This investment thesis also appears on the SumZero platform.

Nigeria’s largest palm oil producer, Presco plc (NGX:PRESCO) earns an attractive rating according to my stock rating methodology, driven less by price than the power of its economics and a valuation that is reasonable-enough to justify investment. Presco is uniquely positioned to benefit from a mix of favorable macroeconomic trends, regulatory barriers, and supply constraints that support elevated palm oil prices. While valuation alone does not make it an outright bargain, Presco’s superior economics, competitive positioning, and high-quality earnings suggest significant upside potential. With global palm oil demand continuing to rise due to its ubiquity in food, cosmetics, and biofuels, supply-side constraints, both in Nigeria and globally, create a compelling investment case. Presco’s deep vertical integration, geographic advantages, and strategic market positioning place it at the forefront of this high-growth industry. Investors should consider the risks of climate volatility and policy shifts, but for those with a long-term view, Presco represents a rare opportunity in the African agribusiness sector.

Restricted Supply and Burgeoning Demand Support Rising Prices

Palm oil, an edible vegetable oil extracted from the many clusters of fruit called fresh fruit bunches of oil palm (Elaeis guineensis) trees, has three main end products: crude palm oil (CPO), which is squeezed from the fruit of the oil palm trees and is mostly used as edible oil; palm kernel oil (PKO), which comes from crushing the kernel in the middle of the fruit and is used in cosmetics; and palm kernel cake, which is made from the remaining kernel after the palm oil has been extracted and is used as animal feed. According to the World Wide Fund for Nature (WWF),

Palm oil is in nearly everything – it’s in close to 50% of the packaged products we find in supermarkets, everything from pizza, doughnuts and chocolate, to deodorant, shampoo, toothpaste and lipstick. It’s also used in animal feed and as a biofuel in many parts of the world

This is due to the ease with which palm oil can be stabilized and their efficacy in maintaining flavour and consistency in ultra-processed foods. A 2015 study found that the average person consumes 7.7 kg (17 lb) of palm oil a year. The WWF found that two-thirds of palm oil consumption goes into food; nearly a third is used in industrial applications and consumer products such as cosmetics and cleaning agents, detergents, and soap; and 5% is used in biofuels, although the country-to-country mix varies. 

Fragmented markets with goods in rising demand often follow what economists call the “cobweb model”: production rises to meet demand, given the lag between production decisions and price observations, a glut emerges, causing a collapse in the price of said goods. An investor’s task then is to question if there are reliable constraints on supply that support elevated prices. Vegetable oil economics are defined by restricted supply and rising demand, which has driven a surge in vegetable oil production and prices. Since the 1960s, vegetable oil production has grown markedly, with palm oil production outstripping the rest since 1978, and global palm oil production compounding at 7.34% a year. The reason is simple: palm oil accounts for a third of the world’s vegetable oils while utilising less than a tenth of its cropland. This productivity makes it ideal for meeting the world’s rising demand for vegetable oils. On a per hectare basis, oil palm yields are 11 times greater than those of soybeans, 10 times greater than those of sunflowers, and seven times greater than those of canola.

The Food and Agricultural Organisation (FAO) estimates that 50% more food must be produced in order to achieve food security by 2050. At present, the world is already off its 2030 goals for achieving Zero Hunger. This is particularly acute in Africa, the only region in the world with a growing population, with the third largest economy in Africa by nominal GDP and set to have a population of 312.7 million by 2040, and the 14th largest economy in the world by 2050, local demand for palm oil is likely to continue to grow. At present, Nigeria is a net importer of palm oil, as it struggles to scale production to meet domestic demand. Dr Celestine Ikuenobe, the previous head of the Nigeria Institute for Oil Palm Research (NIFOR), told the Nigerian Tribune that Nigeria requires 3 million tonnes of palm oil a year and is currently only producing 1.4 million tonnes a year. 

Indeed, the government has worked to revive palm oil production since the turn of the century, making land available, and providing aid, in a bid to meet domestic demand and compete with Indonesia. Nevertheless, a combination of climate change and capacity constraints on the part of the Nigerian government have made it hard to properly grow palm oil production. Stagnating supply is not just a Nigerian story: production has fallen in Indonesia and Malaysia as well, despite rising demand, not only for food, but, crucially, for use in biofuels, as the shift from fossil fuels continues unabated. As with Nigeria, climate change and capacity constraints, not merely from the government, but from the financial sector, have made it hard to grow production.

Barriers to Entry Protect Presco

The most important of competitive advantages are barriers to entry. These barriers to entry are a function of the enormous transaction costs involved in creating a competing firm: the capital investments needed are high, with Presco’s invested capital as of 2024 being N238.67 billion, and there are regulatory constraints and land acquisition challenges that are hard to overcome. Presco’s deep relationships with local distributors and local communities place it at the head of the queue when it comes to acquiring customers and land. A rival would not only have to match Presco’s capital investments -as well as that of the other oligopolists-, it would have to break their relationships with local distributors and local communities. So, the industry dynamics not only protect Presco’s position, they tend to smooth the capital cycle. 

In terms of regulations, it should be understood that regulations are, whether they are good or bad, a transaction cost. Concerns about the impact of environmental, social and governance (ESG) impacts of palm oil production have led to regulations such as the European Union’s Regulation on Deforestation-free Products (EUDR), exact costs for producers that will discourage the emergence of market entrants and protect large producers from competition. In addition, these costs are passed through to consumers, and Isabella Weber’s work on price controls suggests that “large corporations with market power have used supply problems as an opportunity to increase prices and scoop windfall profits”. In other words, firms have the ability to profit from supply problems. Regulations are likely to grow as the world tries to control the impacts of palm oil production on the environment. 

