RIA Channel Host (00:03):
Hi everyone. Thank you for joining us for today's webcast capital Sleep Small cap market structure sponsored by Diamond Hill. Today's webcast will provide one CFP, one IWI and one CFA CE credit. If you have questions on credit, please give us a call via the number on the console. We welcome and encourage your questions. You can type your questions in the q and a box and we'll do our best to get to as many of your questions as possible Materials have been made available for download from the documents window to the right of your screen. We appreciate your feedback. Please take a moment to take our brief survey that's located at the bottom of the console. We will cover quite a bit of information during today's webcast. If at any point in time you're interested in scheduling a one-on-one meeting with Diamond Hill, please click the confirm button in the media request box on your screen. Lastly, in the event missed any part of today's webcast or simply would like to watch it again, our replay will be made available and all registers receive that information in my email. With that, I'm please introduce our speaker today from Diamond Hill. Aaron Monroe, CFA portfolio manager and Kristen Sheffield is C-F-A-C-I-P-M, portfolio specialist. I will now turn the webcast over to Kristen. Welcome Kristen. The floor is yours.
Kristen Sheffield, CFA, CIPM (01:10):
Great, thank you. Good afternoon everyone, and thank you for joining us on this first Friday of October. Today we're going to be focused on the small cap market structure and some of the opportunities that are being created by a little bit of neglect within this area of the marketplace. And we've got quite a bit to unpack today, but we wanted to kick things off, getting a little bit of feedback from the audience. So we're going to start off with a couple of quick poll questions here.
RIA Channel Host (01:46):
Yeah, great. Alright, so we have two poll questions and then we hope that you will participate. We appreciate your feedback. So the first question is, do you currently have a dedicated allocation to US public small caps in your client portfolios and the options are a no. I do not currently allocate to US public small caps. B, yes below 10% or C? Yes, more than 10%. So you can make your selection by clicking directly on the screen and pressing submit while we wait for the results. Again, another reminder that we are going to be taking questions from the audience at the end of the presentation, so feel free to put your question in the Q and a box and we'll get to as many of your questions as possible. Okay. The question again is do you currently have a dedicated allocation to US public small caps in your client portfolios?
No, I do not currently allocate to US public small caps. Yes. Below 10% or yes below or more than 10%. Okay. It looks like we've got a good turnout. Let's see what the audience has to say. Okay, so it looks like the top answer is yes below 10%. Okay, let's go ahead and move on to our next question. So if you do not currently allocate to us public small caps, what is the primary reason why A relative underperformance to large cap B? I utilize private equity for exposure to small companies. C, volatility and risk profile or D and a I already allocate to you as public small caps. All right. Make your selection by clicking directly on the screen. And then just a reminder that today's other research by Diamond Hill is going to be available for download and you can find that by clicking on the documents window to the right of your screen. Okay. The question again is if you do not currently allocate to US public small caps, what is the primary reason why relative underperformance to large cap? I utilize private equity for exposure to small companies volatility and risk profile or na, I already allocate to US public small caps. Okay, so let's go ahead and see what the results are. Okay, so it looks like the top answer is na, I already allocate to US public small caps. Alright, with that I will turn it back to you Kristen.
Kristen Sheffield, CFA, CIPM (03:59):
Perfect. Thank you very much. We appreciate your participation in our questions there and I think it's an interesting kind of backdrop to start our conversation. I don't think it's any kind of secret, Erin, that small caps have underperformed large caps for quite a bit of period of time and I want to have you kick us off with maybe opining on why that might be.
Aaron Monroe, CFA (04:29):
Sure, thanks. Thank you all for attending. I found that those polls a little bit interesting. Appreciate that over three quarters of you utilize US public small caps and I think this is kind of an important slide here as you looked at the second poll question and really the largest a response for why not to is because of the underperformance S at the large gaps. And I can appreciate that. I think when you break down this space in its entirety, it is no secret that there isn't a Microsoft and NVIDIA tucked into the small cap small company space. These businesses tend to be a little bit more cyclical. There's a fair amount of more leverage and many of them, some have fairly binary outcomes overall. Their capabilities and capacity to invest in the technology or the innovation that's necessary for these businesses to really perform at peak levels is not at the same level as their larger cat brethren. But at the end of the day, I also think there's some other kind of forces at work that have perpetuated this challenging environment for small companies in general. So what might those be? I think if you flashback to the last small cap renaissance back in the early two thousands, passive investing just wasn't as prolific as it is now. This chart really highlights it. Back in 2000, 2002, 2004, 20 ish percent of small cap investors were using passive investments. It's over half now. I've seen numbers between 45 and as high as 65 70. I don't think the force that puts within the small company space kind of the reinforcing nature that has, I think I can't go without notice and keeps the valuation dispersion in place, keeps the asset class just generally challenged to perform on a broad basis.
