In the last five years, investment advisor and fund administrator, Diamond Hill Investment Group, Inc. (DHIL: 156.60/share), has been far from being a market darling. Both growth and profitability have been challenged, with profits see-sawing along with returns. The culprit is easy to see: the economics of active management is driving down fees and growth in assets under management has simply not made up the difference. So, although the firm’s strategies are largely ahead of the market, ensuring growth in a sector losing the war against passive investment instruments, Diamond Hill has lost potential revenues. In this period of storm and stress, a management whose interests are aligned to those of its clients has created value, and grown free cash flows, while prudently deploying capital. The market’s response to all this has been to price Diamond Hill at a 14% discount to its economic book value. With its history of growing assets under management, and achieving market-beating returns, the company presents a buying opportunity and earns an “attractive” rating from me.
Growth and Profitability Are Challenged by Secular Trends
Diamond Hill has grown revenue from $136.62 million in 2019 to $142.33 million in the last twelve months (LTM), compounding at 0.82% a year. By way of comparison, according to Credit Suisse’s “The Base Rate Book”, the median 5-year sales CAGR for firms for the 1,000 largest firms in the world between 1950 and 2015, was 5.2%. Using various accounting adjustments I make to strip away the impact of non-recurring and non-core items and arrive at a superior estimation of core profitability, I found that Diamond Hill’s net operating profit after-tax (NOPAT), has declined from $65.62 million in 2019 to $41.86 million in the LTM. The reader can see the details of how I calculated NOPAT as well as other metrics and how I used my reverse discounted cash flow (DCF) model to test various scenarios involved in this article in the accompanying spreadsheet.
Declining NOPAT is a consequence of falling NOPAT margins (NOPAT/revenue), which have declined from 48.03% to 29.41% in the aforementioned period. In parallel, Diamond Hill's average invested capital turns (revenue/average invested capital), a measure of balance sheet efficiency, has risen from 0.98 to 1.23. Falling NOPAT margins and more efficient use of capital have combined to push returns on invested capital (ROIC) down from 47.27% to 36.2%.
Nonetheless, Diamond Hill's ROIC is noteworthy, and a function of its asset-light business model, which allows it to scale without much incremental investment. The company's largest expenses are related to compensation.
Superior Fund Management Is a Competitive Advantage
Diamond Hill offers 10 strategies across four asset classes: US Equity, International Equity, Alternatives, and Fixed Income. Since inception, seven of these strategies have outperformed their benchmarks. Details can be seen in page 23 of the company's 2023 10-K. In the 2021-2023 period, eight of the firm's strategies outperformed their benchmarks. Essentially, Diamond Hill has proven itself as being capable of doing that difficult thing of beating the market. The company delivers its returns thanks to its disciplined pursuit of investment prospects trading at a discount to estimated intrinsic value and taking a long-term view of its holdings. In its 2019 annual report, Diamond Hill explains that "The key factors in determining the intrinsic value are normalised earnings and earnings growth rate, payout ratio and dividends, terminal earnings multiple, and required rate of return." The company's investment success has made it attractive to investors.
Under Heather Brilliant, who took over as CEO in 2019, Diamond Hill has grown assets under management (AUM) from $23.4 billion to $29.3 billion, compounding at 4.6% a year. Similarly, assets under advisement (AUA) have grown from $1.1 billion in 2020, the first year for which total AUA data is broken out, to $1.8 billion in the TTM, compounding at 13% a year. This is especially impressive considering that passively managed funds have enjoyed large net inflows while actively managed funds have suffered large net outflows, for years. Per Diamond Hill's 2023 10-K, in 2023, for example, passively managed funds enjoyed inflows of $527 billion whereas actively managed funds suffered outflows of $458 billion. ETFs enjoyed inflows of $580 billion whereas mutual funds suffered outflows of $510 billion. This secular and irreversible trend has been of such an order that in 2023, total assets held by passive products was greater than those held by actively managed products for the first time.
