Diamond Hill Investment Group (NASDAQ:DHIL)
Q2 2014 Portfolio Manager Conference Call
July 16, 2014, 2:00 p.m. ET
Julie McConnell - Director, Business Development Marketing
Bill Zox - Portfolio Manager
Tom Schindler - Portfolio Manager
Chris Welch - Co-Chief Investment Officer
Chuck Bath - Managing Director
Rick Snowdon - Co-Director of Research
Ric Dillon - Corporate CEO
Chris Bingaman - Co-Chief Investment Officer
Austin Hawley - Co-Director of Research
Welcome to the Diamond Hill second quarter 2014 portfolio manager conference call. [Operator instructions.] I would now turn the call over to Ms. Julie McConnell. Ms. Julie McConnell, you may begin.
Great. Thank you, operator. Good afternoon everyone, and welcome to the Diamond Hill second quarter portfolio manager conference call. We certainly thank you for joining us this afternoon. Again, my name is Julie McConnell, and I will be moderating today’s call.
To start our call this afternoon, Bill Zox, who, as many of you may know, is portfolio manager of our strategic income strategy, will provide an update on deleveraging in the United States. After Bill's comments, our portfolio managers will review second quarter results for our strategies. I then will open the call for questions.
When we’re ready to go to the Q&A session, the operator will provide instructions if you would like to answer a question over the phone. You also can type a question on your screen at any time throughout the call, and we’ll be sure to address it during the Q&A session. And all of our portfolio managers will be available to answer your questions.
As always, we have a few important compliance statements to go over before we begin. The opinions expressed by portfolio managers are their own, and are subject to change at any time as circumstances change.
Any discussion of specific portfolio holdings will be as of June 30. Portfolio holdings are subject to change without notice. And finally, a complete list of portfolio holdings as of June 30 is available on our website. The next slide provide additional important disclosures and we would just ask that you review this at your convenience.
Moving on to slide five, we have a few additions to our staff during the second quarter to announce. Specifically, we’ve added depth to our research team with the addition of both a credit analyst and a research associate.
John McClain joined the research team as a credit analyst. John is working very closely with Bill Zox, who, as I already mentioned, is portfolio manager of our strategic income strategy, and John also is working with the entire Diamond Hill research and portfolio management team. John earned a bachelor’s degree from the University of Kentucky, an MBA from Carnegie Mellon, and has earned his CFA designation.
In addition, Micah Martin joined us as a research associate and is a member of the consumer discretionary sector team. Micah earned a bachelor’s degree from Cedarville University, an MBA from Ohio State University, and is a level two candidate in the CFA program.
We’re very excited about the addition of both John and Micah, and we’ve already seen meaningful contributions to our research efforts from both of them.
We’re also pleased to announce that Faith Stevenson has joined our distribution team as a director of institutional business development. Faith brings extensive experience in both intermediary and institutional distribution and will work with clients and prospective clients in the northeast United States. Faith has a bachelor’s degree from Ohio State University and she also holds the CFA designation.
So with that, I’ll now turn the call over to Bill Zox. Again, Bill will provide an update on deleveraging in the United States, and then Bill will start our strategy updates with remarks on the strategic income strategy. Bill?
Thank you, Julie. This is now the third year that I’ve discussed deleveraging in the United States. Deleveragings are different than normal economic cycles, and they are very rare. I’ve found these resources to be the most helpful in understanding them, and I also want to thank Alex Gardner and Jack Parker for their help in putting these slides together.
This slide shows that private sector debt has declined more than government debt has increased. If you look in the far right column of the table on the right, since 2008, government debt has increased by 27 percentage points of GDP, but offsetting that, household debt has declined by 18 percentage points, and financial institution debt has declined by 29 percentage points. So as a result, total debt has declined by 20 percentage points in GDP, and this shows that we have gone through a significant deleveraging in the United States.
Turning to the next slide, this shows how successful deleveragings in other economies have played out in the past. And Sweden and Finland, in the early 1990s, are two deleveragings in recent decades, and in both cases, the deleveragings went very well.
What you see in these deleveragings is you have the period of recession, where real GDP growth in Sweden and Finland was minus 3% over that period. Then you have a longer period where the private sector is deleveraging, where economic growth tends to be very slow. And in this case, that period was 4 to 6 years, with 1% economic growth.