In Indonesia, expansion has been further slowed by the number of land disputes the country’s 1,000 palm oil producers are involved in, such as those involving Astra Agro Lestari. In 2012 -I could not find later data-, 59% of Indonesia’s palm oil producers were involved in land disputes. In 2021, the country recorded 4,000 land disputes between local communities and palm oil producers.

Geographic Concentration Presents a Fertile Risk

Oil palm trees are native to west and southwest Africa, with the species name, guineensis, referring to the historic region of Guinea, as opposed to the modern-day state. In the last century, it has become naturalised in Madagascar, Sri Lanka, Malaysia, Indonesia, Central America, Cambodia, the West Indies, and several islands in the Indian and Pacific Oceans. American oil palm E. oleifera and the Attalea maripa, are also used to make palm oil. 

Although Nigeria for a long time led the production of palm oils, it was supplanted by Indonesia and Malaysia decades ago, at a time when Nigerian palm oil production was essentially moribund at the end of the twentieth century. Largely through World Bank loans and governmental support, the industry was revived. In 2021, palm oil accounted for nearly 40% of the world’s production of vegetable oils, with around 56% of production emanating from Indonesia, and approximately 26% from Malaysia, even though there are 42 producers of palm oil across the world. Nigeria is the world’s fifth largest producer, responsible for just about 2% of global production. Globally, it is cultivated on large plantations and smallholder plots.

This state of affairs presents obvious risks, risks which the world has already experienced: on April 28, 2022, President Joko Widodo announced that Indonesia was suspending “cooking oil raw materials and cooking oil” exports in order to “ensure the national availability of cooking oil” and keep it affordable.  That announcement was tempered a few weeks later, when the government exempted crude palm oil exports from the ban. Although the ban was lifted three weeks later, it revealed the risks inherent in the global production of palm oil, that any disruptions to production in Indonesia or Malaysia could send the price of palm oil soaring. Climate change and capacity constraints are likely to define the industry for the foreseeable future, making rising long-term prices more likely. Ex-Nigeria supply-side shocks will benefit Presco and the Nigerian palm oil industry as a whole.

Vertical Integration Deepens Dominance

The palm oil value chain consists of producers of varying sizes, processors, traders, consumer goods manufacturers (CGMs) and retailers. At the refining and internal trading level, the market structure is oligopolistic, whereas at the production level, supply is fragmented, with suppliers from smallholders to large plantations, and manufacturing encompasses a vast array of CGMs in a rapidly diversifying market. 

Presco’s vertical integration is a consequence of the fact that it derives a competitive advantage from controlling the entire value chain from plantation to refined products: by owning its own oil palm plantations, palm oil mills, palm kernel crushing plants and vegetable oil refining plants, it can guarantee round-the-year supply of high quality speciality fats and oils, such as Palm Fatty Acid Distillate (PFAD), Crude Palm Kernel Oil (CPKO), Stearin, Olein, Refined Bleached Deodorized Oil (RBDO), and Special Palm Oil (SPO), while bringing transaction costs down, gaining cost predictability, and reducing dependency on fragmented supply chains. Not only does vertical integration drive down costs, it gains an ineffable advantage in innovation. An example of this is Presco’s addition of a Jerry can plant to bottle palm oil and vegetable oil in 5 and 25 litre jerry cans, so that they are more accessible by households. 

Presco’s vertical integration, and scale advantages allow it to produce and sell larger amounts of palm oil with lower cost and higher quality, while spurring innovation and realizing higher NOPAT margins than the competition.

Soaring Growth with Record Profitability

Presco’s revenue has ballooned from N12.72 billion in 2019 to 198.16 billion in 2024, compounding at 58.64% a year, while its NOPAT has even more impressively ballooned, from N2.92 billion to N83.77 billion, compounding at 95.63% a year. In tandem, the company’s NOPAT margin has leapt from 14.82% to 42.28%, while its invested capital turns have improved from 0.65 to 1.04. As a consequence of rising NOPAT margins and invested capital turns, Presco’s return on invested capital (ROIC) has surged from 9.58% to 43.92%.

Owner-Operators Align Incentives for Success

Belgian agro-industrial firm, the Société d'Investissement pour l'Agriculture Tropicale or the SIAT Group has been involved with Presco since 1991, the year of Presco’s incorporation. Siat’s ownership and management of Presco, and the personal investment of its CEO, Felix Onwuchekwa Nwabuko, in Presco, mean that the interests of management and shareholders are properly aligned. 

When Siat came on board, Presco operated from 2,700 hectares on the Obaretin Estate, a palm plantation that had previously been owned by the old Bendel State Government. Siat’s involvement came at the request of Presco’s controlling company, textile manufacturer, President Industries Nigeria Limited (PINL), who valued Siat’s experience in plantation investment and management in West Africa. Siat has grown its shareholding from 33% in 1991 to 50% in 1995 and then 100% in 1997 when PINL divested its shareholding in the company. Presco listed on the Nigerian Stock Exchange in 2002, with Siat retaining a 60% shareholding. 

Under Siat’s management, Presco has obtained the 2,800 hectare Cowan Estate at Ajagbodudu from the Delta State Government; a further 6,500 hectares at Obaretin Estate, the 13,100 hectare Ologbo Estate from Edo State Government; and more recently, the 17,600 hectare Sakponba Concession in the Orhionmwon Local Government Area in Edo State, from where Presco will grow oil palm and rubber.  Moreover, until 2021, Siat fully controlled Siat Nigeria Limited (SNL), before transferring its assets to Presco in order to deepen Presco’s vertical integration. SNL’s acquisition brought with it 16,000 hectares of oil palm plantations that SNL had bought in 2011 from the River States Government’s Risonpalm operations. In total, Presco has a land bank of 40,000 hectares, of which 25,000 are fully planted. 

