Description

Diamond Hill Investment Group (DHIL) $107.36

Summary

Diamond Hill Investment Group (Nasdaq: DHIL) is an institutional asset manager. Using a value investment philosophy, DHIL manages $20b in assets under management across 14 equity and credit strategies. DHIL provides its services to individual and institutional clients through mutual funds and separate accounts.

Valuations have fallen sharply for active asset managers over the last several years as the combination of asset outflows, fee pressure, and increased operating expenses has taken the shine off what has historically been an excellent business model. At a current valuation of 3x EV/EBIT, Diamond Hill trades well below an estimated private market value of 10x EV/EBIT. This discount was exacerbated in a sharp selloff in Q1 2020.

While the market capitalization is $372MM and enterprise value is $166MM, DHIL has no analyst coverage. With a solid balance sheet and a shareholder friendly management, I expect that this valuation discount will not persist, and the Company has announced a new $50MM share repurchase program following the completion of the previous $50MM program announced in 2018. The Company has historically paid a consistently growing special dividend in December. The yield on the 2019 special dividend is 8.3% and is 9.3% on the projected 2020 special dividend. My target is $200, or 86% above the current quote.

Background

Stating the obvious, the last several years have been challenging for most active investors. The artificially low interest rates orchestrated to lift the economy out of the 2008-2009 recession have had several unintended consequences in financial markets, including reduced volatility. Low volatility combined with the accelerated growth of indexing strategies has resulted in relatively low active industry alpha, outflows from active managers and increasing fee pressure on remaining assets.

Diamond Hill has grown assets and revenues at a respectable rate over this period and continued to build intrinsic value. Average fees have remained solid but have declined since peaking in 2015, caused by product mix, performance, and fee pressure.

The investment advisory business is generally a fantastic business model. There are no receivables; clients and assets tend to be sticky yielding revenue stability and visibility; and there has been a great tailwind of positive market returns over the last several decades boosted by increasing capture of investors’ savings into managed strategies either directly or via institutional proxies like pensions and 401(k)s. Historically, these characteristics yielded high valuation multiples for investment firms.

The world has changed over the last decade and the quality of the investment business has declined. Increasing competition and the ubiquitous dissemination of financial information has reduced alpha and, in combination with the growth of passive investment strategies has resulted in fee pressure, resulting in anemic revenue growth and earnings pressure. This has resulted in sharp multiple compression for investment firms that are not growing.

The Opportunity

I am clearly talking my own book here, but I believe that rumors of the death of active investment management have been greatly exaggerated.

Insiders own 17.3% of the shares and the company has been actively repurchasing stock. Most of the book value consists of cash and investments in their funds. There is no debt. They brought in a new CEO last year from outside the company. While operating performance will vary from year to year, they have an unblemished track record of growing intrinsic value over any rolling five-year period.

If they simply continue to repurchase shares and pay dividends, the stock price should eventually reflect intrinsic value, even if predicting when is challenging. I think it’s unlikely, but they could consummate a transaction to realize intrinsic value.

The Data

Currently, DHIL is trading at 1.2x TTM EV/Revenues, 2.9x TTM EV/EBIT, 9.2x TTM earnings and only 4.1x earnings net of cash) In comparison, a behemoth like Blackrock (BLK) trades at low teens EBIT. Historically, active managers traded in a valuation range of 10x – 15x EV/EBIT.

My base case assumptions are that over the next two years, revenues stabilize and exhibit moderate growth for the industry. Additional consolidation is likely to occur, with private market valuations above current pricing. Under this scenario, it would not be unreasonable to assume that multiples expand towards the low end of the historical average of 10x – 15x EBIT. This would represent over 300% growth from the current quote before considering the growth of cash and investments on the balance sheet over this period.

From 2013 – 2017, valuation ranged from 8.4x – 9.7x EV/EBIT, but was in a tighter band of 9.4x – 9.7x in all but one of those five years. Private market value is 8x – 10x EBIT, which equates to $189 - $221 on TTM EBIT (which I estimate can grow 5% in the near term). This represents 77% - 107% upside.

Unlike many investment advisors, DHIL has shown itself to be shareholder friendly. There is a single class of stock that is not controlled by management (employees and directors own 17%) and they have repurchased shares in the past at what have proven to be attractive prices. They recently announced a renewed $50MM share repurchase and accelerated their purchases in Q1 2020.

If my assumptions prove to be incorrect, the downside is well protected by several factors including: a balance sheet with $59/share in net cash and investments, a likely 2020 special dividend of $10/share yielding 9.3%, a highly variable cost model that can be flexed down if situations warrant and a robust market for investment advisor acquisitions. Good things happen to cheap stocks when the underlying company is growing intrinsic value, has a solid balance sheet and has a shareholder friendly management.

Catalyst

Hard catalyst would be a transaction, but I think that is unlikely. Soft catalysts are simply continuing to execute and grow intrinsic value while repurchasing shares when attractively priced and paying a high dividend. Eventually, this should be reflected in the stock price.