And then once the private sector is done deleveraging, and the deleveraging transitions to the government sector, growth tends to accelerate. And what you saw in Sweden and Finland was a much longer period of government deleveraging where economic growth accelerated from 1% to 3%.
Last year when we discussed this, it seemed that it might have been close to this transition between project sector deleveraging and government deleveraging, and I think that the evidence is even more persuasive this year that we’re in the early stages of this transition.
If you turn to the next slide, this shows that household sector deleveraging is well advanced. Household debt as a percentage of GDP in the U.S. is now below the median of this group of the 10 largest mature economies. This data is a couple of years old, but it shows that we’re below the median, and now to the mean, of those 10 large economies. So I think this supports the contention that household deleveraging is very well advanced in the U.S.
Turning to the next slide, this also shows a very important inflection point, where we had basically 57 years where household debt grew in the U.S. and in almost every case by more than 5% a year. It looks like there were maybe two or three years where the growth of household debt was below 5%.
And then we had four years in a row in 2009 through 2012 where household debt actually declined in the U.S., so that shows that this sort of a deleveraging is very unusual and certainly in our economy and all other economies.
Incidentally, each percentage point of household debt is about $130 billion in today’s economy, so if we go from minus 1% to 2% in household debt to a positive 2% to 4%, that’s going to be very meaningful to the economy. Each percentage point of debt is $130 billion.
And as long as household debt does not grow faster than nominal economic growth, household debt will not grow as a percentage of the economy. So I think to go from negative to positive is very important, and I would expect household debt to grow closer to nominal GDP growth, call it maybe in the 4% to 5% range, somewhere approaching that, in coming years.
I’m going to run through some of these remaining slides a little more quickly. The next slide, if we could skip, six indicators of deleveraging progress, McKinsey has done some good work in this area, and they identify these indicators of progress before an economic recovery becomes self-sustaining. And I think we have made excellent progress on virtually all of these.
If you turn to the next slide, this just shows the financial sector has stabilized and lending volumes are rising. On the next slide, we talk about two factors here. The second one, credible medium-term [unintelligible]. The medium term looks pretty good in terms of the federal deficit at this point.
Now, the longer term, we still have work to do, but if you look on the first chart, the deficit is projected for 2014 at I think about 3% of GDP or maybe a little bit less, and we are projected to be in roughly that range through the end of this decade. And then things get a little bit more difficult, so we definitely have some work to do long term on deficit reduction, but we look pretty good over the medium term.
Where we really, I think, have been weaker, structural reforms have been implemented. I think the government can clearly do more to promote long run economic growth, so we definitely still have some work to do in that area of structural reforms.
On the next slide, exports are growing. You see that clearly there. The next slide, private investment has resumed. I think we can check that one off. And then finally, the housing market, it has certainly stabilized. Residential construction has revived, but that growth has not been as fast as I and many others would have expected.
The growth in single family residential construction in particular has stalled out at about 600,000 homes per year, when that used to run, for single family homes, much more like a million plus. I still expect steady growth from these depressed levels as job growth and household formation continues to progress. And that will be important for economic growth.
And then finally, this data is now a couple of years old, but it shows that the U.S. fiscal situation is much better than most other large, mature economies. Among other things, we benefit from a large and diverse economy, with a financial sector that believe it or not is a much smaller portion of our economy than any other of the major economies.
In conclusion, we continue to track the pattern of successful deleveragings and we are transitioning from private sector deleveraging to government deleveraging. Expect economic growth to accelerate somewhat, and in the last two quarters of 2013, economic growth was 4.1% and 2.6%. Then we had this anomalous first quarter where it was -2.9%, but forecasts for second quarter GDP growth are once again, I think, 3%, right around 3% give or take.
So I do think that we are in a period of higher economic growth and I think we are, again, tracking a successful deleveraging. Now I’m going to turn to the strategic income fund in particular.
John McClain, as Julie mentioned, joined us on June 30, as a dedicated credit analyst. John is an excellent credit analyst with six years of experience in the high yield market. He is especially complementary to us because he follows a number of credits that we do not, because they do not have publicly traded equities in many cases. John also has strong relationships with all of the major high yield broker dealers. He has already made an important contribution to our efforts, which you will see in our disclosures in the coming months.
Turning to the next page, this is a very important side. As I mentioned, every quarter we are focused on our absolute return objectives of inflation plus 3% and 7% nominal, each measured over rolling five-year periods. There is no index or peer group which fits our strategy, so it is important to evaluate our performance on a risk-adjusted basis.
