From Equity Research to International Investing With Heather Brilliant

25:30I would say in general, we probably put a little bit more bias towards valuation as the primary consideration and competitive advantage as very important, but maybe second to valuation as a primary consideration. So valuation, high quality, competitive advantage. Are we leaving out any other specifics that go into the investing stock selection process? I mean, very concentrated portfolios and a long-term perspective. So I love when I hear concentrated portfolio because I immediately think high active share, no closet indexing. Exactly. So when you say concentrated, how concentrated is concentrated?

26:12So our large cap strategy has about 50 positions in it. That's pretty concentrated. Exactly. So I think that gives you an example. Small cap is more than that, but it's still less than 100. Small cap is always more than large cap. We're going to talk a little bit about small cap later, which has been kind of fascinating what's been going on in that space, lagging for as long as it has. But before I get to that, I want to talk about not only how you express the philosophy in investments, but the different strategies you run in equity and fixed income. I know you do separately managed accounts. You do mutual funds, and you also do a CIT.

26:53Explain those choices. So essentially, we try to offer our intellectual property to our clients in whatever vehicle that they need it to be in. We started out kind of focused on mutual funds as the vehicle, and we've really diversified away from that because of client interest. Clients have asked us for separate accounts, model delivery, CITs, and we have happily obliged. Now I'd say the big topic on the table is ETFs. The challenge with ETFs is that you cannot constrain capacity. And we believe very strongly that in order to make sure that we can always deliver for our existing clients, we have to be able to constrain to close strategies.

27:33To be able to say no and close the fund down, not just fire hose of capital coming in. Exactly. And as many very popular ETFs show, and as just as fundamentally true, you cannot close an ETF today. And so in order to take capital in an ETF, we have to figure out some kind of solution to that. And we have not figured out a solution. That's really interesting. So I know you're running about$29 billion total. How big is the biggest fund where you say, OK, we're pretty close to capacity here? So our large cap strategy was close to new investors until about a year ago. And so over the course of history, we've closed four strategies over time.

28:14And, you know, generally, I'd say we take a lot of things into consideration. Our clients actually like to be able to put new clients of theirs into the same strategies. And so it can be very disruptive for client bases for you to just abruptly and suddenly close strategies. So it generally is something that we plan as we see it coming and really try to collaborate with our clients so that we can appreciate where it may create a challenge for no reason. But in general, yeah, we've closed. At times we've had small cap, mid and large cap. Smed. Yeah. By the way, a little industry jargon. I always laugh when I say that.

28:50Listen, we lapse into jargon all the time. So small and mid cap. Yes. So I would imagine the large cap has bigger capacity, 8, 10, 12 billion. Where do you start to run into, hey, for 50 stocks, this is as big as we want to get? Yeah. I mean, we think the capacity for that is somewhere around$25 or$30 billion. Oh, so you haven't really run into issues with that yet. Yeah. I mean, I would say that's for the strategy overall. So it partially depends on how much is in the fund versus in other areas. But in a small cap or a SMID, you can say to your investing partners, hey, we're getting to the point where we're just about capacity constrained.

29:32Don't be surprised if this closes next quarter, next year. How far out do you plan it? I mean, generally, if it's flows related, it's easier to plan. If it's market related, it's harder because, you know, if all of a sudden small caps make a comeback, you know, when you didn't think you were anywhere close to closing, it can come up more quickly. With large cap, I'd say it also depends on how low you go in terms of market cap, right? How small a company will you put into a strategy that is considered large cap? So for us, I'd say that is a big swing factor that constantly gets debated. And what we always try to do is look at the actual history, where we actually invested clients' capital, because that is what has created our track record and that we need that in order for it to be repeatable in the future.

30:15That's really interesting. So what do you use as a benchmark for the large cap fund? Is it just the S &P 500 or something a little broader? We use the Russell 1000. So much broader. I was going to say, if you want to just arbitrarily draw a line in the sand, the top half of the S &P 500, I would imagine those 250 stocks can be considered large cap. Or what's the line in the sand? Above$10 billion, above$25 billion? It's hard to even judge when we have so many companies that are trillion dollar market caps these days. Well, that actually brings up a really interesting point in time, I'd say, with our markets being so driven by such a small number of stocks.