Rasheed Sarumi represents Siat on Presco’s board as chairman. Nwabuko serves on Presco’s board as a non-executive director and has direct and indirect interest in Presco, totalling 151,700 units. Nwabuko, who previously served as the managing director of Presco and SNL from February 2015 to March 2024, was succeeded by Reji George as Presco’s managing director. 

This alignment of interests is manifest in the growth of Presco’s ROIC -which, as aforementioned, grew from 9.58% in 2019 to 43.92% in 2024-, and economic profit. I found that Presco’s economic profits swelled from N2.45 billion to N46.96 billion between 2019 and 2024.

Presco Has Further Upside

At the present price of N750/share, Presco is trading at a 119.6% premium to its economic book value (EBV). this is hardly “attractive” as I have signaled. My stock rating methodology balances earnings quality and valuation to assign stocks into a bucket somewhere between “very unattractive” to “very attractive”, and Presco scored as attractive, thanks largely to its earnings quality and an attractive MICAP that underestimates Presco’s competitive positioning. 

The company’s price-to-EBV (PEBV) ratio of 2.27 implies that the market expects Presco to grow its NOPAT by 127% from current levels with a market-implied competitive advantage period (MICAP) of just six years. In order to grow NOPAT by 117% from current levels, over the next six years, Presco would have to grow revenue by its 3-year compound annual growth rate (CAGR) of 33.11%, while maintaining its 3-year NOPAT margin of 31.47%. As these operating hurdles are within Presco’s historical range, they are fairly achievable, even though they are aggressive.  

If Presco can grow revenue at its 5-year CAGR of 58.64% over the MICAP, while maintaining its 3-year NOPAT margin, the stock is worth N2,104/share today, an upside of 180.5% from the present price.  

One can of course foresee catastrophe: while the markets expectations are rooted in Presco’s operating achievements,  fall in revenue growth to a still-high 20%, due, say, to climate induced disruptions, while maintaining 3-year NOPAT margins, would mean that the company is worth just N227/share.

This investment thesis first appeared on SumZero on 27 December 2024, when the position was initiated. It was closed on the 4th of April 2025, with a total shareholder return (TSR) of -4.91%.

Steel Dynamics, Inc. (STLD: $117/share) proves a simple and compelling thesis: first, its alignment of shareholder and management interests have ensured that the firm has created shareholder value, and, given that these incentives remain in place, the firm can be trusted to act in the best interests of its shareholders; secondly, free cash flows (FCF) generation has been such that the firm should be viewed as a source of safe, growing dividends; lastly, the risk-reward profile of the firm, as expressed by its earnings quality and valuation, make it an attractive investment in terms of my stock rating methodology.

Vertical Integration is a Competitive Advantage

Steel Dynamics was founded in 1993 as a steel company operating one electric arc furnace (EAF) steel mill in Indiana, and has since evolved into what it describes as a “lower-carbon emissions metals solutions company, providing diversified high-quality products and enhanced supply-chain solutions”, operating seven EAF steel mills shipping, 15 flat roll steel coating lines, a copper rod and wire operation, 70+ metals recycling operations, and 9 steel processing operations, with a 16 million tonnes steel shipping capacity. It is the fifth largest steel company in the world, in terms of market capitalisation, and the fifth largest steel producer in North America. 

The company has a vertical manufacturing model connecting its metals recycling platform, and steel mills and fabrication operations, which helps it hedge against steel price volatility. Vertical integration allows Steel Dynamics to locally source scrap material; melt the recycled scrap metal into steel in its EAFs, which are more energy efficient and produce less greenhouse gas emissions than traditional blast furnace technology; roll that steel into finished steel products, fabricate them, and reclaim end-of-life steel material as feedstock for new steel products. Consequently, in periods of low steel demand, the company can source its needs internally, whereas in periods of high steel demand, it can purchase what it needs. Not only is its metals recycling platform its largest supplier of recycled ferrous scrap, it is also expected to be its largest source of recycled aluminum scrap in its planned aluminum operations. As the reader will see in the chart on Steel Dynamics’ capital allocation, a consequence of that is that there has been negative net working in three of the last five years, with a net investment in working capital of $1.3 billion between 2019 and the LTM. This vertically integrated model permits Steel Dynamics to have a higher through-cycle steel production than other steel producers, and to enjoy low, highly variable costs, industry-leading profitability.

Peer-Group Leading Profitability

Revenue has compounded by 11.3% a year from 2019 to the last twelve months (LTM) ending in 3Q 2024, from approximately $10.5 billion to $17.9 billion. By way of reference, according to Credit Suisse’s “The Base Rate Book”, the 5-year mean and median sales compound annual growth rates (CAGR) for the 1950 to 2015 period were 6.9% and 5.2% respectively. Steel Dynamics combines exceptional growth with profitability. Net operating profit after tax (NOPAT) has shot up from $720.4 million in 2019 to $1.73 billion in the LTM, compounding at 19.2% a year. In parallel, Steel Dynamics’ NOPAT margin has enlarged from 6.9% to 9.7%, while its invested capital turns declined from 1.53 to 1.38. The result of this is that, as will be further discussed further in the section, “Alignment of Shareholder and Management Interests”, that returns on invested capital (ROIC)¹ have grown from 10.6% to 13.3%. 

Steel Dynamics’ profitability compares favourably to peers such as Nucor Corp. (NUE) and CMC (CMC).

Alignment of Shareholder and Management Interests

Steel Dynamics’ long-term incentive plan (LTIP) performance awards seem geared toward achieving the firm’s financial, operational and strategic goals. In order to ameliorate the principal-agent problems that are so rife in business, 25% of the long-term incentive plan (LTIP) performance awards are tied to annual after-tax ROIC relative to a “steel selector comparator group”, composed of companies such as Nucor and the Commercial Metals Company. The rest of the awards are equally tied to revenue growth, operating margin, and cash flow from operations as a percentage of revenue. 