This shows our [sharp] ratio over the last 1-, 3-, and 5-year periods compared to the Morningstar Intermediate Term High Yield and Multisector Bond categories. We continue to be pleased with our risk-adjusted returns based on this measure.
And the only other comments I will make just in general terms about the strategy is yields are still very low, both in government bonds and in corporate bonds that we focus on, so we continue to have a defensive posture. We’re much more focused on that CPI plus 3% objective, looking out from today, and we’re not even in every case targeting yields that high.
So we’re very much in preservation of capital and generating a return that at least keeps up with inflation in this environment. We are confident that we’ll have better opportunities to get more aggressive where we can target that CPI plus 3% and 7% nominal over the 5-year time horizon, but we’re not targeting that in this current low yield environment.
With that, I’ll turn it back to Julie.
Thanks, Bill. To continue with our strategy update, we’ll now turn the call over to Tom Schindler for an update on the small cap strategy. Tom?
Thanks, Julie. The Diamond Hill Small Cap Fund Class I returned 6.16% in the second quarter, compared to the 2.05% return of the Russell 2000 Index. That brings the year to date return for the fund to 8.3% compared to 3.2% for the Russell 2000.
Year to date, 2014 has seen the reversal of two trends in small caps, namely small cap outperforming large cap and growth style indices outperforming value style indices. For example, in the five years ending December 31, 2013, the Russell 2000 Index had outperformed the Russell 1000 Index by a cumulative 15 percentage points or about 1.5 percentage points annually on a compounded basis.
During that same timeframe, the Russell 2000 Value Index had trailed the Russell 2000 Index by a cumulative 24 percentage points or about 2.5 percentage points compounded annually. Through yesterday, on a year to date basis, the Russell 2000 Index trailed the Russell 1000 by almost 800 basis points and the Russell 2000 value index led the Russell 2000 index by 164 basis points.
The fund had been positioned somewhat defensively, and skews toward the larger end of the small cap spectrum. However, stock selection has been the primary factor in the fund’s year to date outperformance and that has been fairly true in most all sectors.
Of particular note, stocks classified as industrials, including Avis Budget, Trinity, and Hub Group and energy stocks including Cimarex, [unintelligible], and [unintelligible] have been especially strong performers. Detractors have been more limited, and would include consumer discretionary companies [Liquidity] Services and Steiner Leisure.
To illustrate the importance of stock selection in the recent past, consider Avis Budget, current the fund’s largest holding. There are three meaningful players in the car rental business: Hertz, Avis Budget, and privately held Enterprise. During the slightly more than one year that we’ve held it, Avis Budget’s stock price has just over doubled. Larger competitor Hertz is up only about 16%, which slightly trails the market averages. So there’s been an industry consolidation where pricing has been strong across the industry, but Avis has done a much better job than other public company Hertz in capitalizing on that.
Now, in looking at the sectors in terms of sector changes in the past year, the most notable change is the reduction of the consumer discretion and consumer staples, which has largely been responsible for the increased cash percentage.
In consumer discretionary, reductions in the positions of [Aarons], Hillenbrand, Live Nation, and Tenneco and the underperformance of Steiner Leisure account for the changes. And in consumer staples, the reduction in Energizer and the acquisition of Harris Teeter somewhat offset by meaningful additions to Flower Foods and BNG Foods would account for the change in the consumer staples.
The fund continues to have the largest absolute exposure to the financial sector, with insurance companies comprising the most significant subset of that. Portfolio statistics were fairly stable. I’m going to highlight just one of the new positions, Aircastle. At an estimated 85% of intrinsic value, the discount is not as large as the average initial discount at time of purchase through the fund’s history, but this is among the better expected returns found in the current small cap environment.
Key to the investment thesis is management’s future allocation of capital as the company has shown a flexible business model. The best returns the company has earned historically have been by being opportunistic buyers of used passenger aircraft, which they then lease and ultimately dispose of. They have also been participants in new aircraft leasing, have been investors in debt security secured by aircraft, and have even gone into [unintelligible] airlines at times.
This willingness to direct cash flows to the highest prospective returns has also been evidenced at times when they’ve repurchased shares when they’ve thought that’s been a better return than continuing on in new projects.
With that, I’ll turn it back to Julie.
Great, thank you, Tom. Next, we will hear from Chris Welch, with comments on the small mid and midcap strategies. Chris?
