Diamond Hill Capital (Trades, Portfolio) Management follows an intrinsic value-based investing philosophy with a long-term perspective. With this approach, Diamond Hill’s Select (all-cap) strategy has had an average annual return of 7.76% since its inception in 2005, outperforming the benchmark Russell 3000 Index, which had average annual return of 6.88%.
The Select Fund is managed by Rick Snowdon and Austin Hawley, who joined Diamond Hill in 2007 and 2008. Both managers recently took the time to answer investing questions from GuruFocus about topics ranging from their investing philosophy, to their view on embattled Valeant Pharmaceuticals (VRX, Financial), the fund’s fourth-largest holding as of the third quarter.
Rick Snowdon (left) and Austin Hawley manage Diamond Hill Capital's Select Fund
1. Please tell us how you each got your start in investing and specifically value investing.
Rick Snowdon: The first segment of my career was in the downstream portion of the oil industry. During that time, I became very interested in the fundamental forces that drive the ultimate value of oil and other energy commodity contracts, and this eventually led to my initial involvement in the markets as a trader. At some point, I became interested in the added complexity of valuing stocks, and I took the CFA exams to help expand my knowledge base. Value investing has always been the only investment philosophy that made any sense to me. As such, I felt very fortunate to become a client of Diamond Hill back in 2003 and a member of the investment team in 2007.
Austin Hawley: My first job out of college was as a fixed income analyst at Putnam Investments, not because I had any great desire to be a bond investor, but because it seemed like the best offer at the time. After being in that role for a while, I realized that I really enjoyed the analytical aspects of the job, and I became interested in analyzing whole companies, not just their debt. I went to business school and had a professor who assigned some of Warren Buffett (Trades, Portfolio)’s past letters as reading, and that started me on a track towards value investing. After business school, I went back to Putnam as an equity analyst covering insurance companies. To learn about the industry, I tried to read anything Buffett had ever written about the industry, and that initial knowledge and research started a virtuous cycle – I started reading anything related to value investing that I could find and tried to put those skills to work as best I could. Eventually I felt so passionately about the philosophy that I chose to seek out a firm that specialized in intrinsic value investing, which led me to Diamond Hill.
2. Did you have any mentors along the way, either at Diamond Hill or elsewhere? What was the most valuable thing you’ve learned from them?
RS: Chris Welch, another portfolio manager at Diamond Hill, took me under his wing when I first joined the firm as an analyst, and I’ve learned a great deal from him. The trait that most impresses me about Chris is his ability to cut through the noise and efficiently get to the heart of any investment topic.
AH: I’ve had lots of people throughout my career who gave me great advice and helped me achieve whatever success I’ve had. Bob Howell, a professor at Tuck School of Business at Dartmouth, introduced me to the notion of intrinsic value, taught practical accounting skills and encouraged an appropriately skeptical view when analyzing a business. At Diamond Hill, I’ve been lucky enough to work with some remarkably talented investors like Tom Schindler, Chuck Bath, Chris Welch and Rick. If I had to single any of them out in terms of influence, I would say that Chuck Bath and Chris Welch have had a big impact on me in terms of temperament and professional approach to fiduciary duty. So many bad things happen in this industry because people make emotional, short-term decisions, and I am always struck by the consistency and balance that Chuck and Chris bring to their jobs. If a particular investment goes poorly, you won’t ever hear one of them get angry or do something rash; they’ll try to figure out the fundamental impacts, assess probabilities and make a rational decision. Importantly, that decision will always be made with the same goal in mind – superior long-term results for clients. Truly believing in a long-term orientation and acting with a long-term horizon in mind can be a huge advantage, and that is one of the most important things I’ve learned in my career.
3. Can you describe the idea generation process for the Select Fund? Do you use a screener?
RS: We rely on the same research team as all of the other Diamond Hill strategies, and all new ideas are presented to us at the same time as the other strategies. Our mandate is concentrated all cap, so we have fewer names and a broader opportunity set. To make sure that our portfolio is always representing the best ideas in the firm, we developed an internal screen which shows us a snapshot of fundamental data, valuation metrics, and the key assumptions made by Diamond Hill research team members in deriving estimates of intrinsic value for all of the stocks held across the firm.
