The noted Diamond Hill manager discusses the shorter durations of competitive advantages, how low inflation has curbed firms' pricing power, and what he considers to be the market's 'sweet spot.'
Editor's Note: The following interview with Chuck Bath, comanager of Diamond Hill Large Cap, was recorded on March 4, 2020. As such, it doesn't incorporate recent market volatility, and the manager's views and positions may have changed since the recording.
Our guest on the podcast is Chuck Bath, a portfolio manager who has logged a tremendous record over nearly 40 years. Since 2002, Bath has been manager of Diamond Hill Large Cap, a $6 billion fund that earns a Morningstar Analyst Rating of Gold. He is assistant portfolio manager for Bronze-rated Diamond Hill Long-Short.
Prior to joining Diamond Hill, he steered Nationwide Fund to outstanding returns during 17 years at the helm. An accountant by training, Bath uses a patient value-oriented approach, seeking out companies with above-average returns on capital that are trading below his estimates of intrinsic value.
Background
Chuck Bath bio
Diamond Hill Large Cap DHLAX
Diamond Hill Long-Short DIAMX
"Diamond Hill: Accounting for Taste," by Lawrence Strauss, Barron's, Dec. 12, 2015.
Strategy and Portfolio
"Permanent Change Versus Long-Term Fundamentals," by Chuck Bath, March 10, 2020.
Diamond Hill Intrinsic Value Estimator
Security Analysis, by Benjamin Graham and David Dodd.
Warren Buffett on Durable Competitive Advantage, April 21, 2018.
"Valuing U.S. Equities: A Historical Perspective," by Chuck Bath, Austin Hawley, and Nate Palmer, as presented at the CFA Institute Financial Analysts Seminar in Chicago, Sept. 26, 2014.
International Business Machines
"State AGs, Justice Department Discuss Google Antitrust Probe," by Diane Bartz, Reuters, Feb. 4, 2020.
"The Charles Schwab-TD Ameritrade Merger Shocked Wall Street. Why It Had to Happen," by Lisa Beilfuss and Daren Fonda, Barron's, Dec. 16, 2019.
Organization/Succession
"Diamond Hill Announces Addition of Austin Hawley as Co-Portfolio Manager on Large-Cap Strategy," Dec. 18, 2017.
"Channeling His Inner Buffett," by Marla Brill, Financial Advisor, Dec. 2, 2019.
Christine Benz: Hi, and welcome to The Long View. I'm Christine Benz, director of personal finance for Morningstar, Inc.
Jeff Ptak: And I'm Jeff Ptak, global director of manager research for Morningstar Research Services.
Benz: Our guest on the podcast today is Chuck Bath, a portfolio manager who has logged a tremendous record over nearly 40 years. Since 2002, Chuck has been lead manager of Diamond Hill Large Cap, a $6 billion fund that earns a Gold rating from Morningstar's analyst team. Chuck also comanages the Bronze-rated Diamond Hill Long-Short fund. Prior to joining Diamond Hill, he steered Nationwide Fund to outstanding returns during 17 years at the helm. An accountant by training, Chuck uses a patient value-oriented approach that seeks out companies with above average returns on capital that are trading below his estimates of intrinsic value.
Chuck, welcome to The Long View.
Chuck Bath: You bet. Thank you.
Benz: So, let's talk a little bit about your strategy for people who are not familiar. Your strategy is often described as relative value. Can you explain what that means for people who aren't steeped in the various shades of value investing?
Bath: Yeah, certainly. And by the way, I like the title, The Long View, because that's very central to how we invest, taking a long-term perspective. But in terms of how we view value, it is a discount to intrinsic value, not necessarily just a statistically inexpensive price relative to book value or earnings. And why does that matter is because in calculating our estimate of intrinsic value, we include things such as five-year revenue growth and margin changes in that calculation. So, as a result, growth gets incorporated into our calculation of value. At the end of the day, we are trying to buy stocks of companies as if we're buying that business at less than that business' worth. That's our discount to intrinsic value.
But I think it is a bit shortsighted to not include or incorporate growth into the calculation. Because let's face any business, if they were making an acquisition and trying to buy the entire company, they would certainly incorporate what the growth outlook is for that company in determining what price to pay. And what we have found over time viewing the successes and failures of our individual investment decisions, those decisions that many times worked out best were those companies not just at inexpensive value, but there was an inexpensive value where the intrinsic value was growing over time. And many of our more problem investments will be stocks where we found that we were tempted by the inexpensive valuation, but the secular deterioration in fundamentals proved to overwhelm valuation.
So, if you think about it, what we're doing is like any other business person would be doing and trying to buy an entire business. And that's how we're valuing that company. We have our own model, which we call the Diamond Hill Valuation Model, which calculates that intrinsic value. But the thought process, what's going through their investment mind is, what is this business worth.
Benz: So, we want to spend a little bit more time on your strategy. But before we get into that, can you just give us a little bit of background on how you gravitated to this specific strategy that you use? It sounds like you were Graham and Dodd disciple from your early days as an investor.
