The transcript from this week’s, MiB: Heather Brilliant, Diamond Hill, is below.
You can stream and download our full conversation, including any podcast extras, on Apple Podcasts, Spotify, YouTube, and Bloomberg. All of our earlier podcasts on your favorite pod hosts can be found here.
~~~
This is Masters in business with Barry Ritholtz on Bloomberg Radio.
Barry Ritholtz: This week on the podcast, I have an extra special guest, Heather. Brilliant is CEO of Diamond Hill. They are a publicly traded investment manager, stocks symbol DHIL, that have been public since day one since 2016. Heather comes from with a fascinating background, having previously been in a number of other places, most notably Morningstar, and, and she has a very specific approach to investment management and thinking about stock selection. They do a number of things at Diamond Hill that many other investment shops don’t. Not only are they very much aligned with their investors, they regularly close funds when they get too large, when they reach capacity and run the risk of reducing performance. All of their portfolio managers not only are substantial investors in each of their funds, but they do a disclosure year that shows each manager by name and how much money they have invested in their own fund. Kind of unique. I wish more mutual funds and ETFs showed that data. I found our conversation about her work and Diamond Hill to be absolutely fascinating. They have a very unique approach. I think you’ll find it fascinating. Also, with no further ado, my discussion with Diamond Hill, CEO Heather. Brilliant, Heather. Brilliant. Welcome to Bloomberg.
Heather Brilliant: Thanks for having me, Barry.
Barry Ritholtz: Well, thanks For coming in. So let’s start with your background. A bachelor’s in economics from Northwestern and then an MBA from University of Chicago. It sounds like the career plan was always finance. Was that the plan?
Heather Brilliant: It was not the plan. I actually wanted to be a lawyer and so I started out as a political science major and that really came from my experience on the debate team in high school and college was a big part of what influenced me. And I realized after undergrad actually, that the skills you learn in debate can really be applied to picking stocks where you really have to understand both sides of the story, but you still have to come down on one side and make a decision. And so I felt like all of those experiences just really led me to love investing.
Barry Ritholtz: Huh, really, really interesting. So what was your first job out of undergraduate?
Heather Brilliant: I worked at Bank of America and, and they had a wonderful corporate finance training program. So since this was a relatively late decision that I came to, it was great to have those kind of six to eight weeks of training before they set us loose.
Barry Ritholtz: And, and what led to the decision to get an MBA at Chicago?
Heather Brilliant: Well, actually I had, I had pursued the CFA program first, and I learned about the CFA from a colleague at Bank of America, and I got right on it. As soon as I learned about it, I thought, this is great, and wished I’d even known about it sooner. And then I had a role at one point where they told me to advance to the next level I needed an MBA and it was an investing role. So I said, why would I need that? I have a CFA. And they said, sorry, rules are rules. And I never wanted to be told that again. So I thought I’ll just get an MBA too.
Barry Ritholtz: And how did you find University of Chicago? There are some legendary professors there, Eugene Fama, Dick Thaylor, just really an incredible lineup.
Heather Brilliant: There really are. And it was a very rigorous program and I learned so much from classes that I never thought I would find exciting, like marketing. You’d think that marketing is pretty straightforward, but it turns out, you know, the University of Chicago figures out how to put a quantitative lens on pretty much everything and putting a quantitative lens on marketing back then, you know, 20 something years ago was, was pretty innovative. And I just thought it was, it was really a neat way to, to learn about it.
Barry Ritholtz: The old, the old joke, half of our advertising dollars are wasted. We just don’t know which, once you start doing things online, that kind of changes. You really can track that, can’t you? [Exactly].
So, so you’ve held analyst roles and a number of asset managers. You mentioned Bank of a, you were at Dry House Capital, cocktail Capital. Morningstar, tell us what you learned at at such varied institutions.
Heather Brilliant: I really learned how to appreciate investment philosophies and figure out what my own personal investment philosophy was. My first equity research job was at DRE House and they’re very aggressive growth momentum oriented, but I was on the international team. And so the guy who was running the team at the time had a pretty fundamental approach, really looking for more earnings momentum as opposed to price momentum. And I just realized how he always veered towards higher, higher quality companies. And so I kind of leveraged that when I went to Morningstar because they’re very focused on quality, the whole concept of economic moats, but also about buying companies when they’re trading at a discount to intrinsic value. And it just seemed so much smarter to me to figure out ways to make sure that you’re putting the risk reward in your favor.
Barry Ritholtz: And you were at Morningstar for about 14 years. Tell us what brought you there? What, what sort of work were you doing?
Heather Brilliant: So originally I went there because I liked their equity research philosophy, and most people don’t even know they do equity research even to this day. But
Barry Ritholtz: You think Morningstar, you immediately think of the mutual fund star system.
Heather Brilliant: Yeah, absolutely. But they had a whole team that was growing at the time because of the whole Spitzer settlement. And so they were hiring lots of people to come in and be, be equity analysts. And so it was just a great opportunity to get to apply a more fundamental investment philosophy. And from there, I I really realized that while I loved being an investor or making investment recommendations, I also felt like it wasn’t perhaps my true genius and that I might be more successful in the long run to focus on a leadership direction of my, my career. And so it was, I was actually only 30 when I got the opportunity to run the equity research team at Morningstar. So it was just a really great kinda early career opportunity to try out managing at scale. Huh,
Barry Ritholtz: Very interesting. I specifically recall what I thought at the time was a very bold and brave research report that Morningstar put out looking at the history of, of their star rating system. And they pointed out, if you only could know one thing about a mutual fund if you knew nothing but the cost, that would generate a little bit of positive return versus following any other system. And I give them a lot of credit for saying, yeah, yeah, we built our business on the STAR system, but hey, in a pinch, just look at what the expense ratios are.
Heather Brilliant: It is fascinating how, how big a discrepancy that creates because you know, the expense is a sure thing and the expected future returns are very uncertain. And so I think you have to take expense into consideration.
00:06:59 [Speaker Changed] So you become CEO of Morningstar. Am I pronouncing this right? Is it Australia or Australia? Asia.
