Kristen Sheffield, CFA, Portfolio Specialist (0:13)
Hello everyone. I'm Kristen Sheffield, equity portfolio specialist at Diamond Hill, and today I'm joined by co-portfolio managers of our Select strategy, Austin Hawley and Rick Snowdon. Welcome back to the webcast and thanks for joining me today.
It's been another interesting year thus far for investors and despite losing a little bit of steam recently, I think the most notable theme in 2023 has been the dominance of what has been dubbed the Magnificent Seven, which at the midpoint of this year, these seven stocks accounted for 28% of S&P 500 and had returned just north of 60% as a group. And this list certainly includes some undeniably fantastic businesses. You're talking Microsoft, Amazon, things of that nature. But one might argue that there comes a point where valuations begin to reflect that fact, and sooner or later, the historic tightening cycle we've seen from the Fed should factor into the math here as well. I know we own some of these businesses in Select, and I thought a good place to start would be to check in on how our exposure has evolved throughout this year and any thoughts on where things stand with this cohort more broadly?
Rick Snowdon, CFA, Portfolio Manager (1:35)
Yeah, sure, I'll talk about that, Kristen. So yeah, those are names you list are some great businesses. Not surprisingly, they carry some very demanding valuations though, and even more so after running up 60% or so in the first half of the year.
Starting the year, we owned Amazon, Microsoft and Alphabet, all of which we purchased in 2022 during the selloff of large tech. Microsoft and Alphabet, we were pretty familiar with from having owned them in the past. At those reduced valuations at the time and with what we felt was a pretty good understanding of the businesses, we found them, those three names, very attractive. As I recall, we were a bit early, maybe pretty early as they all declined further into the end of 2022. And fortunately, that gave us an opportunity to add to them along the way.
Entering 2023, to get to your question, these were a pretty good chunk of the portfolio. These three names were 13% to 14% of the portfolio, I believe at the beginning of the year. And this year, as we all know, the performance has been much better than last year. Amazon's total return as of this morning (as of 15 Aug 2023) when I looked it up, has been 62%. Alphabet’s has been 46%. The companies’ fundamental results have been very impressive, but with stock prices appreciating even more rapidly, discounts to intrinsic value and therefore relative attractiveness have both declined as well. That led us to exit Microsoft again back in June, and we've trimmed Alphabet and Amazon pretty significantly. So collectively the two we still own Alphabet and Amazon — those now represent closer to 5% of the portfolio today.
Kristen Sheffield (3:19)
Thanks, Rick. Another group that has certainly received a bit of attention this year has been regional banks and perhaps in a little bit of contrast to mega-cap tech. This is an area that has clearly been impacted by the Fed hiking rates over 500 basis points in relatively short order.
Earlier this year, we saw two of the largest bank failures in US history, but since the mini-crisis in March and April, things seem to have stabilized for the most part. Austin, any thoughts on where things stand today and current exposure to banks within Select? And then maybe a little bit as a follow-up to that, additional comments on financials and positioning within the sector?
Austin Hawley, CFA, Portfolio Manager (4:05)
Sure, I'll try to hit on all those points. So first, specifically in regards to the regional banks. The environment for regional banks since March, since we had this kind of mini-banking crisis has been about as we expected it. And when I say that there's a couple key fundamental issues that have emerged that we got concerned about during March and it have kind of again evolved about as we expected. And the first of those is that we've had pressure on funding costs. So, deposit costs have moved up pretty significantly as banks are competing much more intensely to acquire high-quality deposits. The second issue that's raised its head that we were concerned about is we've had further indications that regulatory capital requirements are likely moving higher over the next several years. And, in particular, this will impact the regional banks more so than the largest SIFI (systemically important financial institution) banks.
And both of these issues have become more apparent as we've moved through earnings season over the last month or so. We've seen pressure on net interest margins across the banking industry, and it's been especially prominent amongst the regional banks. And then we've heard of a lot of banks expressing more caution than we've seen in the recent past about returns of capital to shareholders. And that's largely because they're worried about potentially higher capital requirements as we move forward over the next several years.
So, what we've done in the portfolio, and this really started back in March as we were kind of in the heat of the moment we had these bank failures, is we've repositioned our exposure a little bit, especially with regards to the banks that we hold. And our banking exposure today is a little bit more skewed towards large cap banks, those big SIFI banks, with a new position in Bank of America that we entered in the second quarter, that's our largest exposure to banks today.
And we have shifted away from some of the regional banks where we had more exposure recently. And that's continued into the third quarter as we've now fully exited our position in Truist, one of the larger regional banks. And so today we have two banks. We own Bank of America, which is our largest position, and then Webster, which is a larger kind of mid-size regional bank with a pretty unique funding profile because of its exposure to the HSA market. Collectively that's about 6% of the portfolio. So, a pretty modest exposure to banks today despite having 28% to 29% of the portfolio in total exposed to financials. And so let me address that second part of your question — the financials more broadly. If you look at our financials exposures, we have very large exposures today to insurance as well as housing, and then also a significant exposure to alternative asset managers.
