Kristen Sheffield, CFA (0:12)
Hello everyone. My name is Kristen Sheffield. I'm an equity portfolio specialist at Diamond Hill. Today on the webcast I'm joined by co-portfolio managers of our Select strategy, Austin Hawley and Rick Snowdon. Welcome back to the webcast guys, and thanks for joining me today.
Rick Snowdon, CFA (0:28)
Yeah, thanks, Kristen.
Austin Hawley, CFA (0:29)
Thanks, Kristen.
Kristen Sheffield, CFA (0:31)
We’ll just go ahead and dive right in. I think it was maybe this past April or May when I first heard the term Magnificent Seven, and I think we all know that over the past year this group has dominated markets, as well as headlines, perhaps somewhat surprisingly given the interest rate environment we’ve seen over that time period.
However, over the past couple of months, we've seen quite a bit of divergence in performance within this cohort. I thought a good place to start would be any thoughts on what, if anything, has changed with this dynamic or perhaps other general observations on the market to kick us off?
Austin Hawley, CFA (1:13)
Great. I'll take that one, Kristen. It has been really remarkable just how the Magnificent Seven narrative has dominated the markets over the course of 2023, especially. So, it's been interesting to see early this year that we have had some pretty meaningful divergence between the companies that are in that group, those seven companies. And I think when you get down to it that divergence has been driven by the same thing that usually drives large divergences in stock performance, which is that we've had some significant changes in the fundamentals in the near-term — earnings as well as cash flows — and that's collided with some pretty lofty expectations that were baked into the valuations of these businesses. I think it is really important to note that these are individual companies that have their own trends in terms of earnings and cash flows and drivers that contribute to their growth.
We often talk about them like they’re one unit and they move in unison, but what we've seen this year is that's definitely not the case. These are all different companies with some similar drivers, but a lot of differences as well.
And so, one of the things that I think is interesting is to look at the extremes this year. If you look at Nvidia, Nvidia's earnings estimates for 2024 so far this year have moved up 20%. That is a huge move in expectations for earnings at Nvidia. At the same time, the valuation multiple for Nvidia coming into this year had actually moved down pretty significantly to the point where it was trading at about 25 times earnings. We've seen that multiple move way back up all the way to the kind of mid-thirties multiple, and those two things interacting together create this huge return year-to-date for a company like Nvidia.
On the flip side, you've seen the exact opposite happen at Tesla, where you've seen earnings estimates just this year down 15% to 20%, and at the same time, the multiple that investors are willing to place on those earnings has collapsed as well. And so, you've seen Tesla sell off nearly 30% year-to-date. and the other five companies fall kind of somewhere within there, but it really has been driven mostly by fundamentals combined with varying levels of lofty expectations for those companies.
One final point here that I think is just interesting to note with regard to Select, we've actually owned five of the seven Magnificent Seven at some point in the last decade. We owned Apple back before there was anything called the Magnificent Seven, but we've owned all of those five companies as individual companies based on our expectations of the earnings of those businesses and the valuation we see. We do not think of that group of companies as this kind of homogeneous mix of businesses that move in unison. We evaluate them like we would any other company — based on our expectation of how the fundamentals will evolve over time and the valuations. And what we've seen is after having a pretty large weight in a few of those companies back in 2022, some of those valuations have moved way up, and we've reduced that exposure to the point where we only own one, Amazon, today in Select.
Kristen Sheffield, CFA (4:52)
That's a great segue. I think it's really important to remind everyone how we're thinking about that, and they are individual businesses, and you mentioned we've been involved with a number of these in the past and only own Amazon today. So, what are we particularly excited about with Amazon, and what do we think the market or other investors might be missing here?
Rick Snowdon, CFA (5:18)
Yeah, so I'll take that, Kristen. So, for one, I think we’re not so concerned about the AWS (Amazon Web Services) slowdown as some others seem to be. We believe the growth will snap back. There's been this period of sort of optimization on the part of the cloud customers and that has kind of disproportionately — because of the way the market shares are and the types of clients that Amazon and particularly Microsoft have — that's sort of disproportionately impacted AWS and Amazon, but that appears to be coming to an end and I think that was highlighted on the earnings call, which was just a couple weeks ago. And so, I think that we might be looking at that a little bit differently. And, I guess on that point there's just a ton of cloud migration left to happen, maybe as much as 80%. So, we got to keep that in mind.
