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.