Bath: Yeah, and I think many investors, the influence of the early days in their career are most impactful. And when I started in this business in 1982, I began working with my boss who was a portfolio manager at a large insurance company. And you can imagine with an insurance company investment approach, they had a very long-term time horizon. And when they have that long-term time horizon, it's very important to, as I say, to focus on not just the quantitative metrics--my background being in accounting, I thought I would be much more quantitative. But I became much more qualitative in nature looking at issues such as the competitive nature of the market, pricing flexibility a company has, how much market power they have, how much market share they might have versus their competitors, is their market share growing or losing. Those sorts of things were very impactful in the early part of my career as I saw many of the most successful investments being stocks we owned for a very long period of time, whose intrinsic value was growing because the underlying success of the company, even as the valuations expanded with the bull market in the 1980s.
Benz: So, I had read that you said that you've increasingly focused on the economics rather than the accounting, even though you were an accountant by training. So, let's talk about that. What prompted that evolution in your thinking?
Bath: Well, I guess, it was getting the feedback of successes versus failures and seeing what things in common your successes had and what things in common your failures had on individual investments and realizing, in many cases, the most driving factor in the success of the investment was its competitive position in the marketplace and not whether I paid 10 times or 11 times earnings for that company. Because if you take a long-term perspective, if you think about it, you're thinking about someone who's truly investing in this company. Excess returns should be competed away over a long period of time. So, what is it that's unique about this company that allows these excess returns to not be competed away? Is it a dominant market share? Is it an oligopolistic market structure, those sorts of things, which I've found over time--the thought process of a long-term investor is what is unique about this company that allows it to earn excess returns over long periods of time and not just a producer of a me too product who may have excess returns in the near term, but that any excess returns will get competed away.
Ptak: What's your perspective on the durability of competitive advantages today versus maybe when you started your career as a portfolio manager?
Bath: Yeah, that's a very good question. I would say, and as you can imagine, the competitive advantages have been shorter in duration. When I first got started as an investor, you could almost count on companies who are having short-term issues with their competitive position in the marketplace would return to their former position in the marketplace. So, many times, when a company would have near term earnings problems, it was attractive to investors to invest not at an expensive valuation but to turn around the fundamentals. It has become, in my opinion, much harder, probably since the late 90s, as the pace of technological change has increased, much harder for companies to recover their competitive position in the marketplace once it's lost.
A classic example is of course, IBM, which was, when I first got started in 1982, was 6% of the S&P 500 and its competitive position in the marketplace looked impregnable. But as the rapid pace of change in technology, we know what's happened. IBM has struggled for the last 30 years, while new upstarts, the names like Microsoft, for example, took over their position as dominant competitors in the technology space based upon rapid pace of change. And in many ways, companies like IBM, who had a large installed base of business, who were unable to act with the swiftness of a Microsoft, I think of Walmart versus Amazon as well too. Sometimes those companies with a large installed bases had difficulty being as nimble and as a result, their competitive position was diminished. So, that is something that has changed, I would say, in the last 20 years versus the first 20 years of my career, the pace of change and the difficulty of companies maintaining their competitive edge once it's been lost.
Ptak: So, do you think sort of the plight of the also-ran, so to speak, that you were describing there, do you think that has any implications on the success of value investing or just reversion to the mean generally speaking? You would think that those types of names, right, they lose their position, they get nice and cheap, and then you can invest in them in hopes that you enjoy a nice bounce back. Do you think that perhaps competitive dynamics of the market have impeded that process?
Bath: Yes, as you can imagine, we talk about that a lot at work here with a couple of portfolio managers regularly. We're trying to think what is different now that makes it so much more difficult for weakened competitors to return to their former position. One thing I don't hear talked about as much is that kind of inflation. As inflation has declined, and companies therefore have lost a lot of pricing power, you really have to be able to grow volumes rather than gain price. And many of the times, companies who were recovering from near term competitive weakness were able to use price as a metric to return to profitability in the 1980s, and even in the early 90s, there is still some level of pricing flexibility sort of across all businesses as inflationary expectations were higher and companies could take pricing. As pricing is much more difficult to take, you need to offer your customers a product which they find uniquely valuable and provides value to them not just on a price basis. You need to be able to grow volumes. And so, I think if they were to look at what has changed in a macro economic sense which has made it much more difficult for companies to turn around their fundamentals, it's the disappearance of inflation, and therefore disappearance of pricing as a tool for companies to drive their turnaround.
Benz: So, can you walk us through an example of a company in the portfolio that sort of demonstrates the characteristics that we've been talking about that has the sustainable competitive advantage, a company that you want to own for a long time?
