Back-Door Access to an Excellent but Off-Limits Value Strategy
Diamond Hill Mid Cap shares approximately 70% overlap with its stellar but closed sibling Diamond Hill Small-Mid Cap.
The following is our latest Fund Analyst Report for Diamond Hill Mid Cap A (DHPAX). Morningstar Premium Members have access to full analyst reports such as this for more than 1,000 of the largest and best mutual funds. Not a Premium Member? Gain full access to our analyst reports and advanced tools immediately when you try Morningstar Premium free for 14 days.
Diamond Hill Mid Cap’s deep, stable bench and disciplined approach to relative-value investing earn it a Morningstar Analyst Rating of Gold.
An experienced manager is at the helm here, and a solid bench of sector specialists provides support. Chris Welch has served as this strategy’s lead manager since its December 2013 launch but has run a similar strategy, Diamond Hill Small-Mid Cap (DHMAX), since its 2005 inception. Welch has backup from assistant managers Chris Bingaman and Jenny Hubbard, who have also been in their roles since this strategy’s inception. Diamond Hill's portfolio managers draw upon a centralized research team of about two dozen sector specialists who each cover their respective industries across the capital structure.
The team works together to apply its disciplined approach to value investing. Bottom-up, fundamental analysis is key. The analysts model cash flows over a five-year time horizon to estimate intrinsic value. Welch then constructs a portfolio of companies trading at discounts to these estimates that have strong cash flows, attractive business models, and durable competitive advantages. This disciplined approach has worked on other Diamond Hill strategies, such as Diamond Hill Small-Mid Cap, which is closed to new investors and shares approximately 70% overlap with this strategy. Strong stock-picking and solid downside protection has rewarded investors over time.
That said, the track record here is mixed, albeit over a short time frame. From its inception through September 2019, its 7.6% annualized gain trails its Russell Mid Cap Index benchmark by 1.5 percentage points but tops its average mid-cap value Morningstar Category peer by the same amount. It has not yet endured a full market cycle, but it has shown its ability to protect on the downside. For example, in 2018’s rocky fourth quarter, the fund’s 13.5% loss was less than its benchmark’s 15.4% drawdown. The team’s sound approach has worked in similar strategies over longer time periods. This helps strengthen conviction in the strategy’s long-term prospects.
Performance | Neutral | by Linda Abu Mushrefova, CFA Oct. 3, 2019
A short, mixed record under manager Chris Welch warrants a Neutral Performance rating. From its inception in December 2013 through September 2019, the fund’s 7.6% annualized gain trailed its Russell Mid Cap Index benchmark by 1.5 percentage points but topped its average mid-cap value category peer by 1.5 percentage points. However, it has not yet endured a full market cycle and has shown flashes of downside protection. In 2018’s rocky fourth quarter, for example, the fund’s 13.5% loss was less than its benchmark’s 15.4% drawdown. Indeed, the fund captured just 92% of the index’s losses in market declines, suggesting some relative strength in those periods.
The strategy has tended to lag in rising markets as it opts for high-quality, steadily growing companies rather than speculative fare. For example, for the year to date through September 2019, it has lagged its index by over 3 percentage points. Stock picks in the financials and utilities sectors have detracted the most.
Nevertheless, the fund still tops its mid-value peers in 91% of three-year rolling periods dating back to Welch’s start. Welch’s success in a similar strategy with a longer track record, Diamond Hill Small-Mid Cap DHMAX, suggests that this variation could also deliver over a full market cycle.
Price| Positive | by Linda Abu Mushrefova, CFA Oct. 3, 2019
Attractive fees earn a Positive Price rating. The I share class accounts for roughly 76% of assets. Its 0.78% expense ratio is 10 basis points below the median for similarly distributed peers, and its low minimum investment of $2,500 makes it more accessible than its typical institutional peer, adding to its attractiveness. The A share class accounts for 15% of assets and its 1.07% levy is low relative to peers. The Y share class houses the rest of the assets and charges a reasonable 0.66% relative to peers.
Trading costs as a percentage of average net assets are below average, too, thanks to the team’s patient style. The fund’s 2018 brokerage commission fees of 0.01% were well below its mid-cap value peers’ 0.05% median.
Process| Positive | by Linda Abu Mushrefova, CFA Oct. 3, 2019
Lead portfolio manager Chris Welch’s successful execution on a disciplined approach to value investing earns a Positive Process rating.
