Brian Fontanella, CFA (00:11):
Hi everyone. My name's Brian Fontanella. I work on the portfolio specialist team here at Diamond Hill. And today we're here to talk about the Diamond Hill long short strategy. And we wanted to talk a bit about the strategy itself and what you can expect from it as an investor, but also talk a bit about the current environment and how the portfolio is positioned. And to do that, I'm joined by Nate Palmer, co-portfolio manager of the Long Short Strategy. Nate, thanks for joining.
Nate Palmer, CFA, CPA (00:35):
Hey, thanks for having me, Brian.
Brian Fontanella, CFA (00:36):
So Nate, I wanted to start with a little bit of an overview of Diamond Hill and the strategy itself. So how do we at Diamond Hill think about value investing? And then what does the strategy look like in terms of things like number of positions, exposure levels, and then how are we trying to add value for clients with the strategy?
Nate Palmer, CFA, CPA (00:54):
Yeah, for sure. So Diamond Hill's an intrinsic value focused asset manager. We were founded 25 years ago based on the belief that we can identify a subset of businesses that the market is pricing differently than what they're actually worth. And we do really deep research on each company that we're considering as an investment, and we think we can identify a subset of businesses that truly are mispriced. There are thousands of businesses out there. We think that we can identify a small group where there's a meaningful mispricing between what the business is actually worth and how the market's perceiving it today. I'm a portfolio manager on our long, short strategy. I view long, short as the purest expression of that intrinsic value approach because not only do we own a portfolio of businesses that trade at discounts to intrinsic value, but we have a short book of businesses that we think are particularly unattractive investments given the combination of future fundamentals and current market price.
On longs, we want to get more than what we pay for, but on shorts, we think that we can identify businesses that for specific reasons the market is too optimistic about. And if we successfully identify both longs and shorts that are mispriced, then we think we can generate pretty attractive risk adjusted returns for our clients. And so from a structure standpoint, the long short portfolio typically has roughly 90% gross long exposure and 30% gross short exposure. So that gets you to 60% net exposure and 120% gross exposure. We get there by having roughly 50 long positions and 40 short positions. And then in terms of evaluating us, how we evaluate ourselves and how I think the most objective way to evaluate us from a client standpoint is the long short spread. And so the extent to which our longs outperform our shorts, and we want to go one level deeper and say, we want our longs to outperform the Russell 1000, and we want our shorts to underperform the Russell 1000.
And if we generate a favorable long short spread with Alpha generated in each of the long book and the short book relative to the Russell 1000, then we think we generate pretty attractive risk adjusted returns for clients.
Brian Fontanella, CFA (03:07):
Okay. So as a liquid alternative strategy, long short strategy with roughly 60% net exposure, how do you tend to see clients use this strategy in portfolios? Yeah.
Nate Palmer, CFA, CPA (03:43):
So this really is a hedge fund strategy, but in mutual fund form. And so with that comes daily liquidity and no lockup. I think we see it used in a pretty wide variety of ways. I think downside protection is one theme that we hear often and something we take very seriously in the way that we manage the portfolio. I think a lot of clients want to participate in the long term returns of equity markets, but with mitigated downside through a combination of the structure of the portfolio being 60% net exposure on average. And also, if we're effective at constructing a short book that generates alpha, that should provide even additional downside protection relative to what you would expect structurally. I think some clients use it as a volatility dampener in portfolios. Sometimes you'll see it as a replacement for a portion of equity market exposure, given that it typically has less volatility than a comparable long only strategy.
I think some clients really like that a higher portion of the total return and long short is a function of alpha rather than beta. If you believe that we're skilled at identifying mispriced businesses as we do, then alpha is a pretty attractive source of return. And so I think there are several ways that this strategy gets utilized in client portfolios and ultimately we're focused on generating alpha in each of the long book and the short book and generating favorable risk adjusted returns for clients no matter how they use it.
Brian Fontanella, CFA (04:53):
So there's a wide variety of alternative products out there in the market. Now, what makes this strategy compelling relative to other options within the category, whether that's hedged equity, less liquid alternatives, et cetera?