Bath: Well, we could look at Abbott Labs, for example, who has dominant market positions in diagnostics, in nutrition. Those large market shares using nutrition as an example allows it to enter markets worldwide with a competitive product. China used to be a market that was really close to American nutrition companies. This would be like infant formula combined with nutrition products for the elderly. And their strong position worldwide opened the market for them when China became an available market. Also, their diagnostics business where they are a leading provider of diagnostic tools into the healthcare business. And there is very little reason for their end customers to move any way away from the dominant players because the strength of their competitive position is so unique and the cost to their end customers is so small, that it's much more important to have the diagnostic system from an Abbott rather than to try to go to another customer who might offer "a cheaper solution."
So, those are the kinds of dominant market shares or unique technology, which allows companies to be much more competitive and maintain their competitive position over long periods of time. Abbott has been uniquely adept at acquisition as well, too. They bought St. Jude Medical several years ago, which gave them an inroad into the cardiac rhythm management business, which is an important player in a very large end business, a competitive niche they could not have gotten short of acquisition.
Ptak: It's definitely a high-quality business. Why do you think it's mispriced?
Bath: That's a good question. I think probably because people do not accept--their revenue growth numbers can be sustained for long periods of time. I mean, I've talked to our analysts on that. We've got pretty decent revenue growth expectations, north of 5%, but I think they can actually be a little bit better than that. And so, the fact that they can grow revenues at that pace, expand margins, earnings growth more rapidly, I think that that is sort of a rare trait to be found in the businesses which I think investors tend to undervalue. It's been my opinion over history that investors tend to overvalue high levels of short-term growth and undervalue average levels of steady growth. And so, the fact that names like Procter & Gamble and Abbott Laboratories, those are typical of companies that can grow earnings faster than the market and consistently, with very little volatility, and yet those seeking growth tend to gravitate towards higher growth names than that and those seeking value tend to think that those stocks are too expensively priced. I think, in fact, that's many times the sweet spot of where the best value in the market may lie, those companies that can provide steady consistent growth over long periods of time. If you think of it in its simplest way, sort of, a very above average companies at very average or slightly below-average prices.
Benz: So, in looking at the portfolio, it appears that there are stocks that we think of as sort of traditional growth names like Alphabet as well as more traditional value names like Eastman Chemical. So, do you think about the portfolio in that way? Or do you want each of the companies in the portfolio to have a similar set of characteristics?
Bath: In the case of both of those names, I've looked at those individually. In the case of Eastman, it's relatively cheap because they have some businesses which are technically challenged, but they do have some plastics businesses, which are growing nicely, and provide a platform for which the company reinvest and grow, as well as to make acquisitions as well too which they've had some success with. But that's a slightly different situation with Google, where I just think it's been a company with high double-digit revenue growth for extended period of time, which the market seems very reluctant to put a premium valuation on, probably because the business has gotten a little bit controversial, but the controversy surrounds they have too much market power from a regulatory sense. Some people feel that way. So, that is, I would say is a nice problem to have, if you will, that your company is sort of too powerful in the marketplace. The balance sheets outstanding, there's plenty of cash on the balance sheet. So, two entirely different companies, both representing value in my opinion, but the value is expressed in entirely different ways.
Benz: So, how do you approach the regulatory risk for Alphabet, for example? Can you walk us through like how you discount that issue?
Bath: Well, what I've looked at--and if I ask myself five years from now, this is often done in our calculation of intrinsic value, I look at the revenue growth, what is discounted in the marketplace, what I think is going to happen, in many cases, because of the regulatory environment, I will assume some regression towards the mean, if you will, that the revenue growth slows. And there may be not the ability to take margins where they otherwise might be because of the regulatory risk involved. And still, the stock comes out as very inexpensive relative to intrinsic value.
So, obviously, you can put numbers into the model, which would make it appear less valuable. What we're trying to do is study those numbers, which make the most sense, what seems reasonable. And often I feel like our bias in many ways is to be too conservative. So, when we're looking at future revenue growth, I think our assumptions are a regression more towards low of levels of revenue growth, because this level is hard to sustain, and they might have to reinvest in order to assuage regulators. But so far, the regulation has been a lot of talk and very little action. But you don't want to discount this.
Some of the--think of Microsoft, for example, in the late 1990s, their antitrust issues were a problem for the company for quite some time. Back in the 1980s, IBM, their antitrust issues were problematic for quite some time. So, antitrust is something important, and if we monitor it closely because it can have a long term competitive impact, one thing that I'm less concerned about from time to time I hear discussion of breaking up some of the larger companies like Google or Facebook, I would think as a share owner that is less concerning outcome. When I think back when AT&T was broken up, the shareholders did very well with the breakup of AT&T, even as regulators were solving what they felt was an antitrust problem. Even if you go on all the way back to The Standard Oil Trust, the breakup of Standard Oil, shareholders did very well with that breakup.
So, there are two sort of approaches regulators could take. If they were trying to break up a Google or a Facebook as an investor as a shareholder, I wouldn't say I'm OK with that. I'm not encouraging it. But if it did happen, I'd be less concerned about it. But a firmer regulatory stance, where there's a consent agreement and a reduction and an ability to compete. That'd be something I'm more concerned about. So far, doesn't seem like it's going that way. But this is something we have to monitor.
