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Fund Times: Frank Talk on Energy from Diamond Hill

Plus, news on Matthews, value managers buying Dell, Oppenheimer, American Funds, Fidelity, and more.

Morningstar Analysts, 10/16/2006

We're always glad when we see fund companies communicate with shareholders in a straightforward manner, and Diamond Hill Capital Management's third-quarter shareholder letter is a fine example of good communication. Without sugar-coating performance, the letter begins by admitting that the "performance of our diversified stock funds in the third quarter of 2006 was not good," and it goes on to explain that the funds' sizable energy stake was largely responsible.

While the market rebounded strongly in the third quarter overall, crude oil futures dropped from more than $75 per barrel to near $60, sending many energy-focused equities into negative territory for the quarter. Both Diamond Hill Long-Short DIAMX and Diamond Hill Small Cap DHSCX, which have energy stakes comprising more than 25% of assets, were hurt by these declines. In the third quarter, Long-Short declined a small 0.06% and Small Cap a more significant 4.69%. Despite these short-term troubles, however, management at both funds still believes its long-term positions in companies such as Cimarex Energy XEC are well founded.

This is because management at these funds believes that "current equity prices embed long-term commodity prices on the order of $35-45 per barrel of oil and $5-6 per Mcf (thousand cubic feet) for natural gas, whereas we believe probabilities favor higher average prices."

Management sees long-term price averages more in the vicinity of $55 per barrel of oil, and $8 is their intrinsic value estimate for natural gas. Several factors go into this assumption, such as the firm's view that emerging-markets economies will continue to spur strong demand for oil, while years of underinvestment in new oil production facilities will take a while to come online. Additionally, the managers believe that the so-called "terror premium" on oil prices, namely the threat that political instability in some parts of the world may result in supply disruptions, is not unfounded. For natural gas, the Diamond Hill team believes that declining production from the Gulf of Mexico, combined with the continuing impact of the harsh 2005 hurricane season, will be factors leading to higher gas prices than markets currently expect.

In the end, only time will tell whether the Diamond Hill management teams are correct on the energy sector or not; however, we think this advisor's communication with shareholders is better than many.

New Managers Supplement Matthews Fund
Matthews International Capital Management has recently announced the appointment of two new comanagers to Matthews Japan MJFOX. David Ishibashi and Taizo Ishida have joined veteran Asia region manager Mark Headley, who took over this portfolio in late 2000.

We're glad to see that the new managers bring significant experience to the team. Before joining Matthews, Ishibashi was a Japanese equities analyst at Lazard Asset Management from 2003 to 2006, and before that, he had a decade of experience as a portfolio manager at Citigroup Capital Markets. He has also held various positions at S.G. Warburg, Baring Securities, and Nomura Securities. Before coming to Matthews, Ishida worked as a Japan and Pacific Basin portfolio manager at Wellington Management Company from 2000 to 2006. Previously, he worked as a senior analyst on the international investment team at USAA Investment Management Company, after holding several positions at Sanford Bernstein.

Overall, we're impressed with these hires, which add to the fund's already impressive team. Headley, who has been with Matthews since 1995 and also serves as the firm's president, has a broad resume in Asia/Pacific investing. Additionally, the firm added a second dedicated Japan analyst to its staff earlier this year, so with the new comanagers we think the team at Matthews Japan is deep and experienced.

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