00:07:07 [Speaker Changed] It was Australasia, but it’s important to know that Australasia really means Australia, New Zealand and the Pacific Islands. Oh, okay. So gotcha. It doesn’t actually mean all of
00:07:15 [Speaker Changed] Asia. I got it. So, so did you have to relocate? Were you, were you working
00:07:18 [Speaker Changed] There? I did, yes. My family and I moved to Sydney, Australia. It was
00:07:22 [Speaker Changed] Great. And what was that like? Sydney looks like it’s a blast.
00:07:24 [Speaker Changed] I consider Sydney one of the most majestically beautiful cities in the world. Huh? It is. It was so wonderful. Every day we lived there, I felt lucky
00:07:32 [Speaker Changed] And, and livable. Right. It’s not like Hong Kong or New York or some other cities that can be a little much to take if you’re not from there.
00:07:41 [Speaker Changed] It’s very livable from like a human interaction standpoint. Yes. But it is very expensive. So I do think a lot of people struggle, especially, you know, when you see some cities that have suffered with very high housing costs, Sydney is definitely right up there.
00:07:54 [Speaker Changed] Sure. So, so you’re at Morningstar for a while. You leave for a year and come back. Tell us what brought you back to Morningstar?
00:08:02 [Speaker Changed] I left because I thought I was being offered my dream job. And so I went to a hedge fund for a year. I learned so much in that year, I’ll never regret doing it. And it was the only time in my career where I’ve had responsibilities for recommending shorts as well as longs. So I think it was very eyeopening from a lot of perspectives, but ultimately I just really felt like the intensity of the role and expectations was not gonna be tenable. And I was at the point in my life where I was ready to have a family. And so it just made more sense to stick with the philosophy I believed in, but do it in an environment that I felt like could give me a little bit more opportunity to, to have balance.
00:08:43 [Speaker Changed] And, and then post Morningstar, you end up in the late 2010s as CEO of first State investments for the Americas. Tell us a little bit about that role and and what you learned being CEO there.
00:08:56 [Speaker Changed] Yeah, so I mean, I love my time in Australia and we were there almost four years. And at the end of that time, I, I really felt like as much as I had learned and experienced at Morningstar, it was time to to move on. And so I had a lot of contacts in Australia at that point, and one of them was the CEO of what was at the time called Colonial First State Global Asset Management. And so First State Investments was the non Australia part of that business. And so they hired me to basically move to New York and run their business in the Americas. And in the process of doing that, the business which had been owned by the Commonwealth Bank of Australia ended up being sold to Mitsubishi UFJ. And so it was a really interesting time to kind of see through that whole process. And it’s called First Centier. Now the business does still exist, but yeah, it was, it was a really interesting couple of years.
00:09:45 [Speaker Changed] And if I recall correctly, Mitsubishi Bank during the financial crisis was a financier of a couple of pretty substantial US banks, maybe Morgan Stanley, I, I don’t remember. Is that right? Yeah. And so tell us a little bit about what your experience was like. You were there before Mitsubishi bought them. Correct?
00:10:03 [Speaker Changed] My last day was the day the acquisition closed.
00:10:05 [Speaker Changed] Oh, so you helped facilitate this. What was your role in that, that acquisition?
00:10:10 [Speaker Changed] I mean, the, the deal was definitely done in Japan and Australia, not in the us right? So I certainly had a lot of interaction with the, the team from Mitsubishi that was based in New York and kind of helping facilitate some of the transition that would, that would be happening. But I had already taken the, the role with Diamond Hill, and so I helped them, you know, for a little bit of time to kind of navigate through the final aspects of the transition.
00:10:34 [Speaker Changed] And, and I don’t recall if this was on the podcast with John Mack or in John Mack’s book, but he had nothing but really nice things to say about Mitsubishi. I mean, they helped save Buoyant Stanley, he was certainly appreciative of that, but he seemed to think that there were no nonsense. They looked at the data, they made a fast decision one way or another. He was pretty pleased with them. I’m assuming you had a similar experience.
00:10:58 [Speaker Changed] Yeah, and I’d say one thing that’s so great, and just to over generalize about Japanese bank owners is that they tend to be very long-term oriented. And so they’re making decisions about investing for the future and not just about, you know, making quarterly earnings or any kind of short-term pressure.
00:11:14 [Speaker Changed] So we’ll talk about long-term investing in a bit. Tell us what brought you from First State investments to Diamond Hill,
00:11:22 [Speaker Changed] Given some of the transitions with First State, I, I knew it was, it was time to maybe consider the next opportunity. And so I had actually interviewed for a couple of things when I got a call from a recruiter about Diamond Hill, I had actually never been to Columbus, Ohio before I went there to interview. And so when the recruiter called me, I said, you know, it sounds really interesting. I feel like the investment philosophy alignment is great, but I’ve never been to Columbus, so no. And so he said, well, wait, wait, they’re coming to New York for the first round of interviews, I think you should just take the meeting. What’s the downside? And so I, I was actually a little skeptical, but the more I researched the company, the more compelled I was. It. I mean, not only is the investment philosophy very aligned with the way I think about investing, but the team is incredible. And even from my first trip to Columbus, I realized what an amazing livable city it is. And it’s a growing city, which is, you know, something not a lot of cities in the US can claim today. And so, yeah, it, it ended up being, I think, a really good fit.
00:12:24 [Speaker Changed] So since you mentioned investing for the long run amongst the Japanese banks on the Diamond Hill Firm website, your tagline is invested in the long run, shouldn’t that be the norm in asset management? Aren’t we all supposed to be invested in the long run?
00:12:42 [Speaker Changed] I think it absolutely should be the norm because it is generally what our clients are seeking. And I think there’s just so many pressures that cause so many investors to think shorter term. And even investors who claim to be long term are often thinking in one year increments as opposed to the more like five year increments that we’re really trying to think about.
00:13:01 [Speaker Changed] So is that the fault of the end investor? Is it the institutions that really look at quarterly results? I know some hedge funds look at monthly or weekly results that seems to be, you know, nothing more than random noise, but they seem to focus on it. Who, who should we be blaming about this sort of short-termism that can be endemic in the investing world?