4. How do you go about accessing a company’s intrinsic value?
AH: We believe in a textbook definition of intrinsic value: the present value of the cash flows an investor can expect to receive over the life of the investment. However, we also know that estimating intrinsic value is not a precise exercise and can be as much art as science. Therefore, we have a process that is respectful of the textbook definition of value but allows for common sense judgments about key inputs. We model out all the companies that we invest in over five years and discount back all cash distributions, including a conservative terminal value, to the present using a required return consistent with the risk of the investment. Our terminal multiples are based on our view of a company’s expected risk and growth rate in five years, and our discount rates are based on our view of the risks inherent in the business – things like leverage, demand stability, likelihood of disintermediation, etc. Note that we are not using Beta to calculate discount rates or doing any complicated calculations to arrive at weighted average cost of capital (WACC) or a terminal multiple. Rather we are making common sense judgments based on our perception of risk, which we define as a permanent impairment in capital, and the returns available on competing assets.
5. Do you meet with management? If so, what qualities do you look for before investing?
RS: We always assess the quality of management teams before investing, but we don’t always meet with them. The number one thing we look for is a commitment to grow per share intrinsic value through prudent capital allocation.
6. What are your guiding principles when deciding whether to sell a holding? Are there any notable examples where you re-entered the position later on?
AH: Decisions to sell an investment are inevitably about risk. We define risk as a permanent impairment of our clients’ capital, and we do all that we can to avoid situations that increase the odds of a permanent impairment of client capital. With that framework in mind there are several reasons we might sell: First, the stock price has increased to a level above our estimate of intrinsic value. In this situation, we will first re-evaluate our model assumptions, but if we believe the stock price is above our best estimate of intrinsic value we will sell. Holding a stock above intrinsic value exposes our clients to permanent capital impairments. Second, we will sell if we are wrong about our fundamental analysis. If our estimate of intrinsic value declines to a level below the stock price or if we believe we can no longer confidently estimate intrinsic value, we will sell the shares. Third, we may sell if we have a much better opportunity. Translated into our language of risk, we may sell a security with a narrow margin of safety (discount to intrinsic value) to purchase a security with a wider margin of safety (discount to intrinsic value). Finally, we have absolute limits on position size (7% at market value) and will trim a position if it appreciates beyond that level. We don’t have any notable examples of selling and re-entering a position over the past few years.
7. Many investors talk about the risk and reward trade-off and the probability of outcomes. Do you use any methods to calculate the probability of certain outcomes, and if so, can you describe it?
RS: One of the most valuable features of the co-manager structure we employ on the Select strategy is the constant conversation that naturally occurs between the two of us. Austin and I have various running conversations all day long about our holdings, and much of that involves exploring and weighting different fundamental scenarios. Calculating a weighted average isn’t hard; it’s making sure that we’ve adequately considered the full range of possibilities and the most likely probabilities that’s key.
8. Turing Pharmaceuticals received considerable backlash for hiking the price of one of their drugs, which in turn prompted several media outlets to examine similar practices at Valeant. Could this increased attention on the business model affect the company in the long term?
RS: Yes, it will probably become more difficult for Valeant, and others, to raise prices going forward whether from a legal, structural or public relations standpoint. However, there seems to be a misperception about the extent to which Valeant’s organic growth has been driven by pricing versus volume. Year to date, organic revenue growth has been 15% with half of that coming from volume. Also, management has indicated that large price increases have been limited to 10% of the business. This segment, as a percentage of the total, will shrink over time, and management has indicated an aversion to additional M&A focused on “pricing opportunities.” For the next five-year period, we expect 6% to 7% annual revenue growth with likely two-thirds of it driven by volume. The stock is currently priced for no growth, or worse, so even if there is no ability to raise prices, there is still very significant upside in the stock.
9. Please walk us through the investment thesis for Twenty-First Century Fox (FOX, Financial). What are your thoughts on the partnership with National Geographic?
AH: Twenty-First Century Fox is a media company with interests in domestic and international cable networks, film and TV production, domestic broadcast TV and a 39% equity stake in Sky PLC, the British pay TV provider. Over the past year or so, two issues have pressured the company’s valuation: a decline in domestic advertising spend for broadcast TV and uncertainty about the durability of the current pay TV distribution model (the bundle). In our opinion, Fox is exceptionally well positioned to deal with these issues, but its current valuation reflects none of the positive growth we expect. The National Geographic channels don’t represent a meaningful piece of our analysis, but they are a part of the cable networks segment, which we expect to drive much of the value in Fox over coming years.