30:58And we generally think that creates opportunity, not only in the large cap space, but really across the cap spectrum. But even in the first half of 2024, more than 60 % of the return came from six companies. And so I do think we're getting to the point where what you see going on under the surface is so different from what the overall, quote unquote, market return looks like these days. I'm so glad you said that. Every time I have a discussion about passive or indexing with people who are convinced it's going to destroy the structure of the market. My answer is always, wouldn't that create more inefficiencies elsewhere in the market if all these flows are blindly going into passive?

31:40And there's certainly a reason for that. But tell us about how that leads to inefficiencies that savvy investors can take advantage of. Yeah, I think you can see this particularly in smaller cap companies right now, where, as you alluded to earlier, the Russell 2000 versus the Russell 1000 has basically underperformed by 95 % from the end of 2016 until now. That's amazing. It's stunning. And it's true that smaller cap companies are much more challenging because 40-ish percent of small cap companies don't make a profit. Right, right. I think we're at 7 % of the S &P 500 is not profitable, which is a fraction of what it was in like the late 90s.

32:25Much more of the big caps weren't profitable. Today, they're all money machines. The small caps really are kind of struggling against that. And the interesting thing is that small cap active managers have outperformed for three out of the last four years. But in small cap, about 60 % of assets are invested passively. It's actually only 50 % in large cap. So it's kind of surprising that investors are relying on passive strategies in a category where active management makes a huge difference. So let me make sure I'm hearing that correctly. 60 % of small cap is indexed versus 50 % in large cap, and more small cap managers are beating their benchmark than large cap managers.

33:10Am I getting that right? Exactly. So that kind of goes back to, hey, the more indexing there is, the more opportunities there are for inefficiencies to be discovered. Yes, but I would say that one element of reality I think that has for managers who are focused on smaller cap companies is that you can't buy an undervalued company in small cap necessarily and assume that it's going to appreciate because of valuation. Because we don't know when or what will cause the market to re-rate small cap. And so, you know, this has been going on for, you know, basically a decade or more, depending on how you look at the data.

33:44So I think given that, what we see is our analysts and portfolio managers increasingly focusing on investing in small caps that are high-quality businesses, generating cash flow, returning that cash flow to shareholders, where essentially the cash return is going to get you what you need as an investor and you don't need the valuation to re-rate. If it does, it'll be bonus. That's dividends and buybacks in terms of, you know, David Einhorn said something very similar when people were saying the market structure was broken by passive. And I know he's in that camp. He said it made us rethink our approach to valuation.

34:22And if merely buying inexpensive stocks wasn't going to get you the performance you need, well, then you had to find the stocks that were doing something to raise their valuation themselves, mostly through return of capital to investors. Yeah, that was a great episode. I think Einhorn had a lot of really good points that I think were really valid. So you agree with him? It's, hey, we like these stocks that are actually participating. And there are opportunities being created by the rise of passive. So let me ask one other question about the rise of indexing. It has helped to contribute to fees coming down across the industry.

34:59You're a public company. How do you deal with those fee pressures that seem to be endemic throughout all of investing? I mean, from the beginning, we really tried to take a very thoughtful approach to setting our fees. And we really try to think about what do we believe the excess return is that we can generate over the long run? And how can we charge a fair price for that so that we can make sure we can pay the investment talent that we need in order to generate those returns, but also make sure that the shareholders of the firm are getting paid back for the capital they provide. and ultimately that the clients are getting a return after fees that makes sense for them.

35:37And so that kind of third to third to third mentality has led us to set fees at a place that, you know, generally do not exceed the median of kind of Morningstar categories for fees. And we look at that, too, because we really want to make sure that we are not charging more than we think is the value we can generate. Fair enough. This is Caroline Hyde. And I'm Ed Ludlow, inviting you to join us for Bloomberg Tech, a daily podcast focusing exclusively on technology, innovation and the future of business. Every weekday, we bring you the top headlines from the world's biggest tech companies. From finance to defence, AI to entertainment and from startups to the magnificent seven.