00:13:26 [Speaker Changed] I don’t know if we can really blame any one party. I think it’s kind of systemic at this point where you have companies reporting earnings on a quarterly basis. So many public companies expected to issue guidance and then meet that guidance or else, you know, essentially. And I think a lot of investors have figured out how to effectively make money for their clients with shorter term time horizons, otherwise they wouldn’t be doing it. And so I think there’s enough forces out there that lead to people thinking that they can make money doing it, but I think there’s more opportunity to take a longer time horizon or a longer term perspective because then you can really think about, you know, what, what are the earnings power, what is the long-term earnings power of this business? And how can I think about myself as an owner of it in partnership with the management team as opposed to, to thinking about kind of where the stock price is going.
00:14:16 [Speaker Changed] Huh. So, so we kind of joke about the illiquidity premium, but really we should be talking about the long-term premium that’s being overlooked. Maybe there’s a substantial marketing efficiency there.
00:14:29 [Speaker Changed] I think there is, because, you know, while I do think that clients like to invest for longer time periods, they only have so much patience. And when you take a really long time horizon, you can have multi-year periods of underperformance. And so that’s not something that every client is willing to tolerate. And it’s, it’s also very hard, I think for every, for all the parties involved to be able to consistently know, you know, is this under performance because my investment manager is sticking to their philosophy, or is it a deeper issue and I should be, you know, running for the hills. And so I think it’s really, really important to have a consistent philosophy and be able to show over, you know, as much time as possible, ideally decades or more that your ability to focus on a long time horizon really does come back around and generate out performance for your clients in the long term. Huh,
00:15:16 [Speaker Changed] Really, really interesting. So let’s talk a little bit about Diamond Hill stock, symbol DHIL. What’s it like running a public company? They, they’ve been public since 1996,
00:15:30 [Speaker Changed] So yes, it has been a public company really since the founding, because essentially there was an already public business that the, the founder of Diamond Hill kind of merged into or used as the beginning of Diamond Hill. So there was never a, a moment where the company went public. It’s really just been a, a factoid of the whole history of the
00:15:48 [Speaker Changed] Company. It’s been public from day one. Yes, huh. So earlier we were talking about investing for the long haul. What sort of challenges are there when shareholders are looking for quarterly results? They’re looking for revenues and improvements in profits. How do you get people to focus on the long term when every three months there’s a snapshot of here’s where we are in, in, in the cycle.
00:16:13 [Speaker Changed] There’s nothing we can do to avoid the fact that we need to publish our results every quarter, but there are actually things that a lot of public companies do that are not a requirement, for example, quarterly earnings calls and guidance. And so those are things that we don’t participate in because
00:16:27 [Speaker Changed] No, no guidance, no, no quarterly call. Correct. Just you release the the numbers and let the chips fall where they may.
00:16:33 [Speaker Changed] Exactly. And the reason why that’s so important is because we don’t want to, on a quarterly basis, be essentially pressured into focus on a shorter time period by people asking questions about a shorter time period. And we do think that the short time periods are noise. And so what we do instead is we hold a shareholder meeting or a, a management presentation for shareholders once a year where we do, you know, kind of take a step back and look at the year in review our expectations going forward and really try to lay out, you know, the strategy and, and how we are evolving in this ever-changing market.
00:17:07 [Speaker Changed] Diamond Hill has always been public from day one. The founder sort of reverse merged the company into an existing pub public entity. Does that mean the float isn’t giant? That a lot of the, a lot of the holdings are, are held by founders? How much of the stock publicly trades?
00:17:27 [Speaker Changed] It’s actually pretty, pretty big. It’s about 80%. So it is just under 20% owned by management and directors. I think actually if you go public, there tends to be a more of a concentration in owners holding founder
00:17:41 [Speaker Changed] Stock.
00:17:41 [Speaker Changed] Exactly. But when, when the situation is more like using stock to fund the beginning years of the company, I think it ends up leading to a more diverse shareholder base.
00:17:50 [Speaker Changed] And you mentioned founders and and managers. What about employees? Do they have the opportunity to participate in an ESOP or anything like that?
00:17:59 [Speaker Changed] We have a, a very strong commitment to an ownership mentality. And we think that owning a piece of the company is part of that. It’s really just a small part of it in the grand scheme of things. It’s more about thinking like an owner when we’re making everyday decisions. But we do reinforce that by providing a grant of shares that vest in five years for every employee when they start. And then we have programs to, you know, allow for employees to purchase shares at a discount and also to be able to participate for certain roles in a long-term incentive program. You,
00:18:29 [Speaker Changed] You, you mentioned ownership mentality. As I was clicking around your website, I found a fascinating document that shows each of your portfolio managers by name, the funds they manage and how much of their own dollars are invested in their own managed funds. And very often these are seven figures or more millions of dollars invested in their own funds. Tell us a little bit about that.
00:18:58 [Speaker Changed] I’m so glad you brought that up because I do think it’s a really big differentiator for us. We have really focused on the fact that if we’re invested alongside our clients, we’re making decisions for them that will be in our best interest and their best interests. So we really think that it creates alignment to have our portfolio managers meaningfully owning shares of the funds that they manage. Now, of course, that is completely up to them, but when we’re hiring people or promoting people, we really do make sure that it’s clear that this is, you know, something that we think is a differentiator for us. And I’d say part of it is reinforced by the fact that we do have policies that prohibit our employees from investing in individual securities because we want their time to be devoted to making the right decisions for our clients and they can benefit from that as a client. And so I think that’s really just led to a culture where we really all feel like we’re there for the benefit of our clients.
00:19:51 [Speaker Changed] What, what’s a better advertisement for a mutual fund than the fund manager having millions and millions of dollars invested in that exact fund?
00:19:59 [Speaker Changed] Absolutely.
00:20:00 [Speaker Changed] So, so there’s another line on your website that kind of caught my attention, our curiosity uncovers unique opportunities. Tell us a little bit about that.
