Diamond Hill: A Diamond In The Rough?
Diamond Hill Investment Group is a simple, predictable, and profitable business that trades at a reasonable price. Better yet, they’re value investors — “intrinsic value” appears on the first page of their 10-K. The cherry on top? They’re in a “take rate” business — asset management — that we understand well.
Business Model
Diamond Hill is a registered investment advisor that manages mutual funds and separately managed accounts.
Their investment philosophy is similar to our own. They do bottoms-up research to identify discrepancies between a security’s price and intrinsic value. Their portfolio, like ours, is driven by individual security decisions rather than macroeconomic forecasts.
Diamond Hill manages $26.4 billion spread across twelve strategies: 9 equity and 3 bond. Equity strategies comprise 90% of AUM (assets under management). Their large-cap fund carries almost half of the firm’s AUM.
For the most part, Diamond Hill’s performance has been solid. 75% of its strategies are ahead of its benchmark since inception.
Diamond Hill primarily makes money from management fees. Management fees accrue as a percentage of the average daily AUM. In 2019 Diamond Hill’s management fees averaged 0.59% of AUM.
Diamond Hill also makes money from mutual fund administration fees. Mutual fund administration comprised about 6% of 2019’s revenue. These are levied as a percentage of average daily AUM. They vary between 0.05% and 0.21% of AUM.
Diamond Hill also earns incentive fees on a minority of its funds. Incentive fees are based on results over rolling five-year periods. They’re only recognized at the end of the five-year period. Historically, they’ve not been meaningful.
Diamond Hill’s management fee rate has been declining for a number of years. The primary culprit is a shift in mix. Diamond Hill’s bond funds have grown faster than their equity funds. Bond funds carry lower management fees, which has pressured Diamond Hill’s overall take rate.
There’s also been an industry-wide shift from active managers to low-cost passive funds like Vanguard and BlackRock offer. This has removed some of the pricing power active managers once enjoyed.
Source: Author, Data From Diamond Hill 10-Ks
Fortunately for Diamond Hill, AUM growth has more than offset its declining fee rate. AUM grows from AUM inflows and market appreciation of existing capital. Since the market tends to rise over time, AUM will also. So long as Diamond Hill doesn’t see meaningful net outflows, AUM growth should more than offset a declining fee rate.
Diamond Hill’s growth is particularly valuable because it requires no incremental capital. Incremental expenses are primarily salaries. Diamond Hill only employs 120 people, up from 32 in 2006. Personnel has grown at a 10% CAGR while AUM has grown at a 15% CAGR.
Diamond Hill’s asset gathering strategy is well diversified across a range of distribution channels. Their largest customers are registered investment advisors, independent broker-dealers, wirehouses, and bank trust departments. Diamond Hill does sizable and growing business with institutional consultants, who make recommendations to foundations, endowments, and pensions. These relationships could produce large lump-sum inflows someday. Consultants are, at least theoretically, “smart money” who are less likely to make knee jerk reactions in response to short-term performance and market fades (Gamestop anyone?).
Valuation
A company like Diamond Hill is relatively straightforward to value. Future returns depend on Diamond Hill’s future AUM, management fee rate, and expenses.
Over the last five years, AUM has grown at a 9% CAGR. This is about the rate of return of the company’s largest equity funds.
There’s no telling what the market will do in any given year, or how Diamond Hill’s funds will perform. All we can do is get comfortable with their process. Good processes tend to produce good outcomes over long periods of time. Diamond Hill’s bottom-up value-centric approach combined with their multi-decade track record of outperformance gives me confidence that a blow-up is unlikely. I’m willing to assume that their current AUM is stable, but I wouldn’t want to price in any growth. This provides a margin of safety.
Overall management fee rates are likely to continue compressing. For valuation purposes, I’ll assume the rate dips 10% from its current run-rate.
If fees average 0.5% on $26.4 billion of AUM, revenue will be $130 million (rounding). Operating expenses were $88 million in 2019, which I’ll round up to $90. That leaves a $40 million operating profit or $13 per share. I capitalize this at 10x, which is a no-growth multiple. This means that the company’s operations are worth $130 per share. This is a slight discount to the stock’s $150 price.