In its 2024 Proxy Statement, management remarked that it believes after-tax ROIC “provides an indication of the effectiveness of the company’s invested capital” explaining that it calculates after-tax ROIC as: Net Income Attributable to Steel Dynamics, Inc / (Quarterly Average Current Maturities of Long-term Debt + Long-term Debt + Total Equity). There are flaws to this measurement, one of which is that the numerator, total net income, includes non-core, non-recurring items, and another of which is that its measure of invested capital does not account for items such as after-tax accumulated asset write downs, so that management is not being properly judged for its stewardship of invested capital. Nevertheless, in 2023, the firm earned an after-tax ROIC of 32%, the highest of the S&P 500’s materials companies. According to my calculations, Steel Dynamics has grown ROIC from around 10.6% in 2019 to nearly 13.3% in the LTM. This compares favourably with peers Nucor and CMC, whose ROIC rose from 9% to 11% and 6% to 9.3% respectively.

We can assess management's performance in terms of growing shareholder value through an analysis of its economic profit². Since 2019, Steel Dynamics has compounded economic profits by 14.2% a year, from $234 million to $466.3 million³.

Tying executive compensation has a further benefit to the firm and its shareholders: in an industry whose capital cycle is historically defined by wild ebbs and flows, having leading firms such as Steel Dynamics, Nucor, CMC, and U.S. Steel tying some portion of executive compensation to either ROIC or return on capital employed (ROCE), strengthens the industry’s sense of value and helps to spread more rational industry behaviour. Firms are less prone to aggressively expand capacity in response to rising prices, aware of the dangers of industry-wide overcapacity and that growth can be value-destroying. For those firms whose executive compensation is already tied to ROIC or ROCE, the odds of their benefitting from value-destroying behaviour on the part of rivals, are higher.

Value-Creating Capital Allocation

Steel Dynamics’ capital is allocated to eight major areas: mergers & acquisitions (M&A), sporadic purchases of short-term investments, capital expenditures, dividends, debt repayment, gross buybacks and changes in net working capital.

Of these, I will discuss three elements to show management’s skill at value-creating capital allocation: dividends, gross buybacks and capital expenditures.

Dividends are Supported by FCF

Steel Dynamics has expanded its regular cash dividends from $0.24 per share in Q1 2019 to $0.46 per share in 1Q 2024, compounding annual dividends by 13.9% a year. In 2024, the firm is paying a dividend of $1.84 per share, with a yield of 1.57%. Moreover, although in that period FCF has declined from $233.4 million in 2019 to $509 million in the LTM, for a cumulative $5.7 billion, it has only paid out $1.4 billion in dividends. This gulf between FCF generation and dividend payments is an expression of the quality of the dividends and the scope which the firm has to grow them.

Gross Buybacks Reward Continuing Shareholders

According to my calculations, Steel Dynamics has traded below its economic book value (EBV) throughout the 2019-2023 period, only trading at a price-to-EBV (PEBV) ratio above 1.0 in the LTM, so it is hard to assess management’s ability to resist the temptations of buying its stock at elevated prices, especially given that the LTM PEBV of 1.22 is attractive.

What can be said is that gross buybacks have rewarded continuing shareholders, building their long-term value per share. Buybacks have also reduced Steel Dynamics’ share count from 214.5 million to 153 million. With $1.3 billion in buybacks in the LTM, the firm has a buyback yield of 7.22%, for a total shareholder yield of 8.79%.

Steel Dynamics’ Hidden Growth Capex

Investors typically use depreciation and amortisation as a proxy for a firm’s maintenance capex, however, as Venkat Ramana R. Peddireddy’s work reveals, this often leads to the costs of inflation and technological obsolescence being ignored. Calculating Steel Dynamics’ maintenance capex using Peddireddy’s method shows that in the LTM, depreciation and amortization exceed maintenance capex is $57.5 million greater than decoration & amortisation, suggesting that the firm’s growth capex is larger than investors may conclude.

Investments into Working Capital

As aforementioned, Diamond Hill’s net working capital as I calculate it is equal to its operating current assets (operating cash, which I estimate to be 5% of total revenue, operating investments -investments less Deferred Compensation Plan Investments in the Funds-, accounts receivable, and other current assets), net of its non-interest bearing current liabilities (NIBCL) (accounts payable and accrued expenses and accrued incentive compensation). Net working capital has burgeoned from $100.5 million in 2019 to $125.7 million in the LTM, or 92% of the firm’s total assets. Importantly, revenue is equal to 116% of net working capital, revealing an asset light business model. Net working capital has compounded at 4.6% per year, showing the modest incremental investments needed to grow the business. Operating investments compose 91.4% of total assets and are the largest component of net working capital. This is because, while operating current assets have risen from $135.8 million to $154.7 million in that time, the value of non-interest bearing current liabilities (NIBCL) has declined from $35.3 million to $29 million. In 2019, 2020, and 2022, net working capital has declined, making it a source of cash. This is important given that research by Robert L. Kieschnick, Mark Laplante, and Rabih Moussawi reveal that, “the incremental dollar invested in net operating working capital is worth less than the incremental dollar held in cash for the average firm”.

Steel Dynamics Has Room to Run

With a share price of $117 per share, Steel Dynamics has a price-to-EBV (PEBV) ratio of 1.22, which indicates that the market expects its NOPAT to grow NOPAT by 22% from its present levels, despite a history of compounding NOPAT by 19.2% a year. I used my reverse discounted cash flow (DCF) model to analyse the implied value of the stock based on conservative assumptions about Steel Dynamics’ future growth in cash flows. 

In the first scenario, I quantify the expectations baked into the current price, and assume that,

• Steel Dynamics maintains its current NOPAT margin of 9.67%, 
• revenue declines 3.4% in 2024, then grows 2.27% in 2025 and 7.51% in 2026, in line with consensus estimates, before growing 4.9% thereafter. 