00:20:11 [Speaker Changed] So on the equity side in particular, a lot of what we do really is to do very deep fundamental research on companies from a bottom up perspective. And so we’re constantly looking for new ideas and opportunities to put in the portfolios, but despite that constant curiosity, our portfolios do not have very high turnover because we are taking such a long-term perspective. So we’re looking for businesses that are fundamentally mispriced relative to what we think, you know, a normalized earnings environment would result in. And sometimes that’s caused by dislocations for the business that we think will reverse. Sometimes it’s, you know, growth potential in the future that we don’t think is priced in. But there’s always gotta be some element of the valuation really being compelling. And I think, you know, if you’re really looking at the intrinsic value of a company and estimating the cash flows the business can generate and looking for opportunities where the stocks are mispriced relative to that, you have to take a long term perspective.
00:21:06 [Speaker Changed] I’m hearing a couple of things and I want to ask some follow up questions. So, bottoms up, stock selection, pretty obvious it, it’s not that you’re doing sector rotation or market timing, you are purchasing specific companies, but then the added layer is you’re purchasing them at a discount to intrinsic value. So this sounds a lot like traditional value investing, which has had a rough couple of years. How do you differentiate yourself from, you know, traditional value investors?
00:21:38 [Speaker Changed] I mean, I think there’s a lot of what we do that I would say is not too far from being traditional value investor. I’d say both for Diamond Hill as for a lot of investors, there’s kind of an ideal out there where you wanna buy a company that has a strong competitive advantage trading at a discount to what you think those future cash flows are worth. That is kind of the fundamental perfect investment opportunity for almost any investment philosophy. And I think the difference between, you know, a traditional value investor versus, you know, we kind of call ourselves intrinsic value investors versus someone who calls themselves a growth investor is just really, you know, what do you prioritize when you don’t have that ideal situation? So for us, you know, we’d still rather buy a higher quality business trading at a small discount than a low quality business trading at a big discount. But fundamentally I’d say it just, it really requires you to understand, you know, what is the competitive position of this business and how predictable are those future cash flows.
00:22:32 [Speaker Changed] When I hear competitive position, I immediately think of the Morningstar moat you described earlier. Tell us how that works into your investing philosophy.
00:22:42 [Speaker Changed] It, it was interesting coming to Diamond Hill. I think one of the reasons why the portfolio managers were comfortable hiring me as you know, the first external CEO that they had ever had is because I had very widely talked about economic moats and investing with an eye on sustainable competitive advantage. But even in the book I wrote in 2014, you could see that the focus on competitive advantage can never be absolute, you always have to take valuation into consideration. I would say in general we probably put a little bit more bias towards valuation as the primary consideration and competitive advantage as very important. But maybe second to valuation as a primary consideration.
00:23:24 [Speaker Changed] So valuation, high quality, competitive advantage. Are we leaving out any other specifics that are, go into the investing stock selection process?
00:23:35 [Speaker Changed] I mean very concentrated portfolios and long-term perspective.
00:23:39 [Speaker Changed] So, so I love when I hear concentrated portfolio ’cause I immediately think high active share. Yes, no closet indexing.
00:23:47 [Speaker Changed] Exactly.
00:23:48 [Speaker Changed] So, so when you say concentrated, how concentrated is concentrated?
00:23:52 [Speaker Changed] So our large cap strategy has about 50 positions in it, which
00:23:55 [Speaker Changed] Is, that’s pretty concentrated.
00:23:56 [Speaker Changed] Exactly. So I think that gives you an example, you know, small cap is more than that, but it’s still less than a hundred. Small
00:24:03 [Speaker Changed] Cap is always more than than large cap. We’re gonna talk a little bit about small cap later, which has been kind of fascinating what’s been going on in that space lagging for as long as it has. But before I get to that, I want to talk about not only how you express the philosophy in in investments, but the different strategies you run in equity and, and fixed income. I know you do separately managed accounts, you do mutual funds and you also do a CIT explain those choices.
00:24:35 [Speaker Changed] So essentially we are try to offer our intellectual property to our clients in whatever vehicle that they needed to be in. You know, we started out kind of focused on mutual funds as the vehicle and we’ve really diversified away from that because of client interest. Clients have asked us for separate accounts, model delivery, cis, and we have happily obliged now I’d say the big topic, you know, on the table is ETFs. The challenge with ETFs is that you cannot constrain capacity and we believe very strongly that in order to make sure that we can always deliver for our existing clients, we have to be able to constraint to close strategies or to,
00:25:13 [Speaker Changed] To be able to say no and close a fund down, not just fire hose of capital coming
00:25:18 [Speaker Changed] In E Exactly. And as many very popular ETFs show and as you know, just is fundamentally true, you cannot close an ETF today. And so in order to take capital in an ETF, we have to figure out some kind of solution to that and we, we have not figured out a solution.
00:25:33 [Speaker Changed] Hmm. That, that’s really interesting. So, so I know you’re running about 29 billion total. How big is the biggest fund where you say, okay, we’re, we’re pretty close to capacity here?
00:25:44 [Speaker Changed] So our large cap strategy was close to new investors until about a year ago. And so over the course of history, we’ve closed four strategies over time and you know, generally I’d say we take a lot of things into consideration. Our, our clients actually like to be able to put new clients of theirs into the same strategies. And so it, it can be very disruptive for client bases for you to just abruptly and suddenly close strategies. So it generally is something that we plan as we see it coming and really try to collaborate with our clients so that we can appreciate where it may create a challenge for no reason. But in general, yeah, we’ve closed at times, we’ve had small cap smid and large cap smid. Yeah. By
00:26:27 [Speaker Changed] The way, a little industry jargon, I always laugh when I say that we listen, we laugh since jargon all the time. So small and mid cap. Yes. So I would imagine the large cap has bigger capacity, eight, 10, 12 billion. Where do you start to run into, hey, for 50 stocks, this is as big as we want to get.
00:26:45 [Speaker Changed] Yeah, I mean we think the capacity for that is somewhere around 25 or 30 billion.
00:26:49 [Speaker Changed] Oh, so you haven’t really run into issues with that
00:26:52 [Speaker Changed] Yet? Yeah, I mean I, I would say that that that’s for the strategy overall. The, you know, so it partially depends on how much is in the fund versus in other, you know, other areas. But,
00:27:02 [Speaker Changed] But, but in a small cap or a smid you can say to your, your investing partners, Hey, we’re getting to the point where we’re just about capacity constrained, don’t be surprised if this closes next quarter, next year. How far out do you plan it?
