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Standing Out By Not Fitting In

By John McClain, CFA and Bill Zox, CFA

February 2019

Diamond Hill’s high yield strategies have added value compared to peers, benchmarks and the investable passive alternatives over the last five years while the high yield market has been through more than a full market cycle. We believe that two factors explain this performance. First, we are laser-focused on continually improving our unique and sustainable structural advantages in the high yield market. Second, the high yield market is becoming less efficient over time. The combination of these two factors is the holy grail for an active manager.

Information Edge and Analytical Edge

The key to our information edge is to work with our research team to identify undervalued bonds which are more often smaller weights in or excluded from the benchmark. Most of the largest or more benchmark-oriented investors overlook these bonds. Our analytical edge derives from our emphasis on forward-looking forecasts of the long-term intrinsic value of the business and free cash flow generation as well as the quality of management as both operators and capital allocators. Further, while many investors are fearful of near-term uncertainty, our long-term temperament allows our investors to capture this uncertainty premium on a systematic basis.

Focus on Value, Not Benchmark Weights
What you don’t own is just as important as what you own. If we can’t forecast the size and timing of a company’s cash flows, we will not invest. Conversely, we will take a meaningful position in a bond that we understand and find undervalued irrespective of its weight or inclusion in the benchmark. Managing too closely to the benchmark could impede the ability to outperform and can be particularly problematic in corporate bond portfolios where the largest weights in the benchmark are from issuers with the most bonds outstanding.

Differentiated Research
At Diamond Hill, we utilize one research team of industry specialists responsible for covering the entire capital structure across all market capitalizations. We concentrate our efforts on understanding those businesses that will allow us to maximize our advantages over the long term.

Long-Term Investment Temperament
We employ a five-year view when valuing businesses and evaluating investment performance. This long-term approach distinguishes us from peers who are either unwilling or unable to stand apart from the crowd. Debt and equity markets often react the same to incremental information even though the effect on each is very different. As we evaluate businesses across the entire capital structure, and we place little weight on near-term career or headline risk, we are uniquely positioned to take advantage of these dislocations.

Execution Edge

The key to our execution edge is adaptability which allows us to take advantage of constantly changing market structure. In contrast, some of the largest high yield managers lobby for changes to market structure to reduce the disadvantages of their size. Opportunities for an execution edge are more prevalent in the secondary market so it is essential to always be nimble in the secondary market. One particularly valuable execution edge comes from providing liquidity to the market by buying when there are forced sellers and selling when there are highly motivated buyers. Speed is essential to an execution edge so our high yield portfolio managers execute their own trades.

Nimble in Secondary Market, Selective in New Issue Market
We are committed to maintaining an asset level that will allow us to be nimble in the secondary market and selective in the new issue market even if that means closing strategies. The high yield bond asset class is less liquid than domestic small cap equities. Active small cap managers with greater than $10 billion in small cap equities under management are increasingly rare yet the high yield market is dominated by managers of that size and larger. At that size, managers may become reliant upon the new issue market to take meaningful new positions and they may incur excessive market impact costs when they enter or exit a position in the secondary market. High yield portfolio managers face adverse selection in the new issue market as corporate CFOs have more control over when they issue bonds than portfolio managers have over when they must deploy capital. This mismatch typically allows companies to save on interest expense and costs portfolio managers performance. These factors make it difficult for the largest managers to generate attractive risk-adjusted returns over complete market cycles.

Liquidity Provider Rather Than Liquidity Taker
Because of the combined effects of each of these structural advantages, Diamond Hill is in a strong position to enhance our risk-adjusted returns by acting as a liquidity provider when volatility spikes and liquidity comes out of the high yield market. This means that we want to be buyers when the market is dominated by forced sellers and sellers when buyers are forcing their agenda. Many managers talk about being liquidity providers but few are able to do so. Partnering with clients who understand our intrinsic value investment philosophy as well as our structural advantages and who share our long-term investment temperament allows us to be a liquidity provider rather than a liquidity taker.

Portfolio Managers Execute Their Own Trades
Opportunities to take advantage of an edge in execution are often fleeting so our high yield portfolio managers execute their own trades. Communication between dedicated traders and portfolio managers would slow the process down to the point that execution edge could not be maximized. Our portfolio managers also place a high priority on being the most adept on electronic trading platforms which are an increasingly important venue for execution edge.

High Yield Market Is Becoming Less Efficient

We believe that our structural advantages are getting more valuable over time as the high yield market becomes less efficient. Increased price transparency and post-financial crisis regulatory changes have dramatically reduced liquidity in the high yield market. At the same time, ETFs and other model-based strategies have increased liquidity mismatches. While these issues are most obvious in stressed markets, they are apparent to us on a daily basis.

Capacity Discipline is the Key to Sustaining Our Advantages

The thread that ties all of these structural advantages together is capacity discipline. The high yield market is dominated by firms that have grown high yield assets under management well past the point that these structural advantages would even be possible. At Diamond Hill, we have carefully aligned our interests with those of our clients. As a result, we are committed to closing our high yield strategies before we grow to a size where we would no longer have these structural advantages.

Declining Liquidity in the Corporate Bond Market Leads to Opportunity

The views expressed are those of Diamond Hill as of February 2019 and are subject to change. These opinions are not intended to be a forecast of future events, a guarantee of results, or investment advice.

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