Also, if you contemplate the overall industry of asset managers, we've gone through this period of asset manager consolidation back 20 years ago, just over a third of assets, were within the top five money managers now we're over half, almost 85% of assets are with the top 25 asset managers. So if you contemplate the industry structure that we operate in now as asset managers, what's our capability to make small companies large positions within our portfolios? It's diminished significantly over the last 20 years. So you have those two major forces in play. And then within our industry, the individuals that I would highlight as maybe being tasked with finding interesting investment opportunities outside of the buy side and maybe works complimentary to us is sell side research.
But this is a for-profit endeavor. So these individuals have left the space, left the capitalization, as you can see, the amount of sell side coverage on a small company on the Russell 2000, Russell Microcap is significantly lower than the s and p 500. Just the other day I saw someone launch on Apple, surprisingly, which was the 69th analyst to the following Apple. I'm not sure where their disposition, I appreciate the position of confidence that you can add something to the narrative, but at 69 individuals covering a very large company, I question kind of what do you believe your value add is to the discussion. Whereas in small and micro, there really has a large significance of companies that just go unfollowed or just have a couple individuals a kind of highlighting their investment qualities. So really all of this is a big area that all these different forces has created a very large space of capital that no one's really following. And that's really where the capital of sleep comes from. It's 2000 businesses that is under followed, under invested in, passively invested in. And the challenge being on some level is these are usually the levers that are utilized to converge price to intrinsic value over time or to bid up a company, not necessarily the movement of cash flows through the passive indices. So we have to really kind of contemplate because there are good investment opportunities in the space, but we have to kind of contemplate how do we attack the area, if you will.
Kristen Sheffield, CFA, CIPM (11:01):
Yeah, it sounds like I'm talking about some of the historical levers of price discovery maybe being either muted or even broken.
Aaron Monroe, CFA (11:10):
Yes, yes, exactly.
Kristen Sheffield, CFA, CIPM (11:12):
I think can appreciate some of the secular trends that you're talking about. I think some of these we would most people be aware of it maybe under appreciate the impact on the small cap market. I think another trend that has been happening is just the incidence of private capital and perhaps fewer public companies available. So how does that kind of work into this discussion and the overall landscape as you see it?
Aaron Monroe, CFA (11:45):
Yeah, so it's a question we get a lot about companies are staying private longer. Yes, this is true. Many of these tend to be though on the more innovative side of the business that are staying private longer, which for us, I look at it from their more of a binary outcome potential. It isn't the type of business that I would tend to analyze and find to be a fairly conservative or prudent investment for our intrinsic value-based focused investors. So I'm comfortable with that portion of the businesses being private. You have also levering up a fair amount of businesses, but at the end of the day, small cap is a beautiful place for active management, for selecting individualized companies that can then add value or grow their value, create value for our partners. So while the number of opportunities has gone down, there are still new opportunities coming to the market and we're really looking for a handful, 50 to 60 companies to construct a portfolio, which I find to be still very applicable or palatable within the overall universe. There's a little bit of a misnomer I guess about companies coming public.
So this slide right here highlights that we have had a fair amount of incidents of companies coming public. They've just come in maybe a little bit of a different fashion. If you want to look at the SPAC attack, if we will. I did the math on here where the three years called 19 95, 96 and 97, the three peak years prior to the.com bubble generated roughly 2000, 2009 to be exact based on this public companies or IPOs over that period of time. But they all went through the traditional path 2019, 2020 and 2021 when companies were being coming public. But more in the spac, the hopes and dreams coming public, the easy path if you will. And there's still some very good companies that have been public that whole period of time brought forth 2011 companies. So almost identical, which I think is fascinating as we think about and contemplate companies being private longer, are there enough? Yes, I do believe that there are enough opportunities. I do believe companies have been coming public and we're picking up in the news at this point, a fair amount of the discussion about continuation vehicles or the need for private equity to get access to retail clients because they need places to put their businesses that they don't really want to own within their actual LPs. PS it would not shock me to see we have this avenue of a traditional IPO market. It would not surprise me to see some of these companies coming public as the amount of capital in the private equity space. Those businesses are looking for a home and there's no real bidders out there anymore.