Under this scenario, the company has a market-implied competitive advantage period (MICAP) of less than a year. 

If one assumes that:

• Steel Dynamics’ NOPAT margin rises to 13.3, its 3-year average, and,
• revenue grows by 11.3%, its 5-year CAGR

Then the stock is worth $155, an upside of 32% from the current price.

If, however, 

• NOPAT margin is 12.65%, its 5-year average, and,
• revenue grows by -0.56%, its 3-year CAGR

Steel Dynamics’ stock is worth $148, an upside of 26.5% from the current price.

Impact of Footnotes Adjustments and Forensic Accounting

Here below are details of adjustments made to Steel Dynamics’s quarterly reports for the LTM period:

Income Statement: I made $203 million in adjustments to calculate NOPAT, with the net effect of reversing the impact of $23.9 million in non-operating income. The adjustments are equal to 1.4% of Steel Dynamics' GAAP net income.

Balance Sheet: I made $3.1 billion in adjustments to calculate invested capital with a net decrease of $2.1 billion. The largest of these adjustments was $1.8 billion in excess cash, equal to 11.6% of Steel Dynamics' reported assets.

Valuation: I made $4.6 billion in adjustments with a net effect of decreasing shareholder value by $3.1 billion. Aside from total debt, the largest adjustment to shareholder value was $943 million in estimated deferred tax liabilities, representing nearly 5.3% of Steel Dynamics’ market cap.

1. NOPAT/Average Invested Capital ↩︎
2. Economic profit margin*invested capital, where economic profit margin refers to ROIC - weighted average cost of capital (WACC). ↩︎
3. DataWrapper does not recognise LTM as a valid date format, so "2024" in the charts really means "LTM". ↩︎

In his paper, “The Nature of the Firm”, Ronald Coase proposed that firms exist because there are transaction costs to organising economic activity through the price mechanism such that when they exceed the benefits of market transactions, it becomes cheaper to organise certain economic activities within a firm, where they are coordinated administratively, rather than in the market. One can apply this framework to understand why active asset managers have had their pricing power, in the form of fees, eroded over time.

The Steady Erosion of Pricing Power

That same logic explains why passive management funds exist: asset managers face enormous transaction costs in attempting to create a diversified portfolio of stocks that can outperform the broad market, from research costs to trading costs and commissions and the tax implications of trading. Passive management funds exist because their broad diversification, and lower trading frequency and the scale they can achieve, allows them to capture the broad market return, while eschewing the transaction costs of active management. Active managers are at a disadvantage because they have higher transaction costs and are less likely to achieve market returns for clients even before they deduct for fees.

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 than profits, define investing, not merely because they are more probable, but also because losses impact portfolios more profoundly than gains. Indeed, such is the nature of risk that, in the long run, even in a fair game¹, wealth is destroyed. Daniel Bernoulli called this, “nature’s admonishment to avoid the dice”. I noted in a discussion on future S&P 500 (market-weighted) 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. 

In a study of the cost of using active managers, “The Deadweight Loss of Active Management”, Moshe Levy studied the Sharpe ratios of U.S. active equity funds against that of the S&P 500 -as a proxy for the market-, using the CRSP Survivorship-Bias-Free Mutual Fund Database for the December 1991 to March 2021 period. The results are shocking: 92.1% of funds underperformed the S&P 500 and investors incurred total annual losses of $235 billion, due to $186 billion for inefficient portfolio allocation, and $49 billion in fees. When firms outperform the market, that outperformance is typically modest, whereas when they underperform the market, the results are often cataclysmic. So, while the S&P 500 had a Sharpe ratio of 0.288, and the average Sharpe ratio of active funds was 0.192, the best Sharpe ratio among active funds was 0.392, an outperformance of only 0.104, while the lowest Sharpe ratio among active funds was -0.475, an underperformance of -0.763. 

Yet, people must invest, and for most of the modern era, they have relied on active managers to do so. In his paper, “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 some 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 passive funds. 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, and such that their geometric mean approaches its arithmetic mean. As passive funds are more diverse than active funds, with, for example, the S&P 500 holding 500 stocks, or the Russell 3000 holding 3000, their chances of capturing the excess returns available on the market are far higher than for more concentrated portfolios held by active funds. 

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, than passive funds, although William F. Sharpe believed that active managers can match market returns pre-fees and that it is fees that are the source of inferior active management returns. Empirically, 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. Morningstar’s research found that real estate is the only category in which the 10-year success ratio for active managers exceeds 50%. 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 add value over long periods, even if more than 75% of the gross value added is eroded through costs.

The United Kingdom’s Competitions and Market Authority (CMA) noted that 

…‘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. 

²At 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 over half of US long-term 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 managers, a pressure that is likely to continue. 

Given that few active managers have succeeded in fundamentally reducing their information costs and earning extraordinarily high long-run returns, the typical active manager has to accept declining fees. Quite simply, active managers do not have meaningful “pricing power”. A study by McKinsey tells us that revenue-weighted pre-tax operating profit (NOPBT) margin declined three points between 2019 and 2023, while revenue compounded by 3.3% a year, and costs by 4.3% a year. Similarly, in that period, model portfolio constituent, Diamond Hill, experienced a fall in its NOPBT margin from 61.9% to 50.3%, as a result of the confluence of revenue compounding by an anemic 0.018% a year, while adjusted operating expenses compounded by a margin-eating 3.7%. 

In her 2023 letter to the shareholder, Heather Brilliant, CEO of Diamond Hill -whom I have written about here and on SumZero-, said, 

And, of course, costs have been rising for asset managers — including distribution costs, growing product suites and the related data and technology to support them, operational and IT costs, and the ability to retain top investment talent to deliver strong results for clients. At the same time, rising revenues over the last 15 years have enabled a lack of cost discipline to persist within the industry. With revenues now slowing, the industry is starting to see the implications of higher cost structures.

