The Found Money Interview: Diamond Hill’s Jason Downey on Analyzing the Value of Companies, Challenges in Small Cap Investing, and more.

Jason Downey
Research Analyst, Diamond Hill Investments
Jason Downey, CFA, has a B.A. in economics from OhioWesleyanUniversity. Straight out of college, he started at Diamond Hill Investments as an analyst and trader, and since 2006 he has been able to focus on his work as a research analyst.
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How did you wind up in this line of work?

Initially, I was planning on going to law school, but as an undergrad I started to have an interest in investing. I read a couple of Peter Lynch’s books, which got me interested in Warren Buffett. Sophomore year, on spring break my beach read was Buffett: The Making of an American Capitalist [by Roger Lowenstein]. The light bulb went on—this was exactly what I wanted to do.

My reading moved on to Benjamin Graham [“the Father of Value Investing”]. When I was really getting into Graham, I read an article in the local paper, the Columbus Dispatch, about a new firm right there in Columbus, Ohio, whose investing philosophy was along the same lines of the Buffett-Graham approach. It was a perfect fit. I met with them a couple of times, they helped me out with a major project in my senior year, and then they offered me a job. I jumped on it.

The first few years, I was going through the CFA program and my primary duties were trading and operational stuff, with analytical work on the side. During that time, I worked on some restaurants and some retail companies. After I got through the CFA program and the firm was large enough to bring in a dedicated trader and build up the research area, I became a full-time analyst—it was about this time last year. I started modeling our existing transportation holdings and focusing on that sector about a year ago.

Some of our readers may not  be familiar with the way you used the term “modeling" just now. Could you elaborate on that for us?

Essentially, we're trying to determine what kind of cash a company can generate over a longer period of time, at least three to five years: what kind of sales; what kind of profitability; factoring in the capital intensity of the business, what kind of investments they need to make to generate those profits; and—after the financing [to get the resources] to do all those things—what is going to be available to the equity holders. We make all those projections, we apply an appropriate discount to those cash flows to account for the time value of money—and we estimate the business’s intrinsic value.

You're trying to come up with a mathematical description of the company and how it operates?

Yes—how the company operates, the fundamentals of the business, the capital intensity, the expected sales and profitability—there's math that goes into that, pretty basic math, trying to determine how much cash will be generated for the equity holders.

So our clients can tell the teenagers in their lives that people actually do use high school algebra in the real world.

[laughs] Exactly.

I want to talk to you about Diamond Hill’s investment philosophy, and the distinction between “price” and “intrinsic value.” How does Diamond Hill understand that distinction, and how do you try to act on it?

Price is what you pay; value is what you get. If we see a discrepancy between price and value, we’ll attempt to take advantage of that discrepancy. 

What we try to do is find businesses that we think we can evaluate [accurately], businesses within our “circle of competence.” We do both long and short strategies, so if the company looks like there might be a [price/value] discrepancy on either side, that calls for further analysis. We model how the company operates, looking at the cash they can throw off for the next five to ten years. And, given those expected cash flows, we place a value on the company, “best guess” estimate. If there is a wide discrepancy between that value and the price at which the company is trading, then we'll try to exploit that discrepancy that the market is providing.

One of Diamond Hill’s stated preferences is for firms with the ability to earn excess returns. Could you tell us about that?

Ideally, we like to invest in businesses that have a competitive advantage that allows them to earn excess returns—a brand name, an existing infrastructure—some sort of “moat” that shields them from competition. Now, as long as we feel there's a major [value] discrepancy in the price, we're willing to invest in a wide variety of businesses. But obviously, all else being equal, you would rather invest in a good business that has a competitive advantage. It’s like having the wind at your back. Lots of times, those are hard to come by.

Indeed! — Long-term capital flow is another idea that you emphasize.

That's getting back to the idea of, how much cash can the company generate—over a long period of time. We’re not sitting here trying to determine whether or not a company is going to beat the consensus [of analysts’ expectations] for next quarter or even next year. We're trying to take a hard look at the long-term fundamentals of the business.