And that comes from our positions in AIG and Allstate in the case of insurance, Mr. Cooper in the case of housing, and then KKR in the case of alternative asset management, that is the significant majority of our exposure in financials. And then we have that 6% exposure to banks. And so, it's very interesting to put it all in context where we have a large exposure to financials, the largest sector exposure in the portfolio, but our exposure to banks, the industry that I think most people would identify with financials is pretty modest. And so, we found the most attractive areas within financials outside of banks recently, but we do still find that sector broadly very attractive.
Kristen Sheffield (8:17)
It's really helpful to get your thoughts there, Austin. I want to switch gears a little bit and talk about something it seems like we've observed over the past couple of years, which is a sort of whipsaw across a variety of industries, seemingly due to some combination of lockdowns and reopening, a lot of the supply chain issues and mismatches in timing between supply and demand. And it seems like in some cases it's taken a bit longer for these frictions and whipsaws to show up than others, and most recently we've seen an uptick in mentions on earnings calls from a number of materials and industrials businesses, mentioning destocking weighing on near-term fundamental results. Is this something you observed within the Select portfolio and how do you assess if this is more of a cyclical issue that may create opportunity or something more worrisome?
Rick Snowdon (9:18)
Yeah, I'll take that one, Kristen. So yeah, it's definitely something that we've seen in the Select portfolio. It's going on all across the economy. It makes me think about this simulation that I saw when I was in business school called the MIT beer game, and at the time it was a staple in business school logistics classes, and I certainly hope it still is. Basically they split the class into teams with each player on a team representing one node in the supply chain for beer, and then supply and demand shocks are introduced by the professor like a heatwave or a fire at a brewery or whatever, bad crop for the hops and whatever grains go into beer, and they create this wild mismatches in orders and fulfillment, way more than you would've expected or I would've expected. You get double and triple ordering and then still nothing shows up and then the inventory doesn't actually start showing up and then all of a sudden it finally does show up right when you don't need it.
And then there's been way too much capacity added and all these ripple effects happen backwards and wreak havoc in that direction too. So, I think this is basically what we've seen with COVID. We had this hard shutdown, as you alluded to, and then we restarted and fits hard and then you had further setbacks and it's wreaked all kinds of havoc. It is surprising that it's still going on, but it really is, I think back on that class and that situation, it really shouldn't be surprising.
Names in the portfolio that come to mind with regard to destocking are Ashland, Wesco, Target, Texas Instruments, and I'm sure there are others. And the problem with situations like this is it makes you question what normalized revenue and profits actually are. You need to figure out if previous levels were misleadingly high because the industry was producing too much while inventories were running up, or are current revenues and margins truly low due to a wave of destocking, or is there some kind of structural problem, other structural problem that's going on — are there end demand challenges, softness, people switching out of the products, the products that your company might provide or possibly just share loss. Maybe the company's just doing poorly relevant to competitors. So that's a challenge, but determining normalized revenue and profitability has always been the first step in estimating intrinsic value for any company at any time.
It's an imprecise analysis and shocks make it harder, but it's what we do. Wading through the destocking noise forces us to take a hard look at signals about end demand. We look at what competitors are experiencing, and we have to look for signs like I mentioned before of any change in competitiveness. Our eyes are peeled, but as of now we don't see anything for our holdings that would suggest that this phenomenon is anything but transitory supply chain waves that were initially kicked off by Covid. And in fact, in some situations this can create an opportunity.
Ashland, for example, has sold off pretty significantly as they've experienced the second round of destocking. So, this is two times that they've seen customers back off on orders to get their inventory right-sized, and Ashland has backed off on their production. So that cuts down on overhead absorption and margins get hit and it leads to all this sort of noise, but we believe management has responded accordingly. We don't think it's an end-demand problem, we don't think it's a loss of competitiveness and management is actually steadily buying back shares on the weakness, and we in turn have added to the position as well. So, in that case, it's an opportunity after you've done the hard work to understand the situation.
Kristen Sheffield (13:16)
I like your analogy. I also hope they still play that game in business school. It sounds like is something that you talked about is that these whipsaws and ebbs and flows, they can also create opportunity in one of the companies. You mentioned Target as something that you all initiated in Select back in June and certainly a business that was a big beneficiary, particularly early on in the pandemic, ended up with elevated inventory to work through among other recent headlines. Austin, can you talk about the dynamics that created an attractive entry point for Target and what we like about that business?
Austin Hawley (14:00)
Sure. So, when we bought Target in June, it was after nearly a year I think of talking about that company internally with our analyst and discussing the opportunity or a potential opportunity in Target. And at the time, if you go back a couple quarters, a few quarters, we really liked the company and we liked its long-term prospects because Target's one of really a handful of retailers that is invested heavily behind a true omnichannel offering for the customer. And it's also a company that has a very strong management team with a history of innovation in the retail space. And we thought they had very strong growth prospects over the next several years in an industry that's relatively mature. However, there was one issue that we just couldn't overcome and it's the issue that Rick just talked about, which is you had a company in Target that had benefited in a huge way during the pandemic and they had a massive growth in sales well above what the historical trend had been.