Nate Palmer, CFA, CPA (05:06):
Yeah. I think I'd start by saying that by design, the strategy is very straightforward. So we don't use options or derivatives. We don't use financial leverage. The way that we're generating our returns, which is through identifying mispriced businesses, remains very consistent over time. And so we want the strategy to be straightforward. We want to be very clear about what's going on in the portfolio. We're very transparent by design. We disclose our holdings monthly. Each, the long book and the short book gets disclosed monthly. So clients can see what's going on in the portfolio. Obviously, we talk about what we're doing in the strategy, but they can verify that everything going on in the portfolio is consistent with the stated objective and we're doing what we say we're doing. I think daily liquidity relative to other alternative strategies is a differentiator. And then within certain client portfolios, this might provide some liquidity diversification and the fact that you have that daily liquidity, there's no lockup.
I think another thing I'd point to, we think we're very skilled at shorting. We have a long track record of doing it. We think that the track record of the short book is something that we're very pleased with. When you contrast that with using options to mitigate downside risk, we view shorting, if you're good at it as a much more cost effective way of getting downside protection. When you short a stock, you receive the cash proceeds and you can invest those cash proceeds into something that you think is a particularly attractive investment. When you look at some of the strategies that use options for downside protection, oftentimes you're paying something in the ballpark of 500 basis points or giving up 500 basis points or so of return to get that downside protection via options. And so in a high return environment, if the market does 15% a year, maybe you're okay for going 500 basis points of return.
If you're in a lower return environment at some point in the future, you may feel differently about foregoing 500 basis points of return to use options for downside protection. And so in our view, an intelligently constructed short book is a more cost effective way to produce downside protection and risk adjusted returns for clients. And the last thing, just from a practical standpoint, given the liquid alternative nature of the Diamond Hill long short strategy, you don't have to worry about a K-1. Everything's very simple from a tax and reporting standpoint. And so we think it's a pretty attractive strategy in the alternatives category.
Brian Fontanella, CFA (07:50):
Okay. Let's talk a little bit about the opportunity set. How easy or difficult is it to find attractive long and short opportunities in this environment, and where are you finding those opportunities?
Nate Palmer, CFA, CPA (08:01):
Yeah. I think in the current environment, just given where overall market valuations are, the opportunity set to populate the short book is larger than the opportunity set when we're looking at potential new longs. We're still finding plenty of opportunities for each the long book and the short book, but I would characterize this environment as particularly attractive in terms of the number of things that we're interested in digging into as potential shorts. I think on the long side, we're finding a subset of businesses that we think are pretty interesting, but it's very idiosyncratic in nature. It's businesses for which there's something pretty specific that the market's fixated on that we think the market may be overemphasizing near term and maybe intermediate term uncertainty and overlooking some of the longer term opportunity for businesses. And so, with artificial intelligence, I think that it's producing opportunity for us in each the short book and the long book.
I think there are plenty of companies out there that are telling artificial intelligence stories that maybe lack substance and we get pretty excited about shorting businesses where the market's excited about a narrative that may not be justified by future fundamentals. And then there are certain long positions where we got the opportunity to purchase them at the prices that we did because the market was excessively focused in our view on risks from artificial intelligence rather than some of the opportunities that may still exist for some of these businesses longer term. And so I think if you looked at the short book, you would say that we're finding plenty of opportunity in consumer discretionary, in technology, and in kind of one-off idiosyncratic situations, we have a couple of healthcare situations that we think are pretty unique and attractive in the short book. And then in the long book, we have found some opportunity in technology as the market has, we think, fixated too much on risks rather than opportunities, but we're really finding opportunity across sectors in the long book, just in idiosyncratic situations.
Brian Fontanella, CFA (10:12):
Okay. So building off some of those comments, why is this type of strategy appealing in this environment where valuations are fairly elevated?
Nate Palmer, CFA, CPA (10:21):
Yeah. Well, I think if you go back 15 years and you had known 15 years ago that the market might do something like 15% annualized returns for 15 years, you wouldn't have really wanted a 60% net strategy because in that high return environment, typically higher net exposure is better. I think from this starting point where valuations, broad market valuations appear somewhat elevated and expected returns are likely lower than historical averages, it's a pretty interesting time for a strategy like this with lower net exposure, but where the objective is to generate alpha in each the long book in the short book and generate risk adjusted returns that way, in a lower return environment, a higher portion of your return is attributable to alpha or stock selection. And in order to earn an acceptable total return, we think that in a lower return environment, stock selection is going to be a much more prominent driver of return.
And so we think that a strategy like Long Short, if we generate the kind of long short spread that we believe we're capable of, it's a pretty interesting environment for a strategy like this.