Diamond Hill does a lot of small- and mid-cap investing. What are some of the challenges about those areas?

Right now, I think, especially in the small caps, valuation is one of the issues in general. Six or seven years ago, prior to my arrival here, there was a huge valuation discrepancy between small-cap value stocks and large-cap stocks. But that discrepancy has reversed itself, and finding attractive opportunities in that space has become a bit of a challenge. If you looked back at our portfolios in 2000-2003, you would see that a much larger percentage of our portfolio was dedicated to small-cap companies. Now it's tilted more towards the mid-cap to larger cap companies.

Back then, people were excited about large-cap growth companies and were paying all sorts of multiples for them. Small-cap value companies were being kicked aside because they weren't the exciting stocks of the day. Diamond Hill and other investors like us saw the value of those companies, and a quarter or two of underperformance didn't discourage us.

That's the central tenet to our philosophy. We don't know what's going to happen over a short period of time, but we have confidence that in the long term the stock price and the value of the business will converge. 

And when they start converging, it’s time to move on to other investments. Are any sectors still attractive for small-cap bargain hunters?

In both our large- and our small-capitalization portfolios, the energy sector is still the biggest percentage of our holdings, and we’re finding it the most attractive of opportunities. That's been the case since about 2003. In the small caps, the weighting is not as high as it was at one point, but still it's close to 20%.

Tell me about your own main areas of research.

I'm focused on transportation. I still follow a few retail companies, restaurants, a couple of sporting goods retailers. A year and half ago we had a large position in the airlines. We still have a large position in AirTran Holdings. But we've pared back most of our other airline investments.

What are the trends in airlines that you see right now?

Over the last couple of years, we've seen load factors increase pretty dramatically—planes are flying fuller. Demand has hung in there, and supply started coming off as Delta and Northwest entered bankruptcy. The US Air merger with America West brought supply further into balance with demand. So once you have planes flying 80% full instead of 50% or 60% full, the irrational pricing—it’s common in that industry to disregard profitability—is not quite as tempting. You've still had huge swings in profitability over the last couple of years. Towards the end of last year we began paring back.

Tell me about the companies that you decided to hold onto and the ones you decided to let go.

Two that we sold were American Airlines and US Airways. The stocks appreciated due to the prospect of consolidation in the industry, following US Airway’s bid for Delta. Following this run-up we felt that the stock prices fully reflected the companies’ increase in profitability. We also had some longer-term concerns regarding labor and the need to replace aging fleets. Once the stock prices got to the points that reflected our estimates of intrinsic value, we sold them.

AirTran Holdings is a low-cost carrier that we held onto. AirTran’s profitability has suffered due to excess capacity and an aggressive competitor in its main markets, and in response Airtran cut back its growth. They had been growing their planes about 20% per year in capacity, but after July they have no more new planes coming on for the remainder of this year.

Their hub is in Atlanta, which is Delta’s primary hub. Delta’s cost structure is much higher than AirTran's, but in an attempt to stop losing market share they would cut prices. So if AirTran is not making much money, Delta is actually losing money on those routes. That makes AirTran's job harder, because it's essentially a commodity business. You have to match those prices; otherwise nobody's going to fly on your plane. And you have all these fixed costs.

But now Delta is pulling off some of its domestic capacity, to shift it to their international routes. Right now the Delta mix is roughly 30% international and 70% domestic, and they want to get that to a 50%-50% domestic/international mix over the course of the next few years. Also, emerging from bankruptcy, the proposals they put forth to the creditors committee assumed levels of profitability that won’t let them price their products like they had been. So, you should have a more rational competitive environment in Atlanta for AirTran over the next several years.

AirTran management has done a tremendous job on the cost side of the business. We think AirTran is going to become much more profitable over the next couple of years, and their current price does not reflect that. So we’re still holding that company.

You mentioned that you still follow some restaurants. What's going on in that area?

