Long-Short Fund Portfolio Manager Q&A

Portfolio Specialist Brian Fontanella recently sat down with Portfolio Managers Chris Bingaman and Nate Palmer to discuss the Long-Short Fund and why its long tenure (nearly 20 years) and straightforward approach are advantages.

Q: Could you give an overview of the Diamond Hill Long-Short Fund?

Traditionally, hedge funds had been the primary investment vehicle for long-short equity strategies. However, hedge funds often charged high fees and offered limited liquidity to investors. The Diamond Hill Long-Short Fund was created with the idea that by combining a more client-friendly fee structure with the daily liquidity of an open-end mutual fund, more investors could gain access to the benefits of long-short equity investing. The Fund utilizes our deep knowledge of businesses to generate alpha by identifying both long opportunities and short opportunities. Today, it is one of the longest-tenured long-short mutual funds in the category.

Like all of our strategies at Diamond Hill, the Long-Short Fund is managed using our intrinsic value investment philosophy. It is a long-biased fund that has averaged around 60 percent net exposure over long periods of time. Total gross exposure has typically been in the 100 to 120 percent range, but prospectively, we anticipate total gross exposure is likely to be in the 110 to 130 percent range, with a similar net exposure of around 60 percent.

Q: You mentioned your intrinsic value investment philosophy. Could you expand on that?

When we are evaluating a business, we are considering its prospects over the long term, which we define as at least five years, and applying a business owner mentality. We are estimating what the business is worth, which is the present value of the cash flow that it generates over time. We want to determine what a rational business person would pay for the entire business, and what a partial ownership interest in that business is worth. We seek to take advantage of instances in which a stock is trading at a discount to intrinsic value on the long side, or trading at a premium to intrinsic value on the short side.

Q: Why do people use liquid alternative strategies like this one?

It could be for a variety of reasons. In some cases, investors desire to have a greater portion of their total investment return determined by stock selection rather than overall equity market exposure. Because equity markets tend to rise over long periods of time, the Fund is intentionally long biased. However, because the Fund is managed with net exposure between 40 and 75 percent, it often demonstrates lower volatility than the Russell 1000. Additionally, we believe that we can add value through stock selection in both the long book and the short book. If we succeed in doing this, the Fund should produce an attractive return profile while also having lower exposure to equity market fluctuations than a typical long-only strategy or a long-short strategy with 100 percent net exposure.

Q: What makes this Fund different than other liquid alternative strategies?

By design, our Long-Short Fund is relatively straightforward and easy to understand. We are trying to find longs that are undervalued and shorts that are overvalued, and we are not using leverage or derivatives to create certain exposures. Then, we are building the portfolio based on where we find these opportunities, which also means that we are willing to look meaningfully different than the benchmark. Our shorts are not intended to be a hedge against specific long positions. Rather, each position in the portfolio has a company-specific investment thesis. Valuing businesses and identifying instances in which the market price has deviated from the intrinsic value of the business is the key to how we intend to add value through stock selection in both the long book and the short book.

The Fund also has close to a 20-year track record, and over that time there have been a wide variety of market environments. Many strategies in the category have started in the past five or ten years. We view it as an advantage that the Long-Short Fund has navigated different market environments and generated strong returns for clients since its inception.

Q: What is the performance objective of the Fund?

Our primary benchmark is the Russell 1000, but since the Fund has averaged around 60 percent net exposure over a long period of time, the 60/40 blended benchmark is a measure of how successfully we have added value through stock selection. So this is the benchmark we measure ourselves against, and the primary relative performance component of our incentive compensation is based on generating performance in excess of this 60/40 blended benchmark over rolling five-year periods.

Q: What is the capacity for the Fund?

Our stated capacity is $4 to 5 billion. We want to keep the Fund at a size that allows us to take advantage of opportunities on the lower end of the market cap spectrum while staying relatively concentrated. On the long side, we are very mindful of the size of our position relative to a company’s total shares outstanding. For short positions, we always consider the level of short interest, along with the ability to borrow shares and the cost to do so. In that regard, having a much larger fund would make it more difficult to manage the short book with the position sizes and number of holdings that we believe make sense for the Fund.

Q: How do you as portfolio managers work together to manage the Long-Short Fund?

We meet daily and discuss the portfolio and our ideas for potential additions to the portfolio on both the long and short sides. We have backgrounds that we believe are complementary to one another and find it beneficial that we bring different experience from a sector perspective. So with 80 to 90 total portfolio holdings, including longs and shorts, this structure allows us to make sure every position receives the necessary focus.

Q: Talk about your interactions with the analyst team. What do those conversations look like?

We have a team of approximately 30 research analysts and associates, each typically covering a couple of industries, and they play a significant role in identifying investment opportunities for the Fund. With each analyst covering a relatively small universe of companies, they are able to go very deep in understanding those businesses and industries. Our interactions with the research team are a very important part of our investment process. We are in frequent communication with research team members regarding both existing holdings as well as new opportunities. Additionally, we each attend sector team meetings on a regular basis.