36:17We highlight the latest stories of the people and companies pushing the tech sector to new frontiers and the politics that shape global tech markets. We do this all every weekday, then bring you the most important conversations and analysis in our podcast. Search for Bloomberg Tech on YouTube, Apple, Spotify, or anywhere else you listen. Join us every afternoon on your commute home and stay ahead of the tech news cycle. That's the Bloomberg Tech Podcast. I'm Caroline Hyde in New York. And I'm Ed Ludlow in San Francisco. Subscribe today, wherever you get your podcasts. So we were talking earlier about small caps.

36:53they've been lagging not just since the pandemic, but pretty much the past decade. What do you think the reason for that is? Is it access to capital or international markets? What's been holding small caps back? I actually think there's a couple of things, but the biggest is that small caps have not done so poorly as much as large caps have just done so excellently. And so I think that's partially these five stocks really driving the market that we're really seeing come to a head this year, but really has been going on for the last several years. And we've seen concentration in the large cap side of the market among those five companies getting greater and greater over that time period.

37:35So it's just very hard for any kind of diversified portfolio to keep up with that. And you can see that in a diversified large cap portfolio, in any kind of actively managed large cap portfolio relative to indexes. And you can certainly see it in small caps as well. Right. I have a friend who's a trader who says, hey, you can't eat relative performance. Right? Exactly. So we talked a little bit earlier about profitability. 93 % of big caps are profitable, but only a little more than half of small cap stocks are profitable. How important are earnings to the small cap sector as a driver of returns?

38:14I mean, I think quarterly earnings probably should be less of a driver for small caps because, you have to take a long-term perspective and really think about when they might become profitable. And I think also small caps tend to have more issues with debt. So it's really important for small cap investors to be very aware of the leverage that the companies are carrying. And I think in this environment, too, to really understand the interest rate that that leverage carries and the potential interest rate that they may face when needing to refinance that debt. And it seemed like the large cap and mega cap stocks did a great job in refinancing before the pandemic.

38:52Small caps did not have access to the same amounts of capital at the same prices. How big of a factor is that? I think it's a huge factor. And you also see less leverage, certainly as a proportion of cash flows, when you're looking at large caps versus small caps. So they're more levered, and they did not have the same access to benefit from all that cheap capital when it was available. Diamond Hill is known mostly as a stock shop, as an equity shop, bottoms up stock selection, but you also do fixed income and bonds. Tell us a little bit about the fixed income side of the work. Yeah, so about$4 billion of our assets under management are in fixed income strategies today.

39:34And that's really grown over the last couple of years because we brought in a team in 2016, have been building a track record since then, primarily in two strategies, core and short duration securitized. And in both of those strategies, I would say our biggest point of differentiation is our focus on securitized assets, which kind of gives us the opportunity to be able to make investments in areas that I think other bond managers either don't know as deeply or are more focused on macro trends where we take a bottom-up approach there, too. So it's really given us, I think, the opportunity to shine in markets where it's been harder and harder to outperform in fixed income.

40:16And so creating that long track record, then as we saw the environment change and the interest rate regime change, we've really been able to benefit from that and deliver for clients. And when I think of securitized assets, we typically think of mortgages and things like that. What sort of securitized assets are you guys playing with? Yeah, certainly mortgages is on the list. I'd also say asset-backed securities, which can include things like credit card receivables or car loans or things like that that I think are more consumer-oriented. And so that's an area where there's been a lot of concern as concern about recession ebbs and flows.

40:52You definitely see people's concern about asset-backed securities move in line with that. Yeah, the recession concerns seem to have been a perennial miss since the last recession, since the COVID recession, which was a hot minute. And then all people were doing was expecting a recession in 21 and 22. And even during the downturn in the market in 22, this is it. This is what's going to finally cause a recession. And then a giant snapback in 23. I know you guys are bottoms up stock pickers. How impactful is all that macro noise on your process? I mean, I'd say it actually creates more opportunity than anything, because when the market starts really worrying about a recession, then it generally undervalues companies that are more cyclical and in terms of their long term, you know, cash flow generating abilities.

41:45And when the market's not at all worried about a recession, then you can generally find opportunities in more defensive areas of the market. And so we do try to kind of keep in mind where we think the economic outlook could be causing a different short-term perspective than a longer-term perspective. So 2022 must have been a friend from the military always describes that as a target-rich environment. What were you guys doing in 2022 when the S &P was down about 20 % and the NASDAQ was down about 30 %? Yeah, I mean, I think those are good examples, but I actually think the environment is better right now.