Thanks, Julie. The Small Midcap Fund Class I shares have outperformed the benchmark for all the periods shown on the slide here. In the second quarter, we’re ahead by about 180 basis points ahead of the benchmark, and that was driven primarily by individual stock selection. There were a couple of stocks that were impacted by corporate actions, either actual or possible future corporate actions.
So in the case of Molson Coors, there was increased speculation that Anheuser Busch is going to acquire SABMiller. Molson Coors has a joint venture with SABMiller in the U.S., the Miller Coors, and if Anheuser Busch makes that acquisition, then Molson Coors would likely be able to buy the portion of the joint venture they don’t own at a favorable price, creating value for shareholders. So the stock rose 27% during the quarter.
And then Energizer announced that they were going to split the company into two parts. One will be a battery or household products division and the other company will be a personal care division. I think it’s interesting that you see kind of an increase in corporate actions across the market.
I think in part, that’s because management teams have been so effective across a number of industries in cutting costs over the recent years that now as management teams look for ways to continue to improve operating margins and create value, oftentimes they’re left with some type of corporate action as the primary way to do that. So we’ve seen that in a number of areas across the market.
There were no significant detractors from performance. There were some stocks that underperformed, but nothing significant that I’d call out. Looking at the next slide, in terms of changes in sector weights year over year, the one I’d really highlight is financial sector. It’s up to 29.3% of the portfolio. We have a sector limit, that our maximum position in any sector is 30%, for diversification reasons, so we’re right there with financials, at our maximum.
And I think Willis Group, one of the big three insurance brokers, is a good example of the type of stock that we’re finding attractive in the market today. I feel like it’s a very low risk opportunity, and it’s 4.9% of the portfolio. We added a little bit to it during the quarter. I believe at 4.9%, it’s the largest weighted position we’ve had in the portfolio in the past five years, so that gives an idea of the conviction level I have in terms of Willis Group.
So financials has been an increased weight over that period. Moving on to the next slide, looking at transactions, Tom talked about Aircastle. That was the only new position in the quarter. In terms of eliminated positions, Allegheny and KeyCorp are financial stocks. We sold those as being right up at the limit in our financial sector weight. We needed to sell them to add more to a couple of other positions, Willis Group as well as Brown & Brown, which is another insurance broker.
And then in the case of Greatbatch, this is a company that’s done well for us. They manufacture a lot of parts for medical device companies, so they’re an outsourcer, but they’ve also increasingly used some of their own internal R&D to produce products. And as more of the value of the company is based on their internal R&D, that adds a little bit of risk to the situation. So as that was approaching their intrinsic value estimate, we exited that and added those funds to some other positions.
And let me move on to the midcap strategy. The midcap strategy we started at the beginning of this year, so it’s just been around for six months. We had good absolute returns, both in the question and year to date. We trailed the benchmark for the year to date period. The individual strong performers during the quarter were similar to this mid fund. Both Molson Coors and Energizer, as well as a few other holdings, are in both of the strategies. In fact, there’s about 80% overlap of the holdings in the midcap strategy relative to small cap.
And looking at the sector allocations, this is a comparison versus the end of the first quarter, since the strategy’s only been in existence for the year to date period. Two big movements there were a decrease in industrials by 130 basis points, an increase in consumer discretionary by 120 basis points. And those are both due to transactions, which I’ll talk about coming up right here.
Looking at the next page, new position in Ross Stores. It’s an off-price apparel retailer. It’s a very similar model to TJX, which we own in a number of other strategies. One of the things I like about Ross Stores, again similar to TJX, they’ve improved their operating margin by about 500 basis points over the past few years and essentially they’ve improved that margin through increases in their gross margin.
And they’ve achieved those increases through strong inventory management, strong merchandising, and I feel like those improvements in gross margin are more sustainable than cost cuts, cuts to SG&A over time.
So I feel they’ve done a really good job of managing the business, and also have been shareholder friendly. They’ve reduced their days sales outstanding by more than 20% over the past six years, returned a lot of capital in the form of share repurchases.
And I feel like the stock is not given the premium that it deserves in the marketplace. So it’s a $14 billion market cap company, something that was eligible for midcap. It was not eligible for small caps. So we did buy it in the midcap strategy.
And then other transactions, we sold Staples mid-quarter and bought it back before the end of the quarter to take tax losses. And we were able to buy it back at a lower price, so that was nice. And then in terms of eliminated securities, Southwest Airlines had very strong fundamentals, very pleased with the gains we got in that stock, but as the stock rose in price, we were unable to justify a higher valuation, so we completely sold out of that position.