The Economics of Active Management Are Prohibitive
How then to explain Diamond Hill's tepid revenue growth in light of its trend-defying AUM and AUA growth? The answer to the riddle is simple: revenue is driven by the interaction of AUM and AUA and average advisory fee rates, and in a world of constant fee rates, revenue growth would track growth in AUM and AUA, but where fee rates fall, revenue growth is dragged down. In the table below, I have estimated a crude "prospective revenue" number, which is simply 2019 average advisory fee rates multiplied by the ending AUM and AUA. I say "crude" because it does not neatly map the levels of AUM and AUA at which each fee is earned, and so, in 2019 for example, it differs from realised revenue, but, it is instructive: if in the LTM Diamond Hill could charge the same fees it did in 2019, its revenue would be more than $40 million greater, or nearly 30% higher than realised revenue.
For reasons outlined in the Appendix, "An Overview of the Economics of Active Management", declining fee rates are a secular and irreversible trend. Brilliant is not oblivious to this. In her first letter to the shareholders, she said,
While our equity strategies have generally performed well relative to peers over the last 10 years, it has been more difficult for us to outperform core passive benchmarks (e.g. Russell 1000 Index). Over the last decade, equity market returns have exceeded historical norms, driven by the performance of rapidly growing and statistically expensive companies, making it more challenging for value-oriented managers like us to demonstrate the alpha we can add over the course of a full market cycle. We continue to believe our strategies will outperform their respective passive benchmarks, net of fees, over a complete market cycle, supported by a shared commitment to our intrinsic value-based investment philosophy, long-term perspective, disciplined approach, and alignment with our clients’ interests.
Those forces working against active managers have only grown stronger since she began her tenure.
Management Has Created Value
Management creates value, i.e., the economic benefit that arises from owning a business, when it grows revenue, and earns a ROIC in excess of the opportunity cost, or what standard financial theory now calls the “weighted average cost of capital” (WACC). The dollar value of this is economic profit, which is simply the spread between ROIC and WACC multiplied by the firm's invested capital. Diamond Hill has earned an economic profit in every year since 2019, earning over $212 million in economic profits between 2019 and 2023. In the LTM, the firm has earned nearly $32 million in economic profits.
Free Cash Flows Highlight Prudential Dividend Payments
Diamond Hill paid out dividends for 17 consecutive years. In 2019, the firm paid a special dividend of $9/share, and in 2020, $12/share. The company initiated regular quarterly dividends in 2021, at $1/share, which grew to $1.50 share the following year, a level which it has maintained. The quarterly dividend, annualised to $6/share, grants the shareholder a 3.8% dividend yield. Moreover, the firm's dividend payments are dwarfed by Diamond Hill's free cash flows (FCF).
Between 2019 and the LTM, Diamond Hill earned nearly $360.82 million in FCF, equivalent to 89% of its current enterprise value. In that time, it paid out nearly $190 million in dividends. Only once, in 2021, did dividend payments exceed FCF, and if this is maintained, this will improve the already high quality of the dividend growth opportunities.
Share Buybacks have Been Value-Focused
Diamond Hill's share repurchase philosophy mirrors its investment philosophy: the firm aims to repurchase its shares when there is a meaningful discount between its estimate of intrinsic value and the share price. It is difficult to judge the firm on this count given that it has mostly traded at a discount to its economic book value (EBV), the steady-state value of the firm. In only year, 2022, has the firm traded at a level above its EBV, and there, it had a price-to-economic book value (PEBV) ratio of 1.62, just 0.02 points into neutral attractiveness in my rating system. That is a mere error -on my part- away from being attractive (1.1 < 1.6).