But wait, there’s more! Diamond Hill is overcapitalized. They have $93 million of cash, $139 million of investments in their own strategies, and zero debt. Backing out $14 million of redeemable noncontrolling interests in their consolidated investments and $2 million of deferred capital gains tax on unrealized profits, Diamond Hill has $216 million of excess capital. That’s $70 per share.
Adding in the company's excess capital to their operating business suggests intrinsic value is around $200 per share. That’s 33% above the stock’s current price.
Backing investments out of Diamond Hill’s stock price, the operating business is trading for just 6.4x pre-tax earnings and about 8x after-tax earnings.
As a double-check for reasonableness, we can apply Marty Whitman’s rule of thumb for valuing asset managers. He thought they were worth book value plus 2-3% of AUM. Diamond Hill’s book value per share is $65.11 — basically its excess capital. 2-3% of AUM per share is $154 to $230. So Whitman would ballpark Diamond Hill’s intrinsic value between $219 and $280 per share.
Capital Allocation
Companies that generate lots of free cash flow which they cannot reinvest organically run the risk of destroying shareholder value with poor capital allocation.
Fortunately, Diamond Hill is in the investment business and understands capital allocation. Historically Diamond Hill has used its free cash flow to seed new strategies and pay special dividends. Now the company is in “harvest” mode. They don’t plan to seed new strategies in the near future, which means they'll have even more distributable cash flow.
Special dividends have been the cornerstone of Diamond Hill’s capital allocation policy. They’ve paid one every year since 2009. These special dividends became more regular in December 2013 when they paid out $1 per share. Every subsequent December they’ve raised the payout by $1 per share. This culminated in a $9 per share payout in 2019. In December 2020 the payout jumped to $12. This gives the stock an 8% trailing yield.
In October 2020 Diamond Hill authorized a regular quarterly dividend. These will begin with a $1 per share payout in Q1 2021. The company will still consider paying special dividends each December.
Diamond Hill has also been returning capital through stock repurchases. They authorized a $50 buyback program in Q3 2018 and again in February 2020. They have subsequently retired $69 million of shares through Q3 2020. That’s 15% of today’s market cap, which adds about 7.5% to the stock’s annual yield. Between dividends and repurchases, Diamond Hill is returning 15% of its market cap to shareholders annually. Their current authorization still allows for $31 million of buybacks.
As a good value investor, Diamond Hill’s repurchases are price sensitive. Their proxy states:
“We will only engage in share repurchases when we believe the current market price is below our estimate of Diamond Hill’s intrinsic value.”
“We intend to continue to repurchase our shares when they trade at a meaningful discount to our estimate of the firm’s intrinsic value.”
This is exactly what we want our managers to do.
Incentives
Every single Diamond Hill employee owns the company’s stock. Collectively, they own 17% of the company, which substantially aligns their interests with shareholders. Further, employees are only allowed to invest their own capital in Diamond Hill’s own funds alongside Diamond Hill’s clients. This policy minimizes conflicts of interest and maximizes skin in the game.
Diamond Hill compensates portfolio managers based on their trailing five-year performance. Unusually, Diamond Hill does not incentivize one or three-year returns. This helps managers focus on long-term results.
Diamond Hill’s offices are in Columbus, Ohio. This is, on balance, a good thing. It may make recruiting tougher. But it keeps Diamond Hill’s managers away from New York City’s groupthink. Columbus also has one of the lowest costs of living of any sizable American city. Diamond Hill doesn’t have to pay New York City salaries for employees to live well.
Forward Returns
Diamond Hill’s core operating business trades for 8x after-tax earnings. Since it needs no capital to grow, Diamond Hill could sustain a 12% dividend at this price. I’d expect payouts to be even higher over the coming years as Diamond Hill returns their excess capital.
This yield provides a substantial hedge against AUM outflows. Historically, Diamond Hill’s AUM has compounded 9% annually. Without inflows or outflows, Diamond Hill’s AUM should grow in tandem with the stock markets, or about 6-9%.