Brian Fontanella, CFA (11:39):
Okay. The strategy today has a decent amount of exposure to the technology sector with larger positions in companies like Microsoft or Alphabet, Meta, or Taiwan Semiconductor. I think most people tend to think of these companies and stocks as quote unquote growth stocks. What makes these attractive investments to us as value investors? Yeah.
Nate Palmer, CFA, CPA (12:00):
I mean, it's probably worth starting with the fact that each of those has been a relatively long-term holding in the portfolio. And so Microsoft has been in the portfolio for well over a decade. Alphabet was added in 2016, Meta was added in 2018, and then Taiwan Semi was added in January of 2023. And so with each business, we got a chance to buy a company that we thought was a very attractive business to own with a long-term perspective at a period of time when there was some near term and maybe intermediate term uncertainty, the market was fixated more on near and intermediate term risks and maybe overlooking some of the longer term opportunities. And so anything that we consider investing in, we're focused on what do we think the business is worth and then what are we paying relative to that intrinsic value of the business or what we believe intrinsic value is.
And so with each of these businesses, we thought we got the opportunity to establish a position at a discount to intrinsic value, but the other and maybe what's ultimately been at least as important driver of return is that the intrinsic value of these businesses has grown at a very attractive rate over our holding periods. And so while the market returns of each of those companies have been attractive, our estimates of intrinsic value have grown at even higher rates than the market price has appreciated. And so that's allowed us to continue to own these businesses for long periods of time and benefit from the compounding that takes place owning businesses like this. I'd also say we do have, if you look at our largest positions, Citigroup and AIG are also among the largest positions in the strategy and they're more prototypical value investments. And so we're looking to find opportunity anywhere that we can.
I think the majority of the portfolio probably would get classified more as companies that might be viewed as classic value investment type opportunities, but all else equal, we would rather own businesses that are growing rather than businesses that are challenged from a growth standpoint. We just don't want to prepay for that growth. We want to get more than what we're paying for when we're establishing long positions. And the businesses that you referenced, I think that's how it worked out. We got more than what we were paying for, even if they weren't necessarily viewed as prototypical value investments.
Brian Fontanella, CFA (14:22):
Nate, for a long, short strategy like this to add value for clients over time, you have to be adding value in the short book. We talk about that a lot. Talk about the strategy's history of alpha generation on the short side and what's contributed to that.
Nate Palmer, CFA, CPA (14:35):
Yeah, For sure. So when I got involved in the strategy back in 2018, we had a lot of data to look at. We had data going back to 2002 of the short book and we wanted to make sure we understood what the strategy had done well historically and what had been more challenging historically as a way to refine our process and make sure that we were focusing on what we were most skilled at. And there were a couple of profiles of shorts that stood out and the first one of those were trying to short very high revenue growth businesses, call it 30 plus percent revenue growth type businesses. And often our short thesis on those businesses was something related to revenue growth decelerating and the market failing to realize that revenue growth was going to decelerate. The problem with that profile of short thesis is you have to be pretty precise about the timing because if a business just grows for an incremental two or three years at 30 plus percent relative to what we were forecasting, the intrinsic value ends up growing a lot as a result of that.
And so that was one profile of short that we've certainly deemphasized. That's not to say that we would never short very high revenue growth businesses, but we're much more disciplined and precise about the thesis when we do short, very high revenue growth businesses. And the other profile of short that had been problematic was very statistically cheap businesses. And often the thesis was something around how challenged the business was and just how tough of a time they were going to have competing. The problem is if you short a really challenged business at seven times earnings, the risk reward of that short might not be particularly favorable just because of how much pessimism is already reflected in the market price. And so if you look at 2018 through 2025, we've generated favorable alpha in the short book each year during that period. And at Diamond Hill, we like to look at things on rolling five year periods.
And so if you look at the trailing five years, we've generated over 800 basis points of short book alpha annualized over the trailing five year period. And so while I'm pleased with those numbers, I think at least as importantly, we feel like we have a process that's repeatable and reliable. We have two analysts who focus exclusively on shorts and we have a large research team at Diamond Hill that has very deep industry knowledge that opportunistically recommend shorts. And we think that combination has produced a pretty effective process of generating short book alpha over time.
Brian Fontanella, CFA (17:06):
Date, I think that was all very helpful and insightful. Thanks for the great conversation.
Nate Palmer, CFA, CPA (17:19)
Yeah. Thank you, Brian.