Kristen Sheffield, CFA, CIPM (00:11):
Hello, everyone. My name is Kristen Sheffield, portfolio specialist here at Diamond Hill, and today I am joined by co-portfolio managers of our Select strategy, Austin Hawley and Rick Snowden. Thank you both for joining me today.
Rick Snowdon, CFA (00:23):
Sure.
Austin Hawley, CFA (00:24):
Hey, Kristen.
Kristen Sheffield, CFA, CIPM (00:25)
There's really no shortage of topics to cover, so let's just jump right in. We've seen a bit of broadening out in terms of what's working so far this year with some rotation into small caps and cyclicals and away from mega cap tech. However, AI continues to be the dominant theme in markets, and it seems like each week or even day, a new industry comes under significant scrutiny about the threat of AI disruption. So maybe we can start at a high level, Austin, with some general thoughts on the market so far this year.
Austin Hawley, CFA (00:58):
Yeah, great. So it does feel like we've moved into sort of a new phase in the AI investment cycle in 2026 with more commercialization of some of the AI tools and it seems like more rapid adoption in corporate America of some of those tools. And with that, we've seen a real fear in the marketplace about how that impacts some of the incumbent business models, especially some of the intermediaries, but also how it impacts just labor more broadly and whether we might have a real impact on unemployment in the United States. And so I would describe what we've seen as just the series of rolling market panics. And I do think it's driven mostly by fear of the unknown, but panics about certain areas of the market that may be impacted. So first it was software that we saw sell off very significantly, both in 25, but quite a bit early in 26.
Then it was the insurance brokers, then it was wealth managers, then it was commercial real estate brokers, and it went kind of on and on. And it seemed to be the same thing over and over again with the market really showing some panic and selling these whole areas off by as much as 10 to 15% in a given day. And so that's been the big theme that I think a lot of people have read about. And when they think about the market year to date, it's this impact of AI on specific industries and broadly on labor. Behind the scenes, as you point out, there has been a pretty significant broadening out in the marketplace. And it's been in areas like smaller market caps. It's been cyclicals, especially the non-AI oriented cyclicals, and then some underperforming areas of defensives like consumer staples. And we've benefited in those areas.
We've had names like Regal Rexnord in the portfolio that were up as much as 50% year-to-date. On the flip side, we have an area like software that's down, in many cases, 20% or more year-to-date. And that's certainly hurt us as we look at the results so far this year. I'd say the big takeaways we're kind of two months into the year is that rebound across some of those smaller market cap cyclicals and some of the defensives like consumer staples has been positive as those have been areas we've been leaning into, but they've been pretty big moves. And it's left the market in a place where we're at valuations that are very, very high and there are fewer places to hide where you can really find valuation cover that protects you on the downside. And so that's the challenge we find ourselves facing today.
Again, kind of two months into 2026, the pockets of value are few and far between, and we are trying to find places where we don't have to take too much risk as we think about positioning the portfolio.
Kristen Sheffield, CFA, CIPM (04:24):
That's a good place to start. Thanks for those comments, Austin. And you kind of hit on this a little bit in terms of some of the exposure within the portfolio, but also one of the first industries to be at the center of the AI disruption and volatility was software, which has been under pretty significant pressure across the board. I think when I start seeing headlines declaring SaaS apocalypse, I feel like you start to wonder if we're at a point that's kind of near max pessimism. And I know this is an area in the portfolio that we've been adding to a bit. So Rick, can you talk about assessing opportunity versus threat for companies like an Adobe or a Salesforce and our thinking there?
Rick Snowdon, CFA (05:14):
Yeah, definitely. And I think I would toss Wix in there as well, which is a company we own, which helps small businesses create and maintain their websites, as well as run their businesses with tools like e-commerce, scheduling, billing, even connecting into their accounting and tax software. So all three of those companies, as you mentioned, Adobe, Salesforce and Wix are aggressively adding AI capabilities to their products to enhance value for their customers. So there's the opportunity side of it, but the other side of the equation is to what extent does AI threaten them? Like Austin's talking about with all these different industries and these scares that we've seem to be rolling through every few days. So does it increase competition? Does it erode moats? Does it destroy demand? And the net of those, it seems obvious, but the net of those two questions, does it strengthen them or what are the ways it strengthens them versus what are the ways that it threatens them?