Sort of a mixed bag, as far as same-store sales go. There's a lot of concern over an economic slowdown, but, like I said, we have long/short strategies. As of our last filing we had a long position in McDonald's, while we were short Red Robin Gourmet Burgers, PF Chang's Bistro, and Panera Bread. That tells you how we feel about the valuations relative to the business fundamentals in the casual dining segment. We think the stocks are ahead of themselves in a lot of cases.

What basic criteria do you use to eliminate unsuitable companies?

There is no cookie-cutter method that we use. We look at the valuations and the competitive landscape of the business. If we thought it was a broken business model, we wouldn't invest. The primary thing is valuation. If we feel we can understand the business and place a value on it, then we won't eliminate any opportunity. I guess you could say our circle of competence is the only limiting factor.

Your website has a really fascinating tool that provides an approach to determining intrinsic value for stock prices. Could you tell us how that valuation model works?

Yes, the button is “Financial Model.” It's a simplified version of the software that we use internally. You can come up with your own set of assumptions for a company, plug them in, then determine an estimate of intrinsic value for the company with a five-year horizon—revenue assumptions, profitability assumptions . . .

Palmerston Group likes investors’ interests to be aligned with those of the investment managers. How does Diamond Hill try to accomplish that?

Once an investment professional joins Diamond Hill, all future personal equity investments have to be in our products—mutual funds, private partnerships, or company stock. [Note: Existing holdings do not have to be sold.] We can't have anything outside of that.

We have to eat our own cooking.

You closed your small-cap fund to new investors in 2005. Could you tell me about that decision, and how that helped your existing shareholders?

Especially in small-cap equities, it becomes much more difficult to outperform the market as you become larger. You have to buy far more shares when you are a $500 million fund than you did when you were $10 million fund, so that makes it much more difficult to acquire the shares without moving the stock price. Having more assets under management limits your ability to take outsized positions, even if you find really attractive opportunities. To preserve our ability to take large positions when we feel they're warranted and keep market impact from becoming onerous, we closed the fund to the public when we thought it was an appropriate size, roughly $500 million.

Could you talk about one of your firm's recent investments and why it was made?

Motorola is a new position that was established in the first quarter. I'm not the analyst on that particular company, but it has margin issues. Some competitors have driven down pricing on their most profitable phone, and the stock price over-reacted to some short-term news. But over the longer term, they should be able to right the ship. They're going to focus on getting their profitability levels back up. We feel this will prove to be a good investment, in spite of the short-term pain.

Because Diamond Hill is a relatively small organization, is it easy to stay in contact with the rest of the research analysts there?

We all sort of sit together and bounce ideas off each other. I sit next to the energy analyst—a key input to transportation. We often have conversations related to that. It's a pretty cohesive group here, with a lot of interaction between the analysts and portfolio managers. Not much in the way of egos, a pretty laid-back, collaborative culture.

 Relatively few investors know much about what research is like. If you could tell us a little about your day, it would be interesting for our readers.

I don't know if interesting is the right word. It's a lot of reading, and a lot of modeling. Reading the newspaper, industry journals, research reports. Every day you're reading about your industry—our existing holdings and the other companies in that sector. As news comes in, we update our models of our existing holdings. And then there's all the things that we do not have a position in, that look interesting! Someone who walked around here and looked at us might not say it was exciting, but we enjoy it. We’d do it as a hobby if it wasn't our profession.

Thank you very much for being so generous with your time.

Opinions expressed by the analyst are his own and are subject to change at any time as circumstances change.

As of 4/30/07, the companies mentioned were owned by various Diamond Hill mutual funds in these weights: AAI: 2.8%, Small Cap Fund; 2.4%, Small-Mid Cap Fund; 1.6%, Select Fund;1.0%, Long-Short Fund. LCC: 0.8%, Small-Mid Cap Fund. MCD: 4.5%, Large Cap Fund; 3.9%, Select Fund; 3.9%, Long-Short Fund. MOT: 1.3%, Large Cap Fund; 1.3%, Select Fund; 1.0%, Long-Short Fund. PFCB: -0.6%, Long-Short Fund. PNRA: -0.5%, Long-Short Fund. RRGB: -0.5%, Long-Short Fund.