Brian Fontanella (0:12)
Hi everyone. My name is Brian Fontanella, portfolio specialist at Diamond Hill, and today, I am joined by Nate Palmer, co-portfolio manager of Diamond Hill's Long-Short strategy. Nate, thanks for joining.
Nate Palmer (0:22)
Thanks for having me, Brian.
Brian Fontanella (0:23)
All right, so I wanted to start by getting a little bit of a lay of the land. Equity markets are basically at all-time highs. I'm curious what the opportunity set looks like today. How easy or difficult is it to find new ideas on the long and short sides?
Nate Palmer (0:38)
Well, a lot of companies are being valued at what seems to us like pretty full multiples on what may ultimately be peak or near-peak operating profit margins. And those situations tend not to be the type of risk-reward profile we're looking for when we're doing our work on companies for the long book that we hopefully can own at a discount to intrinsic value. But this isn't supposed to be easy.
What we're seeking to provide in the long-short strategy are risk-adjusted returns that are more appealing than what an investor would get by owning the broad equity market. And in any market environment, we believe we can identify individual businesses that are being mispriced. The opportunity set evolves over time. And the areas of the market where we're most focused change over time too.
As a generalization, I'd say recently, we've been less interested in economically sensitive businesses at current market prices, but in the last few months of 2023, we added both Extra Space Storage and Lab Corp to the long book. And I'd characterize those as attractive businesses with relatively steady cash flows to which the market's assigning too low of multiples in the near term, given that they aren't high revenue growth or highly innovative businesses.
So, there are opportunities out there. And a couple of other areas in which we feel like we own businesses at attractive prices are financials, both certain banks and property and casualty insurers, and also a couple of the large communication services companies where we believe we own these businesses at pretty reasonable multiples relative to their abilities to grow revenue and operating profit at attractive rates for many years into the future.
The same dynamics that make this environment tougher to find particularly attractive long positions make it a pretty appealing time to dig into potential short opportunities. We believe there are plenty of economically-sensitive businesses trading at full multiples of what we view as top of the cycle or as good as it gets fundamentals. And in any environment, there are businesses that the market's too optimistic about.
But in certain environments, like the current environment, we feel like there are a disproportionate number of potential shorts to dig into. And just as a reminder, we value businesses relative to normalized or mid-cycle fundamentals. Here we sit in 2024, and it's been a long time since we had a classic economic cycle. And so, we suspect that some market participants have kind of forgotten that we will still have economic cycles going forward. We don't think that the current environment is just going to persist forever, and cycles are a thing of the past. So, we think the discipline of continuing to value companies, whether we're looking at it as potential longs or potential shorts relative to normalized or mid-cycle fundamentals, will ultimately prove effective for the strategy and our clients.
Brian Fontanella (03:37)
I want to ask about the technology sector. Obviously, it's been very topical recently and really for the last few years. Our exposure to the sector on the short side has increased fairly notably over the past couple of years. So, are there some common characteristics of those positions that's made that a more fruitful area to find new short ideas?
Nate Palmer (03:57)
I think within technology, there's been some element of a rising tide lifting all boats. In some cases, it's probably warranted, but in other cases, we think it's maybe not so warranted. We've seen what we believe is some speculative excess around AI optimism, artificial intelligence optimism, that we think is probably unwarranted for certain businesses. Market prices imply a set of future fundamentals for some technology businesses that we do not believe those companies are going to be capable of achieving.
I would say if you look at our short book, there are certain companies that we view as attractive short opportunities where we think that these companies are actually being disadvantaged by technological change regardless of what their management teams are saying or what current market sentiment might be. We think that, just directionally, these companies are disadvantaged rather than advantaged by artificial intelligence and some of the technological evolution that's taking place in the world.
In some of these cases, I think management has crafted a narrative that the market generally believes, but our view of the future fundamentals is pretty different than the market's generous current interpretation. I think a key part of our process is independent thought and making sure that we're objective and balanced in how we're assessing businesses and both the current and future fundamentals of those businesses. And ultimately, we have to be right about the future fundamentals of businesses. If we're not approximately right about the future fundamentals of any business, then we don't deserve to generate alpha being involved in that business.