This is the fundamental reality and challenge facing active managers. The other reality 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 and will continue to be attracted by active managers. 

Conflicts of Interest Are Endemic to Active Management

In Coase’s theory of the firm, he argued that firm size is a function of rising marginal costs of organisation, so that a firm will stop growing when the marginal costs of organisation equal the marginal benefits. The active asset management industry suffers from diseconomies of scale. It is ironic, for example, that just as Warren Buffett became recognised as a kind of prophet of a secular religion, Berkshire Hathaway was approaching diseconomies of scale. Buffett himself observed that his best period was in the 1950s, when he “killed the Dow”. Increasing scale reduces the investable universe, focusing attention on larger and more widely understood opportunities -eroding any information advantage, i.e; increasing information costs-, and carries the risk that large block trading negatively impacts the strategy³. Michael Jensen’s agency theory views the firm as a “nexus of contracts” tying stakeholders together, wherein a principal delegates decision-making authority to an agent in a relationship of asymmetric information. Conflicts of interest arise when contracts and financial incentives do not align an agent’s self-interested desire for wealth and leisure with the shareholder’s need for wealth maximisation. Yet, as Chengdong Yin discovered, active fund managers are paid more as the size of fund assets increase, even at the risk of hurting fund performance. Thus, typically, there is misalignment of interests in the typical investor-fund manager relationship, with firms policing their size as much as is needed to maintain style average performance. With compensation linked to both fund performance and fund size, a manager who cannot earn market-beating returns is rationally obliged to continue to grow fund assets, because what counts is the total compensation package, not the share attributable to performance or size.

1. That is, one where one has an equal chance of winning and losing. ↩︎
2. The SPDR® S&P 500® ETF Trust has a net expense ratio of 0.0945%. ↩︎
3. Renaissance Technology, a firm that enjoys pricing power, found that in commodity markets their trading activity directly impacted market prices. ↩︎

Initiated on the 15th of October 2024, this position was closed on the 4th of April 2025 with a total shareholder return (TSR) of -31.3%, a victim of market mayhem.

Nucor Corporation (NUE: $152/share) is a stock I discovered while studying CMC. Like CMC, its executive compensation aligns shareholder and management interests. It has the added advantage of generating free cash flows (FCF) in such abundance that there is scope for growth in dividend payments. The stock earns a “very attractive” rating according to my stock rating methodology.

Growing Revenue and NOPAT

Since 2019, Nucor has compounded revenue by 7.7% and net operating profit after tax (NOPAT) by 21.2% a year. NOPAT margin has risen from 6.4% in 2019 to 11.6% in the last twelve months (LTM), while the firm’s invested capital turns have declined from 1.4 to 1.2. Given that return on invested capital (ROIC) can be calculated as,

ROIC = NOPAT margin x invested capital turns = (NOPAT/Revenue) x (Revenue/Average Invested Capital)

the net impact of rising NOPAT margins and declining invested capital turns has been an increase in ROIC from 9% to 13.8%.

Free Cash Flows Support Dividends

Nucor has increased its quarterly dividends from $0.40/share in Q1 2019 to $0.54/share in Q2 2024. In the LTM, investors can earn $2.16/share in dividends on an annualised basis, with a yield of 1.4%. The quality of dividends depends upon a firm's long-run free cash flow (FCF) generation. The greater the gulf between FCF generation and dividend payments, the greater the ability of management to increase future dividends, whereas if dividends are greater or equal to FCF generation, the scope for growth is compromised and a firm may find it needs to scale back its dividends. In that vein, one observes that since 2019 Nucor has generated $14.2 billion in FCF, some 35% of its enterprise value, and paid out $2.8 billion in dividends.

Shareholder and Management Interests are Aligned

The economist Michael C. Jensen, the greater unraveller of the mystery of how executive compensation is tied to shareholder value, died this year. It is by a curious coincidence that my previous piece on CMC hinged upon the fact that its executive compensation is tied to the creation of shareholder value. This is true also of Diamond Hill, whose management and analysts are invested in the business and invest alongside clients. I could extend this to include Meta Platforms, a firm controlled and run by Mark Zuckerberg, a man whose fortune is wholly tied to the success of the business. Nucor follows in that tradition. Like its peer competitor, CMC, and other firms in the basic materials industry, Nucor long tied its executive compensation to ROIC. In my piece on CMC, I noted that,

The stock market allocates capital to where it may be most productively used, which is to say, where it can earn the highest ROIC. There is abundant evidence that a management that focuses on ROIC delivers value for shareholders:

• ROIC is the primary driver of long-term corporate valuation, responsible for over 56% of the change in enterprise value/invested capital.
• All the seven firms whose stock prices rose by over 10% in 2008, had a history of earning high ROICs and continue to do so.
• Geoff and J. Gay Meeks found that 70% of mergers fail to generate operating gains thanks to the disincentives to create value embedded in executive compensation.

Per Nucor's 2024 Proxy Statement, "Executive Officers should be compensated through pay elements (base salaries and annual and longterm incentives) designed to create long-term value for our stockholders and to reinforce a strong culture of ownership." Consequently, 25% of Nucor's annual incentives, and 50% of the cash and restricted stock that make up the long-term incentive plan (LTIP) to annual "return on average invested capital" (ROAIC), a form of ROIC, assessed against the performance of a "Steel Comparator Group".

As discussed, Nucor has grown ROIC from 9% in 2019 to 13.8% in the LTM. The firm's economic profit, measured as,

Economic Profit = (ROIC – WACC) x Invested Capital

demonstrates the extent of value creation that management has overseen: Nucor's economic profitability has risen from $269 million in 2019 to $1.2 billion in the LTM, compounding at 34.8% a year.