Q: What are you looking for in an investment idea? Does it differ for longs and shorts?

For both longs and shorts we are looking for businesses that we understand, have a good grasp of the fundamentals, and can estimate future cash flows within a reasonable range of outcomes. The resilience of the business is an important consideration. For a long position, a resilient business is one that even if we knew the cycle was going to end tomorrow and the fundamentals may deteriorate somewhat in the near term, over the next five years we would remain confident we would generate an attractive return. Conversely, we are looking for a lack of resilience on the short side. That would be a business that might have some combination of financial and operating leverage, or is in secular decline, and if we enter a downturn the value of the business is likely to be impaired. Ideally, on the long side you want to find great businesses trading at a large discount to intrinsic value, and the opposite on the short side.

We also want to know where the expected returns are coming from. In other words, is the source revenue growth, margin changes, cash return to shareholders, or multiple expansion or contraction? These will be the things we know we will have to monitor going forward, and it applies to both longs and shorts.

Q: Do you have different time horizons or holding periods for longs versus shorts?

For valuation purposes, the time horizon is the same for longs and shorts. We are modeling every business out at least five years and are valuing a business through a cycle over a long period of time. However, the holding period tends to be shorter on the short side. This is because most companies are generally growing their intrinsic value over time, which, all else equal, narrows the gap between price and intrinsic value.

Q: Is there a minimum discount or premium to intrinsic value necessary to start a position? Is it different for longs compared to shorts?

Both the discounts on longs and premiums on shorts will vary depending on the environment and opportunity set. Our outlook regarding the range of likely outcomes, the type of business, its competitive positioning, characteristics, etc. will also impact what we believe is an adequate discount or premium to intrinsic value when making an investment.

Q: How is the portfolio constructed?

The portfolio is constructed on a bottom-up basis, so our exposures are a function of where we are finding opportunities, meaning we will often look different than the index. Our guidelines in terms of individual positions and industry/sector exposures are all based on absolute limits, so if there are certain sectors in which we are not finding value, we will have little or zero exposure to them. For example, we currently have no long exposure to real estate or utilities.

Q: How do you think about position sizing?

For both long positions and short positions, position size is a function of the discount or premium to our estimate of intrinsic value, and our level of conviction in the position. Our largest positions tend to be trading at wider discounts to our estimate of intrinsic value or are positions we have a lot of conviction in, and sometimes both. Currently, the average position on the long side is around 1.8 percent. On the short side it is about 0.7 percent (both numbers are as of September 30, 2019).

Q: What is the range of net exposure that can be expected from the strategy?

The stated range for net exposure is 40 to 75 percent, and 60 percent is approximately what we have averaged over a long period of time. Generally, we are likely to be in that ballpark, say 55 to 65 percent. But in November and December 2018, we found a lot of opportunities on the long side and we were reducing short exposure as the market sold off. By year end, net was approaching 70 percent. It is unlikely to get down close to 40 percent but hypothetically, if the market was up 50 percent in the next six months, we would very likely have net exposure meaningfully below the current level of just below 60 percent. It may not be all the way down to 40 percent, but it is possible and we certainly like having the flexibility to take it there.

Q: Have you refined your process over time?

A couple of years ago we had a relatively small number of short positions that performed poorly enough that they produced an outsized impact on the performance of the short book. Our hit rate has been pretty good with many positions underperforming the market and some generating positive contribution to return, but the performance of a few larger positions hurt our overall performance. In general, the valuation of these businesses seemed extreme, but their fundamentals continued to be stronger than we had anticipated. What we have started to do a bit differently is focus a little less on valuation and a bit more on fundamentals. In other words, more of a focus on shorting businesses that we believe will be fundamentally challenged, even if they do not necessarily appear statistically expensive.

The other modest change is that we concluded we wanted to hold more short positions at lower average position sizes. The downside for a short position is infinite since the stock can theoretically go up forever, so we want to manage that risk by not having short positions much more than 2 percent of the portfolio.

Q: What types of environments do you think the Fund will do well or poorly in?

We believe the Fund should do well in a lower expected return environment. If we can add value through stock selection on the long and shorts sides, we should be able to meet or exceed a long only benchmark in that type of environment. An environment in which there is a lot of volatility is also beneficial for the Fund since it provides the opportunity to take advantage of mispricings on both the long and the short side.

If you had gone back 10 years and knew the market was going to essentially go straight up for the next 10 years, a Fund like ours with 60 percent net exposure on average probably would not have been the most attractive investment opportunity from a total return perspective. So it is not surprising that the category is out of favor at this point in the market cycle. Essentially, strategies like Long-Short are likely more attractive in a lower expected return environment where there is more of a premium placed on alpha generation rather than just beta.