Ptak: Since we're talking risk, maybe you can talk about at the individual holding level, how it is you managed that. I guess I can think of a couple of examples. One is margin of safety requirements, so to speak. I would imagine that's probably an ingrained part of your process, since you talked about wanting to buy things at discounts to your estimate of intrinsic value, and probably the amount of discount will flex depending on your assessment of the risk of the business concern. And then, the other dimension is position sizing and how you handle that. Can you talk about each one of those things?
Bath: Yeah. In fact, you did a very good job of explaining our margin of safety risk management tool. And basically, what we're looking at is buying stocks, as you said, at discounts or estimates of intrinsic value. The reason that is a risk control is, in fact, if our calculations are understanding that that business value is incorrect, the business value could decline and still be at a discount, therefore protecting our investment to downside volatility. That is, I view, as our most important risk control is that discount to intrinsic value. But also, as you mentioned as well too, we have controls regarding the specification risks and tools to make sure that the company is broadly diversified. I don't want to run and manage a non-diversified portfolio. So, there are limits on sector and position sizing to be sure that the portfolio remains a diversified equity portfolio because that at the end of the day is what our clients are looking for us to provide.
Benz: Well, speaking of that, you run a concentrated version of this Large Cap strategy for institutional clients. And the performance has been very good. So, I'm wondering if you can talk about any takeaways from running that concentrated approach that have lent themselves to running the Large Cap fund.
Bath: We were running this fund before clients asked us for the concentrated portfolios. So, the record is a little bit shorter. But I think it goes back to 2011 for the concentrated strategy. But in fact, the concentrated strategy is meant to have the same levels of kind of diversification we offer in our current portfolio in terms of sector diversification, but with fewer names, and therefore more concentration in individual stock selection. There would be 20 names in the portfolio. And it would be simplistic to say it'd be the 20 largest holdings in the large cap portfolio because in fact, if we're using 20 largest holdings, we would skew our diversification by sector differently. So, we monitor the sector diversification to try to offer the same level of sector diversification that our Large Cap strategy provides, but with 20 names in the portfolio, and therefore each name being a little bit larger. So, for the most part, they are certainly our largest holdings in the large cap portfolio. But with one or two exceptions, they may be a little bit smaller in order to maintain sector diversification.
Ptak: Maybe back to the Large Cap fund, if I may, for a moment, maybe you can sort of quick give an example. We've been talking names and also talking about competitive attributes. So, maybe you can give maybe a quick contrast, a name that based on your assessment you consider to be a little riskier, and therefore, you would demand a bigger margin of safety versus another business that maybe is more of a toll keeper where it's more predictable, and you wouldn't demand the same margin of safety. Can you give a quick example, maybe a contrast you would draw between those two types of names?
Bath: Yeah, one that comes to mind right away is Chevron, oil company, because the risk involved in the oil and gas business is different than other areas of the marketplace. And so, even with a dividend yield, which is substantial, and we find that as a big mitigator to the downside risk, nonetheless the industry in which it operates is highly volatile and difficult to analyze to the extent that often geopolitics can drive long-term supply/demand issues. So, that might be an example of a name which might have a larger discount versus the name of Procter & Gamble, whose growth is steady, whose end markets are well consolidated, they provide differentiated, higher-end products that customers want and driving volume growth, but will have a smaller discount to intrinsic value because the business is so non-volatile. Those would be examples of two very large cap companies with different levels of volatility and different levels of analytical risk, and therefore different position sizing, different discounts to intrinsic value.
Benz: So, we've been speaking about competitive advantages, businesses with competitive advantages. So, I'm wondering if you can talk about that with respect to your fund and your process. What do you feel is your team's competitive advantage relative to like a Fidelity who is looking hard at large cap stocks like these or any number of investors and maybe have many more analysts to put to work on all of these companies and sectors?
Bath: Yeah, I would say having a demonstrated willingness and ability to take an extremely long-term focus as an investor. When I got started in 1982, and as I told you, I was working for an insurance company, I viewed that to be the norm. Over my career, I've felt time horizon has become shorter and shorter in an investment. And that provides the opportunity for discipline investors with a long-term time horizon to take advantage of short-term changes. In fact, a classic example right now is what's going on with the market and the coronavirus. Now, certainly, the coronavirus is a serious problem that we're going to have to deal with. But if you take a long-term perspective, and you're valuing this company five years from now, so you're looking at what this company will look like in 2025, does the corona virus outbreak of the year 2020 have a meaningful impact on its valuation 2025? And so, discounting back that 2025 valuation, you'll find it's not a zero impact, but it's a very small impact on our assessment of intrinsic value, any near-term weakness in earnings based upon coronavirus. Yet, the market sold off, what, more than 10% in a week.