The net of those is going to drive whether or not these businesses grow or contract. And consequently, whether they're cheap or they're expensive today, we of course think that they're cheap and attractive or else we wouldn't own them, but we continue to try really hard to evaluate those two sets of factors that I mentioned and we could be wrong. There's no doubt about that. A key question though is the extent to which lock-in protects these businesses. For instance, Wix customers, they seem unlikely to me. These are small businesses. They seem very unlikely to me to gen up their own website and systems with AI, not to mention spend the energy to maintain them over time. And I think the same for Salesforce and Adobe with regard to larger enterprises, their customers can probably build their own systems. I mean, they could have from the beginning, but now it's easier, but the risk of disruption to their ongoing businesses, the risk of distraction and the risk of just losing best in class functionality seemed like pretty high hurdles to me. But these are far from certain things and that's why they've traded off so much and that's why we continue to evaluate them on a near real-time basis.
Kristen Sheffield, CFA, CIPM (07:28):
Another area I wanted to ask you about is we, of course, build the portfolio from the bottom up. And with Select having a broad universe in terms of the full market cap spectrum being available as a pool of opportunities, but also being concentrated best ideas, I think it's often interesting to see if there's any pockets or themes in terms of ideas that are bubbling up in the portfolio. Over the past several quarters, the main theme seems to be opportunity and high quality, stable or defensive large cap businesses. Can you talk about that dynamic, Austin, and maybe give us an example or two in the portfolio?
Austin Hawley, CFA (08:11):
Yeah, sure. I'd be happy to. So I think that assessment's exactly right. The biggest theme you've seen in the portfolio is that Rick and I have been moving out a little bit of some of those smaller cap and cyclical names have done really well for us over the last couple years and increasingly finding more value. And really for the first time in probably over a decade, I think you have to go back to 2014 to see a time where we had this much kind of large stable business exposure in the portfolio, but that's where we found the best value. And it's in names like Colgate, like Abbott, like Waste Management, all names that we've added to over the course of the last 18 months or so. And what we've seen happen in the market is that the big theme that everyone knows about, the build out of AI infrastructure is dominated all else over the last 18, 24 months.
And it's led to huge stock price increases in areas that provide infrastructure to the AI CapEx build out. And that would be industrials, power companies, semiconductors would be some of the most obvious areas. And we've seen these huge outsized gains and a lot of attention around that area. And the one place where we've seen some stocks really be neglected in our opinion is some of those super stable, high cashflow producing, high quality businesses that tend to be pretty recession resistant in terms of their revenues. And that would include names like Colgate, again, Waste Management, Abbott, Aon.
And these names are at multi-decade lows in terms of relative valuations today. So we've seen the market creep higher and higher while these companies have seen their valuations dwindle or in some cases compressed by meaningful amounts. And so Colgate's a great example. And so let me just talk a couple minutes about Colgate. We bought Colgate in the summer of 25, and Colgate's a name that was trading at a 30-year low of relative valuation compared to the market when we bought it. Colgate has dominant positions in household products like toothpaste. This is stuff that people buy in a repetitive nature and don't have significant risk of technological disruption, and they tend to be very resilient through downturns. Colgate's faced some headwinds in terms of its fundamentals over the last couple years. We think we're right at the point, that inflection point where we're start to see some improvement in revenue growth and earnings growth.
But in the meantime, we're getting a 2.5% dividend yield, a one to 3% reduction in share count annually. And we think eventually we're going to get to a place where we get mid-single digit revenue growth, slightly better on profit growth. And that gives us, when you add all that together, a fundamental return between cash payout yield and growth in the business that's double digits and double digits without a lot of valuation risk, especially relative to the marketplace. And so when you think about big positions in Colgate and Abbott and the portfolio, it's certainly not as sexy or exciting as some of the names you've seen in the Select strategy over the last 13 years that Rick and I have been managing, but it's reality. It's what the market is giving us. And it allows us to still deliver good absolute returns without taking the risks that I think are necessary to reach for something beyond that because I don't think it's available in the market today.
Kristen Sheffield, CFA, CIPM (12:15):
That's a helpful color. And talking about some of the opportunity you're seeing within large cap. And you alluded to this a little bit, Austin, but this is a bit of a shift in terms of where we had been finding new opportunities a few years ago and where incremental new ideas were tending to come from small and SMID areas of the market. So I'm curious, what does exposure look like there today, and how would you characterize some of the opportunities down the cap spectrum?