Kristen Sheffield, CFA, CIPM (15:54):
I think that's a good transition because that's a good reason potentially for a company to come public. I think this is a lot of airtime or narrative around why companies might stay private, but there's plenty of reasons why they would come public. So maybe can you talk about some of the reasons for companies to come public?
Aaron Monroe, CFA (16:17):
For sure. So these are four companies specifically that we actually own within our small cap strategy, but each one of them has come public in recent history and all for different reasons. So why might a company come public for large conglomerates? I think sometimes they have an asset that they feel the public markets aren't appropriately valuing or giving them credit for. I actually think about this as I highlight that this company, specifically the Titan America, it reminds me a little bit of a John Malone move with Liberty, where they would create almost a tracker stock to help illuminate the value of an underlying business. So Titan America is a large multinational cement and building materials company, but they had a US division cement business that really had some very unique qualities, characteristics had performed very well and they didn't feel like it was getting the credited deserved within the public markets.
So they recently issued an IPO this year we actually participated in the PO of the market. It's a long run business with good stewardship, a great balance sheet, and really unique assets. So we were very happy to own a stake in that company. They only brought public about 15 to 20% of the business, but their disposition was that by being public with this segment of the business, it would better reflect the overall value of the conglomerate. Another reason why companies have been coming public is there might be a business looking for an exit event, a family looking for an exit event. When you look at Utz, the salty snack manufacturer based out Pennsylvania, they're like a hundred year old business. This is a long run business that's done very well. They're the number two or three player in most of their categories and was really looking for how do we move this business to the next stage, next stage of their development. Now this company came via spac.
We did not own it during that period of time. We felt that while it was an interesting company, the valuation wasn't there. They had taken on a lot of debt and like most specs, you were able to highlight maybe or illustrate potential fundamentals or growth plans that maybe wouldn't necessarily be as promoted during a traditional IPO process. But this was a business that we've kept our eye on. They've brought in a manager from Post Holdings, which is actually a company that we all have owned for quite some time within multiple portfolios here at Diamond Hill and think very highly of them as operators. So we just kind of bided our time and waited for the market to give us the opportunity to own a long run business that we felt like had really good characteristics and good opportunities was very durable and actually bought a stake in it in April as it sold off with a bunch of the market. Now there also can be more strategic reasons for a business to want to have public shares. So in the case of Proficient Auto Logistics, they're in the process of consolidating or building out a nationwide auto logistics platform.
And in order to effectuate that consolidation, they needed public shares to give stakes into all the small regional auto logistics companies that they were acquiring for them to participate and be owners within the overall business. So Proficient, which was kind of a brainchild of Rick Ell who did something very similar with the company SA in a less than Truckload Freight disposition is going through a very similar playbook with proficient and utilize the public markets to at first consolidate five various regional auto logistics companies and has since acquired a handful more to build out what right now is about the number two auto logistics company and is looking to build that kind of shared services operating leverage through shared services, build out the backhaul, delivering customer service and really become the dominant player within auto logistics and the public shares enables them to kind of continue to go about acquiring other small regional players but also enable them to participate in the long term of the company.
And then most of us are probably familiar with REITs and how for most real estate companies, it's kind of imperative for them to have a public listing. Strawberry Fields is a REIT that focuses on skilled nursing facilities, but was one that was fairly small regionally located and their path forward was to go out and acquire other regional companies, regional real estate properties and would need access to the equity portion of their cost of capital through the public markets. Most REITs have what they call an ATM or an at the market filing in the public markets where at any point in time in which they find a transaction interesting, they're able to automatically issue shares into the public market to create value for the overall business. So strawberry fields, it's no different in that, but again, highlighting a very true real business reason for them to be a public company.
Kristen Sheffield, CFA, CIPM (23:30):
Yeah, I think it's helpful you think about exit events, but maybe not necessarily some of the also strategic reasons that you could be a public company. And then just to the question we get so often about, is there opportunity to see a number of businesses that have become public in the last two or three years actually in the portfolio I think is very illuminating. I think it's a good time to pause again for another kind of question from the audience.