And we were trying to get comfortable with what sustainable long-term earnings power was, and we thought there were so many moving pieces given that rapid jump during the pandemic that we just couldn't quite get comfortable with the valuation based on the current earnings power.
And so, what we chose to do is to wait and watch earnings come in over a couple quarters, continue to have discussions with our analysts about what we were seeing, and wait for a better opportunity. And we got that opportunity earlier this summer when a couple of trends kind of intersected. The first trend is a normalization of that rapid growth that we saw during the pandemic. We saw sales start to trend lower at Target, and we saw the management team take very decisive actions to try to reduce their inventories and that meant some short-term pain in terms of margins because they needed to discount to get a bunch of inventories out of the system to get to a sustainable level to start to grow off of again.
And that was somewhat expected. We didn't know exactly when that would occur, but we thought it was likely. And so that was a welcome change, from our point of view. We were starting to get towards a more normalized level. The second thing that happened is that we had a short-term disruption in sales when Target got kind of enmeshed in controversy around their merchandising around Pride month and you had some boycotts that took place and a real disruption in sales in the short term.
And so, when you had these two things happen and intersect and earlier this summer we had seen the stock price sell off very dramatically from kind of in the $160s range to down to the $130s range in a very short period of time. And for us, that was the opportunity we were kind of looking for. We're starting to get closer to normalized earnings and we had what we viewed as a likely a temporary issue in terms of the short-term hit to sales that would normalize over time. And so that was the opportunity. We continue to have a very similar view to what we've talked about for the last couple of years in terms of long-term normalized earnings power and our favorable outlook for the company. It just took waiting for that opportunity to present itself to get a valuation that we thought made sense.
Kristen Sheffield (17:56)
Another area that we've seen fits and starts but mostly fully reopened these days has been travel. Along with that, perhaps some of our onsite visits that we like to conduct from time to time at various companies, I think that's kind of returned to full steam ahead in 2023. And Rick, I know you recently just went and visited a new facility that SunOpta just opened down in Texas. Can you talk about what sort of information we're looking to glean when we do a site visit like that and any insights in this case in particular?
Rick Snowdon (18:34)
Yeah, sure. So, you're right, things seem generally back to normal in that regard. We're starting to see management teams come through our offices again. The investment team seems to be doing a lot more travel to conferences and onsite visits. And I did attend, you're right, an investor day at a new SunOpta facility in Midlothian, Texas, near Dallas back in the late spring.
Onsite visits aren't a critical part of our process, but I do think that they help on the margin. Personally, when I attend something like that or talk to management, I'm looking to accomplish a few things. First, I'm looking to just add context to my understanding of the company, for instance, as simple as it sounds, just increasing my vocabulary around the nuts and bolts of the business and the industry. And that's the sort of thing that makes future earnings calls and developments easier to understand, to contextualize and to analyze.
Second is looking for signals from people outside. This would be more like on an onsite visit, like at SunOpta to look for signals from people outside of the top management ranks that confirm or challenge my understanding of the business and the key initiatives, recent developments, challenges, opportunities. Are they using the same language? Do they seem to be focused in the same directions as what management says? And frankly, even do they seem to say exactly the same thing as management, which makes you think maybe they're all sharing the same script a little bit too tightly. And frankly, I guess in the end, one of the best parts of a trip like that is it just removes the inherent distractions of being in the office, being glued to your computer and lets you focus very intently on one of your holdings for a whole day or so.
Kristen Sheffield (20:24)
Great. Thanks, Rick. I guess before we wrap up, any final thoughts or comments you guys would like to share about the market, current opportunity set or anything you're keeping your eye on or excited about?
Austin Hawley (20:39)
I'll take a shot at that one, Kristen. And I guess I'd leave people with a message that I hope is becoming very familiar to anyone who's listened to these podcasts or webcasts with Rick and I over the last couple years. And that is that we believe very strongly that there are real advantages to managing a portfolio like Select, a portfolio that's concentrated but has broad flexibility in terms of where we can invest.
Our industry creates lots of artificial boundaries around where people can invest, whether it be by market cap range or style box, but it creates a real impediment to managers fully capitalizing when market dislocations present themselves. And Rick and I have been very active in terms of trying to reallocate the portfolio and capitalize fully when we see opportunities, when we see meaningful changes in the relative valuations across the market.
And I think that combination of having a broad opportunity set and managers that are acting decisively to try to reposition the portfolio towards the most attractive opportunities can really pay off over time. I'd want to be clear, we always get the timing wrong. We've never called the bottom right, but over the long term, acting decisively to try to reposition has, I think, clearly benefited our clients in a pretty meaningful way. And my hope is that will continue in the future.
Kristen Sheffield (22:23)
Great. I think that's a great place to leave it. Rick and Austin, thank you for joining me again today, and I've enjoyed our conversation and look forward to the next one of these in six months or so.