Client-Company Interests Are Aligned
Principal-agent conflicts occur when a diffuse shareholder base cannot exercise control or rigorous oversight on management, a management whose interests differ from those of shareholders and has greater information at hand about the business. In her 2019 letter, Brilliant highlighted one source of principal-agent conflict: scale:
While size is an advantage when producing a commodity product like an index fund, it has a real cost for investors in active strategies that must be carefully managed. The business of active investment management favors scale, many times at the expense of long-term client outcomes. There is an inherent conflict of interest between active asset managers and clients: more assets under management lead to higher revenue for the manager but can negatively affect performance generated for existing clients. If portfolio managers are incentivised to grow assets under management, their time may be spent attracting new investors rather than delivering outstanding investment results for existing clients. In addition, this approach may allow the strategy to grow to a point where size begins to inhibit the ability to generate excess returns.
Capacity management is a critical component of our ability to act in the best interests of clients. Adding value for our clients is predicated on our willingness to differ meaningfully from the benchmark (and ability to be right). In order to deliver a high-conviction, truly active portfolio, we must first ensure a foundation of capacity discipline. At Diamond Hill, we seek to grow our strategies to the point where our revenue allows us to attract and retain the investment talent necessary to generate excess returns for our clients while simultaneously protecting the portfolio manager’s ability to add value. We address this by giving all portfolio managers sole discretion in determining the capacity for the strategies they manage, as well as decision rights on when to soft close a strategy. Because we base incentive compensation on investment results, we motivate portfolio managers to close a strategy before it reaches a size where their ability to generate excess return is hindered. Through meaningful investment in their strategies, portfolio managers are incentivised to optimise investment results (rather than grow assets under management) because their personal investments, along with our clients’ investments, also benefit from excess return generation. At Diamond Hill, we are committed to prudent capacity management that puts our clients’ interests first.
Capacity management and tying incentive compensation to investment results are two pillars of Diamond Hill's approach to closing the gap between client and management interests. The other is having its employees invest in Diamond Hill's funds alongside its clients. According to the company's code of ethics, its employees are forbidden from investing in individual securities or competing firms’ funds where Diamond Hill has a strategy encompassing that segment of the market. In effect, Diamond Hill puts its employees into the same position as its clients to ensure that they invest in the best interests of those clients.
Current Valuation Presents a Buying Opportunity
As mentioned in my discussion of the firm's share repurchase program, Diamond Hill has tended to trade at a discount to its EBV. At current prices, the firm has a PEBV of 0.88, which implies that the market expects NOPAT to permanently decline by 12% from current levels, with revenue declining by -0.88% a year. This is strangely catastrophist considering that, despite its challenges, Diamond Hill more than doubled its 2022 NOPAT in 2023, and, if anything, Diamond Hill can be accused of having volatile NOPAT, rising one year, and declining the next. The reader can see how I arrived at this conclusion in the sheet titled, "Price-Implied Expectations" in my accompanying spreadsheet.
If Diamond Hill can maintain current NOPAT margins and grow NOPAT by nearly 4% a year compounded, the stock is worth at over 4% a year, it$231.07/share, a 48% upside from its current share price. The calculations that went into this are in the sheet titled, "Reverse DCF (Optimistic Scenario)".
Appendices
1. An Overview of the Economics of Active Management
The paradox of investing is that it is essential for the preservation and growth of wealth, and yet, most investments fail to preserve wealth or beat their benchmark. Economic losses, rather profits, define investing, not merely because they are more probably, but also because losses impact portfolios more profoundly than gains1. Indeed, such is the nature of risk that even in a fair game, that is, one where one has an equal chance of winning and losing, in the long run, wealth is destroyed. Daniel Bernoulli called this, "nature's admonishment to avoid the dice". I noted in my discussion on prospective S&P 500 returns, that,
In his earthquake of a paper, “Do Stocks Outperform Treasury Bills?”, Hendrik Bessembinder found that, between 1926 and 2017, four in seven U.S. stocks had lower compound returns than one-month Treasuries. In terms of lifetime dollar wealth creation, he found that just four percent of public companies generated the net gain for the entire U.S. stock market, with the rest earning returns that merely matched Treasury bills. In “Long-Term Shareholder Returns: Evidence from 64,000 Global Stocks”, Bessembinder, Te-Feng Chen, Goeun Choi, and K.C. John Wei, found that this positive skewness of stock returns was a global phenomenon. Between 1990 and 2020, 55.2 percent of U.S. stocks and 57.4 percent of non-U.S. stocks, had lower compound returns than one-month U.S. Treasury bills. In terms of lifetime dollar wealth creation, they found that just 2.4 percent of the 64,000 firms they studied generated all the net gain of the global stock market. Ex-U.S., just 1.41 percent of firms generated $30.7 trillion in net wealth creation. The implications seem clear: an active manager is more likely to create a portfolio that underperforms one-month Treasuries, than outperforms it.