RIA Channel Host (24:04):
Yeah, absolutely. So our next poll question is, is it finally time for small caps to outperform large caps and the options are yes or no? Alright, again, you just click make your selection by clicking directly on the screen and pressing submit. And as a reminder, if you missed any part of today's webcast or something would like to watch it again, a replay will be made available and I'll register, receive that information by email. Alright, the question again is, is it finally time for small caps to outperform large caps and the options are yes or no? I'll give it just a couple more seconds and then we will share the results. So go ahead and make your selection by clicking on the screen and pressing submit. Okay, looks like we've got a good turnout, so let's see what the audience has to say. Okay, so it looks like the top answer is yes. Alright, back to you Kristen.
Kristen Sheffield, CFA, CIPM (24:54):
Alright, we like to see that, I mean I know many of you are utilizing public small caps, so good to see the confidence there. I think maybe Aaron, what do you think here? Is it time?
Aaron Monroe, CFA (25:11):
It seems like it is possible if you contemplate the situation, right, if you have a more accommodative federal reserve, which seems to be the narrative these days now that don't ignore some of the inflationary concepts there, but at present the drumbeat is for a more accommodative fed. I think that sets up relatively well for, as I've discussed before, some of the general makeup of, and I'm talking more in a generalization of the index itself because of its structure, the more binary kind of innovative businesses is about one third ish. So one side of the index, they would be appreciate having some cheaper capital elongating the duration of the investment there, which may support allow them to get a bid. And then the more levered side of the index I think as well would also as they need more accommodative to get more commercial work going, more infrastructure investment, more supportive of their debt and refinancing, just generating more cash flows and not necessarily to support their, just to support their debt. But I think at the end of the day, part of this is yes, I think we're due, will it come now? I don't know, but I think that there is actually a more durable path to small company investing than just potentially what this trade may exist, but the trade is very real. Do not get me wrong.
Kristen Sheffield, CFA, CIPM (27:07):
Yeah, I think we've spent a little time talking about some of the structural dynamics happening and contributing to the opportunity that you're talking about. And you highlighted this a little bit, but I'd like to spend some time talking about how can active investors take advantage of this opportunity in a kind of repeatable, durable way. And one of the things that we get asked is just how do you attack, you say nearly 2000 companies and you got into this a little bit, but how do you think about the universe and break that up when you're thinking about where to look for opportunities?
Aaron Monroe, CFA (27:50):
Yeah, I mean I just highlighted we have a pond of, I think it's 1,960 companies is what makes up the Russell 2000. There is a large portion of this that is distressed. These are cheap stocks. I tend to view them a little bit more of path dependent type of businesses. As an investor, I find it challenging to put capital into a company that I need to embrace the economic path or the path of their industry in order for them to just exist, not thrive but to exist. And for companies who take on too much debt, I think this is very much the reality of where they live. So I tend to avoid those types of companies. I feel that our responsibility as portfolio managers is to put ourselves in the best position to think rationally. And patience and temperament to me are the clearest ways to do so. And therefore highlighting the businesses themselves and making sure the businesses are not vulnerable to economic wins, if you will, or the tail whip of where things go or whatever declaration may occur next week, next month, three years from now, I think is really worthwhile. The other portion of this I kind of talked about a little bit earlier is the more binary outcome innovation. I'm not a biologist or a molecular scientist, I don't understand single molecule pharmaceuticals. There's a large portion of the Russell 2000 that is more biotech oriented.
Now I do appreciate more of the life science tools and things of that. It kind of gets a little bit more into a picks and shovels mindset there for the healthcare industry. But at the end of the day, I tend to find those businesses a little bit more challenging for me to feel their prudent uses for my client's capital. So really I'm looking for resilient companies that have long-term opportunities that are underappreciated by the market. These businesses are not only trading below their intrinsic value, but they're also creating value. And I'm looking to find maybe 50 to 60 of them, which in a pool of nearly 2000 or more, if you can contemplate the shadow businesses that aren't even in an index at this point, it is a very doable thing and I feel like it's also highly repeatable. I don't foresee if you contemplate those things that's putting the capital sleep, the incidents of passive, the manager consolidation and sell side kind of going away in general, those strike me as secular, not cyclical trends. So the opportunity set I believe is very real and sustainable for us.