So, that, in my mind, is an example of a market taking a very short-term focus. Yes, there will be near term earnings issues surrounding companies whose businesses have been upended by the virus and that is certainly unfortunate from a business perspective. And certainly, it's a humanitarian crisis as well too. But in terms of the decline in the intrinsic value of Procter & Gamble based upon the 2025 discounted back, based upon the coronavirus breakout in 2020, it's pretty meaningful. So, to sell off Procter & Gamble in that environment I think is a shortsighted perspective as an investor.
Ptak: Given that you run daily liquidity money, how have you ensured that your client base shares that same long-term perspective to allow you to do your job?
Bath: Well, that's a good question. For the most part, I mean, obviously, I monitor cash flows on a daily basis and the cash flows have been relatively stable. And in fact, we've got, because I've just got a report, we've got one large inflow coming in tomorrow. So, we monitor that on a regular basis. We know what cash flows are going to be approximately. We know what the daily flows are relatively stable. And then, if we have a large trade coming one way or the other, we will know that in advance. Our clients have been very good about that. If they're going to make a big trade one way or the other, they generally let us know until we're prepared. But for the most part, I have not seen any meaningful change in cash flows in the last couple of weeks, even as the volatility of the market is increased. There's been some small outflow but on a multi-billion-dollar fund an outflow of $1 million or $2 million is not at all problematic to manage.
Benz: So, in addition to managing some of Diamond Hill's long-only funds, you also contribute to Diamond Hill Long Short. Can you talk about your role in that fund and what your focus is there relative to your co-portfolio managers?
Bath: Yeah. I'm the assistant on that. The co-portfolio managers make the decisions I am supporting. And quite frankly, most of my support is on the long side of the portfolio.
Benz: OK.
Bath: And so, I will meet with them at least weekly. The portfolio manager is right next door to me. So, I'll pop into his office where we as well discuss ideas. But mostly, it's on the long side. And because he is all cap on the long side, many of the ideas in the Large Cap strategy are also in the Long Short, but many are not as well, too. But we will discuss where we're finding opportunities on the long side of the portfolio. I will from time to time, if I ask if my thoughts are on the short side of the portfolio, I would say, the vast majority of my efforts are supporting on the long side of the portfolio. And it's only in a support role. The three gentlemen you've discussed are the decision-makers on the portfolio.
Ptak: If you were running a short fund, what do you think it would look like?
Bath: Well, that's a good question. And I've looked back at what I've seen, and my focus would be, because we've looked at our own history of short-selling, my focus would be more probably on companies with problematic fundamentals and even accepting some--I guess I would accept more valuation risk in order to invest in fundamental risk, if you will. The way you've referred to on the short side many times is valuation shorts. In other words, a thriving company whose fundamentals are outstanding, but the valuation is ridiculously high, I would not want to be--those are generally not where I'd be looking for shorts. earlier in my career when I was more involved in the Long Short portfolio, that is an area where we looked at for shorts, and we didn't have nearly the success there that we had in shorting companies we felt were fundamentally challenged. So, if I was running the entire short portfolio, my focus will be where's the fundamentally challenged businesses, it's going to make this company not thrive, but struggle for an extended period of time. Now, there will be periods of time generally often coming out of an economic recovery where that strategy will be problematic. Like in 2010 and 2012, when many companies coming out of the last recession performed outstanding even though they're fundamentally challenged, because of the short-term cyclical recovery in their businesses. That can be problematic in the near term on the short side. But in terms of secular outperformance on the short side, that would be the focus of my concerns.
Benz: So, we've had this bifurcation in value performance relative to growth and a lot of value managers have argued that value is really quite cheap currently. A question for you is, your fund has performed pretty well all along, would you expect it to perform less well than perhaps some deeper value funds might in a resurgence of value stocks?
Bath: Well, I felt the deeper value was, in fact, the better value, I would be moving more of the portfolio to that area. It is not that I am there in that portion of the market because of some sort of, top-down biases. Rather, that's where I'm finding value in the marketplace. But having said that, yes, in the period of time when I've had my most struggles, I've mentioned, in 2010 and 2012 when I think lower-quality companies coming off the bottom of a recession were rallying very strongly, and therefore, I was not participating in some of those rallies. So, those would be periods of time when I would perform more poorly. But I don't want you to walk away saying that area of the market is an area I cannot invest in. Rather, that is an area where I'm not finding value. I could theoretically be more exposed there if the value was presenting itself. But I continue to look for areas.