Nucor Has Room to Run

At the current price, Nucor has a price-to-economic book value (PEBV) of 1.05, which means that the market expects Nucor to never grow NOPAT by more than 5% from its current level, despite the firm's 5-year record of compounding NOPAT at over 21% a year. Using my reverse discounted cash flow (DCF) model , I analyse the implied value of the stock based on conservative assumptions about Nucor’s future growth in cash flows.

In the first scenario, I quantified the expectations baked into the current price. I assume,

• Nucor maintains its current NOPAT margin of 11.56%, and
• revenue declines 10.68 in 2024 and grows 1.74% in 2025 and 6.31% in 2026, equal to consensus estimates, and 6.31% thereafter

In this scenario, Nucor has an implied competitive advantage period (CAP) of less than a year. 

If one assumes that:

• Nucor's NOPAT margin rises to 14.08%, its 5-year average and
• revenue grows revenue by 7.68%, its 5-year revenue CAGR

The stock is worth $236.32 today, a 55% upside to the current price.

If, on the other hand, one assumes that

• Nucor's NOPAT margin is 14.67%, its 3-year average
• revenue declines by 2.17% a year, its 3-year revenue CAGR

The stock is worth $223.81 today, a 46.4% upside to the current price. 

Impact of Footnotes Adjustments and Forensic Accounting

Here below are details of adjustments made to Nucor's quarterly reports for the LTM period:

Income Statement: I made $530.4 million in adjustments to calculate NOPAT, with the net effect of adding $360 million in non-operating income. The adjustments are equal to 15% of Nucor's GAAP net income.

Balance Sheet: I made $8.74 billion in adjustments to calculate invested capital with a net increase of $6.1 billion. The largest of these adjustments was $3.8 billion in excess cash, equal to 11.1% of Nucor's reported assets.

Valuation: I made $13.15 billion in adjustments with a net effect of decreasing shareholder value by $5.6 billion. Aside from total debt, the largest adjustment to shareholder value was $1.2 billion in estimated deferred tax liabilities, representing nearly 3.4% of Nucor’s market cap.

Initiated on the 9th of October 2024, CMC, a victim of market mayhem and concerns about near-term profitability, the position was closed on 4 April 2025, with a total shareholder return (TSR) of -21.24%.

CMC (CMC: $52/share), formerly known as the Commercial Metals Company, has a history of profitable growth, thanks to its competitive advantages, the alignment of shareholder and management interests and a focus on value creation. The stock earns an attractive rating based on my stock rating methodology and is my stock of the week.

A History of Profitable Growth

Since fiscal 2019 (FYE 8/31), CMC has compounded revenue by 6.9% per year, and compounded net operating profit after tax (NOPAT) by 23.3% a year. In that propitious time, NOPAT margins have more than doubled, from 3.85% to 7.86% in the last twelve months (LTM) ending Q3 2024, as its invested capital turns have declined from 1.58 to 1.27. The net impact of this has been to improve returns on invested capital (ROIC) from 6.99% to 9.99% in the aforementioned period.

Vertical Integration is a Competitive Advantage

In 1915, when the Russian immigrant, Jacob Feldman, founded the company in Dallas, Texas, as the American Iron & Metal Company, CMC was a recycling company, in fact, just as a single scrap yard, yet, when in their 2023 letter to stockholders then executive chairman, Barbara R. Smith, (now succeeded by Robert S. Wetherbee), and president and chief executive officer, Peter R. Matt explained the firm’s rebranding from the Commercial Metals Company to CMC, they remarked that this reflected CMC’s evolution into “a leading construction solutions provider with a growing commercial portfolio spanning multiple platforms.” Today, CMC is a vertically integrated network of recycling facilities, steel mills and fabrication operations providing ferrous and nonferrous scrap metals (“raw materials”), finished long steel products such as rebar, merchant bar, and semi-finished billets for rerolling and forging applications ("steel products"), fabrication and post-tension cable offerings (“downstream products”), and construction-related solutions, such as Tensar geogrids and Geopier foundation systems from its operating segments in North America, its most important segment, and Europe, which consists largely of a vertically integrated network of recycling facilities, an electric arc furnace (EAF) mini mill and fabrication operation in Poland. 

Vertical integration allows CMC to locally source scrap material; melt the recycled scrap metal into steel in its EAFs, which are more energy efficient and produce less greenhouse gas emissions than traditional blast furnace technology; roll that steel into finished long steel products, fabricate them into custom shapes and lengths, and reclaim end-of-life steel material as feedstock for new steel products. This five-stage process is sustainable: 98% of its raw materials are made from recycled material and 89% of its co-products and waste streams are recycled or converted into other products. 

In his seminal paper, The Nature of the Firm, Ronald Coase observed that, 

When we are considering how large a firm will be the principle of marginalism works smoothly. The question always is, will it pay to bring an extra exchange transaction under the organising authority? At the margin, the costs of organising within the firm will be equal either to the costs of organising in another firm or to the costs involved in leaving the transaction to be “organised” by the price mechanism.

Vertical integration is not only a question of whether it is both more manageable and cheaper to organise economic activities within a firm as opposed to without, but, as Clayton Christensen found in the The Innovator’s Solution, it touches upon the question of innovation:

…when there is a performance gap — when product functionality and reliability are not yet good enough to address the needs of customers in a given tier of the market — companies must compete by making the best possible products. In the race to do this, firms that build their products around proprietary, interdependent architectures enjoy an important competitive advantage against competitors whose product architectures are modular, because the standardisation inherent in modularity takes too many degrees of design freedom away from engineers, and they cannot not optimise performance.

