Kristen Sheffield (0:13)
Hello everyone. My name is Kristen Sheffield. I'm an equity portfolio specialist at Diamond Hill. And today on the webcast I'm joined by co-portfolio managers of our Select strategy, Austin Hawley and Rick Snowdon. Thanks for joining me today, guys.
It's been an interesting past four to five weeks in equity markets, so I thought we could start by getting your thoughts, Austin, on some of the market volatility we've seen particularly in early August and then was that moving the needle at all in terms of opportunity or activity in the portfolio?
Austin Hawley (0:46)
Yeah, so it has been a pretty exciting start to the third quarter here, both with the CPI report in early July and then the market selloff in August. The short answer is yes, we did actually have some activity in the portfolio that was directly related to some of that volatility, especially in early August. And frankly, we would've liked to have some more activity, but the window to act turned out to be very short during that August selloff.
If you look at what happened in August, the broad indices, so if you think about the Russell 3000 as a broad index, was down roughly 6.5% over three days beginning on August 1st. But then if you look at what happened over the next two weeks, the market just steadily moved higher to the point where today we're close to all-time highs again on the broad indices. And those markets were actually up I think 10 out of 14 days after that initial volatility. So, if you didn't act in a very bold way initially when the market sold off, if you weren't completely prepared, it was hard to get stuff done over the next couple of weeks as the markets moved up.
So, we've talked a lot about how we try to be opportunistic in the Select strategy and you'll see our turnover move around a little bit more during periods of market volatility. And that was the case here, but in a more modest way. And usually when we're trying to take advantage of the volatility, it's usually one of two things. We're either trying to initiate new positions that we think are more attractive than something else we own in the portfolio or actively trying to reposition within the names we own to what we find most attractive at any point in time.
And we actually had a little bit of both of those scenarios. We had started to buy a couple new positions in the Select strategy in the second quarter, and those names, or in July, I should say, both International Paper and Builders FirstSource. And we didn't finish those positions initially because the prices started to move up on us. That selloff in August gave us an opportunity to finish those positions and get them to full positions in the portfolio. So, using that volatility to get better prices for those new positions.
The second thing we did was reposition a little bit within the names we already own. And if you look from the end of the second quarter through the depths of those first few days in August, the area that sold off by far the most was the growth-oriented names. And so, when we looked in our portfolio, the two that we found to be attractive on a relative basis in early August were Amazon and then Coherent. And those are two of our more growth-oriented names. Those names were down 20% to 25% from the end of the second quarter. So, a pretty meaningful move for those companies, and we bought a pretty meaningful additional stake in each of those companies during that selloff in August.
So not a ton of activity, but definitely we were trying to make the most of that period of time. If it had gone on a few days longer, I think we would've gotten even more done, but very happy that we were prepared to take action during that brief selloff.
Kristen Sheffield (04:19)
I think that's a helpful color for volatile times in the market. I wanted to zoom back even a little bit further in terms of some of the activity within the portfolio because over the last 12 to 15 months, we've seen a notable uptick in exposure to real estate and health care sectors within the portfolio. And knowing that Select is a concentrated best-idea strategy where we're looking for opportunities on a bottom-up basis, I was still curious if you had observed any sort of themes or had thoughts on what's been driving you all finding opportunities in these areas more attractive lately?
Rick Snowdon (05:00)
Yeah, I'll take that Kristen. You're right, we've definitely increased our weights in those two sectors, but sort of as always, the theme is that individual stocks begin to look cheap for us, that's really the reason that we get in.
In the case of real estate, I'd say there is sort of a low-level theme, which is that it was the outlook of higher for longer interest rates was settling in and becoming pretty pervasive. It did weaken the two real estate names that we purchased, which were Extra Space and SBA Communications. So Extra Space we bought about a year ago and SBA we bought maybe six months ago, but there were for sure other contributing factors in the case of each of those names that got it down below the hurdle where they made sense for us.