00:27:17 [Speaker Changed] I I mean generally if it’s flows related, it’s easier to plan. If it’s market related, it’s harder because, you know, if all of a sudden small caps make it come back, you know, when you didn’t think you were anywhere to close to closing, it can come up more quickly with large cap. I’d say it also depends on how low you go in terms of market cap, right? How small a company will you put into a strategy that is considered large cap? So for us, I’d say that is a big swing factor that constantly gets, gets debated. And what we always try to do is look at the actual history where, where have we actually invested clients’ capital because that is what has created our track record and that we need that in order for it to be, you know, repeatable in the future. Huh.
00:27:54 [Speaker Changed] That, that’s really interesting. So what do you use as a benchmark for the large cap fund? Is it just the s and p 500 or something a little broader?
00:28:03 [Speaker Changed] We use the Russell 1000
00:28:05 [Speaker Changed] So, so much broader. Yeah, I was gonna say, if you wanna just arbitrarily draw a line in the sand, the top half of the s and p 500, I would imagine those 250 stocks can be considered large cap or, or like what’s the line in the sand above 10 billion, above 25 billion. It’s hard to even judge when we have so many companies that are trillion dollar market caps these days.
00:28:30 [Speaker Changed] Right. Well that actually brings up a really interesting point in time. I’d say with our markets being so driven by such a small number of stocks, and we generally think that creates opportunity not only in the large cap space but really across the cap spectrum. But you know, in even in the first half of 2024, more than 60% of the return came from six companies. And so I do think we’re getting to the point where what you see going on under the surface is so different from what the overall, you know, quote unquote market return looks like these
00:28:59 [Speaker Changed] Days. You know, I I’m so glad you said that Every, every time I have a discussion about passive or indexing with people who, who are convinced it’s gonna destroy the structure of the market, my answer is always wouldn’t that create more inefficiencies elsewhere in the market if all these flows are blindly going into passive? And there’s certainly a reason for that, but tell us about how that leads to inefficiencies that savvy investors can take advantage of.
00:29:29 [Speaker Changed] Yeah, I think you can see this particularly in smaller cap companies right now where, you know, as you alluded to earlier, the Russell 2000 versus the Russell 1000 has basically underperformed by 95% from the end of 2016 until now.
00:29:45 [Speaker Changed] That’s amazing.
00:29:45 [Speaker Changed] It’s stunning and you know, it’s, it’s, and it’s true that smaller cap companies are much more challenging because, you know, 40 ish percent of small cap companies don’t make a profit. Right? And so, right there are,
00:29:56 [Speaker Changed] I think we’re at 7% of large ca of the s and p 500 is not profitable, which is a fraction of what it was in like the late nineties, right? Much more of the big caps weren’t profitable today, they’re all money machines. The small caps really are, are are kinda struggling against that.
00:30:13 [Speaker Changed] And the interesting thing is that small cap active managers have outperformed for out of three of outta the last four years, but in small cap about 60% of assets are invested passively. It’s actually only 50% in large cap. So it’s kind of surprising that investors are relying on passive strategies in a category where active management makes a huge difference.
00:30:35 [Speaker Changed] So let, let, let me make sure I’m hearing that correctly. 60% of small cap is indexed versus 50% in large cap and more small cap managers are beating their benchmark than large cap managers. Yes. Is that, am I getting that right? Exactly. So that kind of goes back to, hey, the more indexing there is, the more opportunities there are for inefficiencies to be discovered.
00:30:59 [Speaker Changed] Yes. But I would say that one element of reality I think that has for managers who are focused on smaller cap companies is that you can’t buy an undervalued company in small cap necessarily and assume that it’s going to appreciate because of valuation because it, we don’t know when or what will cause the market to rerate small cap. And so, you know, this has been going on for, you know, basically a decade or more depending on how you look at the data. So I think given that what we see is our analysts and portfolio managers increasingly focusing on investing in small caps that are high quality businesses generating cash flow, returning that cash flow to shareholders where essentially the cash return is gonna get you what you need as an investor and you don’t need the valuation to rerate. If it does, it’ll be bonus
00:31:45 [Speaker Changed] That that’s dividends in buybacks. In terms of, you know, David Einhorn said something very similar when people were saying the market structure was broken by passive, and I know he’s in that, that camp. He said it made us rethink our approach to valuation and if merely buying inexpensive stocks wasn’t gonna get you the performance you need, well then you had to find the stocks that were doing something to raise their valuation themselves, mostly through return of capital to investors.
00:32:14 [Speaker Changed] Yeah, that was a great episode. I think Einhorne had a, a lot of really good points that I think were
00:32:19 [Speaker Changed] Very valid. So you can you agree with him, it’s, hey, we like these stocks that are actually participating. Yeah. And there are opportunities being created by, by the rise of passive. So, so let me ask one other question about the, the rise of indexing. It has helped to contribute to fees coming down across the industry. You are a public company. How do you deal with those fee pressures that seem to be endemic throughout all of investing?
00:32:47 [Speaker Changed] I mean, from the beginning we really tried to take a very thoughtful approach to setting our fees and you know, we really try to think about, you know, what do we believe the excess return is that we can generate over the long run and how can we, you know, charge a fair price for that so that we can make sure we can pay the, you know, investment talent that we need in order to generate those returns, but also make sure that the shareholders of the firm are getting, you know, paid back for the capital they provide and ultimately that the clients are getting a return after fees that makes sense for them. And so that kind of third, a third a third mentality has led us to, to set fees at a place that, you know, generally do not exceed the median of kind of Morningstar categories for fees. And, and we look at that too because we really wanna make sure that we are not charging more than we think is the value we can generate.
00:33:35 [Speaker Changed] Huh, fair enough. So we were talking earlier about small caps, they’ve been lagging not just since the pandemic but pretty much the past decade. What do you think the reason for that is? Is it access to capital or international markets? What’s been holding small caps back?
00:33:55 [Speaker Changed] I actually think there’s a couple things, but the biggest is that small caps have not done so poorly as much as large caps have just done so excellently. And so I think that’s partially these five stocks really driving the market that we’re really seeing come to a head this year, but really has been going on for the last several years. And we’ve seen concentration in the large cap side of the market among those five companies getting greater and greater over that time period. So it’s just very hard for any kind of diversified portfolio to keep up with that. And you can see that in a diversified large cap portfolio and any kind of actively managed large cap portfolio relative to indexes. And you can certainly see it in small caps as well. Right.
