Diamond Hill Research Analysts And Research Opportunities Fund
April 16, 2012
In the letter titled “Managing for the Long-Term” dated June 16, 2010, Ric Dillon wrote about how the evolution of our organizational structure enables us to better manage our investment portfolios and business for the long-term. As mentioned in that letter, Diamond Hill began as a portfolio manager- focused investment team. Our portfolio managers continue to be the ultimate decision-makers in their respective strategies; however, we have also developed a strong team of analysts who provide valuable support to the portfolio managers. Additionally, our clients now have the opportunity to further benefit from the expertise of our analyst team through the Diamond Hill Research Opportunities Fund, a strategy which is team-managed by the Diamond Hill research analysts. This Fund shares the same intrinsic value1 investment philosophy and process as our other strategies, but it is distinguished in two ways: First, it is entirely managed by the research analysts – those closest to the information; and second, it has broader investment parameters than our other strategies. With the addition of this new strategy, we thought it would be beneficial to provide some information not only about the strategy, but also about the importance of our research team to our investment process and the future of our firm.
Our intrinsic value investment philosophy is at the core of everything that we do at Diamond Hill, and this philosophy is shared by every member of our investment team. This philosophy is based on the belief that a company’s intrinsic value is independent of its stock price. The guiding principles of the philosophy are the following:
- We treat every investment as a partial ownership interest in that company
- We always invest with a margin of safety2 which we believe can maximize the protection of capital and the return on capital
- We possess a long-term investment temperament
- We recognize that market price and intrinsic value tend to converge over a reasonable period of time
This shared philosophy, which has remained the same since Diamond Hill’s founding, has allowed us to build a cohesive research effort which is process focused rather than outcome focused. Though outcomes matter in the long run, we can only control the process. It is only by constantly improving the quality of research and decision-making that we believe we will be able to influence our outcomes and deliver outstanding investment results to our clients over the long-term.
There are three key elements of our research effort that we believe lead to both success and sustainability:
- Structure of the research team and the analyst role
- Hiring the right people
- Alignment of interests and retention
Research Team Structure:
Pursuing an investment philosophy such as ours requires a deep understanding of the current and likely future economic drivers of businesses and industries, and the research analyst role at Diamond Hill was designed to best promote this in two important ways: First, our research analysts are industry specialists, focusing on no more than a handful of related industries. Second, we intend for the research analyst position to be a career role rather than a stepping stone to that of a generalist portfolio manager, as is often the case in our industry. By focusing on only a few industries and doing so for long periods of time, we believe our research analysts can best develop the deep circles of competence necessary to identify outstanding investment opportunities consistent with our investment philosophy. For individual investment professionals to embrace this narrow focus for such a long period of time, we believe it is necessary for the research analyst to have the potential to be as highly valued and compensated as a portfolio manager. This is our clear intention as the tenure and contribution of our analysts increases.
Maximizing the potential for success also requires establishing appropriate coverage areas, both in terms of size and content. This is done through careful evaluation of the research needs as well as through the interests and background of the individuals on the research team. Research analysts generally have a universe of 60 to 100 companies, actively following and maintaining detailed models on 15 to 25 companies.
At Diamond Hill, we emphasize independent decision-making and accountability; however, in coming to these independent decisions, we still seek to leverage the knowledge and experience of our peers. To further information sharing, our 18 research team members (14 analysts and four associates) are organized into five sector teams. Each sector team meets on a regular basis to share relevant information and experiences and to explore ideas. Each team is led by a research analyst (Sector Leader) and also includes one portfolio manager member who lends extensive sector knowledge as well as mentorship to the team and its members. In addition to leveraging the years of cumulative experience of the portfolio manager, this also keeps the portfolio managers close to the idea generation and research process.
Hiring the Right People:
Without the right people, a great structure is worthless. Thus, we are very deliberate in our hiring process and always focused on the long-term. Our process includes multiple rounds of interviews with various members of the investment team. We believe the lengthy interview process not only helps us to make better hiring decisions, but it also helps candidates to become more familiar with Diamond Hill. This familiarity aids candidates in determining whether Diamond Hill is a place where they can thrive; the employment decision is, after all, a two-way street.
In terms of what we look for in candidates, intelligence and commitment are crucial requirements, but we also focus very intently on cultural fit. We realize that parts of our culture are fluid and will naturally evolve as new personalities contribute to our makeup; however, certain core elements of our culture must remain constant. These include our shared investment philosophy, flexibility of thought, intellectual curiosity, diversity of perspectives and humility. Alignment of these core elements creates an environment of trust, which leads to open and efficient communication and, in turn, good investment decision-making. Thus, we pay a great deal of attention to cultural fit during the interview process.
One source of research analyst candidates is our pool of research associates. Research associates are essentially “research analysts in training”. They typically have less experience and are still working to complete the Chartered Financial Analyst (CFA) exams. The work performed by associates varies by team, but generally consists of supporting research analysts and building an understanding of specific areas of coverage. Once research associates pass all three CFA exams, they are eligible to be considered for promotion to analyst; however, to be promoted they must also meet the criteria to which we hold all external candidates. Promotion must be earned.
Finally, the decision to add incremental resources (people) is made at the sector team level to ensure that whomever we hire fills a real need and that there will be meaningful and challenging work for this person. We also realize that it takes time to digest new resources, and we want to be sure that a given sector team is ready to incorporate and develop a new member.