Welch’s process follows Diamond Hill’s sensible, bottom-up approach. He buys companies when their market prices are lower than the estimate of their intrinsic business value and sells them when they reach that value. The firm’s centralized research group models companies’ cash flows using a five-year time horizon. Analysts dive into balance sheets and income statements to estimate cash flows, normalized earnings, and an appropriate growth rate. Model assumptions are left to the analysts’ discretion, but portfolio managers reserve the right to modify any inputs. Stocks trading at a discount to the team’s estimates of intrinsic value are eligible for inclusion, and Welch sizes positions according to their risk profile and margin of safety. All else equal, the more conviction the team feels in a company’s moat or ability to sustain its competitive advantage, the higher the allocation.
In addition to its focus on valuation, the team also hunts for quality and durability. It looks for businesses with stable cash flows and defensible competitive advantages. Such companies tend to hold up better on the downside and reward investors over a full market cycle.
Lead manager Chris Welch and his team collaborate to build a portfolio of 50-70 holdings with attractive valuation characteristics. Specifically, portfolio holdings tend to have lower price/earnings and price/book ratios than the average mid-cap value category peer or its Russell Mid Cap Index benchmark. Further, the fund doesn't adhere to the index's sector weightings, and cash can grow when markets become frothy but has stayed below 10%.
The portfolio also looks attractive on quality characteristics. For example, its return on invested capital ranked higher than its average peer and benchmark. It also tends to exhibit more growth characteristics than its typical peer, as reflected in its above average cash flow growth, book value growth, and sales growth figures. Portfolio holdings such as Boston Scientific (BSX) and NVR (NVR) contribute to the fund’s core-leaning tendencies. Despite above-average exposure to growth stocks, the team applies its valuation-focused approach consistently and does not invest in speculative businesses.
Finally, Welch and his team preserve the portfolio’s mid-cap orientation. Welch targets companies with market caps of $1.5 billion-$20 billion and will let holdings run above that if their valuation and fundamentals remain compelling. Still, the portfolio’s $8.3 billion average market cap as of September 2019 was below the $10.5 billion peer median.
People | Positive | by Linda Abu Mushrefova, CFA Oct. 3, 2019
The team’s stability and deep industry experience contribute to this fund’s Positive People rating.
Veteran Chris Welch has served as this strategy’s lead manager since its December 2013 launch. He has backup from assistant managers Chris Bingaman and Jenny Hubbard, who have also been in their roles since the strategy’s inception. Assistant portfolio managers at Diamond Hill are expected to be familiar with the portfolios, though the ultimate responsibility lies with each strategy's lead manager. Welch’s industry experience dates to 1995, and he also has lead portfolio management responsibilities for Diamond Hill Small-Mid Cap DHMAX and Diamond Hill Small Cap DHSCX.
Welch draws upon a centralized research team of about two dozen sector specialists and associates who each cover their respective industries across the capital structure. Those analysts average more than a decade of industry experience, and well over half have earned the CFA designation. The group has weathered recent turnover without much disruption. Two analysts and an associate left in 2017, and another associate left in 2018. Overall, retention on the team remains exemplary.
Finally, the team’s interests are closely aligned with investors'; Welch invests more than $1 million in this fund while Bingaman and Hubbard each invest between $100,001 and $500,000.
| Positive | by Linda Abu Mushrefova, CFA Oct. 3, 2019
Diamond Hill’s strong investment culture and mission-driven focus earn a Positive Parent rating.
Diamond Hill has consistently adhered to the intrinsic-value philosophy that drives all its strategies. When it has launched new strategies, the firm has taken a measured approach. For example, the investment team spent the better part of a decade building out global research coverage prior to launching its international and global strategies. It has also proved its willingness to close strategies and errs on the side of conservatism when it comes to capacity estimates.
Portfolio managers are aligned with clients through the firm’s long-term-focused compensation structure that is closely tied to its strategies’ results. Employees are not permitted to invest in equities or non-Diamond Hill offerings where the same capability exists internally, making them investors alongside fundholders. The firm also boasts exceptional retention, and its thoughtful approach to succession planning ensures that transitions are seamless and telegraphed well in advance.
Diamond Hill recently appointed its first dedicated CEO in Heather Brilliant, who worked at Morningstar from 2005 to 2017. Brilliant’s priorities include growing brand awareness, but we expect its investor-led focus to stay intact. A mission-driven focus that permeates the firm sets this steward apart.
Linda Abu Mushrefova does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.