Our international equity team is led by portfolio managers Grady Burkett and Krishna Mohanraj. Grady, Krishna and three dedicated global analysts—Yiting Liu, Christopher Piel and Chendhore Veerappan—all conduct deep fundamental analysis in the search for the most attractive opportunities in international and global markets. Several team members were born and raised, educated or spent time living in countries outside the U.S., which provides the team with a unique lens as it considers overseas businesses for investment.
We interact informally daily and more formally on a weekly basis to ensure efficient decision making and to avoid silos of information. We operate as generalists due to the vast nature of the opportunity set, though each team member brings distinct areas of expertise we capitalize on. Our team structure gives us the flexibility to capitalize on opportunities wherever they exist, especially in some of the more esoteric industries globally that are not well covered by Wall Street analysts. We also work closely with our U.S. equity research team on U.S. stocks for our global portfolio, as well as for competitive analysis.
Global markets excite us as investors because the opportunity set is vast and provides ample hunting ground for new ideas. Additionally, the number of listed stocks continues to grow in international markets, unlike the U.S. market where the number of listed companies has significantly contracted over the past decade.
As bottom-up investors in global markets, we’re investing in companies not countries. We are highly selective about what we invest in. We are patient and long-term focused.
Our Investment Philosophy
Under our intrinsic value investment philosophy, we:
- Treat every investment as a partial ownership interest in that company
- Always invest with a margin of safety
- Possess a long-term investment temperament (five years or longer)
- Recognize that market price and intrinsic value tend to converge over a reasonable period of time
If we had perfect insight into a company’s intrinsic value, we would see the stock price rarely matches the business’ underlying value. When the market’s estimate of a company’s value is similar to our estimate of intrinsic value, we have no reason to expect superior returns. When the market appears to be undervaluing a business relative to our estimate of intrinsic value, that business might be a potential investment candidate. Other times, our fundamental analysis may lead us to conclude that the range of outcomes is simply too wide for us to estimate intrinsic value with any precision.
Market events can certainly create opportunities for us to buy shares of a business, in which we have high conviction, at a discount to our estimate of intrinsic value. This happens for a variety of reasons. Sometimes the market is worried about the prospects of a particular country or industry and indiscriminately sells with little regard for long-term value. Other times, a business runs into temporary difficulties that the market is unwilling to look through, causing the company’s share price to fall far below intrinsic value. We may also see a positive fundamental development in the business that we believe the market has not priced in. There are times when we can’t identify a reason for the discount. Regardless of the cause, when we have high conviction that a company’s shares are trading at a meaningful discount to our estimate of intrinsic value, we look to buy.
Our Investment Process
Our process leads us to identify higher-quality businesses where we can confidently predict cash flows over longer periods of time. We prefer management teams that have a proven history of good capital allocation decisions. We like strong balance sheets and companies without significant levels of leverage.
As valuation-disciplined investors, we must have the psychological fortitude to buy when everyone else is selling. In uncertain times, we want to be in a position to add to existing holdings or invest in new opportunities. Therefore, it is critical that we deeply understand a business’s long-term intrinsic value. Doing so allows us to invest with a margin of safety and gives us the confidence to invest when markets are unfairly valuing individual businesses.
We then aim to construct a high-conviction portfolio by being highly selective and examining a stock’s relative attractiveness and how it would interact with other holdings at the portfolio level. Our process allows us to invest with high conviction for two reasons. First, we understand our portfolio holdings well, allowing us to rationally interpret new information. Second, our estimate of value is not swayed by short-term stock price movements. These two factors allow us to maintain a long-term focus and not be swayed by market noise.
Idea generation is the lifeblood of our portfolios, and independent thought is a hallmark of our approach. Ideas often come from the experience of our team members who have followed companies for many years. Our team possesses high familiarity with companies’ competitive situations and appropriate valuation levels. We invest from a deliberately broad universe, using our investment experience in international markets to generate ideas. At times, we use fundamental factors to narrow the universe, which may include enterprise value/EBITDA, price/free cash flow, trailing and forward P/E, ROE and price/sales. We also regularly explore areas of the market where we do not own anything—industries or geographies in which we might not have invested before.
Estimating Intrinsic Value
Our approach to valuation is labor-intensive, qualitative and forward-looking. It is core to our process and is our area of expertise. First, we spend time assessing business’s attributes using our 5-point framework:
- Does the company have sustainable competitive advantages?
- How is the industry structured?
- What is the capital structure?
- How well does management allocate capital and execute its strategy?
- How favorable are end-market conditions?
We then use our proprietary investment model to create our estimate of intrinsic value. Future cash flows are forecasted based on our holistic knowledge of the business, discounting those flows at an appropriate rate for the fundamental risk being taken with that investment. The discounted sum of these future cash flows is our estimate of intrinsic value for that business.