And I’ll turn it back over to Julie.
Great, thanks, Chris. Next, Chuck Bath will provide comments on the large cap strategy. Chuck?
Thank you, Julie. Large cap strategy performance, as shown on the current slide, as you can see, the fund trailed in the quarter and year to date. It’s interesting, the financial sector, which is the largest sector in the portfolio, was the biggest detractor in the first quarter, yet was actually very additive in the second quarter.
But overall, I was a little disappointed that we’re trailing year to date. The portfolio statistics you’ll see on the next slide are somewhat typical for this portfolio. Turnover of around 18%, number of holdings in the portfolio right around 50, and cash very low in the portfolio. New names are somewhat indicative of some of the activities that happened in the quarter in terms of our opportunity to develop.
MetLife is a new name in the portfolio. As I said, the financials were the weakest sector in the first quarter in the portfolio. MetLife was typical of another name we own, which is Prudential. Prudential and MetLife both sort of sold off in tandem in the first quarter, mostly due, I think, surrounding interest rate concerns. It created an opportunity surrounding very inexpensive valuation, and so that is a new name in the portfolio.
Noble Energy, another new name, is part of a restructuring of the energy portfolio. The actual weight in the energy portfolio hasn’t changed that much, but the names in the portfolio are in the process of changing as I try to take advantage of many of the names who are beneficiaries of new technology in the energy industry.
I want to own those companies as assets that can benefit by rapid increases in production growth more so than just calls on the commodity itself. Noble is one of those names. Apache you’ll see was eliminated. Basically, we swapped Apache for Noble as Noble is much better positioned and its valuation is very attractive at these levels.
Praxair is also another sort of typical name in the sense that it’s replacing a previous holding, Air Products. We’re in the process of swapping Air Products for Praxair. The attraction is Praxair is quite frankly a better company, with better revenue growth, better margins.
Air Products has done well recently, actually over the last couple of years, as investors have become involved and management more focused on improving margins, but I think they’re only striving to be the company that Praxair already is, and Praxair is a more inexpensive valuation, so I swapped Air Products for Praxair.
21st Century Fox is a new name in the portfolio. It’s a broadcasting company, which I’ve found are generally attractive businesses over time. They tend to be companies that generate a lot of free cash flow, with also good growth as well too.
Now, 21st Century Fox is somewhat topical today, because of the news surrounding their potential acquisition of Time Warner. I’m actually okay with that as a shareholder if the terms are as described today, but I’m afraid we could get into a bidding war and depending upon what the final transaction might look like, I might reserve judgment on whether I would still support that acquisition. But for right now, if I’m asked, I would view that acquisition positively at the price at which it was discussed.
And then the final name that we eliminated, we didn’t really discuss Southwest Airlines, which was eliminated simply because of valuation and the stock price [unintelligible] estimates, as did Knowles, which was spun off [unintelligible]. So those are the eliminated positions, and sort of the thought process behind some of the transactions in the portfolio.
And finally, on our final slide, for the Large Cap Fund, you’ll see the breakdown by sector. As I indicated, financials is the largest sector. Staples has been a large sector for quite some time with healthcare. You’ll see energy down around 10%, which is a relatively average weighting in the portfolio, and sort of a focus of some of the transactions in the portfolio. That portion of the portfolio is being reconfigured.
And the technology sector, again about 10% of the portfolio, mostly populated by some of the more mature, slower growing, but strong balance sheet technology names, such as Apple, Microsoft, Cisco, and IBM.
I think with that I will conclude my comments and pass it back to Julie.
Great, thank you, Chuck. Next we will turn to Rick Snowdon for comments on our Select strategy.
Thanks, Julie. For the quarter, the Select fund underperformed the benchmark by roughly 100 basis points, 375 points for the fund versus 475, a little bit more than that for the benchmark. Year to date, they are even, both around 700 basis points.
In the quarter, industrials, technology, energy, and financials all contributed roughly 1%. Healthcare and consumer discretionary were both slightly negative. Some of the bigger contributing names were Apple, Cimarex, and Hub Group.
On the next page, you can see the sector allocations and how those have changed over the course of the year. I think the most noteworthy ones are technology, which is up about 500 basis points relative to a year ago. That’s entirely owing to increases in the weights as we become more confident in the discounts to intrinsic value there.
