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A Long-Short Story

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Thinking about an absolute return strategy during a period where some major market indexes are at, or near, all-time highs may not sound intuitive, but for clients wondering where the market goes from here, perhaps a long-short strategy with low correlation to the market should be part of the answer.

But instead of following the ups and downs of indexes, Ric Dillon and Chuck Bath, co-portfolio managers of the $1.6 billion Diamond Hill Long-Short Fund (DIAMX), estimate a company’s intrinsic value based on its fundamentals and growth prospects, and evaluate the discount or premium of the stock’s price relative to intrinsic value, to pick individual stocks for the fund’s long and short portfolios. Dillon says advisors could think of an allocation to absolute return strategies, such as the long-short strategy, as “another tool in the risk-control tool bag.”

Because the fund has a long and short portfolio it is difficult to compare it with any long-only index. Nevertheless, the fund has had five-year average annual returns of 11.10% compared with 9.42% for the Standard & Poor’s 500; and 18.14% versus 12.97% for the three years ended May 31. S&P gives the fund an overall five-star ranking, with a three-year rank of five stars and a five-year rank of three stars.

Dillon spoke with Investment Advisor in late May.

What made you decide to do a long-short fund?

At the end of 2000 we started a partnership that was long-short, and this fund was originally a long-only fund. In 2002, we made the decision to change this fund to be long-short. At that time there were very few long-short mutual funds; we were doing a good job on the partnership long-short so we believed we had the ability to do a good job in the mutual fund.

How do you evaluate which stocks to buy, which to short, and which to leave out?

We are limited by design to the U.S market. We use, generally, in this mutual fund $2.5 billion as a market-cap cutoff, and that shrinks the universe to about 1,000 companies. We have 40 or so holdings [each] in the long side and the short side, so in combination, a little less than 100 [positions] or a little less than 10% of that 1,000 [stock] universe.

The longs will tend to be names where we think the valuations are compelling, and that will be a function of things like current valuation and growth prospects and how those growth prospects are being valued. The actual metric that we get to is an estimate of what a company is worth, what Graham called intrinsic value. That intrinsic value is based on an estimate of future cash flows, discounting back to the present. The companies we have long positions in tend to be selling at decent discounts, and at times, sizeable discounts, depending on where we are in the market, to that estimate of intrinsic value.

Similarly our short positions are companies where we think the stocks are selling at considerable premiums to that estimate of intrinsic value, where, perhaps–and frequently this is the case–the growth that is expected is being overvalued. Or, perhaps, growth which might be currently, relatively rapid, is implicitly being extrapolated into the future, indefinitely.

So something that’s gotten ahead of itself?

What one can easily observe over history is that few companies have very high rates of growth sustained for a decade–very few–and high rates would be defined as perhaps 15% annual growth for a decade, and yet many companies where we’re short might be implying that these companies will almost certainly have growth well in excess of 15%; maybe 20% or 25% growth for the next decade, which would be almost unheard of. We’re not talking about little companies that are entrepreneurial in nature; we’re talking about companies that are very established. For them, at that size, to then have this remarkably high growth is a rarity indeed, and yet the companies we’re short tend to be companies where that seems to be a given, and we’re skeptical of that.


So, these aren’t necessarily companies that are doing a bad job?

That’s exactly right. Sometimes very, very fine companies–a good example of this goes back a few years now, when we were short Intel [INTC], and it was a very profitable short for us, and yet it wasn’t because we thought Intel was a bad company. Clearly, the rapid growth experienced in the second half of the ’90s, for instance, had a lot to do with the convergence of two factors: the build-out of the Internet, and Y2K. We could add a third, modernization of our economy and the increasing usage of semi-conductors as a part of that modernization. The company, of course, experienced very rapid growth and yet the stock went up more than even the growth suggested, as if the growth was going to be sustainable or even accelerate, which was clearly absurd. The downside was gradual in the case of Intel, [it took] years for that realization to set in. It’s a perfect example of a very fine company, clearly one of the best companies in the world, whose stock price has been a terrible performer–simply because the stock was too high–not because the company didn’t execute.

Would you talk about winning longs and shorts?

On the long side, the biggest [winner] was a company called PacifiCare Health Systems, which is now part of UnitedHealthcare [UNH]. Even prior to being acquired by UnitedHealthcare it would have been our most successful long position. What this company did was turn around from a catastrophic period when they went from great profitability to actually losing money, and through change in management, which led to a change in strategy, they were able to return to profitability, and the stock, which had behaved as if, perhaps, they were possibly even going to go bankrupt, was very lowly valued, and there was a lot of operating leverage and financial leverage extant. It was one of those situations where getting the turn, plus the low valuation, it had everything going in its favor. Those are rare occasions where you get something that tremendous, but that was by far our best.

On the short side, a company that did really well for us–twice actually–last year, and into this year, was Netflix [NFLX], a company that provides a service supplying DVDs via the mail as opposed to through stores, so it’s an Internet-based retailer. A very fine company, again. I happen to have been a subscriber and liked their service, but their stock price seemed to ignore competition coming from traditional sources, and in the case of Blockbuster, a combination of traditional and similar stores. Blockbuster, of course, has the stores, but then they began offering an Internet-based service, [and] because of the fact that they had the stores, in a certain way, a superior service–my wife and I had to switch to it (laughing). Our analyst, Bhavik Kothari identified the company, saw growth, he wasn’t saying that their earnings were going to decline but he just thought that growth was being too highly valued. Chuck and I shorted that stock in the high $20s back last spring. In the summer we covered that short at around $20 a share, only to see the stock go back to the high $20s, and we put the short position back on, and once again covered it in the low $20s earlier this year. It’s fortunate that we had the opportunity to do it twice, the same company, but I think it’s a good illustration of what we’re talking about.

Is it harder to pick a stock to go long or to go short?

Most people will tell you it’s harder to pick a good short, and probably that’s correct. Generally speaking all companies are building the value of their businesses. On the long side, that is the wind at your back, [because of] the fact that the intrinsic value of businesses generally is growing. On the short side, that’s the wind in your face. Another way of thinking about is if you stay short a good company a long enough period of time, eventually you’ll have no profit, because eventually that intrinsic value will catch up to where you had shorted it.

Where would this fund fit in an individual’s portfolio?

I think long-short strategies generally–ours would be included in this–are more absolute-return oriented versus relative-return oriented. A long only fund, and obviously we have lots of them, when the market’s going up they’re going up; when the markets go down they generally go down. An absolute strategy fund is going to try to make money in any environment, and a good one should have a good chance of making money in any market environment. If this fund is up 3% or 4% when the market’s down 5%, that’s pretty darned good.

E-mail Senior Editor Kathleen M. McBride at [email protected].


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