Rick Snowdon, CFA (12:49):
Yeah, I'll take that one, Kristen. So it's definitely a good observation. I looked at this recently and our weight down the cap spectrum, say below 10 billion and even five billion, those buckets are half the size that they were probably roughly a year ago. So definitely a significant change for us. And I think as Austin alluded to, some of the names down there, how we got there is that just that some of the names down there have done pretty well and got close to IV or got to IV, intrinsic value that is, and we sold them. Or in the case of Mr. Cooper, it was acquired. Ironically, we still actually own Mr. Cooper as a part of Rocket, which is but a bigger company, and therefore it doesn't fall into those buckets anymore. But funny way, we still sort of own it. And the best replacement ideas have been larger names.
Some of the ones that Austin just mentioned, Abbott Adobe, Aon, Kimberly, Berkshire, just looking at the list, Colgate, as you mentioned, Waste Management, and we've only added a couple of small names.
And I guess I just think it's, I know we talk about this a lot, but it's worth reinforcing that we're pretty agnostic. We are entirely agnostic along the cap spectrum, and we just go where we see the best opportunities. And as we've sold, some of those names have done well and replaced them more so with these larger names, that's just kind of where we've wound up. One conversation that it's interesting, I think Austin just said 13 years, so we probably have five conversations, maybe 10 a day. And one conversation we've never, ever had is let's move up or down the cap spectrum. It's just not something that we think about. But as I look at the smaller names in the portfolio now, most of them are really names we've held for a long time like Cimpress and Ashland and CarMax, Red Rock, BuilderSupply. And just in general, these are names that these are pretty good businesses that are managed by good capital allocators and business managers.
And they've all got just different sort of problems over the last whatever period of time and seem to be fighting their way through it and making the right decisions. And we've got a lot of confidence in those companies. So we still have a fair amount of weight down there.
Kristen Sheffield, CFA, CIPM (15:14):
I think that's a helpful context to say you're never targeting one area or another of the market cap, just going where you find the opportunities. And although we've been finding more opportunity up the cap spectrum, it doesn't mean we don't still pick our spots for businesses we think earn a spot within the portfolio. Last question from me for today is with the disclaimer that we, of course, don't have any sort of crystal ball into the future here, but just want to know any thoughts you can share, Austin, on your outlook going forward or anything in particular that you and Rick are keeping your eye on or just concluding remarks?
Austin Hawley, CFA (15:59):
Yeah. Without my crystal ball, I'll offer two thoughts just about the market as we move forward. The first is Rick and I are as eager as anyone to see how some of the improvements in AI technology are implemented in the businesses we own in our business here and how we do our jobs. It is going to be a fascinating time. And it really does feel like we have started to get to that stage where we have real products that are being implemented in businesses, and I think a lot's going to change pretty quickly. And I think we will have a much better view as we move through this year about how AI might be used in businesses as we look out over the coming years. We're just getting to that point of new products being commercialized. And so I'm excited to see that scared in some ways too, but I think it's going to be a fascinating time.
The second point that's maybe more relevant just from an investment perspective is that I think the market is very expensive and I think the market is expensive. And when I say the market, I'm generally referring to kind of the broad cap weighted indices. And I've been especially careful when I say that in the past several years because there've been gaps between the market-cap-weighted indices and the median stock or the average stock. That's a little less the case today. Really, everything's moved up to a pretty expensive level and it's not because there's any shortage of risk. I see plenty of risk in the world, whether it's geopolitical risk, technological disruption, or just competitive dynamics in industries. I think the market is full of risk and it is not being adequately priced in, in my opinion. And so we've been very careful as we think about investing the portfolio over the course of the last couple years as we've seen valuations kind of stay and even creep a little bit higher and we have to take what the market gives us.
And that means not overreaching and taking on risk in an environment where you're not being properly compensated for that risk. And if there's one takeaway in my mind for investors, it's just that, that the market risk reward dynamic is not nearly as attractive as we've seen throughout the time that Rick and I have been managing the Select strategy. And so I think we should have expectations that are in line with that. And if we can get a low risk double digit type of return like I've talked about for some of those more defensive names, I'll tell you, I think Rick and I would be extremely happy with that outcome over the next five years. And that's the way we're trying to think about protecting our client's capital and our capital that we have invested alongside it in the Select strategy.
Rick Snowdon, CFA (19:20):
Totally agree.
Kristen Sheffield, CFA, CIPM (19:22):
Well, great. I think that's good kind of food for thought and a great place to wrap up. So Rick, Austin, thanks again for joining me today. I appreciate the time and insight as always.
Austin Hawley, CFA (19:32):
Thanks, Kristen.