Why We Bought Stock in Diamond Hill (DHIL)- Revisited
By Austin Crites, CFA
Aurora Financial Strategies originally purchased shares of Diamond Hill (DHIL) for clients in individual stock strategies on 09/29/2020
We believe DHIL is worth about $404/share compared to a current price of $188.99 as of market close 12/17/2021
The company has an identifiable economic moat, quality balance sheet, and attractive margin of safety
12/20/2021
Original Post: 10/09/2020
We purchased shares of Diamond Hill (DHIL) for clients on 09/29/2020 and published our thoughts here on October 9th 2020. As an investor, I find it to be good practice to revisit old decisions and the rationale for doing so. It helps to calibrate your confidence levels when making probabilistic assumptions because you can obtain objective feedback. With that in mind, I decided to reflect on our decision to buy DHIL stock while providing an update on the company and my estimate of the value of the stock. The following is the original post with additional commentary in blue:
Why did we make this purchase?
We believe the stock is worth at least $220 but it trades at only $136 as I’m writing this blog. To arrive at this number, we perform detailed financial analysis to estimate the future cash flows of the business. Successful investors buy assets at a significant discount to fair value. By our estimate, the stock should trade at a price 62% higher than it does today. We think it could do much better, but this estimate does not depend on some of the improvements we expect to see in the business. Should the business improve as we believe it should, our models suggest the value is closer to $337 (148% upside potential), a tidy profit.
We purchased the shares for clients at $126.97 prior to publication on 10/09/2020. As of market close 12/17/2021, the stock trades at $188.99 which is approaching the $220 minimum that I thought the stock was worth at the time of purchase.
What’s going on with the dividends?
Also, the company recently announced a $19/share special dividend. Shareholders of record as of 11/29/21 received $19/share plus $1/share regular dividend in cash on 12/10/2021 when was deposited in their account. If you noticed a sudden drop in stock price, that was because people that bought after 11/29/2021 are not entitled to that dividend. In fact, since we purchased DHIL on 09/29/2020, DHIL has paid $35/share in dividends which is equal to $35/$126.97 = 27.6% of our original purchase price from 09/29/2020.
Source: Nasdaq.com
What did I get right? - So far, it appears that I was correct in that the stock was undervalued given the company’s strong financial performance and the uptick in stock price.
What did I get wrong? – In hindsight, I was too bearish on fee compression. Industry trends have led to lower fees over time due to a greater mix of separately managed accounts and the adoption of passive investment vehicles. Diamond Hill actually reversed that trend in 2021. Growth in the remaining fixed income business will be a drag to aggregate fee rates but I expect growth in relatively newer equity strategies to mostly offset in the future. Fund flows were also better than expected. The Diamond Hill culture seems to cultivate longer-term client relationships and their investment strategies have retained clients better than most of their peers. With the investment community starting to warm up to value-oriented investment managers, Diamond Hill may find the wind at their back for the first time in many years. However, they closed the Large Cap strategy to most new clients which will limit new business growth until some newer strategies such as International, Large Cap Concentrated or Microcap gain significant traction.
Updated value – In my original post, I communicated that I believed the value to be north of $220. Since then, the fundamentals have improved significantly. Investment performance has been strong (leading to the realization of performance-based fees) and the value style has shown more signs of being in favor among investors. This has led to better net flows of client assets. Also, it appears that the changes put in place by new CEO Heather Brilliant to allow for increased focus for investment professionals have been well received by employees and should reinforce the company’s moat. I now believe the shares are worth at least $400.
Market Implies: I believe the current market price is implying significant fee compression in addition to annual net outflows of client assets of more than $1.6B per year which is more than they ever had in recent history.
Base: I expect the company to be more competitive than that. I believe the company’s shares are now worth more than $400/share. This assumes 3 basis points of fee compression and no net outflows. They brought in $2.364B in net flows YTD through Q3 but that will be difficult to repeat because they closed the Large Cap Fund this year to new investors.
Bull: I could envision a scenario where newer strategies gain traction more quickly than expected and the other open strategies gain clients as a resurgence in the value-style takes hold. In this scenario, the stock could be worth $570.
Bear: If performance stumbles and clients lose faith in the mangers, Diamond Hill could see systemic outflows. Should net outflows reach $2B/year and fees are discounted there could be considerable downside. In this scenario, I would peg the value at about $144/share, but the stock could decline further.
What does this business do?
Diamond Hill is a financial company that gets paid to invest money on behalf of individuals and institutions. They are based out of Columbus, Ohio and were founded in 1990.
Diamond Hill has made several adjustments to their product line since the last blog post.
First, they sold their High Yield Fund (investing in debt securities below investment grade) to Brandywine Global (a subsidiary of Franklin Resources). Upon hearing the news, I was disappointed. The fund was doing well and attracting new business so I would need to revise my growth assumptions. I had met the portfolio manager, John McClain, a couple years ago and found him to be a very bright and competent investor. Further, the compensation received of $9M plus the potential for $13M later depending on the success of the transition was significantly less than what I thought it was worth. They could have just allowed John to start over at Brandywine and keep much of the business intact. However, I was encouraged by the approach taken by Diamond Hill. They viewed a sale as better for the clients (they wouldn’t need to sell shares to follow John) and the strategy had come to rely on a macro framework while Diamond Hill follows a bottoms-up approach elsewhere. The strategy was no longer a strategic fit and clients would be better off with this arrangement. Diamond Hill was taking the long view, showcasing a client-centric approach and humility that underpins their corporate culture (more on this later).