Healthcare is down about 450 basis points, and that’s due to the net reduction of two names. We have two fewer names than we did a year ago. We actually eliminated five and added back three. And similarly, consumer discretionary is up 650 basis points and that’s due to the net addition of two names there. We eliminated Aaron’s, we added Fox, Jarden, and Whirlpool.
On the last page, we’ve got some statistics, and then new and eliminated names. I’ll just focus on one of the new names, which is Valeant Pharmaceuticals. This is a healthcare company that’s been in research opportunities for a couple of years. It’s grown very rapidly through acquisitions, which is generally not a profile that would be attractive to us.
However, this company is very focused with regard to the type of business they buy. They’re looking for low payer pressure, high touch relationships with doctors, making their products more sticky, and very low patent expiration risk. They’re also very disciplined with regard to the price that they pay for these acquisitions, insisting on very high internal rates of return. They have a solid track record of achieving those.
Finally, they have an extreme focus on cost containment, which includes decentralized operating model, an aversion to open ended R&D spending, as has been the case for a number of years with a lot of pharmaceutical companies, and they also have a very advantageous tax situation due to Canadian domicile.
They’ve been in the news lately due to their proposed acquisition of Allergan, which is the maker of Botox. We believe the company is undervalued as is, even if they don’t get that deal done. And we think that if they were to get that deal done, it would just represent further upside.
One of the reasons that we feel this way is, as I mentioned previously, that they’re very disciplined about the price that they’re willing to pay, and therefore we think it’s highly unlikely that they’ll overpay for this one.
In terms of the existing business, we think we paid a very reasonable price in return for which we’re expecting to get high single-digit organic revenue growth, whereas many companies in the healthcare realm right now are facing declining revenue in light of patent cliffs. We think we also get very realistic margin expansion opportunities. They’re already identified, and we’re getting a management team that’s very focused on return on invested capital.
With that, I’ll pass it back to you, Julie.
Great, thank you, Rick. Next, Ric Dillon, portfolio manager for our Long Short strategy, will provide an update on recent results.
Thank you, Julie. In the quarter, the Long Short fund trailed the Long Only benchmark, but did exceed the secondary 60-40 benchmark. Over the last five years, where we’ve had pretty much a straight up market, of course you would expect a long short strategy to trail, as it has, but our goal over long periods of time is survival of those [unintelligible] benchmarks, which we have done over the past 10 years. And I think over the next five years, we have a very good chance of doing that as well.
On the next slide, you’ll see that our emphasis on the short side - and I’m going to keep my comments to the short side, since most of our long positions and changes thereof have been discussed with our previous strategies - as you know, essentially all of our long positions are held in either our large cap and or our mid cap strategy.
But the consumer discretionary continues to be our highest area of short exposure, and it reflects two things. One, our belief that the consumer in the U.S. is continuing to be somewhat under pressure, and so our caution for that sector, but also, because our research group has been able to, we believe, identify situations within that sector that merit us taking short positions.
In fact, today, our research group published their monthly industry perspectives, and in this months, Todd Schneider wrote “Mind the Gap,” in which he discusses the Gap stores and the qualitative versus quantitative aspects to their earnings and their valuation. And that is one of our short positions, where, again consistent with the idea that the consumer area is probably our best area for short positions.
Turning to the next slide, you can see the various both new and eliminated positions, but what I want to simply make comment on is the fact that a couple of our positions have seen us, in the case of Ubiquity, go short and then [cover] and then short again. As you see at the bottom of that page.
Also, Kansas City Southern was a short position that we covered. It was, I think, one of our biggest contributors in the first quarter, positive contributors, and the stock, after we covered it, I think something below $90 a share, has run back up over $110 a share. And again, our view hadn’t changed, and so we put it back on as a short position.
And this year, as was last year, while in an up market it’s difficult to make money over a short portfolio, we have had positive alpha, meaning that our shorts have gone against us much less than the market. In fact, in the consumer discretionary, we actually did have a positive contribution for the quarter for that sector.
So we’re very pleased with what our research team has done on the short side, and again, once the market ceases to be only upward, as it has been over the past five years, we would expect not only positive alpha, but also positive contribution from our short book.
And with that, I’ll turn it back to Julie.
Thank you, Ric. Next we will hear from Chris Bingaman, with a review of our financial long short strategy.