Alignment of Interests and Retention:
Properly designing the analyst role and hiring the right people have been crucial in building a research team that can add the most value for our clients. Equally as important are aligning our interests with those of our clients and retaining our investment professionals. Proper incentives are the primary answer to each of these challenges, but there is also another element of retention which was touched on previously – our shared investment philosophy and values, which are crucial components of our deeply ingrained culture. We have found these to be key drivers of career satisfaction and retention.
Our incentive system is designed to offer a competitive level of compensation to our investment professionals while also aligning interests with those of our clients. We accomplish this by tying significant portions of incentive compensation to investment results. Across all of our strategies, including the Diamond Hill Research Opportunities Fund, investment results are measured over five- year rolling periods to remove any short-term incentives that might be inconsistent with the interests of our clients. We believe that five years is the shortest period over which investment results are statistically significant and also the longest period over which clients are likely to be patient. Another way in which we align interests is by requiring portfolio managers and analysts to have personally meaningful investments in the strategies they manage. Finally, we seek to eliminate potential conflicts of interest by requiring that portfolio manager and analyst exposure to domestic equities and corporate bonds is essentially confined to Diamond Hill strategies.
Diamond Hill Research Opportunities Strategy
The Diamond Hill Research Opportunities strategy was originally funded as a limited partnership in March 2009. Effective January 3, 2012, the assets of the limited partnership were converted into the Diamond Hill Research Opportunities Fund, a team managed strategy in which each research analyst is allocated a portion of capital (sleeve) to be invested in his or her area of expertise. The Research Opportunities Fund is managed in all material respects in a manner equivalent to the management of the predecessor unregistered fund.
Offering this strategy publicly was always a possibility; however, the primary drivers at inception were internal benefits:
- Communication ‒ The partnership provided a vehicle for research analysts to demonstrate conviction in their best ideas through the investment of capital and communicate their level of conviction in portfolio recommendations to the portfolio managers.
- Performance Measurement ‒ As discussed above, proper incentives are key to aligning our interests with those of our clients as well as attracting and retaining talent.
- Development ‒ In addition to making a recommendation, a research analyst must also think like a portfolio manager, considering position size, gross/net exposures, cash levels, market cap exposure, security types, etc. Thinking within a portfolio context is likely to improve the effectiveness of research analysts.
- Attracting and Retaining Analysts ‒ A career analyst role can be a non-starter for some candidates. Having an opportunity to make investment decisions is appealing to future candidates and could help to retain current research analysts.
The decision to make the strategy widely available was driven by the belief that we can add value relative to a passive benchmark over time by allowing our research analysts to apply their deep industry-specific expertise within a very flexible mandate. Given our flexibility to hold high levels of cash and to short securities, it is likely that lower volatility may also be realized. The Research Opportunities Fund is purposely structured as an all-cap, long-short product in order to maintain our research focus on supporting all of our strategies.
The most unique element of the Research Opportunities Fund is the lack of a gatekeeper or capital allocator. Instead, each research analyst acts as a portfolio manager of a sleeve, investing in companies that fall within his or her area of expertise and exercising the ultimate decision-making authority for security selection in that sleeve.
In addition to being an all-cap strategy, the broad investment parameters also allow for investment in fixed income and international securities as well as the short sale of securities we believe are overvalued. Furthermore, the strategy as a whole has a wide net exposure range of 0% to 100% with an expected typical range of 25% to 90%. The purpose of this broad flexibility is to allow the research analysts to use their deep industry knowledge and expertise to create the maximum value for our clients.
In terms of capital allocation, we target approximately equal weights for our five sector teams (20% each) over long periods of time. Sector team weights can deviate up to five percentage points on either side of the 20% target before cash flows are used to begin moving the weights back toward the target.
Consistent with our philosophy of aligning managers’ interests with those of our investors, our research analysts each have meaningful personal investments in the strategy.
The research team has played an increasingly important role in the Diamond Hill research process and will continue to do so in the future. The Diamond Hill Research Opportunities Fund is a natural extension of our research efforts that not only carries benefits for our existing clients but will also provide benefits to potential investors seeking to invest in a strategy with broader parameters. We appreciate the confidence and trust our clients have conferred upon us. We have always tried to communicate with our clients in an open and transparent manner, and we will continue to do so in the future.
Originally published April 16, 2012
An investor should consider the Fund’s investment objectives, risks, and charges and expenses carefully before investing or sending any money. This and other important information about the Fund(s) can be found in the Fund’s(s) prospectus or summary prospectus which can be obtained at www.diamond-hill.com or by calling 888-226-5595. Please read the prospectus or summary prospectus carefully before investing.
The Diamond Hill Funds are distributed by Foreside Financial Services, LLC (Member FINRA).
Like all mutual funds, Diamond Hill Funds are not FDIC insured, may lose value, and have no bank guarantee.
The views expressed are those of the portfolio manager as of April 16, 2012, are subject to change, and may differ from the views of other portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice.
The Fund uses short selling which incurs significant additional risk. Theoretically, stocks sold short have the risk of unlimited losses. There are special risks associated with small capitalization issues such as market illiquidity and greater market volatility than large capitalization issues.