But the big upside, I think, is probably in retail margins. If you look back to 2018, if you look at the North American retail margins — which it's important to look at those excluding the advertising piece — but back then there really wasn't much advertising, so that sort of covers it. Those retail margins from North America were 5% or maybe even a little bit north of that, whereas recently though, due to this rapid expansion that's happened in their capacity since Covid — probably due to some head fakes too rapid expansion and due to some head fakes that happened due to customer behavior during Covid — those margins have turned negative. And when I say rapid expansion, at the peak of that, we're talking doubling capacity in 18 months. I mean it's extraordinary and frankly almost impossible for me to think about how much expansion that is. As that capacity is absorbed, which looks like it's going to happen in the next number of quarters, those margins ought to turn positive again.
And we think there's really not any reason they can't reach the 2018 levels or maybe even higher. So, you take that, again those are excluding advertising. Then you layer in international, and they've reached the point that they've now been operating in a number of key countries outside of the US or outside of North America for nearly as long as they operated within North America and prior to becoming profitable. And they've been becoming more profitable or less unprofitable internationally, I should have said that first. So, as that all takes place continues to take place, you should get a big boost on the international side too, and then you got to layer back in the advertising. So, there's a big mix-shift benefit there.
Advertising is actually reported in their retail margins, and advertising is growing significantly faster and is significantly higher margin than the rest of the retail business. So, you get a big mix-shift benefit there. And then finally, the new CEO, Andy Jassy has made it clear both in his commentary and his actions that all the parts of Amazon are expected to move toward their respective profit potential. And so that I just give follow through for everything that I've talked about and really drive expanded margins in retail.
Kristen Sheffield, CFA (8:58)
Another group that has been in the headlines quite a bit over the past year in a very different way has been the regional banks, resurfacing again just this past month with fears surrounding New York Community Bank. And I know sometimes volatility and industry-wide concerns can create interesting opportunities, and we recently added Key Corp to the portfolio. So, Austin, can you talk a bit about the opportunity with Key Corp specifically and then maybe any thoughts on the banking industry more broadly?
Austin Hawley, CFA (9:32)
Sure. So, as you point out, there's been a couple different industry-wide issues that have impacted the regional bank industry over the last year, and they've had the effect of basically keeping valuations within the regional bank industry very much in check. In fact, I would argue that the valuations across the regional bank landscape have looked very attractive over much of the last year. I mean, we’re talking about historically low valuation multiples, single-digit multiples on earnings and close to tangible book value in a number of cases. Despite that, we have not been in a hurry to get involved or involved in a larger way in any of the regional banks. And the primary reason is we've been very cautious about the fundamental outlooks for those companies, and it comes down to a few key issues. The first is there's just not a whole lot of loan growth for these companies. So, it is hard for them to kind of grow their earnings without opportunities to significantly manage down their costs. And I think given what’s happened over the last 10, 15 years of these banks becoming much more efficient, I think that’s just a harder ask for banks going forward today.
The second issue is that we've had real pressure on net interest margins and that's largely because we've had increased competition for deposits and especially high-quality deposits at the banks. And this has raised deposit rates and it's squeezed those net interest margins. So, low loan growth as well as declining net interest margins is a tough combination in terms of revenue growth.
And then the final piece that's been more of an uncertainty is what happens with regulatory costs and capital requirements for the banks and the aftermath of the March crisis. And we still don't really know the answer to that. We've had some plans that have been put forth that would significantly increase capital, but we've also had some pretty significant pushback from the industry, and I suspect those are going to get watered down pretty significantly compared to some of the initial goals. But I do think the regulatory costs and capital requirements will be marginally higher going forward. So those have all been a challenge and the reason why we've been a little bit slow to wade into these regional banks despite the valuations.