42:24Really? Yes, because we're in a situation where while the market is up double digits for this year, that's really a kind of high-level perspective that really obscures what's going on under the surface. Where there's a tremendous amount of volatility, we're seeing the performance of individual companies vary widely and is not at all representative of that high-level market return. And so it's kind of like the iceberg analogy, right? It looks tiny from the surface, but when you dig underneath, there's actually a lot more noise going on. And that really leads to a lot of idiosyncratic risk, which is what we look for.

43:00We want companies that are going to sell off when they miss their earnings or create opportunities because of short-term focus that can be overlooked for a long-term investor. And we're recording this in July. So let's put some numbers out there. the first half of the year of 2024, S &P 500 up, I think, 15.3%. But the average stock in the S &P 500 was only up about 6 % and change for the first half of the year. And I want to say the average stock in the second quarter in the S &P was slightly negative. That's right. Down 1.3%, something along those lines. Yep. So really, that seems to really show you what a wide dispersion we have in performance, how does that play into your bottoms-up stock picking?

43:49I mean, I think it creates opportunity because we see companies getting sold off that are really great fundamental businesses, but perhaps are going through a tough time or missed earnings for whatever reason. On the flip side, you see companies that we really believe in and fundamentally in the long term that we may already own also selling off, or companies like the ones leading the market that have been doing so well. And the interesting thing, I think, about those top five companies is that they're actually very fundamentally strong. It's not like we're seeing companies that are so ridiculously overvalued.

44:26They are much more highly valued than the market on average, but that's partially driven by earnings revisions and people realizing more and more how much cash flow those businesses can generate. I think what it's teeing up for is a future environment where anything that causes some instability for those extra large tech companies that are driving the market will really create a very different high level environment for the market that will create opportunities for people who are really focused on bottom up investing. I'm glad you brought up that these aren't like just ephemeral ideas like we saw in the dot com era.

44:59I think the numbers on the Magnificent Seven collectively, they do about $2 trillion in revenue and about$300 billion in profits. Those are giant numbers, kind of hard to argue there's a bubble amongst them. Hey, there's some speculation and there's a little bit of overenthusiasm. But these are really very, very well-run, well-managed companies that have become money printing machines. Yes. I mean, I think that is true. There's still a valuation consideration to be applied. And I think you could argue that they're not meaningfully overvalued right now, but it really all comes down to the future growth expectations and their ability to keep on delivering like this.

45:40And so, you know, if for whatever reason, you know, regulation or some change in the environment caused that to slow down, then it's a lot harder to justify these valuations. I was clicking around the website looking at some of the white papers you guys put out on a regular basis. Let's talk about one or two of those. Uncovering opportunities in commercial real estate, the power of location. Let's talk about stepping into a dangerous area. I think for office space anyway, per square foot nationally has fallen from about$350 to$199. Tell us a little bit about opportunities in commercial real estate.

46:20I think commercial real estate, as our bond managers would say, is clearly an area where the baby gets thrown out with the bathwater. And so if you focus on super high quality opportunities, then I think you can really find mispriced securities, essentially, because everybody is so worried about commercial real estate. And that worry is not without reason, to your point. Particularly in office space. But there's a lot more to commercial real estate than just office space. Absolutely. But I think in very high-quality office, they're finding opportunities as well. And so it's partially, I think, a matter of looking for where investor expectations get so lumped together with the overall category and the bottom-up perspective can show actually there are individual buildings or opportunities in commercial real estate that can provide opportunity.

47:09What about geographies? Diamond Hill is located in the United States, but it seems that your experience has been all over Australia and Asia. Japan has had a great year. We're starting to see signs. Emerging market is doing better. Europe, the perennial laggard, even Europe is starting to show signs of coming alive. How do you look at the rest of the globe? What are your constraints? So we have an international equity team that really focuses on looking for opportunities outside the U.S. And they travel the world meeting with management teams and really uncovering the depth that you can't get just by staying in the U.S.

47:47and looking at the data. They do obviously spend a lot of time doing that. But I'd say that's really led to a focus on areas that are more bottom-up oriented. So just like on the U.S. side, we're really looking for individual companies that lead to opportunity. But you do occasionally find areas of the globe where you either want to avoid it wholeheartedly, even if there might be a company that looks interesting, or where there's a lot of undervalued businesses that we can invest in. And I do think that among technology, which is a very international industry, very global industry, there are some opportunities there.