But I'd highlight three current short positions that are in the technology sector, Asana, Teradata and IBM, and they're somewhat different, but let's talk about each briefly. I think they highlight some of the things that make technology an interesting place to look for potential shorts right now.
Asana is a work management software company. It's a company where we've kind of questioned how valuable their software will ultimately be. It's a company that's struggled to work towards profitability over time and then, more recently, has kind of constructed an artificial intelligence narrative that we tend not to view as favorably as maybe some market participants do. When we got involved with Asana as a short, we thought it was a challenged business that the market was too optimistic about. After listening to their artificial intelligence narrative, we continue to think it's a challenged business that the market’s too optimistic about.
Teradata and IBM, there are some similarities in that we view each as more of legacy technology companies, and at different points in time, I think certain investors had gotten a little more optimistic that maybe they could position themselves to benefit from some of the technological change going on. We know each of these businesses pretty well. We followed them for many years and continue to believe that intrinsic value for each company is meaningfully below the current market price. Ultimately these businesses are going to generate a given level of revenue, a given level of operating profit at some point in the future. And with Teradata and IBM, we think the market is too optimistic about their revenue growth prospects and their ability to achieve operating margins that they would need to justify the current market prices.
Brian Fontanella (07:38)
Alphabet's a large position and has been for some time. How do you think about the risk to their search business from competitors’ generative AI offerings?
Nate Palmer (07:47)
Well, I’ll start by acknowledging that of all the large technology or communication services companies that we're involved in, Alphabet's the one that has the most to lose if they were to get artificial intelligence wrong as they implement it into their business. Now, with that being said, I don't personally believe that they're going to get artificial intelligence wrong. They've been working on artificial intelligence for many, many years, long before it became a popular topic in the investment community. And I'll acknowledge also that they've had a couple of high-profile missteps more recently related to trying to showcase their artificial intelligence offerings. But I'd also point out that those were not missteps that were all that important to their core search business, which is really where they generate the majority of their advertising revenue and profit.
I think a few other distinctions worth mentioning: many of the venture capital-funded artificial intelligence (AI) search companies that have gotten a lot of attention are tending to focus on specific verticals or specific types of searches. Google wants as many searches as can possibly be done on their platform, but at the same time, I think it's worth acknowledging that some of the searches that are maybe most susceptible to some of these more venture capital-funded AI search platforms are not necessarily searches that have monetized all that well over time. So if you're looking at Google as an advertising business, I think you take a little bit of comfort, at least in the fact that the types of searches that have tended to monetize best over time have remained on the Google platform, even in these scenarios where you say, oh, well Gemini can't compete as well with some of this new technology in a specific type of search.
I think it's also worth mentioning that we've owned Meta Platforms, formerly Facebook, since 2018. As Meta was struggling through 2022, we thought the market was overlooking the value of its user base as user engagement remained quite strong. With Alphabet, we believe some of the market pessimism today overlooks that three and a half billion people use Google search. Two and a half billion people use Android. Two and a half billion people use the Chrome browser. Two and a half billion people use YouTube, 2 billion people use Gmail. And then you have other products like Google Maps and Google Docs and Google Drive and Google Photos that each have a billion users. My overall point is that Google's products and services are heavily integrated into the lives of a large portion of the global population, and that's pretty valuable. And I think some of these doomsday scenarios that you've seen more recently probably overlook the fact that there's a lot of value being generated for users of Google's products. And in many cases, the users aren't directly paying anything to use these products that are typically pretty valuable in their lives.
We do get some data on Google search queries. Interestingly, Google search queries have actually continued to grow in the recent past year when there's been a lot of focus on whether artificial intelligence might be disrupting Google search. It's not showing up in the data yet. We will continue to monitor that data and be objective about it as we get it. But we look at Google, we say, okay, we own a business that we think is one of the better businesses in the world at roughly 22 times forward earnings. I use Gemini search results every day. You can go and opt in to see Gemini search results along with traditional Google search results. And I would say that as a user, I've been pretty pleased with the effectiveness of Gemini to understand what I'm searching for and generate results that are useful and valuable to me as a user.
Ultimately, each user is going to decide for themselves where they're getting the best search results and the most value, but I think we remain optimistic that the value that Google is providing for users may actually increase over time rather than be disrupted by some of the artificial intelligence fears that have become more prominent recently.