Kristen Sheffield, CFA, CIPM (31:34):
Yeah, I think it goes to being able to continue to find those kind of neglected opportunities. But when you talk about some of those historical levers being a little bit broken, there might be other attributes that you're kind of leaning into that you're thinking about. You talk about resilient businesses. Can you talk about some of those key characteristics that you're looking for in the businesses that you want to own?
Aaron Monroe, CFA (31:58):
For sure. So you might be wondering, so what do we look for? So when I talk about resilience, for me there's some key characteristics to companies and qualitative pieces that I almost view as the qualitative margin of safety of a company that I want to buy. I want a company that has a capacity to suffer a business that can ride the economic downturns, the challenging environments that we know will exist for small companies at times and ideally those businesses that have a capacity to suffer also have the opportunity to make themselves better during difficult or consolidate market share, expand and better their business. That characteristic, I think it's almost a counterintuitive or a countercyclical element to small company investing that enables me to think rationally and think long-term and put money to work in those companies during difficult times. I want businesses that have and adhere to an ownership mindset.
I love when there's large insider ownership. They're participating in the same economic experience as we are as passive shareholders, but it also focuses the mind, which tends to lead to more prudent capital allocation and various astute operation and focus on long-term capital deployment. And I would like businesses that also have long-term opportunities, companies that are looking to make themselves better and defend their competitive position for not next quarter, not next year, but the next 5, 10, 15 years. Those businesses tend to compound their intrinsic value over an extended period of time and deliver good returns on invested capital as owners of businesses over the long term. Your return should converge to your return on invested capital like the very long term, 10, 20 years down the road. So looking at those businesses that have the opportunities I think is very worthwhile and in a market where the levers to convergence of intrinsic value are broken, value creation is a very important element for investors to take notice. And lastly, which kind of also doves tails a little bit into the capacity to suffer a little bit, but it's companies that use leverage wisely. How are they supported? Do they have a steady cash stream? Do they have a large tangible asset that enables them to support their debt? The debt burden on these businesses is an important feature to ensure the resiliency of the company. If you get over your skis, you're done.
Kristen Sheffield, CFA, CIPM (35:12):
Yeah, it goes back to that kind of path dependency or taking it out of your own hands.
Aaron Monroe, CFA (35:16):
Well, and the other thing I think we think about is if you contemplate the last 15, 20 years, there's been this consistency of bailout and so I don't want to be reliant on the government to bail out our holdings. I'm willing to give up a little bit on the upside to ensure that I feel comfortable with the businesses we own will be fine to exist for a long period of time.
Kristen Sheffield, CFA, CIPM (35:46):
Yeah, I think it's helpful to hear you talk about these conceptually. Let's walk through an actual example so you can bring that to life.
Aaron Monroe, CFA (35:57):
So this is a business that we've owned for a few years, US Lime and Mineral. It's a limestone quarry, limestone product company kind of on the I 35 corridor within the Texas Triangle, Texas, Oklahoma. So some of the key features of the company is limestone's difficult to ship. It's about a 400 mile radius to economically ship. Therefore the limestone production within the region tends to be a bit oligopoly. There's only a couple players to compete against. They have good reserves. They got a net cash balance sheet, big insider ownership, and when we first found it, it had very minimal sell side coverage. So when I kind of go through the checks of the kind of different features that I highlight, capacity suffer, net cash balance sheet, they own their land and their reserves. The ownership mindset there is a large owner that owns nearly two thirds of the company. So we're really partnering with them and their stewardship of this business to run it for the long term. Now with them being a fairly regionally focused and localized business, it's fascinating because they understand the inner workings of the limestone land market within Texas and within that entire space that enables them to continue to support their reserves as necessary in a way that many other companies wouldn't. That insider information, if you will, of there being a local business that's a regional competitive advantage that US mineral has and Texas has just been growing like crazy, so I'm not saying that it's not that's going to go on forever, but there has been in migration for a significant period of time, the state itself is looking to make investments into the company or into the region. And so there's a lot of infrastructure that needs to be supported. A lot of construction in general. I like to own materials businesses that have that type of a tailwind and so they have the long-term opportunities and okay, no debt...
Kristen Sheffield, CFA, CIPM (38:33):
Right in that wheelhouse.