Goodyear Tire is an example, a name that I used to own because I bought their high-end tire business was a franchise underappreciated. I found myself being wrong. So, I look at this company and say at what price would I revisit this and I'm seeing the struggles are so great. I'm not finding value there, even though the stock is down meaningfully from that price. If I did find value there, I would be more inclined to invest in that name. But it would probably have to be more than I think, gee, they're going to have an improvement in the next quarter's earnings, it'd more be a matter of their competitive position, the high-end entire business has gotten better than I realized. So, it's not just like we would be finding value there because there's some short-term pop based upon some cyclical recovery. Rather, I'm seeing a secular change to their competitive positioning. And much of what we have found difficult and finding what's often referred to as a deeper value area of the marketplace and what I discussed earlier, the difficulty of companies who are struggling to turn themselves around has left those companies that look deep value and look cheap, left them continually struggling. I'd say Goodyear is an example. IBM is another name we owned in the past, which I feel is continuing to struggle. So, I would be comfortable buying those names if I saw that these inexpensive valuations are providing a long-term opportunity. I'm just not seeing that. But believe me, we're looking there. We're trying to--we're aware that this is an area the markets underperformed for a long period of time. Often, when that happens, value will present itself because investors will sell not because of an objective viewing of their fundamentals, but rather just out of levels of frustration.
And let me contrast what could happen now versus what happened in 2000 because I was investing then. In 2000, when the technology stocks were in such favor and the high growth areas, a popular area in the marketplace. There were a lot of inexpensive stocks. I remember like Norfolk Southern, Parker Hannifin, (indiscernible) names I owned at the time. And one of the attractions was not just their inexpensive valuation, but the company fundamentals were fine. It was not an issue of these companies were struggling. It's just they could not keep up with the 30%, 40% top-line growth that the in-favor technology stocks were providing, or they didn't have sort of an exciting story about how the Internet was going to change their world.
My point is that is not what we're seeing right now. We're not finding a lot of statistically cheap companies whose fundamentals are fine. It's just that the market is searching elsewhere. When we're looking to find areas – companies that may have been struggling or underperforming at cheap valuations, that display short-term sheet valuations. We're finding companies that are having fundamental problems as well too. That is how I contrast the market of 2020 versus the market of 2000. And by the way, we heavily invested in many of those companies, which I'm discussing with you now, because of their inexpensive valuations.
So, when the "value area" of the market becomes cheap, we're very happy to move there if the fundamentals support that valuation, which we did in 2000. And from 2000 to 2006 or so, those were very important portions of the portfolio. But right now, we're not seeing those statistically cheap companies where the fundamentals are also attractive. Now, one area, I would say, the financial services area, which is a very good portion of our portfolio, that is one area where for the most part we're seeing fundamentals are fine but valuations remain historically inexpensive, basically, due to I still feel investors' reluctance to invest heavily in the sector due to the last financial crisis being so heavily focused in financial services.
Ptak: So, they can't forget and that creates an overhang and that creates opportunity for you? Is that part of the thesis?
Bath: Exactly, yes. That's my opinion as well as my comanager's, Austin Hawley, who is even more focused on financial services than I am.
Ptak: Maybe just to sort of widen out for a moment, and we'll go back to financials perhaps in another couple of minutes here, I guess you bring up another point, which is, I suppose that one of the reasons why it's hard to find these names where the fundamentals are OK, but they've just gotten really cheap is because maybe investors have become more skilled or knowledgeable and they price away some of that opportunity. You've been in the business for a long time and have had to manage through a number of different cycles and competed against a number of portfolio managers. Is it your experience that the competition has gotten stiffer? And could that explain why you're not seeing those bountiful opportunities the way you used to?
Bath: I don't know. I mean, there were a lot of very talented portfolio managers in the 80s and 90s. Certainly, Peter Lynch, you know, obviously those names--Morris Smith who followed after him and Jeff Vinik, who followed after him, those were legendary investors at Fidelity at that period of time, outstanding investors. There was Vanguard Windsor Fund – anyway, my point is, during every investing cycle that I've been in, I'm always impressed by the quality and talent of the competition, if you will. So, it's never easy in this business. And those things which led to successful investments in the 80s and 90s, may be different now. But in terms of talented people, there were a lot of very talented people in the 80s and 90s in our business. In many ways, it was the market turmoil of the 1999 to 2002, which led to so many of the investors of the 80s and 90s, sort of, leaving the business. When I think of, well, someone like Robert Sanborn, who was one of the better investors and who managed the Oakmark Fund to great success in the 90s and then he left the mutual fund business after the tech bubble at that period of time. At that period of time, I felt a lot of the best investors in our business left the business in that period of 1999 to 2002. So, if I were to look at one period of time where I felt like the market was most inefficiently priced and the opportunity was greatest, yet some of the best investors were gone, I would say that was the time period, because in the 80s and 90s, there were a lot of outstanding investors and it's a shame that some of them left our industry in that period of time due to the turmoil of the tech bubble.
Benz: Were you tempted to leave the business during that dot-com era where valuations just didn't make any sense and value stocks got really cheap?
Bath: No, I wasn't tempted to leave the business. But the changes that occurred at my employer were--institutionally we changed our investment discipline led me to join Diamond Hill in 2002. So, I didn't want to leave the business. But I wanted to find an employer where I could sort of, say, practice my craft and discipline in the way I had done it and had success for the preceding 20 years. So, I was eager to join Diamond Hill because I didn't want to leave our industry. But I wanted to manage money in a manner in which I felt would be highly successful. And it worked for me in the past, and that's what Diamond Hill provided.