Yet, people must invest, and for most of the modern era, they have relied on active managers to do so. In his “Exposition of a New Theory on the Measurement of Risk”, Bernoulli gave the world’s first mathematical argument for the benefits of diversification, saying that “it is advisable to divide goods which are exposed to som danger into several portions rather than to risk them all together”, so that the geometric return of the portfolio approaches its arithmetic return. For investing, nothing is a greater testimony to the power of diversification than market indices. A mass of stocks, most of which fail to beat the humble Treasury bill, are together, able to generate positive returns in excess of those of Treasury bills. Since the advent of passive investing instruments, active managers have been battling two powerful forces: firstly, that they face greater information costs in attempting to find that slice of the market that generates excess returns, and secondly, that given the unlikeliness of this, they are more likely to generate inferior returns pre-fees, although William F. Sharpe believed that active managers can match market returns pre-fees. Empirically, the evidence favours my Bernoullian view: studies of active US large cap funds have found that pre-fees, the odds of outperformance are a coin flip and post-fees, the odds crash toward zero. Data from S&P Global’s SPIVA, which measures the performance of active managers against the S&P 500 and other indices across the world, shows that in the last fifteen years, 87.98% of Large-Cap active managers have underperformed the S&P 500, and only 12.02% have outperformed it. However, outside of US large caps, Dr Alex Beath of CEM Benchmarking found that,
...the average fund in the CEM database has outperformed their benchmark by 67 basis points (bps) gross of costs and 15 bps net of costs. It is reassuring to note that the evidence shows that large institutional investors are able to added value over long periods, even if more than 75% of the gross value added generated is eroded through costs.
The United Kingdom's Competitions and Market Authority (CMA) found,
...‘buy-rated’ products outperform their respective benchmarks on a gross of AM fees basis by approximately 23 bps per quarter, on average. These results are highly statistically significant. This is also true however for all the AM products in our sample regardless of their rating, which are also found to outperform their respective benchmarks albeit by a smaller margin (17.4 bps per quarter, on average).
156. Once we take into account AM fees, we find that recommended products continue to outperform the market though only by 4 bps per quarter on average. These results are no longer statistically significant. In other words, because of the variability in the net active returns of ‘buy-rated’ products in the data, the observed outperformance against their benchmarks may be attributable to chance.
At scale, a sliver of outperformance may be enough justification for institutional investors to continue to use active managers. In fact, passive instruments make up just half of US global funds, and 39% of the global funds market, and represent just 23% of global assets under management (AUM). Nevertheless, the effect of these forces is to create downward pressure on fees so that they now approach those of passive managers2, a pressure that is likely to continue until fees are below those of passive managers.
Given that few active managers have succeeded in reducing their information costs and earn extraordinarily high long-run returns, the typical active manager has to accept declining fees. If, as I believe, S&P 500 returns over this decade will be just over 1%, then not only will fee compression continue, but information costs will rise, revenues will decrease, and profitability will slump. This is the fundamental reality and challenge facing Diamond Hill. The other reality facing Diamond Hill is an opportunity and it is that, not only must people invest, but some people want to earn returns greater than those available in a passive investing instrument.
- For example, if a stock loses half its value, its holder requires a subsequent 100% gain in value simply to return to the initial value. ↩︎
- The SPDR® S&P 500® ETF Trust has a net expense ratio of 0.0945%. ↩︎