Aaron Monroe, CFA (38:33):
Yes, and I'll kind of highlight one other that's kind of one of our bigger holdings within our portfolio is Red Rock Resorts. They own their land and resorts. So during a period of time where a lot of casino, this is a Las Vegas locals casino business, a lot of casinos were separating into Opco Propco. They fought against that concept and felt like the ownership of their resorts was going to be very worthwhile for their long term. There's also some interesting legislation within the state of Nevada that makes this very relevant. SB 2 0 8 basically restricts the development of where local casinos can be produced or gone vertical. And Red Rock has a land bank that highlights most of the prime developable regions pieces of land within the area. So not only are they majority stake in the Las Vegas locals market, they also are a governor to the development of future resorts because they own the land that would be developed in the future and now the Fertita family owns over half of the company and they keep it very long-term focused. So all of those different features of the business kind of highlight a lot of what I've talked about and what makes it out to be one of my preferred positions. In terms of a capacity sufferer, I always like to highlight that this is during the pandemic, casinos were shut down, but they own their resorts, which gave them an asset that if necessary they could draw mortgages onto their resorts to sustain their business. Before even doing that, they had over 20 months of liquidity to support the company and then good businesses with owner mindsets make themselves better. Prior to the pandemic property margins were call it mid thirties, low thirties on a normalized basis. And now they went and reworked how they did everything shut down, specific casinos consolidated, and now they're running a business where property margins normalized, property margins are in the mid to upper forties, over a thousand basis point improvement in the profitability of the business during the pandemic. That's fantastic.
Kristen Sheffield, CFA, CIPM (41:20):
Yeah, I think that's a good example too of you had to put yourself in that position beforehand to take advantage of the disruption and dislocation of something that I don't think early anybody saw coming but now becomes an opportunity if you're in that right position. So I think it's helpful for you to highlight how you're thinking about some of the businesses that are well positioned in this environment. How do you think about putting that together and constructing a portfolio of those businesses?
Aaron Monroe, CFA (41:52):
So like I highlighted, I'm not looking to invest in the small cap. I'm looking to invest in very select companies that I think can be supportive and profitable for our clients and our partners. So when I think about constructing the portfolio, it's very much business driven and I want the business performance to drive the performance of the portfolio. I want to create a collection of companies that bring diverse cash flows into the overall portfolio that act maybe as ballast at times.
I could buy an EMP company knowing that I have an airline and fuel is the number one cost into the airline, but those two businesses will act as a bit of a balance for each other. I wouldn't expect them both to do well in the same year, but in the long run I feel like they should both do well and act as a counterbalance. So if I can build portfolio resilience in there by having some of that stuff and having a diversity of the actual business cash flows, I think it's good. I like to own some real assets to help insulate both our businesses' economics.
So the inflationary characteristics that go into those companies, but also for some inflationary resilience for our clients. As I highlighted to start, I really like the concentration. Our top 10 is 35, 40%, our top 20 is about 60, top 30 is 75 to 85% of the portfolio. So you're really getting the bulk of the performance from 2030 businesses that we think are really interesting opportunities. But we operate in an area of the market with a whole lot less liquidity. And so I'd like to find really interesting companies that maybe aren't as liquid but add diversity to portfolio, but I can't make them a very large position. And so that's why I really want that tail that matters, a tail that really punches above its weight. So holdings 31 to 50 or 60, those are really interesting companies that I just can't make them a 4% position or maybe there's something about the business I'm looking and I think it could break this way or that way and I want to see how it breaks before I make it a big position. That's what primarily makes up that tail. But there's some really interesting opportunities out in the public markets that you really kind of got to roll up your sleeves and kind of turn over a bunch of rocks, go to work to find them, but they're really intriguing opportunities.
Kristen Sheffield, CFA, CIPM (45:01):
Yeah, worth a spot in the portfolio but maybe have a little bit of that liquidity constraint. We've got some questions that have started to come in and I want to make sure we leave plenty of time for that. So I think maybe we will turn over to our q and a portion now
RIA Channel Host (45:23):
Before we do the q and a. Just have a few reminders so materials can be found in the documents window to the right of your screen. We appreciate your feedback, so please take a moment to fill out our resurvey. Let's look at it at the bottom of the console our speakers will be taking advisor questions. Please type your question in the box under the slides window. We'll get to as many of your questions as possible in the event your questions not answered on today's webcast, a member of the Diamond Hill team or reach out to you directly and if you'd like to have a conversation to further discuss the ideas that were covered during today's event, please click the confirm button in the meeting request box on your screen. With that, I will turn it over to Kristen to start q and a.