A significant majority of Fox’s profits come from its cable networks, and we expect profits to grow at an above industry rate over the next five years. Unlike broadcast TV, Fox’s cable networks have shown resilient advertising demand and, more importantly, rising affiliate fees. Fox has assets that continue to be desirable even in a world where content can be watched and streamed on demand, namely live sports via FS1/FS2/regional sports networks and news. These are areas where Fox has strong pricing power due to investments made in recent years and low starting fees/subscriber.
In addition, nearly 20% of Fox’s cable network profits are from international networks where pay TV penetration is low and increasing. Fox’s film and TV production studio is responsible for 15% to 20% of profits. This cash flow stream is more volatile and subject to the timing of big budget movies, but over multiple cycles, Fox’s film and TV production segment has had the highest return on invested capital (ROIC) among peers. Broadcast TV is a small and declining portion of Fox’s overall business. While ad spending has been declining low single digits for this segment, the impact has been largely offset by increases in reverse retransmission fees that Fox negotiates with local affiliates. We expect these trends to continue, having little net impact on the segment’s overall profits.
Overall, we expect profits to grow at an above-market rate over the next five years, driven largely by growth at the cable networks. Despite this, Fox trades at a discounted valuation of 12-13x earnings when properly adjusted for the market value of Sky PLC shares. We think this is far too low for a company that is growing at attractive rates with ROIC well above market norms.
10. I’ve been told in other interviews that it’s difficult to evaluate insurance companies, and one approach is to stick with those that have performed well in the past. How do you approach evaluating insurance companies? What indicators should investors pay attention to?
AH: I have been trying to evaluate insurance companies for most of my career, and I have learned a couple of things: insurance companies are difficult to value and the best performing insurance companies – those with an identifiable advantage on either the asset (investing) or liability (underwriting) side of the balance sheet – have been able to compound tangible book value per share (including accumulated dividends) at rates well above the market. So, I would agree that sticking with those who have a track record of outperformance is a reasonable place to start. However, valuation is very important – the wrong price for a great business can lead to a poor investment – and we tend to focus on the relationship between price to tangible book value ratios and expected returns on tangible equity over the next five years.
Our approach to evaluating insurance companies is really three pronged: 1) look for an identifiable advantage such as a niche underwriting market for a specialty insurer or scale for a direct to consumer auto insurer like Geico, 2) compare expected returns on tangible capital to the price paid for that capital and 3) scrutinize the loss reserve history and management’s track record. Loss reserves are the largest liability of an insurance company and represent an estimate of ultimate payouts; a management team that is overly aggressive with its initial loss estimates can show strong earnings in the near term but wipe out long-term owners.
11. Are there any sectors where you’re seeing more bargains than others?
AH: Recently we’ve been spending more time on cyclicals, many of which have sold off significantly over the past three months with the slowdown in China and other emerging markets. The near-term outlook is definitely not rosy for some of these companies, and we’ve seen many industrials reducing outlooks for 2016 as they report earnings this quarter, but we take a long-term view. If we can find a great franchise with stable long-term demand and/or great management, we are willing to invest even in the face of near-term weakness. We have been particularly focused on quality cyclicals with high returns on capital through a cycle and good records of capital allocation, which have sold off due to weakness in the near-term growth outlook.
12. What books would you recommend to a beginning value investor?
- “Value Investing: From Graham to Buffett and Beyond” by Bruce Greenwald
- “Value, the Four Cornerstones of Corporate Finance” by McKinsey and Company, Koller, Dobbs, and Huyett (all from McKinsey)
- Warren Buffett (Trades, Portfolio)’s shareholder letters (a nice summary of which is “The Essays of Warren Buffett (Trades, Portfolio): Lessons for Corporate America” by Lawrence Cunningham)
- “Valuation: Measuring and Managing the Value of Companies” by McKinsey and Company, Koller, Goedhart, and Wessels
- “The Intelligent Investor” and “Security Analysis,” by Ben Graham
- “The Most Important Thing” by Howard Marks (Trades, Portfolio)
- “The Outsiders” by William Thorndike
- “Accounting for Value” by Stephen Penman
- “Simple But Not Easy” by Richard Oldfield