So Key is the first new name we've bought into the portfolio in terms of banking since the mini banking crisis in March. And Key has a few unique characteristics that we think will allow it to overcome some of those challenges that I just referenced. And there's kind of three things I think about that really make Key unique. The first is that Key had a portfolio of interest rates, swaps and treasuries that were meant to kind of minimize the volatility and net interest income, but they had the impact of really tampering down net interest income growth in a rising interest rate environment. They served as a kind of cap on the amount of growth and net interest income that Key was able to realize because of some of these hedges they had in place in the portfolio.
The second issue is that the management team at Key has been undertaking a strategy of trying to shed non-core loans in its loan book. And this has led to a slight decline in the overall asset growth at Key. And so, you've had declining loans and net interest income that's been kind of capped by these hedges. And then the final thing, like many of the other regional banks, Key had a securities book that had some significant unrealized losses due to rapidly rising interest rate environment and this raised some questions around capital adequacy at the bank, like it did some other regional banks, and led to a pretty significant sell off in the stock.
When we think about all these three things together, they've been headwinds for Key over the past couple years. We think they are going to turn collectively into pretty significant tailwinds for Key's earnings power going forward. We're going to roll off those hedges, the swaps and treasury book, over the next two years and all of those hedges as they roll off will be reinvested at significantly higher interest rates, which will provide a tailwind to net interest income.
The same thing's going to happen with the unrealized losses on the security book. About a third of those unrealized losses are going to come back into income over the next couple of years as those securities mature. As they mature, they'll be reinvested at much higher interest rates once again.
And then finally, now that we're kind of done with repositioning the loan book, we think Key is in a really good position relative to a lot of its industry peers to show some modest loan growth going forward. I think Key's going to be able to deliver on above average earnings growth and tangible book value growth over the next couple years. And part of the opportunity is the fact that they've had these headwinds over the last couple years, those are going to go away and they're going to turn into tailwinds going forward.
Kristen Sheffield, CFA (15:23)
Another area I wanted to ask about — something that we've added a little bit to over the past couple of quarters — is real estate. And I know different areas of the market seemingly have reacted to higher interest rates in varying degrees and real estate as a group seemed to be under some pressure over the past number of quarters. This is a bucket that's pretty broad and businesses within the sector can vary quite a bit. Are there particular pockets or industries that we've tended to find more attractive in this space as we've added some exposure to the portfolio?
Rick Snowdon, CFA (16:08)
Yeah, I'll take that, Kristen. So, in the 11 years during which Austin and I have been responsible for managing the Select portfolio, real estate hasn't really been a consistent part of our holdings. But there are two areas, sort of sub-sectors, that we have found attractive and those are self-storage and sell towers, and they share some attributes. They both have sticky revenue, steady growth at high incremental margins with low incremental CapEx, which is fantastic.
In the past we've owned Cube Smart, which is a self-storage company and SBA Communications, a tower company. And recently we've actually had the opportunity to buy back into both of those sub-sectors. One of those was just actually last week we bought SBA Communications at a very attractive price. It was down almost 50% from where it was trading two years ago and actually was at a significant discount to the prices that we paid during the pandemic, which is just kind of hard to think about.
So, why is that the case, I guess, is a good question. So rising rates, as you mentioned, that's certainly part of it, a big part of it. And then some transitory industry stuff that we think should be looked through. So, the industry's had slower than expected 5G deployment, but that's going to have to happen at some point. And then you've also had continuing lease rationalization as a result of the T-Mobile Sprint deal, and that has disproportionately hit SBA Communications, but we think that's fine. It's more than fully reflected in the price. We paid 15 times, we think, roughly 2024 distributable cashflow and after the weakness abates, we think they're going to be able to grow cashflow in the low to mid double digits. So, we think that means it's a very attractive price.
Then on the self-storage side, we bought a different name that we held before we bought Extra Space that was a little bit longer ago, that was in September of 2023. And this is a name, a self-storage operator, that our real estate analyst has long been impressed with. It had underperformed its peers, large storage peers by roughly 20%. And then that group had underperformed the broader market by almost 20%. So significant underperformance there. Some of its weakness was understandable. Again, interest rates, the industry was coming off of a fantastic time during the pandemic, which had resulted in higher occupancy and therefore higher rents. So, sort of a letdown from that. And they were digesting a large acquisition, really the largest acquisition actually in the history of the industry that was expected to be dilutive in the near term. But this is one of only a couple of scale players in a highly fragmented industry and that gives them big advantages when they're competing in local markets against smaller players such as sophisticated pricing tools and sophisticated marketing tools as well as leverage on personnel and all of their operations. So, on that one, our estimates are that we paid mid-teens multiple for likely low double-digit growth over time and a very capital efficient and high incremental margin manner. So, we find both of those to be really attractive.