A couple other things I'd mention briefly, there were rumors that Apple is pretty seriously exploring integrating Gemini into iPhone 16. I think that's a positive data point in terms of how Gemini is competing with other possible solutions that Apple could be interested in. One thing I would say as a shareholder of Alphabet is that they've probably been the most reluctant of the large tech companies that we've been involved in to embrace cost discipline. And so, we think that some increased cost discipline is probably a lever that's still available for them to make the cost structure somewhat more efficient, eliminate some costs where they're really not getting value for those expenditures. If they do that, as we've seen both Meta and Microsoft do, more aggressively, I think that you would likely see growth in operating profit that isn't necessarily reflected in the current market valuation.
So, while we fully acknowledge that anytime you see changes in technology, like artificial intelligence represents, there are risks to incumbent technology companies like Google. But at the same time, we view Google as being quite well positioned to not only navigate this change in technology but ultimately create very significant value for users and for shareholders as they continue to integrate Gemini and artificial intelligence broadly into their products and services.
Brian Fontanella (14:03)
WD-40 was the largest short position in the strategy at the end of February. What sort of characteristics are you looking for in short positions of that size, and what's our thesis on WD-40 in particular?
Nate Palmer (14:14)
Yeah, let's start with short positions in general. We're always looking for businesses for which we can forecast the future fundamentals with a reasonable degree of confidence. There are plenty of businesses out there that get eliminated because we just don't feel like we can forecast the future fundamentals. So that's always the first thing.
And then we're pretty focused on a company's ability to grow operating income. You can grow operating income through revenue growth and/or operating profit margin expansion or contraction. And then, we focus on a range of outcomes. The range of outcomes tends to be pretty important when we think about the right position size for a given short.
WD-40 is a good example. It's a business that we added to the short book in June of 2020, so it's already been in the short book for longer than many shorts tend to be in the short book, and it has meaningfully underperformed the Russell 1000 since we added it to the short book.
But at the same time, on an absolute basis, it's been a positive total return for owners of the stock. And so, us being short on an absolute basis, we have lost money being short WD-40 over this period of time. We initially shorted this business at roughly 45 times earnings, and we viewed it as, I guess, most people are probably familiar with WD-40’s multi-use product. It's a lubricant that can prevent rust. It's kind of a maintenance product that many households have a bottle of WD-40 sitting around the house that they occasionally use for one thing or another.
When we looked at the fundamentals of this business, we viewed this as a mid-single-digit revenue growth type of business where we thought that their ability to expand operating margins was pretty limited. And over the period of time that we've been short, the fundamentals have been roughly consistent with what we forecast.
In fiscal 2023, the company grew revenue at 3.5% percent. If we look at fiscal 2018 through fiscal 2023, revenue grew at about 5.5% annually over that period of time. And then if we look at going back to fiscal 2018, EPS was $4.64; in fiscal 2023, they earned $4.83. And so there hasn't really been a lot of growth like you would expect to see. I mean, typically, when you see a business trading at a mid to high forties multiple of earnings, you think you're going to see high revenue growth, high EPS growth. And that hasn't really been the situation at WD-40.
But we shorted it at roughly 45 times earnings. And at this point, the market's valuing the business at about 49 times forward earnings. So, the multiple has actually expanded during the period of time that we've been short this business, which we view as being inconsistent with what's transpired fundamentally. I would say in most cases where we see the multiple expand on a short while we're short the company, it's been that the fundamentals that the company achieved ended up being better than what we were forecasting when we shorted it. That hasn't really been the case here.
And when we look at consensus EPS for fiscal 2024, it's for EPS to grow roughly 6% year-over-year. And so, this is one of those short positions where we continue to have fairly high conviction that our view of the future fundamentals is approximately right. And the market has continued to award a multiple that is more generous than what we would be willing to award if we were considering this business as a potential long. And so, we are going to let some more fundamental data play out.
Each short is independent of all the other shorts that have been in the short book in the past. I want to be really clear, but sometimes there are similarities between something that we're short today and something that we shorted in the past.
Brown-Forman, which happens to still be in the short book at a relatively small position size, is one with some similar characteristics to WD-40 in that the market was assigning a multiple of earnings that we thought was too generous. We thought we had a view of future fundamentals that we had relatively high conviction in. Ultimately, we were right, but it took longer for the market to realize that the revenue growth and the normalized margin profile of the business didn't warrant as high of a multiple as what the market had previously thought.