DIAMOND HILL PROPRIETARY INVESTMENT MODEL
Our valuation process includes reading through filings, such as 10-Ks and proxy statements. Filings can yield amazing findings—insight into how a company thinks, its culture, its ownership structure, tenure of the management team, executive compensation, joint ventures, etc. We also look for negative clues about a company—reasons not to invest. We take time to understand who competitors are, talk to the investor relations team, read industry magazines, attend conferences and speak with people who understand the company better than we do. We travel extensively (when not in the middle of a pandemic) to meet with management teams and visit company headquarters and local offices or storefronts.
After we examine a company from the inside, we then look at external factors. For example, what do changing health care policies in China mean for this particular Chinese health care provider? Or how will Brexit impact operations for this U.K. company? Because we are constantly looking for new investment ideas, we follow a wide variety of companies operating throughout the world, and have formed opinions about political, economic, inflation and market dynamics for many countries. However, we’re careful not to let our macro views unduly influence our portfolios. As bottom-up investors, we rely on our business analysis and equity valuation work first and foremost. Furthermore, a thoughtful analysis already incorporates economic cycles and country factors into valuation.
Building a High-Conviction Portfolio
When we identify an investment candidate and determine that it is trading to a discount to our estimate of intrinsic value, it is not necessarily added to the portfolio. Rather, when considering initiating a new investment, we ask ourselves two questions:
- Is the investment more attractive than at least one existing holding?
- Will adding this security raise our exposure to a particular country, sector or industry to an undesirable level?
To answer the first question, we compare the discount to intrinsic value for the potential holding to the discounts of current portfolio holdings. If the potential new holding has a similar or wider discount than at least one existing holding, the potential holding might be a suitable addition or replacement. After comparing discounts, we again revisit business attributes using our 5-point framework to understand a company’s industry dynamics, structural competitive advantages, cost structure, management and stewardship, capital structure, and market dynamics. However, at this point we are not evaluating the potential holding in isolation but in comparison to existing holdings. Our goal is to be confident the potential new holding is a superior investment to an existing holding before altering the portfolio.
We don’t have a formula to determine whether to replace an existing holding or allocate additional capital to one holding over another. Each decision is unique. However, two basic principles inform our decisions:
- Given two companies of similar quality, we’ll allocate to the company with the wider discount to intrinsic value.
- Given two companies with similar discounts to intrinsic value, we’ll allocate to the higher-quality company.
In addition to these considerations, we keep exposures in mind when evaluating a new holding, as we have certain risk controls in place as detailed in our portfolio guidelines. Often, we choose to maintain exposures well below our guideline limits. However, we will gladly allocate to the upper bound of any of our exposure limits when the opportunity presents itself.
We regularly compare prices to our estimates of intrinsic value. We consider selling positions under the following circumstances:
- If the market price reaches our estimate of intrinsic value, we will examine our model assumptions. Unless there is meaningful justification to adjust our assumptions, we will exit the position.
- If our estimate of intrinsic value is lowered due to fundamental deterioration such that the current market price is no longer at a discount to our estimate of intrinsic value, we will exit the position.
- If a more attractive investment opportunity is identified, we might sell a holding to purchase a more attractive opportunity.
- If a holding reaches our portfolio guideline limit, we will reduce the position.
To Hedge or Not to Hedge
We are often asked whether or not we hedge our currency exposure. We do not hedge, primarily because foreign exchange fluctuations tend to balance out over the long term. At the same time, the costs of hedging are guaranteed to be a drag on returns year after year. For us, currency risk is embedded in our process. We are cognizant of the currency risk when investing in a particular company, and we tend to look for business models that inherently offer a natural hedge that helps mitigate currency risk.
Take a Mexican airport operator, for example. When the Mexican peso depreciates, it dampens returns for U.S. dollar-based investors. However, the airport operator benefits from increased travel demand because a depreciating foreign currency makes it less expensive for foreign tourists to travel to that destination. Additionally, duty-free sales at airports are always conducted in U.S. dollars, providing the airport operator another boost in revenue. In other cases, where a natural hedge might not exist, we typically demand a higher margin of safety or deeper discount to our estimate of intrinsic value to compensate for currency risk.
We believe the combination of our intrinsic value investment philosophy, depth of industry knowledge, and breadth of idea generation positions our portfolio to generate value-added returns over full market cycles.
OUR SHARED INVESTMENT PRINCIPLES
At Diamond Hill, our primary purpose is to improve our clients’ lives through better financial outcomes. That commitment is evident in our vision—to be an exceptional, active investment boutique that our clients trust to deliver excellent long-term investment outcomes from a team aligned with their success.
We believe these principles are foundational to who we are and how we serve clients, lead to excellent long-term investment results across multiple capabilities and promote enduring client relationships.
Our Shared Investment Principles
The views expressed are those of Diamond Hill Capital Management as of August 2021 and are subject to change. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice. Investing involves risk including the possible loss of principal.