00:34:37 [Speaker Changed] I I have a friend who’s a, a trader who says, hey, you can’t eat relative performance. Right. And that exactly. So, so we talked a little bit earlier about profitability. 93% of big caps are profitable, but only a little more than half of small cap stocks are profitable. How important are earnings to the small cap sector as a driver of returns?
00:35:02 [Speaker Changed] I mean, I think quarterly earnings probably should be less of a driver for small caps because, you know, you have to take a long-term perspective and really think about when they might become profitable. And I think also small caps tend to have more issues with debt. So it’s really important for small cap investors to be very aware of the leverage that the companies are carrying. And I think in this environment too, to really understand the interest rate that that leverage carries and at the potential interest rate that they may face when needing to refinance that debt.
00:35:31 [Speaker Changed] And, and it seemed like the large cap and mega cap stocks did a great job in refinancing before the pandemic small caps did not have access to the same amounts of capital at the same prices. How, how big of a a factor is that?
00:35:47 [Speaker Changed] I think it’s a huge factor and you know, and, and you also see less leverage, you know, certainly as a proportion of cash flows when you’re looking at large caps versus small caps. So they’re more levered and they did not have the same access to, to benefit from all that cheap capital when it was available.
00:36:03 [Speaker Changed] Diamond Hill is known mostly as a stock shop, as an equity shop, bottoms up stock selection, but you also do fixed income and, and bonds. Tell us a little bit about the fixed income side of the work.
00:36:16 [Speaker Changed] Yeah, so about 4 billion of our assets under management are in fixed income strategies today. And that’s really grown over the last couple of years because we brought in a team in 2016 have been building a track record since then, primarily in two strategies, core and short duration securitized. And in both of those strategies, our, I would say our biggest point of differentiation is our focus on securitized assets, which kind of gives us the, the opportunity to be able to make investments in areas that I think other bond managers either don’t know as deeply or are more focused on macro trends where we take a bottom up approach there too. So it’s, it’s really given us, I think, the opportunity to shine in, in markets where it’s been harder and harder to outperform in fixed income. And so creating that long track record then as we saw the, the environment change and the interest rate regime change, we’ve really been able to, to benefit from that and deliver for clients.
00:37:12 [Speaker Changed] And, and when I think of securitized assets, we typically think of mortgages and things like that. What sort of securitized assets are you, you guys playing with?
00:37:21 [Speaker Changed] Yeah, certainly mortgages is on the list. I’d also say asset backed securities, which can include things like, you know, credit card receivables or car loans or things like that that I think are more consumer oriented. And so that’s an area where there’s been a lot of concern as concern about recession, you know, ebbs and flows. You definitely see people’s concern about asset back securities move in line with that. Yeah,
00:37:44 [Speaker Changed] The, the recession concerns seem to have been a perennial miss since the last recession, since the covid recession, right. Which was a hot minute and then all people were doing was expecting a recession in 21 and 22 and even during the downturn in the market in 22, this is it, this is what’s gonna finally cause a recession and then a giant snapback in 23. I know you guys are bottoms up stock pickers. How impactful is all that macro noise on your process?
00:38:19 [Speaker Changed] I mean, I’d say it actually creates more opportunity than anything because when the market starts really worrying about a recession, then it generally undervalues companies that are more cyclical and in terms of their long-term, you know, cashflow generating abilities. And when the market’s not at all worried about a recession, then you can generally find opportunities in more defensive areas of the market. And so we, we do try to kind of keep in mind where we think the economic outlook could be causing a different short term perspective than a longer term perspective.
00:38:49 [Speaker Changed] So, so 2022 must have been a a, a friend from the military always describes that as a target rich environment. What, what were you guys doing in 2022 when the s and p was down about 20% and the NASDAQ was down about 30%?
00:39:05 [Speaker Changed] Yeah, I mean I think those are good examples, but I actually think the environment is better right now because really yes, because we’re in a situation where while the market is up, you know, double digits for this year, that’s really a kind of high level perspective that really obscures what’s going on under the surface where there’s a tremendous amount of volatility. We’re seeing the performance of individual companies very widely and is not at all representative of that high level market return. And so it’s kind of like the, the iceberg analogy, right? It looks tiny from the surface, but when you dig under underneath, there’s actually a lot more noise going on. And that really leads to a lot of idiosyncratic risk, which is what we look for. We want companies that are going to sell off when they miss their earnings or you know, create opportunities because of short-term focus that can be overlooked for a long-term
00:39:57 [Speaker Changed] Investor. And we’re recording this in July, so let’s put some numbers out there. The first half of the year of 2024 s and B 500 up I think 15.3%, but the average stock in the s and p 500 was only up about 6% in change for the first half of the year. And I wanna say the average stock in the second quarter in the s and p was slightly negative. That’s right down down 1.3%. Something along those lines. Yep. So really that seems to really show you what a wide dispersion we have in performance. How does that play into your bottoms up stock picking?
00:40:36 [Speaker Changed] I mean I think it creates opportunity because we see companies getting sold off that are really great fundamental businesses, but you know, perhaps are going through a tough time or missed earnings for whatever reason. On the flip side, you, you see companies that, you know, we really believe in and fundamentally in the long term that we may already own also selling off or companies like the ones leading the market that have been doing so well. And the interesting thing I think about those top five companies is that they’re actually very fundamentally strong. You know, it’s not like we’re seeing companies that are so ridiculously overvalued. They are much more highly valued than the market on average, but that’s partially driven by earnings revisions and people, you know, realizing more and more how much cash flow those businesses can generate. I think what it’s teeing up for is a future environment where anything that causes some instability for those extra large tech companies that are driving the market will really create a very different high level environment for the market that will create opportunities for people who are really focused on bottom up investing.