I think our current belief is that that's still likely to happen with WD-40, but we'll also fully acknowledge that it's been in the short book for between three and a half to four years at this point. And while on a relative basis, it's been a successful short, we would not have anticipated that the multiple would've actually expanded over the period of time that we've been short this business.
Brian Fontanella (19:29)
I wanted to get some of your thoughts on performance of the strategy. You joined the strategy back in 2018. Maybe just give your assessment of the performance over that roughly six-year period.
Nate Palmer (19:41)
Yeah, I joined the long-short strategy back in the middle of 2018, and at that time, there were some aspects of the shorting process that we believe could be improved. A long-short strategy only makes sense if the manager can generate alpha in the short book. Candidly, the 2010 through 2017 time period had been challenging for the short book. We believed there was an opportunity to refine the process and generate attractive levels of alpha by identifying individual companies for which there was both a fundamental component and a valuation component to our short thesis.
We also thought there were opportunities to avoid certain profiles of shorts that had been particularly problematic for the strategy over time. We had data for the short book going back to 2003 and did an analysis of what we've been successful at. And there were a couple of profiles of shorts that had been particularly problematic and where we really hadn't had much success. As we were refining the process, we wanted to emphasize the areas in which we had been successful and minimize the areas where there was a pattern of shorting certain types of businesses where we ended up just not being right about the risk-reward profile of the short.
Ultimately, in the long-short strategy, we're seeking to generate favorable risk-adjusted returns. And we do that by generating a favorable long-short spread. And the long-short spread is the extent to which our long book outperforms our short book. We look at each: the long book relative to the Russell 1000 and the short book relative to the Russell 1000. We want our long book to outperform the Russell 1000, and we want our short book to underperform the Russell 1000. And if we do that effectively, you generate pretty attractive risk-adjusted returns.
At Diamond Hill, we like to look at things over rolling five-year periods. When we look at the beginning of 2019 through the end of 2023, we did a favorable long-short spread of roughly 400 basis points annualized. The short book was particularly favorable. We did roughly 730 basis points annualized of short book alpha over that five-year period.
Now, the long book was somewhat challenged by looking a lot more like the Russell 1000 Value than the Russell 1000 (core). The long book trailed the Russell 1000 by roughly 330 basis points annualized. While we're pleased with the long-short spread of about 400 basis points annualized over that five-year period, we feel particularly good about the short book alpha. We feel like we have a process for generating short book alpha that's repeatable and that we believe will be successful, independent of the market environment, independent of whether growth outperforms value or value outperforms growth. I mean, we think we have a process where we identify individual businesses where we have a differentiated view of the future fundamentals than what's reflected in the current market price.
I think our long book has tended over long periods of time to look more like the Russell 1000 Value. And this five-year period, 2019 through 2023, was particularly challenging for the value investment style. Over that five-year period, the Russell 1000 (core) outperformed the Russell 1000 Value by a little bit over 450 basis points annualized. And so, our long book did outperform the Russell 1000 Value by over a hundred basis points annualized. But we think this is a pretty unique environment. As value investors, we continue to believe that over long periods of time, value investing will work, the value style will work, and we suspect that we're getting closer to an environment in which value will be at least neutral and maybe positive for investors after being a significant headwind over the past five years. And really, going all the way back to 2009, where being value-oriented has been a pretty significant headwind for investors.
In thinking about our short book, I would emphasize one thing we're particularly pleased with is: if you look at each of the last six calendar years, we've generated positive alpha in the short book (vs. the Russell 1000 Index). And that kind of goes along with my prior comments about feeling like it's a process that works kind of independent of the market environment because we've had some of those years have been pretty different than other years. We've had different markets over that period of time. And I'm not saying that every single year we're going to generate alpha in the short book, but we do feel like we have a process that isn't just captured by some sort of style beta or something like that. I mean, we think there is true idiosyncratic risk that we're capturing in our shorting process, and we believe that that's reflected in over 700 basis points annualized of short book alpha over the past five years.
Brian Fontanella (24:47)
Thanks, Nate.
Nate Palmer (0:22)
Thank you, Brian.