Diamond Hill is committed to closing its fund to new capital before they get too big to outperform. This will ultimately cap Diamond Hill’s earnings power, though they have plenty of capacity to grow into for the foreseeable future.
Between 2012 and 2018 Diamond Hill traded for 13-16x P/E. Today it trades for about 14x trailing earnings (8x net of cash and investments). As excess capital is returned, the P/E of the operating business will likely re-rate higher. Accordingly, I’d expect the stock to outperform the business in the near term.
In September 2019 Diamond Hill hired a new CEO. This January, they also hired a new CIO. Formerly, portfolio managers did double duty and served as the CEO and CIO. Now, those managers are able to totally focus on their portfolio. The new CEO and CIO will focus on building Diamond Hill’s brand, telling their story, explaining their philosophy, communicating their edge, and building relationships.
Consultants, who influence pensions, endowments, and foundations seem to be the primary focus going forward. These are “smart money” investors who can allocate billions of capital and are less fickle about short-term returns than retail investors. By building strong, long-term relationships with these allocators, Diamond Hill has the chance to see meaningful, long-term, and sticky inflows.
Diamond Hill seems committed to “harvesting” its seed investments and returning its excess capital to shareholders. So, I’d expect dividends and buybacks to exceed net income for the next couple of years. As the excess capital appears, it will become apparent just how cheap Diamond Hill’s operating business is. This could trigger a re-rating. If AUM continues to rise faster than fee rates decline, the company’s earnings power will also grow. In total, a low to mid-single-digit compound return seems likely, with potential for more upside. The company’s current free cash flow yield provides a hedge against a scenario with AUM declines.
Why does this opportunity exist?
Diamond Hill doesn’t screen well. Most screeners don’t detect its special dividends and don’t show how much it yields. That will change now that they’ll begin paying a regular quarterly dividend in Q1 2021. Further, simple screeners won’t show how overcapitalized the business is. Excess capital inflates Diamond Hill’s P/E ratio and reduces its ROE. As excess capital is returned, the company will catch dividend investors and value investor’s eyes.
No analysts cover Diamond Hill. Their location in Columbus, Ohio means no one is bumping into them in NYC either. Diamond Hill doesn’t do quarterly earnings calls, further reducing their institutional visibility.
Active management and value investing are both out of favor. Passive indexing and unprofitable tech stocks are all the rage. Maybe I’m biased, but bottoms-up value investing seems like a long-term winner. Market volatility and higher interest rates should be good for bottom-up stock pickers. The more people passively index and stop analyzing stocks, the more inefficient markets will become and the more opportunities there will be for the people still doing the work.
Diamond Hill’s market cap is $500 million today. That’s too small for many institutional investors. Moreover, its stock is illiquid. Only $2.5 million worth changes hands every day. Large investors would have a hard time buying a meaningful amount without pushing its price up.
Diamond Hill reported year-over-year EPS growth every year until 2018. In 2018, EPS dipped from $14.50 to $13.50. EPS recovered to $16.0 in 2019 but the stock didn’t. 2019’s revenue declined 6% versus 2018’s on lower average AUM and lower average fee rates. Since then AUM has rebounded, though fee rates have slipped further. The market seems to have concluded that Diamond Hill is in terminal decline. I believe that this is more likely short-term noise. The market’s long-term rise gives Diamond Hill’s AUM a strong tailwind.
Conclusion
Diamond Hill has just about every business characteristic I look for. It’s simple, predictable, and profitable. It trades at a reasonable price, maintains a fortress balance sheet, and has intelligent capital allocation.
Diamond Hill has a “take rate” business model that benefits from the stock market’s rising tide. If Diamond Hill’s value investors can continue to beat the market, AUM should rise and earnings should grow. If AUM is merely flat, investors will still earn an acceptable rate of return from the current yield alone. AUM or average fee rate would have to decline precipitously before the current yield is wiped out. This makes Diamond Hill an asymmetric bet — “heads I win, tails I don’t lose much.”
Disclosure: The author, Eagle Point Capital, or their affiliates may own the securities discussed. This blog is for informational purposes only. Nothing should be construed as investment advice. Please read our Terms and Conditions for further details.