Thanks, Julie. The Financial Long Short Fund had a little bit better quarter in Q1, although the sector in general lagged clearly in Q2. I think it was the worst performing sector of all the major sector classifications during the quarter, and has now lagged on a year to date basis.
On page 51, you can see the industry breakdowns. Not a lot new there over the last year. It’s still emphasizing the main areas that we typically see: banking, insurance. On the banking side, it’s up the cap spectrum into the very large cap money center banks, more so than the regionals. In the insurance side, it’s much more focused on the life insurers as opposed to the property casualty companies that we have been emphasizing in the last few years, and also the insurance brokers.
On page 52, just a couple notable items there. In terms of net exposure, it’s roughly flat versus last quarter. I think we ended the quarter at 78, and I think we were at 77, just up slightly. In Q1 we saw a meaningful increase in net exposure, up from around the 70% level at year-end. So took advantage of opportunities during Q1, and still maintaining a very, very long net bias as we’re still finding lots of opportunities on the long side.
New positions have largely been discussed. State Bank is a small cap bank down in Atlanta, Georgia, run by we think a very shareholder friendly management team. Lots of excess capital, so lots of optionality to grow the bank there, and we think long term the bank will look to execute fundamentally and/or sell the bank in the next fiscal year.
In terms of eliminated positions, iStar was a preferred position. That was a long term holding in the fund. Worked out very, very well. We sold the last bit of it recently, at just under par. U.S. Bank Corp., a very, very well run bank. It’s been a holding in numerous strategies here, and of course this one over very long periods of time. Again, very well managed company, but close to our estimate of intrinsic value and we reduced it in the quarter.
One other noteworthy, it wasn’t completely eliminated, but we sold a meaningful portion of our investment in Winthrop, a REIT that’s been in our portfolio for a number of years. They announced during the quarter that they were going to liquidate the company over a couple of years. And the stock performed very, very well. It was the most meaningful contributor in terms of individual security in the quarter.
So an example of a well-run company, value-oriented management team, with a very meaningful ownership position on the part of that management team. And felt that the value of the underlying portfolio wasn’t being recognized by the marketplace and decided to liquidate that REIT.
So overall, I think, again, the fund remains very, very net long, emphasizing money centered banks, life and insurance brokers on the insurance side. A couple of asset managers are also in the top 10 holdings. In general, feel pretty good about those opportunities on an absolute basis, but in particular on a relative basis, as again, the sector has lagged fairly meaningfully now on a year to date basis.
And I think that’s all I had, so I’ll leave it there and turn it back to Julie.
Thank you, Chris. And to wrap up our strategy update, Austin Hawley is with us to provide an update on the research opportunity strategy.
Thanks, Julie. In the second quarter, the Research Opportunities Fund returned 3.7%, trailing the Russell 3000 by approximately 120 basis points. For the year to date period, the Research Opportunities Fund increased 5.4%, trailing the Russell 3000 by approximately 160 basis points.
Over the long term, the fund has delivered excellent absolute returns while modestly trailing the Long Only benchmark. We continue to expect that over full market cycles, we will add value relative to the Long Only benchmark in addition to delivering appropriate absolute returns.
Turning to the sector exposures on slide 56, you’ll notice that there has been minimal changes in the sector exposures for the Research Opportunities Fund, and this is what we would expect, given the portfolio structure, which is focused on adding value through security selection without actively managing the sector allocations.
Turning to the portfolio statistics on slide 57, you’ll see that we have six fewer names in the portfolio at the end of the quarter, 65 long positions and 21 short positions compared to 68 long and 24 short at the end of the first quarter. In addition, we’ve seen slight increases in both our gross exposure and our net exposure, as we’ve [unintelligible] up slightly more concentrated in our best ideas.
Looking at the new positions, all of the positions have already been mentioned. We’ve had several eliminated positions in the quarter. In nearly every case, these are names that reached our estimates of intrinsic value and capital was deployed to either the new positions or existing positions where we had large discounts to intrinsic value.
Before I turn it back to Julie, I want to provide some brief comments on the insurance brokerage industry, where we now have investments in three firms: Marsh McClennan, Willis Group, and Brown & Brown, with every strategy having investment in at least one of these companies.
While our intrinsic value estimates are based on the specifics of each individual company, there are certainly industry characteristics that help support our positive view of the insurance brokers that we own. The insurance brokerage industry earns sustainable high returns on invested capital, generates large amounts of free cash flow, and for the larger global companies, such as Willis and Marsh McClennan, there are attractive secular growth prospects.
