Fund in Focus: Diamond Hill Small-Cap Fund

Roderick Dillon and Thomas Schindler, co-managers since December 2000S&P Rank: 4 StarsTop-Performing Small-Cap Fund Builds Up Cash As Attractive Investments Dwindle

March 23, 2005 -- The Diamond Hill Small-Cap Fund/A (DHSCX) usually doesn't own many stocks. And for the last year or so, portfolio managers Roderick "Ric" Dillon and Thomas Schindler say they've been having difficulty finding any attractive investments.

As a result, the $88.1-million fund's cash position has nearly reached its mandated 30% maximum after drifting around 20% on average last year, Dillon says.

It's relatively heavy weighting in cash hasn't kept the fund from outrunning its competitors, though. Diamond Hill Small Cap, which began operating in December 2000, returned 24.2% for the 12-month period through February 2005, versus a 13.2% gain for the average small-cap value fund. For the three-year period, the fund registered a 19.2% annualized return, versus a 13.8% gain for the peer group.

Even when investment opportunities seem more promising, the managers typically limit their number of holdings to 50.

"We do want it to be a reasonably concentrated, or a focused, portfolio," Dillon says. "The idea is that the best returns will come from the best situations. We don't want to dilute those by having too many names."

In picking stocks, Dillon and Schindler look for those priced at a discount relative to their estimate of a company's intrinsic value. They also like companies with a competitive edge, a sound balance sheet, and solid returns on equity.

While the managers want to own profitable companies, they're willing to bet on those currently in the red if they think the business is on the verge of posting earnings. Similarly, they like companies that are generating cash, but they'll own those that aren't cash flow-positive if they deem that situation poised to change.

The managers hunt for stocks among companies with market caps of $50 million to $2.5 billion.

In late 2004, Dillon and Schindler bought a stake in Finish Line Inc. (FINL), a retailer of athletic footwear and apparel. The chain looked good, Dillon says, because it was drawing business away from a competitor, Foot Locker Inc. (FL), which in turn was pushing up margins and sales in stores open at least a year.

The fund's No. 1 stock at the end of last year was Southwestern Energy Co. (SWN), a company that Schindler notes has benefited from increased production and higher prices for natural gas.

The fund, whose sector weights are a result of the managers' stock picks, had just over 20% of its assets in energy stocks at the end of December, making it the second-largest sector in the portfolio. Its biggest investments overall included Encore Acquisition Co. (EAC), an oil and natural gas producer that Dillon says has done a good job of locating supplies and boosting production.

When it comes to selling, Dillon and Schindler will unload a stock if it becomes pricey, or if the company's financial fundamentals start to slide. They'll also eliminate a company to raise cash to buy a better looking investment.

Earlier this year, the managers banished appliance maker Maytag Corp. (MYG) from the fund because, they say, the company's profits were disappointing.

In addition to running the Small Cap Fund, Dillon and Schindler own shares in it. Both have a "fairly high dollar amount" invested in the portfolio, according to Dillon.

Looking at small-cap stocks, Dillon expects them to generate positive returns this year, but he doesn't believe they'll perform as well as they did in 2004. Small-caps, which have rallied over the last five years, are no longer undervalued relative to stocks of large companies, he notes.

Contact Bob Keane with questions or comments at:bkeane@investmentadvisor.com.

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