To close the performance gap with each new product generation, competitive forces compel engineers to fit the pieces of their systems together in ever-more-efficient ways in order to wring the most performance possible out of the technology that is available. When firms must compete by making the best possible products, they cannot simply assemble standardised components, because from an engineering point of view, standardisation of interfaces (meaning fewer degrees of design freedom) would force them to hack away from the frontier of what is technologically possible. When the product is not good enough, backing off from the best that can be done means that you’ll fall behind.

Companies that compete with proprietary, interdependent architectures must be integrated: They must control the design and manufacture of every critical component of the system in order to make any piece of the system. As an illustration, during the early days of the mainframe computer industry, when functionality and reliability were not yet good enough to satisfy the needs of mainstream customers, you could not have existed as an independent contract manufacturer of mainframe computers because the way the machines were designed depended on the art that would be used in manufacturing, and vice versa. There was no clean interface between design and manufacturing. Similarly, you could not have existed as an independent supplier of operating systems, core memory, or logic circuitry to the mainframe industry because these key subsystems had to be interdependently and iteratively designed, too.

Today’s CMC has grown larger and more vertically integrated because the transaction costs of modularization have increased and because the firm has found that vertical integration is key to their ability to innovate: by way of example, Smith and Matt pointed out that “CMC was the first company in the world to successfully construct and operate a micro mill and the first company to introduce spooled rebar to the North American market.” The company’s strategic acquisitions also reflect this growing vertical integration: in 2023, the firm acquired Tensar, a designer and developer of proprietary solutions for soil stabilisation; EDSCO Fasteners, a provider of anchoring solutions for the electrical transmission market, and Tendon Systems, a supplier of post-tension cabling systems used in concrete construction. So, for instance, with vertical integration, CMC can ensure a steady-supply of low-cost raw materials from its recycling operations to its nearby steel mills and its fabrication facilities give it a large and consistent source of demand, while giving it forward insight into end customer demand. These operations are located in the highest demand locations in North America and Europe, maximising their value for CMC. 

It can be argued that the costs of modularization are high not just for CMC, but for customers: it is cheaper to deal with one firm across the many stages of construction, a company whose scale allows it to offers its products at competitive prices, than to bear the transaction costs of looking for different partners, negotiating multiple contracts, and monitoring many arrangements.

Executive Compensation Aligns Shareholder and Management Interests

The stock market allocates capital to where it may be most productively used, which is to say, where it can earn the highest ROIC. There is abundant evidence that a management that focuses on ROIC delivers value for shareholders:

• ROIC is the primary driver of long-term corporate valuation, responsible for over 56% of the change in enterprise value/invested capital.
• All the seven firms whose stock prices rose by over 10% in 2008, had a history of earning high ROICs and continue to do so.
• Geoff and J. Gay Meeks found that 70% of mergers fail to generate operating gains thanks to the disincentives to create value embedded in executive compensation.

Under CMC’s executive compensation plan, detailed in the 2023 Proxy Statement, 50% of the annual cash bonus incentive is tied to a target ROIC, and 75% of the performance share units (PSUs) are tied to the attainment of a positive ROIC over a three-year period. CMC's inclusion of ROIC in its executive compensation is key to its creation of shareholder value, as evidenced by rising ROIC and economic profits. Not only has ROIC risen from 6.99% to 9.99% in our analysis period, but the firm has grown economic profits from -$17.1 million to $67.04 million in that time.

CMC's Price Leaves Room for Further Upside

At the current price, CMC has a price-to-economic-book-value (PEBV) of 1.06, which means that the stock market expects that CMC will never grow its NOPAT by  more than 6% above its current level, even though it has compounded NOPAT by 23.3% a year in the last five years. I used my reverse discounted cash flow (DCF) model to analyse the implied value of the stock based on conservative assumptions about CMC’s future growth in cash flows.

In the first scenario, I quantified the expectations baked into the current price. I assume,

• CMC maintains its current NOPAT margin of 7.86%, and
• revenue grows 2.24% in 2024 and 6.07% thereafter, equal to consensus estimates

In this scenario, NOPAT compounds by just 3% compounded through 2026, and the stock is worth ~$51/share today, roughly equal to the current price, for an implied competitive advantage period (CAP) of two years. 

If one assumes that:

• CMC's NOPAT margin rises to 9.26%, its 3-year average and
• revenue grows revenue by 6.9%, its 5-year revenue CAGR, between 2025 and 2026

CMC compounds its NOPAT by about 3% for the next two years, and the stock is worth $67.35 today, a 28% upside to the current price. 

If, however, one assumes that

• CMC's NOPAT margin is 9.26%, and
• revenue grows revenue by 3.88%, its 3-year revenue CAGR

CMC compounds its NOPAT by about 2% for the next two years, and the stock is worth $61.59 today, a 17% upside to the current price. 

Impact of Footnotes Adjustments and Forensic Accounting

Here below are details of adjustments made to CMC's quarterly reports for the LTM period:

Income Statement: I made $73.8 million in adjustments to calculate NOPAT, adjustments that are equal to 13% of CMC's GAAP net income.

Balance Sheet: I made $1.7 billion in adjustments to calculate invested capital with a net decrease of $268 million. CMC's $566 million in cumulative asset write-downs, were among the largest adjustments, equal to 8.4% of CMC's reported assets.

Valuation: I made $2 billion in adjustments with a net effect of decreasing shareholder value by $1.4 billion. Aside from total debt, the largest adjustment to shareholder value was $286 million in deferred tax liabilities, representing nearly 5% of CMC’s market cap.

I published an update on this investment thesis on 23 December 2024 on SumZero. Opened on the 4th of September 2024, the position was closed on the 31st of March 2025, with a total shareholder return (TSR) of -6.56%. I closed the position over concerns that the business would suffer during market mayhem, with no clear signs of a catalyst for positive returns.

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.

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.

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.

1. 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. ↩︎
2. The SPDR® S&P 500® ETF Trust has a net expense ratio of 0.0945%. ↩︎