Second, Diamond Hill closed their Large Cap strategy to new investors before they deemed it too big to generate excess returns for clients. Again, this runs counter to a short-term profit motive but preserves the competitiveness of the product for their customers. They took the long view.
Third, they launched a Concentrated Strategy that focused on the larger companies that were in the Large Cap strategy. This allowed them to serve new customers were attracted to the Large Cap strategy in a way that is intended to preserve the original product by focusing on the largest and most liquid stocks. It was a creative way to satisfy new customers while protecting the interests of their existing clients.
Finally, they launched a Microcap investment strategy (focuses on investing in smaller companies) in a limited partnership format. This leverages their core competency as a bottoms-up stock investor to focus on a relatively less efficient part of the marketplace.
What kind of moat is there?
Diamond Hill is primarily a legacy moat but they do have a small reinvestment moat. The legacy moat is built on a strong investment track record. They earn high marks from 3rd party evaluators such as Morningstar and have built successful track records with their investment strategies that presents a barrier to entry for new competitors. According to FactSet, Diamond Hill has generated average returns on invested capital of 33% over the past 5 years. Diamond Hill is historically well-known for its approach to investing in US stocks but is reinvesting a part of that cash flow to seed new strategies in fixed income and international stock strategies which have been successful so far. Historically, about half of cash flow has been returned to investors through dividends and stock buybacks.
Additional Moat Source: Company Culture
I have spoken with several members of the firm and from top to bottom, they exhibited a quiet confidence and level of humility that is rare in the investment management industry. Most successful investors are extremely intelligent, but they often have difficulty acknowledging their mistakes and weaknesses to the point where it becomes a hindrance to making improvements and working well as a team. This is an incredible asset in a business where intellectual honesty and humility are essential for making sound investment decisions that ultimately determine the attractiveness of the products generating revenue. I was originally concerned about the culture because the founder left a couple of years ago taking some investment professionals with him to start another firm. Under Heather’s leadership, I believe they have made the necessary adjustments to allow the positive aspects of the culture to endure. In addition, they have robust policies for capacity constraints and alignment of investment team incentives to the client experience that underpin what I believe to be a sustainable competitive advantage.
How safe is this investment?
As with any stock, there is plenty of risk. However, we believe the downside risk is less than the upside potential. As part of our financial analysis, we estimate how much a stock would be worth in different scenarios. In a scenario where Diamond Hill lost 10% of their customers every year which would pressure their profits, we believe the stock would still be worth $85. How can this be? All of the company’s shares are currently worth about $427M. The company has no debt outstanding and $164M in cash and liquid investments. If they closed-up shop today and liquidated the business, the cash and investments alone would still be worth $51/share. We do not see this scenario as likely, or we wouldn’t be buying but it is important to try and understand the risks that you take in investing.
Diamond Hill has been aggressively returning cash to shareholders so the downside protection from cash on hand is not as significant as it was before. However, I believe the operational risks have declined. Thus, I peg the value of the shares in my bear scenario to be $144.56 or roughly 24% below the current price. I will reiterate that my bear case assumes that clients withdraw $2B annually from their funds for the next 20 years which is worse than any year in recent history. Possible, but unlikely in my view.
Why is it trading for such a big discount?
There are typically a variety of reasons a stock trades out of line with its intrinsic value. One answer is that small companies tend to get overlooked by analysts and the rest of the investment community. However, the biggest reason appears to be that Diamond Hill’s revenue has been flat the past few years as more investors chase the high-flying growth stocks. Diamond Hill’s products are simply not popular at the moment, but these things run in cycles. We believe the market is overly pessimistic about the future of this company and expect that as the cycle runs its course their products will be popular again. We estimate that a return to growth does not need to happen for this to be a profitable investment, but if that scenario plays it out it would likely lead to a very rewarding investment experience.
The stock is still not popular and doesn’t receive much (if any) coverage on Wall Street, so it tends to be overlooked. Consensus analyst estimates for earnings and cash flow are not readily available, so it takes considerable effort to estimate the value of the stock.
In Summary
At Aurora, we are constantly looking for attractive investment opportunities for our clients. We look for businesses with economic moats, quality balance sheets and attractive upside potential. This blog represents our thinking at the time of publication. If you are a DIY investor, use this only as a starting point for your research and be sure to do your own due diligence. For questions regarding DHIL or our individual stock strategies, please reach out to us!
Invest Curiously,
Austin Crites, CFA
Austin Crites is the Chief Investment Officer of Aurora Financial Strategies, a financial advisory firm based out of Kokomo, IN. He can be reached via email at austin@auroramgt.com. Investment Advisory Services are offered through BCGM Wealth Management, LLC, a SEC registered investment adviser. This blog does not constitute advice. This is not an offer to buy or sell securities. Advisor is not licensed in all states. Any mention of a particular security and related performance data is not a recommendation to buy or sell that security. BCGM Wealth Management, LLC manages its clients’ accounts using a variety of investment techniques and strategies, which are not necessarily discussed in the commentary. Investments in securities involve the risk of loss. Past performance is no guarantee of future results. Clients may own positions in the securities discussed.