Benz: So, you mentioned the financial sector that you think fundamentals are strong there. Let's talk about how declining interest rates affect your thesis if at all. It doesn't sound like they do.
Bath: Well, an inverted yield curve, if it were to be sustained for a long period of time, would be problematic, it would be difficult in terms of net interest margins, and that would be an issue. And right now, we have an inverted yield curve. That's not good. And again, though I take a five-year perspective, does the fact that we have an inverted yield curve in 2020, you have a meaningful impact on the value of Citigroup in 2025? Not really. Now, if I felt that that sort of interest rate environment was sustainable for exceedingly long period of time, well, then, they would have an impact on our estimate of intrinsic value. But I think really, it's a short-term phenomenon. Certainly, in my lifetime, inverted yield curves have not lasted for a long period of time. But admittedly, they are bad for the industry and they might cause a short-term earnings problem for companies. And so, to the extent that they provide a short-term earnings problem, that is something real to be dealt with. But again, the most important input to our estimate of intrinsic value is what the earnings power is five years from now, discounting that back.
And so, our environment right now, there are short challenges because of absolutely lower interest rates and the inverted yield curve. Though what's interesting is, the market was fine, and Citigroup was fine in an environment where 10-year Treasuries were 1.7%, like, six weeks ago what it was. So, that in my mind is very low interest rates. And yet, these companies were doing quite fine in that low interest rate environment. So, a lot depends on what you call a low interest rate environment. The 10-year treasury is one of these things below 1% for an extended period of time, I would think that might be a problem, because it's difficult to get a normal shape yield curve in that environment. I would suspect that's most likely not going to be the case. And so, therefore, the secular outlook for Citigroup was reasonably unchanged based upon near-term changes in interest rates. They can manage in what I would historically call is very low interest rates. But when you get close to zero interest rates, that becomes more difficult. I don't think that is the long-term outlook for interest rates though. And so, therefore, I think these companies should do fine.
Ptak: To what extent does your team's view on potential industry consolidation inform of you that you would arrive at an individual name? I think that you've owned some of the brokerage names, if I'm not mistaken. Charles Schwab, I believe, is still a holding in the portfolio if I'm not mistaken.
Bath: Correct.
Ptak: And so, in those cases, did you take a look at that industry and say to yourselves, well, you know, status quo is not going to be sustainable here. We're going to see some consolidation here. Let's invest in what we think are going to be the survivors, you know, the real dominant firms in the space. Or does that not really play a role in your process?
Bath: Well, certainly, the consolidation in the brokerage business has happened much more quickly than we expected. We started buying Schwab before the deal was announced. But nonetheless, the consolidation I would view it as a positive. But whether they consolidated by deal or another manner, and actually Schwab's taking commission rates down to zero was an indication of their competitive strength in the marketplace. It was a pretty strong decision on their part, and we weren't necessarily expecting that to be the case, but it worked out very nicely in our opinion. Again, those companies we invest in those which we like best to take a long-term perspective, I'm willing to take a short-term hit to earnings like Schwab was in order to consolidate their strong position in the marketplace. So, that was, in my mind, an outstanding management decision by Schwab. Not necessarily expecting, consolidating the industry by acquisition. It could have just been consolidating industry by companies, sort of, leaving the business or their weaker competitors having to merge. But either way Schwab was in such a strong competitive position. They were going to be the long-term winners in that environment.
Ptak: You probably have--I know you have a lot of experience looking at firms that have been acquisitive through the years. There are many individual investors who still look at individual stocks, some of which are acquisitive firms, what advice would you give them about sort of the most important things to focus on in assessing that firm's sort of skill? And I guess, prudence in deciding what firms to acquire and how skillfully they integrate them?
Bath: Yeah, that's a good question. And in some ways, monitoring that situation over time has helped me evolve my view of what our value lies in the marketplace. What do I mean by that? The most successful acquisitions I've seen Throughout my career are companies who are strengthening their competitive position in the marketplace, and maybe even paying up more for a higher-quality acquisition rather than just making an acquisition cheap to try to bring scale. So, when I'm looking at investing in individual companies, I'm seeing what the best managements in the country are doing when they make acquisitions, because in fact, I'm buying a company when I'm buying a stock just like they're buying a company when they're making an acquisition. And those most successful acquisitions have been those companies who are making acquisitions of companies who either strengthen the competitive position of the company making the acquisition or entering them in a new market where they can enter with a strong competitive position. I mentioned Abbott Labs, they are an example of a company who has been a very good acquirer over the years, and in many times, they pay up in order to do that. And I've found that those in my mind have been the best acquirers over the years is, those companies buying high-quality companies and paying a little more for rather than buying low-quality companies cheap.