Kristen Sheffield, CFA, CIPM (46:01):
Great, thank you. Alright, you hit on this a little bit earlier, Erin, but just can you talk about again, if more companies are either getting taken private, staying private longer, and if they do go public, they might not even be small caps. How is that? Is it becoming challenging to find sufficient opportunities? I think you're highlighting here probably able to do so.
Aaron Monroe, CFA (46:32):
I mean at this point we really haven't had a lot of challenges finding companies that I'd like to own for the next five, 10 years. I think the overall portfolio has one to 2% cash maybe maybe even less right now. So there hasn't been a dearth of opportunities. There have been pockets that appear at times where certain industries are being underappreciated and I'll rotate. I think we've had a fair amount of, the narrative has been relatively volatile. If you think pandemic recovery supply chains, break inflation bank run on the cap or bank run deposits, a couple different wars in there and we just had the tariff challenges, if you want whatever you want to call that these different periods of time will create environments where different assets within the small cap space get bid up very strongly and enable us to optimize the overall return profile for the portfolio relative to the inherent business risk. So I haven't seen as many of the different companies actually move in and out of the Portfolio. It's more of recalibrating the position sizes of businesses that I really like, but at present I have not found challenges to find 50 to 60 companies that I really want to own.
Kristen Sheffield, CFA, CIPM (48:24):
Another question I think we tend to get frequently and even in the past six weeks we've seen a really resurgence in small cap performance, but we see a narrative of small cap should outperform a large caps with fed cutting and that hasn't happened. So how is this time different?
Aaron Monroe, CFA (48:50):
I mean to be can it might not be different, but I don't necessarily think you have to rely on fed cutting for your small company portfolio to do well. I think what I've attempted to highlight is that because of the backdrop that we are operating within, a lot of the performance of small caps in general is going to be driven by the passive capital. It creates a bit of a self-reinforcing prophecy, but within that there are very distinct companies and opportunities to be found that can deliver your partners pretty good returns over five, 10 year periods of timeframe that I think should be commensurate with the same returns that you would get from a reasonable large cap manager. So while I totally embrace that, yes, we've had head face before, this seems to set up well, the valuation discrepancy, the underperformance for small cap, is that quantitatively statistical extremes? Is it going to happen now? I don't know, but I think there's another opportunity out there that is significantly more durable than just the straight small cap trade.
Kristen Sheffield, CFA, CIPM (50:24):
All right. This one, switching gears a little bit. What sectors in small cap see the most growth besides industries related to tech and AI directly?
Aaron Monroe, CFA (50:40):
On an overall sector basis? I mean, so areas that we have felt pretty comfortable with have been areas of defense where I feel like there's been significant underinvestment in for years. There are areas of power that a little bit related to ai, but I think in general our power infrastructure is fairly taxed and needs to see some significant investment. A lot of places it's kind of one or two. You can find specific companies that have really interesting narratives for growth, interesting kind of industrials that are finding unique ways to use materials or unique applications within the industry. You've still seen things like automation get decent tailwinds. If we are going through this process of industrial, an industrial kind of reinvigoration across the globe because of the nationalization that occurs, all those individualized plants are going to need reinvestment in tools, equipment, things of that nature. There's definitively places to put capital to work that isn't tied to, that isn't tied to AI or tech at this point. It's just you have to find this is almost like the riches and niches type of thing. Yeah, exactly. You have to really kind of do the work to understand the underlying company and what specifically you own.
Kristen Sheffield, CFA, CIPM (52:38):
All right, I got another one for you. With fertility rates continuing to drop globally and fewer migrants joining the workforce plus AI making some job creation start to soften, how do you think about payroll and labor cost estimates for your companies going forward?