00:41:40 [Speaker Changed] I I’m glad you brought up that these aren’t like just ephemeral ideas like we saw in the.com era. I think the numbers on the magnificent seven, collectively they do about $2 trillion in revenue and about $300 billion in profits. Those are giant numbers. Kind of hard to argue there’s a bubble amongst them. Hey, there’s some speculation and there’s a little bit of over enthusiasm, but these are really very, very well run well-managed companies that have become money printing machines.
00:42:12 [Speaker Changed] Yes, I I mean I think that is true. There’s still a valuation consideration to be applied and I think you could argue that they’re not meaningfully overvalued right now, but it really all comes down to the future growth expectations and their ability to keep on delivering like this. And so, you know, if, if for whatever reason, you know, regulation or some change in the environment caused that to slow down then, then it’s a lot harder to justify these valuations.
00:42:38 [Speaker Changed] I was clicking around the website looking at some of the white papers you guys put out on a regular basis. Let’s talk about one or two of those uncovering opportunities in commercial real estate. The power of location. Let, let’s talk about stepping into a dangerous area. I think the, for office space anyway, per square foot nationally has fallen from about three 50 to 1 99. Tell us a little bit about opportunities in commercial real estate.
00:43:08 [Speaker Changed] I think commercial real estate as our bond managers would say is, you know, clearly an area where the baby gets thrown out with the bath water. And so if you focus on super high quality opportunities, then I think you can really find, you know, mispriced securities essentially because everybody is so worried about commercial real estate and that worry is not without reason, to your point, it it makes sense
00:43:30 [Speaker Changed] Particularly in office space. Yes, but there’s a lot more to commercial real estate than just office space.
00:43:34 [Speaker Changed] Absolutely. But I I think in, you know, very high quality office, they’re finding opportunities as well. And so it’s partially, I think a matter of, of looking for where investor expectations get so lumped together with the overall category and the bottom up perspective can show actually there are individual buildings or opportunities in commercial real estate that can provide opportunity. What
00:43:57 [Speaker Changed] About geographies? Diamond Hill is located in the United States, but it seems that your experience has been all over Australia and Asia. Japan has had a great year. We’re starting to see signs emerging market is doing better. Europe, the perennial laggard, even Europe is starting to show signs of of coming alive. How do you look at the rest of the globe? What are your constraints?
00:44:20 [Speaker Changed] So we have an international equity team that really focuses on looking for opportunities outside the US and they travel the world meeting with management teams and you know, really uncovering the depth that you can’t get just by, you know, staying in in the US at looking at the data. They do obviously spend a lot of time doing that, but I’d say that’s really led to a focus on areas that are more bottom up oriented. So, you know, just like on the US side, we’re really looking for individual companies that lead to opportunity, but you do occasionally find areas of the globe where, you know, you either want to avoid it wholeheartedly, even if there might be a company that looks interesting or where there’s a lot of undervalued businesses that we can invest in. And I do think that among technology, which is, you know, a very international industry, very global industry, there are some opportunities there because when you look at names like TSMC and Samsung that are really fundamentally great businesses, even before AI caused things to go crazy, I think that’s just an area where our teams finding a lot of opportunity.
00:45:28 [Speaker Changed] What about strategic capacity management? How, how does that improve client outcomes?
00:45:35 [Speaker Changed] So essentially that kind of goes back to what we were talking about before where it’s really important to consider the capacity of strategies that we manage so that we can put our existing clients’ interests first. And so when we look at how much we think we can manage in a strategy, we try to take into consideration what the investor experience will be. And you know, if you’re looking at small cap for example, I think it’s easy for people to understand this where, you know, we can clearly see that small cap managers that take on too many assets tend to have a much harder time outperforming the market over the long run. So if we just explicitly say we think we can manage about, you know, two, two and a half billion dollars in small cap and when we get to that point then we’re not gonna take new clients because it’s really important for us that the client experience is more important than our ability to generate more revenue by bringing on more assets.
00:46:25 [Speaker Changed] And and what about long short? You have a fund that runs long short, tell us a little bit about that. What’s the thinking when I, when I hear bottoms up stock picking, I no longer think about short selling, but obviously if you identify something that is mispriced to the downside, perhaps you can also identify things mispriced to the upside.
00:46:47 [Speaker Changed] Yeah, that’s basically the, the philosophical approach that we’ve taken and I’d say there’s a few people on our team, one of the portfolio managers on that strategy and a couple analysts who have really developed expertise thinking about the short side. And so, but fundamentally it really is about valuation. Now it’s harder obviously when you’re trying to short an overvalued company than buying an undervalued one because you can only wait so long if the right, if the stock’s running against you. But we’ve just really developed an approach, I think that takes a little bit more of a, a diversified approach on the short side and gives a little bit more room to situations that might might not unfold as quickly as you
00:47:25 [Speaker Changed] Hope. Are these 1 30 30 funds or are they market neutral funds? How do you structure them?
00:47:30 [Speaker Changed] They are essentially 60% not long. So that’s been our, our focus historically and really what our clients have asked of us. But it is an area that I think could be ripe for innovation because it is easier to think about a, you know, market neutral strategy at an environment where interest rates are positive than it is when there’s zero. And so I think, you know, not to say you couldn’t do it when there’s zero, but I just think it’s a lot harder to make the math work.
00:47:56 [Speaker Changed] Te Tina made it very difficult to be on the short side when there was no alternative to equities, was pretty much the only place, only place you could go. But today with rates over 5%, i, I think the last time I looked at the money market fund, it was about five and a quarter somewhere around then. I, I know you, when we were talking about fixed income, you mentioned securitized assets. What about other forms of private credit? It’s been probably the hottest area in the market over the past few years.
00:48:26 [Speaker Changed] Yeah, I mean whenever there’s an area of the market that is hot, I would say my first instinct is don’t go there. Right? And private credit, I think, I think there are a lot of reasons why private credit has done so well, but you know, and I do think the line is a little blurry in fixed income and sometimes people call things private credit that are arguably in scope for some things that we might take a look at. But we do not have private credit strategies and we do not intend to because, you know, we’ve really been focused on the areas of fixed income where we can identify dislocation. And so that’s really what we feel like we can do in that core and short duration securitized strategies.
00:49:04 [Speaker Changed] I only have you for a few minutes more, let’s jump to our favorite questions that we ask all of our guests. Starting with what’s been keeping you entertained these days? What are you watching or listening to?