48:26Because when you look at names like TSMC and Samsung that are really fundamentally great businesses, even before AI caused things to go crazy, I think that's just an area where our team's finding a lot of opportunity. What about strategic capacity management? How does that improve client outcomes? So essentially, that kind of goes back to what we were talking about before, where it's really important to consider the capacity of strategies that we manage so that we can put our existing clients' interests first. And so when we look at how much we think we can manage in a strategy, we try to take into consideration what the investor experience will be.

49:08And, you know, if you're looking at small cap, for example, I think it's easy for people to understand this, where, you know, we can clearly see that small cap managers that take on too many assets tend to have a much harder time outperforming the market over the long run. So if we just explicitly say we think we can manage about, you know, two, two and a half billion dollars in small cap, and when we get to that point, then we're not going to take new clients because it's really important for us that the client experience is more important than our ability to generate more revenue by bringing on more assets.

49:38And what about long short? You have a fund that runs long short. Tell us a little bit about that. What's the thinking? When I hear bottoms up stock picking, I no longer think about short selling. but obviously if you identify something that is mispriced to the downside, perhaps you can also identify things mispriced to the upside. Yeah, that's basically the philosophical approach that we've taken. And I'd say there's a few people on our team, one of the portfolio managers on that strategy and a couple of analysts who have really developed expertise thinking about the short side. But fundamentally, it really is about valuation.

50:17Now, it's harder, obviously, when you're trying to short an overvalued company than buying an undervalued one, because you can only wait so long if the stock's running against you. But we've just really developed an approach, I think, that takes a little bit more of a diversified approach on the short side and gives a little bit more room to situations that might not unfold as quickly as you hope. Are these 130-30 funds, or are they market neutral funds? How do you structure them? They are essentially 60 % net long. So that's been our focus historically and really what our clients have asked of us.

50:51But it is an area that I think could be ripe for innovation because it is easier to think about a market neutral strategy in an environment where interest rates are positive than it is when they're zero. And so I think, not to say you couldn't do it when they're zero, but I just think it's a lot harder to make the math work. Tina made it very difficult to be on the short side when there was no alternative to equities. It was pretty much the only place you could go. But today, with rates over 5%, I think the last time I looked at the money market fund, it was about five and a quarter, somewhere around then.

51:26I know you, when we were talking about fixed income, you mentioned securitized assets. What about other forms of private credit? It's been probably the hottest area in the market over the past few years. Yeah, I mean, whenever there's an area of the market that is hot, I would say my first instinct is don't go there. And private credit, I think, I think there are a lot of reasons why private credit has done so well. But, you know, and I do think the line is a little blurry in fixed income. And sometimes people call things private credit that are arguably in scope for some things that we might take a look at.

52:02But we do not have private credit strategies. And we do not intend to because, you know, we've really been focused on the areas of fixed income where we can identify dislocation. And so that's really what we feel like we can do in that core and short duration securitized strategies. I only have you for a few minutes more. Let's jump to our favorite questions that we ask all of our guests, starting with what's been keeping you entertained these days? What are you watching or listening to? So one show I've really enjoyed is The Bear. I haven't watched the third season yet, but... We're about halfway through it, and it's really interesting.

52:38Okay, good. I just think it's a great show. First of all, I'm from Chicago, and so I love the Chicago connection and constant visuals from my favorite city. And then I just think their character development is unbelievable. So it's been... I've really enjoyed it. Not just Bear and Sydney, but watching Richie develop from a caricature to a person has really, really been fascinating, culminating with the Forks episode, I think was season two. Yes. Really was very amazing. Let's talk about your mentors who helped shape your career. So I was very fortunate early on in my career to have a couple of kind of managers and leaders that really helped set the stage for a productive future career.

53:22Even at Bank of America, while I didn't end up staying there a tremendously long time, I had the most incredible first manager. And he really helped me see that there were lots of different areas in finance and investing to go into and that he'd be supportive regardless. And I actually still keep in touch with him to this day. And then even at Driehaus, I had a great manager in the International Portfolio Manager at the time. And he really taught me about the kind of fundamental aspects that all investing holds even more momentum-oriented investing. But he also was someone I've turned to in the past to ask deep career questions and kind of figure out where to go next.

