This Newly Rated Mid-Cap Fund Delivers on the Downside
Gold-rated Diamond Hill Mid Cap boasts a deep bench and disciplined approach, but it lags in frothier market environments.
|The following is our latest Fund Analyst Report for Diamond Hill Mid Cap (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 receives a Morningstar Analyst Rating of Gold because of the depth of its bench and its disciplined, bottom-up approach.
The strategy is backed by an experienced and well-resourced team. Chris Welch has been at the helm since the strategy's inception in December 2013. He has been in the investment industry since 1995 and at Diamond Hill since 2005. He's further supported by assistant portfolio managers Chris Bingaman and Jenny Hubbard, who have both been in their roles since the strategy’s inception in December 2013.
The team draws upon Diamond Hill’s centralized research team, which is composed of about two dozen analysts, divided by sector, that boast over a decade of investment experience, on average. Together, they apply a bottom-up approach rooted in their intrinsic value philosophy. The approach adopted here drives all of Diamond Hill’s equity strategies and has rewarded investors over a full market cycle.
The team conducts deep analysis to identify attractive companies trading at a discount to their estimated intrinsic value. The analysts are responsible for modeling cash flows on a five-year time horizon, which includes looking at each name’s balance sheet and income statement to estimate cash flows, normalized earnings, and an appropriate growth rate. Each name trading at a discount to its forecast intrinsic value is eligible for inclusion in the portfolio.
Welch is responsible for portfolio construction and employs an approach that can result in distinct sector over- or underweightings at times. The strategy has outperformed its mid-cap value Morningstar Category peers since inception on a risk-adjusted basis but lags its Russell Mid Cap Index benchmark. Since Welch came aboard in December 2013, the strategy topped its peers in 91% of 22 rolling three-year periods and its index 59% of the time. While it has not consistently topped its index, the team’s disciplined research process should result in solid stock-picking over time and reward investors that stick with it. An added bonus is the fund’s below-average fees, resulting in a lower hurdle relative to many actively managed peers.
Portfolio manager Chris Welch employs a disciplined approach to value investing characteristic of all Diamond Hill's investment offerings: 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 team’s successful execution of its approach earns the fund a Positive Process rating.
Their approach is predicated on bottom-up, fundamental analysis. Diamond Hill’s centralized research group is responsible for modeling cash flows on a five-year time horizon, which results in an estimated terminal value. Analysts dive into each name’s balance sheet and income statement 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 of the inputs for their own analysis. Names that are trading at a discount to their intrinsic value are eligible for inclusion.
The result is a portfolio with attractive valuation characteristics. Specifically, portfolio holdings tend to have lower price/earnings and price/book ratios than the average peer or benchmark. Further, the fund doesn't adhere to the index's sector weightings, and cash can grow when markets become frothy. Welch constructs a portfolio of 50-70 holdings and generally looks for companies with market caps of $1.5 billion-$20 billion.
Lead manager Chris Welch is responsible for portfolio construction. The portfolio-construction process follows a bottom-up, sector-agnostic approach. His sell discipline is driven by the estimated intrinsic value. Once a stock reaches this level, the team will sell it. Further, there is no strict margin of safety required for a name to enter the portfolio and the team will tend to trim a position as it approaches its intrinsic value.
Welch and team have maintained an overweighting in the financials sector since the strategy’s inception in December 2013. They continue to see opportunity in the sector but the team has been hard-pressed to identify new ideas in the current market environment. As a result, cash has consistently been in the high single digits for the duration of the strategy’s lifetime. Welch advises that he will not allow cash to exceed 10% of assets, but this conservative positioning has worked against them in recent years.
It's had more success identifying new investment ideas in 2018 than in 2017, though. For the year to date through September 2018, the team entered into nine new positions, which is more than double the number of names bought in all of 2017. Nevertheless, the team has had to hold on to names where the discount to intrinsic value is shrinking. For example, Boston Scientific (BSX) is a name that is approaching the team’s estimate of intrinsic value, but given the quality of the business they continue to hold it.