00:49:16 [Speaker Changed] So one show I’ve really enjoyed is the Bear. I haven’t watched the third season yet, but
00:49:22 [Speaker Changed] We’re about halfway through it and it’s really interesting.
00:49:25 [Speaker Changed] Okay, good. I just think it’s a great show. First of all, I’m from Chicago and so I love the Chicago connection and constant visuals from, you know, my favorite city. And then I just think they, their character development is unbelievable. So it’s been, I’ve really enjoyed it
00:49:39 [Speaker Changed] What, not just bear and Sydnee, but watching Richie develop into, from a caricature to a person Yeah. Has really, really been fascinating. Culminating with the, the Forks episode I think was season two. Yes. Really was, was very amazing. Let’s talk about your mentors who helped shape your career.
00:50:00 [Speaker Changed] So I was very fortunate early on in my career to have a couple of kind of managers and leaders that really helped set the stage for a productive future career, even at Bank of America. While I didn’t end up staying there a tremendously long time, I had the most incredible first manager and he really helped me see that there were lots of different areas in finance and investing to go into and that he’d be supportive regardless. And I actually still keep in touch with him to this day. And then even at Dre House, I, I had a great manager in the international portfolio manager at the time and he really taught me about the kind of fundamental aspects that all investing holds, even more momentum oriented investing. But he, he also was someone I’ve turned to in the past to ask deep career questions and kind of figure out where to go next.
00:50:49 [Speaker Changed] So let’s talk about books and, and I have to mention your book, why Moats Matter. Tell, tell us a little bit about that and then we’ll jump into what you’re reading currently.
00:50:59 [Speaker Changed] So why Moats matter was really an encapsulation of thinking about competitive advantage and valuation and making investment decisions. And that does encapsulate Morningstar’s investment philosophy and certainly they commissioned the book or, or funded it, I would say. But it was a, a really great experience too because we were able to get a lot of the equity research team involved in writing it. So you’ll see different chapters authored by multiple people, which I think was just a really great way to highlight some of the ways that you can apply competitive advantage thinking to different industries.
00:51:31 [Speaker Changed] And tell us about what you’re reading now and what are some of your favorite books?
00:51:36 [Speaker Changed] So I just started Chip War. I don’t know if you’ve read that, but
00:51:39 [Speaker Changed] I have it, it’s in my queue. I haven’t started it yet, but everybody seems to love it.
00:51:43 [Speaker Changed] It’s fascinating and I think the thing that’s so great about it is there’s just so much around the topic of semiconductors and Silicon Valley and AI and like really just understanding the fundamental underpinnings of how the industry got started and where the power lies and why TSMC is such a critically important company to the whole world. I think everyone should read it. And I also like it because it kind of falls into my favorite category of nonfiction written like a novel or, you know, sometimes that dabbles into a historical fiction. There’s, I don’t know if you’ve read The Devil in the White City, that’s a great book that’s really about kind of Chicago during the world’s fair.
00:52:22 [Speaker Changed] Lars Larson,
00:52:24 [Speaker Changed] LAR, Eric Larson. Yeah,
00:52:25 [Speaker Changed] I, I have a, a whole stack of his stuff. Everything he writes is so fascinating and dense and absolutely reads like a novel. Yeah,
00:52:33 [Speaker Changed] I read something else, I can’t remember the name of it, about the evolution of Edison and Tesla and Westinghouse right around the turn of the century. That I think is another fascinating example of this category where, you know, you’re learning about real events and people, but in a way that feels like you’re reading a novel. So I think there’s a lot of great examples like that. Huh,
00:52:51 [Speaker Changed] Really, really interesting. Our final two questions. What sort of advice would you give a recent college graduate interested in a career in either investment management or finance?
00:53:03 [Speaker Changed] I’d say two things. First, seek experiences that will help you get the role that you think you want in the long term. And that one is really, I think about not only getting experiences from your job and what you’re doing day to day, but also, you know, looking for opportunities to, you know, let’s say you’re an equity analyst, but you wanna move into a leadership role. You can try to volunteer in organizations or serve on the board of a nonprofit that can help develop leadership skills, even though your day-to-day job much, maybe much more, you know, investment oriented, for example. And another thing I’d al I always tell people who ask me this question is, it’s so important to put your hand up and make sure that your manager knows how you want your career to evolve. Because people, I think, assume that they’re gonna get tapped for their next role. And I just don’t think it generally works that way. I think if you can be proactive in saying, I would love to be an analyst on a different sector, or I’d love to be a portfolio manager someday, or whatever it is that you aspire to, then you can work with your manager on making sure you have kind of a long-term plan for developing the right skills instead of just being disappointed when you don’t get the job.
00:54:09 [Speaker Changed] And our final question, what do you know about the world of investing today? You wish you knew 30 or so years ago?
00:54:16 [Speaker Changed] I would say that trends last longer than you think they possibly could. And so, I mean, you could see that right now in the small cap versus large cap performance that we talked about. You could certainly see it even at the, the end of the.com days. You know, you could see it even in like the 2006, 2007 period where so many investors felt like they knew housing was going to collapse, but nobody could actually hold onto their positions long enough, except for very few to end up, you know, making that a positive trade. So I just think there’s so many examples where trends go on so much longer than you think. So you need to make sure to take that into consideration in your future careers.
00:54:58 [Speaker Changed] Thank you, Heather, for being so generous with your time. We have been speaking with Heather Brilliant CEO of Diamond Hill. If you enjoy this conversation, well check out any of the 500 previous discussions we’ve had over the past 10 years. You can find those at iTunes, Spotify, YouTube, Bloomberg, wherever you find your favorite podcasts. Check out my new podcast at the Money Short conversations with experts about topics that affect you and your money, earning it, spending it, and most importantly, investing it at the money in the Masters in Business Feed or wherever you find your favorite podcasts. I would be remiss if I did not thank the crack team that helps us put these conversations together each week. Steve Gonzales is my audio engineer. A of al is my project manager. Anna Luke is my producer. Sean Russo is my researcher. I’m Barry. You’ve been listening to Masters in Business on Bloomberg Radio.
~~~