54:02So let's talk about books. And I have to mention your book, Why Motes Matter. Tell us a little bit about that, and then we'll jump into what you're reading currently. So Why Motes Matter was really an encapsulation of thinking about competitive advantage and valuation and making investment decisions. And that does encapsulate Morningstar's investment philosophy. And certainly they commissioned the book or funded it, I would say. But it was a really great experience, too, because we were able to get a lot of the equity research team involved in writing it. So you'll see different chapters authored by multiple people, which I think was just a really great way to highlight some of the ways that you can apply competitive advantage thinking to different industries.

54:44And tell us about what you're reading now and what are some of your favorite books. So I just started Chip War. I don't know if you've read that. I have it. It's in my queue. I haven't started it yet, but everybody seems to love it. It's fascinating. And I think the thing that's so great about it is there's just so much around the topic of semiconductors and Silicon Valley and AI and like really just understanding the fundamental underpinnings of how the industry got started and where the power lies and why TSMC is such a critically important company to the whole world. I think everyone should read it.

55:17And I also like it because it kind of falls into my favorite category of nonfiction written like a novel. Or, you know, sometimes that dabbles into historical fiction. There's, I don't know if you've read The Devil in the White City. That's a great book that's really about kind of Chicago during the World's Fair. Larson? Yeah, Eric Larson. Yeah. I have a whole stack of his stuff. Everything he writes is so fascinating and dense and absolutely reads like a novel. Yeah. I read something else. I can't remember the name of it, about the evolution of Edison and Tesla and Westinghouse right around the turn of the century that I think is another fascinating example of this category where you're learning about real events and people, but in a way that feels like you're reading a novel.

56:02So I think there's a lot of great examples like that. Really, really interesting. Our final two questions. What sort of advice would you give a recent college graduate interested in a career in either investment management or finance? I'd say two things. First, seek experiences that will help you get the role that you think you want in the long term. And that one is really, I think, about not only getting experiences from your job and what you're doing day to day, but also looking for opportunities to, let's say you're an equity analyst, but you want to move into a leadership role, you can try to volunteer in organizations or serve on the board of a nonprofit that can help develop leadership skills, even though your day-to-day job may be much more investment-oriented, for example.

56:48And another thing I always tell people who ask me this question is it's so important to put your hand up and make sure that your manager knows how you want your career to evolve, because people, I think, assume that they're going to get tapped for their next role. And I just don't think it generally works that way. I think if you can be proactive in saying, I would love to be an analyst on a different sector, or I'd love to be a portfolio manager someday, or whatever it is that you aspire to, then you can work with your manager on making sure you have kind of a long-term plan for developing the right skills instead of just being disappointed when you don't get the job.

57:21And our final question, what do you know about the world of investing today you wish you knew 30 or so years ago? I would say that trends last longer than you think they possibly could. And so, I mean, you could see that right now in the small cap versus large cap performance that we talked about. You could certainly see it even at the end of the dot-com days. You know, you could see it even in like the 2006-2007 period where so many investors felt like they knew housing was going to collapse, but nobody could actually hold on to their positions long enough, except for very few, to end up making that a positive trade.

58:01So I just think there's so many examples where trends go on so much longer than you think. So you need to make sure to take that into consideration in your future careers. Thank you, Heather, for being so generous with your time. We have been speaking with Heather Brilliant, CEO of Diamond Hill. If you enjoy this conversation, Well, check out any of the 500 previous discussions we've had over the past 10 years. You can find those at iTunes, Spotify, YouTube, Bloomberg, wherever you find your favorite podcasts. Check out my new podcast, At The Money, short conversations with experts about topics that affect you and your money, earning it, spending it, and most importantly, investing it.

58:45at the money in the Masters in Business feed or wherever you find your favorite podcasts. I would be remiss if I did not thank the crack team that helps us put these conversations together each week. Steve Gonzalez is my audio engineer. Atika Valbron is my project manager. Anna Luke is my producer. Sean Russo is my researcher. I'm Barry Brits. You've been listening to Masters in Business on Bloomberg Radio.

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