Brokerage commissions and fees represent a small part of a corporation’s total insurance cost, but the brokers provide the largest tangible benefit to clients, with their analysis, advice, and coverage placements. Switching insurance carriers is relatively easy for corporations, because the insurance broker will find markets for the appropriate coverages and evaluate terms and conditions as well as appropriate security.
Switching brokers, by comparison, is much more burdensome for the company, requiring substantial time and effort and also running substantial risk that important data about exposures isn’t transferred properly. These characteristics result in a high switching cost for the insurance broker clients, with client retention rates consistently in the low to mid 90% range.
Price competition is ineffective because of these switching costs and the high benefit to cost ratio exhibited in the brokerage industry, allowing companies to earn outsized returns, free cash flow margins in the mid-teens, and return on invested capital above 20% for each of the firms that we own.
Finally, for the large brokers, Marsh McClennan and Willis, there’s an opportunity to participate in the above-normal growth of the insurance markets in developing countries, where insurance penetration is likely to increase meaningfully over time.
With that, I’ll turn it back to Julie.
Thanks, Austin. That concludes our prepared remarks this afternoon, so operator, we’re now ready to begin the Q&A session of the call.
While we wait for any questions from participants, we do have a question here for Chuck. Chuck, you mentioned acquisition activity when you were discussing 21st Century Fox. What are your thoughts on some other recent big acquisition announcements, like those from Medtronic and Pfizer?
It’s not surprising that acquisition activity is picking up due to low cost of financing and strong corporate balance sheets, but some of these, like Pfizer and Medtronic, the tax inversion strategy has become much more prominent, and has become controversial.
Pfizer did not succeed in their acquisition attempt, so it’s become kind of a moot point there, but Medtronic is acquiring Covidien in a tax inversion type strategy. And actually, there’s some discussion even today about legislation which may hinder or eliminate this strategy, back dated, so it might even affect Medtronic’s acquisition of Covidien.
Medtronic, it’s not as important an issue for them as some others, because their corporate tax rate is already relatively low. But it certainly is an attractive option, and short of a legislation solution, I would expect this to become a much more prominent strategy, especially in certain industries like healthcare. They’re high margin, low taxed businesses in attractive locales such as Ireland, for example, where tax rates are slow low, that can be attractive for these companies. So we’ll see how that plays out.
One important aspect that I should highlight in relation to my fund, I am investing in, and [unintelligible] charter is investing in domestic U.S. companies. Medtronic is a domestic U.S. company. However, if they complete the acquisition of Covidien, they will be reincorporated outside the United States.
That presents a dilemma. Do I remove this Medtronic as an investment for this fund, just because it redomiciles, even though the business really hasn’t changed that much? I think shareholders are looking for me to be somewhat more flexible in this, so I wouldn’t be surprised in the future if these tax inversion deals continue.
Companies who are truly domestic companies but domiciled outside the United States for tax purposes, I would view those as eligible for investment in the fund. We’ll see how this plays out. If this becomes more prominent, domiciling for tax purposes outside the United States may become more common, and may limit the investment opportunities in a domestic only strategy, if you’re going to be that stringent upon things such as country of incorporation.
So it’s a topical subject, but the situation is totally unresolved. Legislative efforts may change the strategy, but short of that, I suspect this type of activity to continue and perhaps even accelerate.
Thank you, Chuck. We have another question that we received. This one is for Bill Zox. Bill, will you talk a little bit about you expect the strategic income strategy to perform in an inflationary and rising interest rate environment?
Sure, the fund has a duration of 2.58 at the end of the second quarter, and we have 48 carefully selected and researched positions, so we feel like we should hold up relatively well in a higher interest rate environment, whether it’s due to inflation, higher real government yields, wider credit spreads, higher volatility, less liquidity. We are very defensively positioned right now with the objective of being in a good position to take advantage of higher yields for whatever reason. So again, that duration of 2.58, we have lots of cash coming in, and we think that we’re in a good position to reinvest that cash if yields do increase for whatever reason.
Operator, are there any questions in the queue at this point?
There are none at this time.
Okay, if we don’t have any additional questions, then we can go ahead and wrap up the call. Thank you all for joining us this afternoon. As a reminder, if you’re interested in listening again, or missed parts of the call, we will have a replay on our website in a few days. Thanks again for joining us, and for your continued support of Diamond Hill, and we’ll look forward to speaking with you all next quarter.
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