals with revenue totaling 50% of its 2013 revenue. The purchase prices are so attractive that we estimate in many cases they are earned back in less than three to four years as management is able to ramp margins from zero to the corporate average. Rural hospitals might not be the greatest businesses in the world, but when you can invest in growing your earnings base at such attractive multiples, per share intrinsic value grows very rapidly.
Q: What is your portfolio construction process?
Our benchmark is the Russell 3000 Index, but we do not necessarily use the weights as reference. We mainly use the benchmark at the end of the quarter, when we discuss our performance with clients.
We build the portfolio one security at a time based on our estimate of intrinsic value and our confidence in the ability of the company to grow that intrinsic value over time. Still, we do have limits on the individual position size, industry weight, and sector weight. The maximum sizes are 7% for an individual position, 20% for an industry, and 35% for a sector. There are no minimum requirements in place.
Our price targets are based on the net present value of our estimate of the intrinsic value. Once a stock reaches that estimate of intrinsic value, we reevaluate and ask the analysts to review their assumptions. If, after the evaluation, the analyst confirms the worth of the company, we exit the position.
We believe that once price and value have converged, it would be a speculation to hold the company any longer. Our strategy is to capture that gap between price and value and any growth in intrinsic value that happens in the meantime.
Q: What is the portfolio turnover in the fund?
We do not manage turnover. Typically, our turnover has been in the range of 20% to 50%. When there are plenty of opportunities on the market and we see ways to add value by trading into companies with much higher expected returns than the ones we hold, turnover may get higher.
When price converges with intrinsic value, we sell, unless we have a reason to change our estimated intrinsic value. The other reason to sell would be when we find a far better opportunity. If a stock is 5% or 10% below our estimate of its intrinsic value and we have an opportunity to invest in a company that trades at a discount of 30% or 40% discount to our estimate of its intrinsic value, we may decide to exit the position. However, we would not trade a 10% discount for a 12% discount.
Q: How do you define and manage risk?
For us, risk is the permanent impairment of our clients’ capital. We do not define it as volatility or volatility relative to a benchmark. Our risk concept is closely tied to our intrinsic value-based investment philosophy and the belief that there is a clear distinction between price and value.
The best way to limit permanent impairment of clients’ capital is to have a good understanding of the worth of the companies we invest in. We aim to always have a margin of safety by buying companies at a discount to their value and we never hold securities that trade at a premium to real value. The easiest way to impair capital is to hold overvalued companies, and we do not do that.
The existing limits on the exposure to individual securities, industries, and sectors manage the risk of making an error, despite the diligent estimate of intrinsic value. It is important to note that these are absolute limits and not relative to any benchmark. We don’t want to fool ourselves at times when the markets, or certain sectors, are in a bubble, which is reflected in the indices. We try to protect our clients’ capital by thinking in absolute terms about the aggregations of exposure.
We have a long-term time horizon. Over a five-year period, a lot of the volatility washes out and it is only about returns. That approach allows us to be very patient and even opportunistic. When something that we own trades off significantly, we can reevaluate it to make sure all the assumptions are correct.