Kristen Sheffield, CFA (20:11)
That's helpful. I think you hit on exactly the fact that that's an extremely broad bucket. I'm thinking about self-storage and cell towers is not the first things that kind of come to mind with real estate.
The last area I kind of wanted to hit on draws on something that is a little bit unique about the Select strategy, which is that combination of concentration and a flexible mandate. So, you are looking for the best ideas across a broad universe, which really creates an interesting perspective and in terms of where those best ideas are tending to bubble up from. I thought a good place to wrap up would be what are you seeing in the market landscape today in terms of where you're finding the most attractive opportunities and any themes there?
Austin Hawley, CFA (21:03)
Yeah, so I'm going to sound a little bit like a broken record here and reiterate some of the themes that we've been seeing for nearly five years now. I mean almost going back to pre-pandemic and that theme is that we've seen more attractive valuations a little bit lower in the market cap range. So, think about more small-cap, more mid-cap stocks making up the portfolio. If you look today, we are about 50%, a little over 50% in what I would call kind of true small-cap and smid-type stocks. And I'm going to roughly define that as stocks, $10 billion in market cap and lower. And that's down slightly from kind of the peaks of exposure to the small- and mid-cap area, but it's still awfully high. If you think about any kind of market cap weighted benchmark, we are way skewed towards small- and mid-cap relative to those market cap weighted benchmarks.
And if you look at the valuations we see today, that continues to be the case that small- and mid-cap stocks are trading at lower valuation multiples than the larger cap stocks, which is an unusual situation. Historically, usually smaller cap stocks have traded at a modest premium to large cap, partly based on the fact that there's some optionality in the potential of being taken out in an acquisition. And so, we still think that's the case.
Having said that, when you look at the market today, we've run up a lot over the course of 2023. We think valuations overall are at pretty high levels and part of the relative attractiveness of both small cap, but also just value stocks broadly, lies in the fact that they aren't as expensive as the market cap weighted universe. It's not so much that they look very cheap, it is just that everything else looks pretty expensive.
And so, we still like the outlook in terms of relative opportunity because those spreads are pretty wide between value stocks as well as some of the small- and mid-cap stocks. However, I wouldn't want anyone to take the message as these are screaming cheap stocks and we have opportunities coming out of the woodwork because that’s certainly not the case. It's been relatively hard to find new ideas.
Now I will make a couple points just looking at some of the recent names we’ve added. If you just look at the last five names we added, I think that’s Key, SBAC, Diamondback Energy, Coherent and Pfizer. And so, we've got a wide variety of sectors that I just mentioned there in those five names. Four of those names fall within that kind of small- or mid-cap bucket, excluding Pfizer, which is clearly a mega-cap stock, and so consistent with that theme. The other thing I'd point out is for those names, if you exclude Coherent, which is more of a faster growing technology company, the other four names are more traditional value stocks: strong balance sheets, great management teams. They produce tons of free cash flow. A lot of that free cash flow is being distributed to us today in the form of high dividend yields for these companies. And I point that out, not because that's something we necessarily look for in investment, it just happens to be where we're finding some more value today, some of those slightly more traditional value stocks that are paying out a lot of the cash to shareholders in the near term.
I guess I'd just wrap all that up for Select in saying it is nice to be a more concentrated value manager with the flexibility we have to look across the market cap range. It's been very helpful in finding some of those names that we found recently in a market that has become relatively expensive in our opinion.
Kristen Sheffield, CFA (25:14)
Well, that's a great place to end. Austin, Rick, thanks again for joining me today. I appreciate the time as always and look forward to our next conversation.
Rick Snowdon, CFA (25:26)
Thanks, Kristen.
Austin Hawley, CFA (25:27)
Thanks, Kristen.