I will say one of the things I look at when acquisitions are made too is, I very much study the fundamentals even more so early after the acquisition is closed. If there is a problem with a company that's been acquired, it generally shows itself in the first one or two quarters after the acquisition. Often, if a company has made a very large acquisition and that acquisition struggles over there afterwards, I look at very closely at exiting that investment, because to me, that is often an indication of perhaps long-term problems to follow. And that's coming from experience because I've owned companies in the past who've made acquisition became problematic, and those problems became serious drags on the entire company. So just sort of a lesson learned from experience. It's important to monitor the consolidation of a large acquisition to make sure it's going as management's promised, and the story doesn't change, the acquisition is being completed.
Benz: So, Chuck, you've had a long and very successful career. You added a few comanagers to the Large Cap fund over the past few years, one actually quite recent. So, if I'm looking at that as a prospective investor, I guess I might wonder if you're formulating some sort of an exit strategy. So, can you talk about that about how prospective investors or people who already own your fund should be thinking about your tenure, your remaining tenure on the fund?
Bath: Yeah, sure. As you'd might be aware, I turn 65-years-old in a couple of weeks. So, naturally, we're not all immortal. So, we have to think in terms of long term for the fund. And basically, just quite candidly, when in discussions with the management of Diamond Hill a few years back – this goes back almost five years when we discussed this issue, and I said, I would let them know when I was about five years away from what I would consider retirement, and a lot of that has to do with family issues. I still have a young child at home and so she's still in school. So, I still don't want to retire until she was graduated and in high school. And so, several years ago, I told the management at the end of 2022 would be the earliest I'd be looking to retire. So, as you know, we think in five-year increments at Diamond Hill. So, we've added a comanager, Austin Hawley, to the strategy in five years in front of that date, so at the end of 2017, 2018 was the first full year Austin was the comanager, such that we'd have five years working together as him as comanager prior to December of 2022.
Now, we've had this conversation as well, being as candid and frank as I could be, I'm not saying that I'm going to retire at the end of 2022. I'm just saying that is the earliest I would look to retire it'd be the end of 2022. And we'll just see how it goes from there. I will say--I always add the caveat, as you get a little bit older, there's always could be health issues that could cause things to change. But as of right now, if everything goes as we all hope it will, knock on wood, I would not be planning on retiring earlier than 2022. And if I were to retire at that point in time, Austin would have been comanager for five years and could easily step in and manage a portfolio. I think Austin is ready right now. If necessary, he could step in and manage the portfolio himself today. But the plan is to the end of 2022 – 2022 would be the earliest I'd be looking to retire.
Ptak: What do you think is most key to a successful transition?
Bath: Shared investment philosophy. I mean, that's part of what I saw at my prior employer, quite frankly, which caused a lot of difficulty I felt was, there was not one core investment philosophy. Here at Diamond Hill, we all share the same investment philosophy. When we are discussing individual investments, we might disagree with the relative success we can see in that investment. But we all know how each other are thinking. So, we're talking the same language as you will. So, if we were to think one attribute which has helped the continuity, not just the transition for this fund, but the management of all our products here at Diamond Hill, is the shared investment philosophy. That means we're all sort of speaking the same language to one another.
Benz: Last question, Chuck. We've seen this torrent of flows going to passive products. What's your thought for investors about why they should keep the faith in active strategies like yours?
Bath: Well, yeah, that's a good question. I would say that active strategies versus passive, there has been cyclicality to that over the years. I mean, I mentioned the period of time in the late 1990s to early 2000, that was also another period of time where passive strategies were taking market share. And that led basically to, in my mind, the most inefficiently priced market in my lifetime. And active strategies worked very well in the period subsequent to that. So, I think it's most important to understand that when passive strategies are outperforming why they're outperforming. When the outperformance of a market is concentrated in a few mega-cap stocks, like has happened, for instance, last year when so much the performance of the funds was driven by Apple, Facebook, Amazon, Google and Microsoft. With so much of the performance of the market is driven by these mega-cap names, that tends to be a period of time where passive strategies have worked very well. But contrary to that, when smaller-cap names or those higher-capitalization names are struggling, then active strategies work very well. The point is that it tends to be cyclical. So, to move from one strategy to another, claiming that this strategy is going to work because it worked in the previous decade, I think is sort of ignoring history where basically, passive strategies move in and out of favor based upon the subset of the marketplace, which is performing very well, and that tends to be cyclical in nature.
Benz: Well, Chuck, this has been a really interesting conversation. Thank you so much for taking time out of your schedule to speak with us.
Bath: Well, thank you very much, and I appreciate the opportunity.
Ptak: Thanks again.
Bath: You bet. Thank you.
Benz: Thanks for joining us on The Long View. If you liked what you heard, please subscribe to and rate The Long View from Morningstar on iTunes, Google Play, Spotify, or wherever you get your podcasts. You can follow us on Twitter @Christine_Benz.
Ptak: And at @Syouth1, which is, S-Y-O-U-T-H and the number 1.
Benz: Finally, we'd love to get your feedback. If you have a comment or a guest idea, please email us at TheLongView@Morningstar.com. Until next time, thanks for joining us.
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