Aaron Monroe, CFA (53:00):
I mean it is very much a company by company basis. You have what I would say is potentially as you highlight a contrary forces, if you have less humans, less people being able to do the work, in theory, you should have to pay more to hire an individual. Yet the efficiencies that AI will give us, all the companies I think will probably stand in the face of that. So therefore I think for me more of the way I've contemplated this is, and the way it shows up in the portfolio more so is I'm less positive about hiring in general, less concerned about wage and labor inflation than what I probably was two or three years ago when we were seeing really big challenges to skilled labor. Many companies, we own a company called Graham Corp that does a lot of critical machinery that goes into submarines. Maybe fleet also has oil and gas implications, but they started their own welding school in order to ensure that they had enough skilled labor to produce. This is kind of a theme with many industrial companies is where they see the bottleneck in their labor force. They've taken it upon themselves to fix. So overall, I am viewing those two forces or those various forces as being kind of for now equalized, but I am not necessarily optimistic about the volume of humans being hired into the future, if that makes sense.
Kristen Sheffield, CFA, CIPM (55:24):
That makes a lot of sense. All right. I'll give you more of a quicker, straightforward one here. Is what kind of position turnover do you have in the portfolio?
Aaron Monroe, CFA (55:34):
So this is a little bit more complicated answer than what it once was. So typically I'd say in the past before the pandemic, our turnover was probably around 20, 25%, about or four to five years you'd have turnover. What I've seen lately because of that kind of the waves of various risks that have come in the pockets being bid up or sold off very quickly, we are in maybe a 50 ish percent type of turnover environment, less so in terms of the actual companies, more so in the position size changes as the quantitative margins of safety expand and narrow and our expected returns or change significantly relative to the inherent business risks. So it's this constant recalibration of the model to ensure that we are positioning the portfolio in the optimized fashion that we can on any given day. So I would like to think in the long term we will probably move back towards that 20 percent-ish range, but I feel that it is my responsibility to execute what I believe is best for our clients at any specific given point in time. It is the environment that we've been handed for five years now.
Kristen Sheffield, CFA, CIPM (57:23):
Yeah, those bouts of volatility can be opportunity, but it may result in a little bit higher turnover. Let's see. We're coming up close to on the hour, but I'm going to get one or two more in here. I will give you this one. How do you frame the universe in the context of either benefiting or being hurt by ai?
Aaron Monroe, CFA (57:55):
The way I frame the kind of artificial intelligence implementations is I think there's certain companies that are really well designed to implement the benefits of this type of company. Things that are doing like processing something very generalized customer service interaction, things like that that unfortunately will displace humans, but I think will be very good for companies. I think in the intellectual or white collar, brain driven jobs, AI is going to be an amazing tool to help leverage and make individuals make your top performers even far superior performers they're going to, if you contemplate our industry in general, I can have a conversation with an AI model about a business that I've uploaded all of their financial data to and I can have a conversation with them at any point in time in which I want to and then I can have that information and have conversations with my team and have a very real and more efficient, more efficient decision being made. So I think there's a lot of these kind of efficiencies that will show up. I do in the back of my head have this, we've had these risks over and over and over again whether it was the internet or I'm guessing the radio and television a long time ago, and individuals find other opportunities to put their talents and skills to work. But this is a very real risk that may take retraining a fair amount of people. And I'm going into that with my eyes kind of wide open that it is a risk to society for the cannibalization of some potential jobs. I think the thing where it maybe shows up in the portfolio a little bit more is we live in a very tangible and real world and that isn't going away. And therefore I find investments in the infrastructure in society and real estate in very real things as being highly worthwhile at this point in time at this juncture of society. Whether it becomes the nationalism that is driving investment into infrastructure and industry, whether that is the risks that are available in more technology oriented businesses because of either, whether you call it valuation or displacement by artificial intelligence. I look for constants and things that I can rely upon before I put my capital to work into those companies. So I think there's an answer in there, but it is an opportunity, it is a risk, it is both and it does show itself within the portfolio as a very real kind of long-term thought.
Kristen Sheffield, CFA, CIPM (01:01:31):
Yeah, I think what I kind of hear you saying is a little bit echoing some of the stuff we've talked about today in terms of it is going to be a little bit more business and industry specific people. Some businesses are going to benefit, some may be displacing or kind of actively thinking about for the long term. We are just a little bit over the hour mark, so I think we're going to go ahead and wrap up here. We really appreciate everyone joining us this afternoon. I know there are a couple of questions that we didn't get a chance to get to. Please hit that kind of connect button. It'll shoot us over an email and we're happy to follow up and have additional conversations with anyone that's interested. So thanks again and have a great weekend everybody.
Aaron Monroe, CFA (01:02:15):
Thank you all. Appreciate it.
RIA Channel Host (01:02:18):
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