The fund’s record under manager Chris Welch has not stood out and earns a Neutral Performance rating. Since its inception in December 2013, its 8.6% annualized gain trails its Russell Mid Cap Index benchmark by 1.9 percentage points through September 2018 but bests its average mid-cap value Morningstar Category peer by 0.7 percentage points. It looks similar on a risk-adjusted basis, topping peers but trailing its index.
Over the long run, investors can expect the strategy to offer downside protection. Since inception, the fund’s 82% downside capture ratio relative to the index showcases its strength. The strategy has, however, tended to lag in frothier market environments and thus has not delivered consistent outperformance in the current market environment. For example, it lagged its benchmark and peers in 2017 owing primarily to its relatively high cash allocation and security selection missteps in the consumer defensive sector. Further, its upside capture ratio of just 86% has resulted in middling returns relative to its index.
Nevertheless, the fund still tops its mid value peers in 91% of three-year rolling periods dating back to Welch’s start and its Russell Mid Cap Index in 59% of 22 periods. Welch’s success in a similar strategy with a longer track record, Diamond Hill Small-Mid Cap (DHMAX), should reassure investors that over a full market cycle, they can expect this strategy to deliver outperformance.
Chris Welch has served as this fund's lead manager since its December 2013 launch. He has backup from assistant managers Chris Bingaman and Jenny Hubbard, who have 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 portfolio management responsibilities for Diamond Hill Small-Mid Cap DHMAX and serves as assistant manager to Diamond Hill Large Cap (DHLAX) and Diamond Hill Small Cap (DHSCX). The team’s stability and deep industry experience contribute to this fund’s Positive People rating.
Diamond Hill's portfolio managers draw upon a centralized research team of about two dozen sector-specialist analysts and associates who each cover about 15 names each in their respective areas. Those analysts average more than a decade of industry experience and well over half have earned the CFA designation. In 2017, the team saw three departures including two analysts and one associate while in June 2018, one associate left the firm. Despite this uptick in turnover, we still have confidence in the bench.
Finally, the team has skin in the game with Welch investing more than $1 million in this fund while Bingaman and Hubbard each invest between $100,001 and $500,000.
Publicly traded Diamond Hill (DHIL) continues to demonstrate dedication to its fundholders, earning it a Positive Parent rating.
Virtuous practices include frequent and transparent shareholder communication and strong alignment of investment teams’ compensation with the long-term success of the strategies. For example, the firm’s universal intrinsic value philosophy as well as its model are available for public consumption on its website. Although Diamond Hill stock is distributed (and restricted for five years) through year-end bonuses, employees are otherwise prohibited from investing in equities and can invest in mutual funds offered only by Diamond Hill. Manager compensation is based on rolling five-year returns. Despite an uptick in 2017 when two analysts and one associate left the firm, retention is exceptional, and portfolio managers and analysts tend to spend their careers at Diamond Hill. Succession and transitions are handled well--CEO Chris Bingaman took the reins in January 2016, after a five-year transition between him and previous CEO Ric Dillon, for example. Investing is at the forefront of the firm: Bingaman still spends most of his time managing money, the firm has been responsible with fund launches and typically seeds strategies well in advance of a formal launch, and capacity management has been thoughtful. Diamond Hill continues to be an exemplary steward of capital.
The I share class accounts for roughly 55% of assets. Its 0.78% expense ratio is 10 basis points below the median for similarly distributed peers and its minimum investment of $2,500 means that it is more accessible than its typical institutional peer, adding to its attractiveness. The Y share class accounts for another 22% of assets and with a prospectus net expense ratio of 0.66%, it has a Low Morningstar Fee Level. The residual is housed in the A share class which charges a prospectus net expense ratio of 1.07%. All of its share classes charge relatively attractive fees, earning it a Positive Price rating.
Trading costs as a percentage of average net assets are below average, too. The fund’s 2017 brokerage commission fees of 0.03% were well below its mid-cap value peers’ median of 0.07%.
Financial professionals are accessing this research in our investment analysis platform, Morningstar Cloud. Try it today.
Linda Abu Mushrefova does not own (actual or beneficial) shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.