Fund in Focus: Diamond Hill Small-Cap Fund

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.