Extra Space, all the storage companies have struggled, or have been weak, I should say, after sort of the boom time of COVID, utilization was lower and rents were lower. And Extra Space was one of the worst performing stocks within that group of companies as a result of likely the sort of digestion of a near-term unpopular merger, which we think is going to add value over time and doesn't concern us.
And then SBAC was weaker likely in large part just due to slower 5G rollout by the carriers. So, in the case of both of those, yeah, interest rates had an impact and certainly helped, but it's not like we had a view on interest rates. But what we feel strongly about is that they both got business models that should compound earnings at very attractive rates going forward. So, we jumped at the chance to buy them on the cheap.
And in terms of health care, no real theme there. We bought Pfizer at the beginning of 2024 and Abbott a few months later. And these just had gotten cheap for different reasons. Pfizer had done extremely well while helping solve the health crisis, the pandemic, and generated significant excess earnings over that period of time as they deserve to. And as those excess earnings work their way out of the income statement, if things have sort of normalized, the stock price fell to a level that was, I think, about 20% below where it was trading before Covid hit.
But they put in the bank, or on the balance sheet, $30 to 40 billion in excess cash from the vaccines. And mostly you can look at it, one way to look at it is that they invested all that in an acquisition of a biotech-oncology company called Seagen that is yet to bear fruit. So that's where we bought that one.
Abbott, we think, is even better business than Pfizer. It's more diversified, has very strong fundamental growth, but it was weakened by the litigation overhang from a very small product where there've been some very big jury decisions. But this is a product, again, it's not very big for them. They don't make a lot of money on it. And we think the whole thing is, first of all, we think they probably shouldn't have any liability if you actually look at the facts. But even if some of these judgements continue, we think the size of them will decline, as happens significantly, and the overall liability is going to be a lot smaller. And so again, two stocks that we were able to get into for different idiosyncratic reasons, both of which we've owned in the past, and so we're pretty familiar with them.
Kristen Sheffield (08:56)
I wanted to get your thoughts on another kind of more recent add to the portfolio is Starbucks, which we saw was in the news recently with the announcement that they had hired the head of Chipotle as their new CEO and got quite a positive initial reaction in the market. I wanted to see what's our thesis for Starbucks? And then I'd be curious to hear your thoughts on the CEO hire and how we think about that impacting our thesis and estimate of intrinsic value.
Rick Snowdon (09:27)
Yeah, sure. I'll take that one too. So, we bought Starbucks back in May, which I think was about two to three months before the announcement that the CEO was being replaced. The CEO, by the way, had been there less than one year. Our thesis was and remains, Starbucks is a tremendous brand with some near-term fundamental weakness in traffic growth and margins. They're being caused by some very addressable operational challenges. And they're challenges that largely come from how popular the brand is. There's just so much traffic trying to get through the stores that it has made things difficult as complexity has increased.
So, the CEO at the time was talking about the right things and we had an open mind about his ability to address effectively these things. However, his replacement with Brian Nichol was really the best news we could hope for. Nichol's experience is extremely applicable. As you pointed out, he turned around Chipotle, he was at Taco Bell before that. The experience that Chipotle was addressing complexity of the stores, relieving bottlenecks while preserving and enhancing the brand, which is exactly what needs to happen here. So, does it increase our estimate of intrinsic value? I'd say right now, not officially. However, it certainly increases the confidence we have in the estimate and over time I think it very well could increase our estimate of intrinsic value.
Kristen Sheffield (10:54)
I want to go back to you, Austin, in terms of, we talked about the spike in volatility that we saw earlier this month and looking forward, it seems like there's really no shortage of events that could be impacting volatility from US elections to heightened geopolitical tensions, continued focus on inflation and the Fed. So how are you thinking about some of these more macro-oriented risks? And I know we don't have a crystal ball to predict the future, but any thoughts you can share on your outlook for equity markets or the strategy going forward?
Austin Hawley (11:31)
Sure. So, as you point out, Kristen, we are definitely not macro investors. We are very focused and as Rick talked about the names in health care and real estate, we are very focused on the fundamentals of individual companies and that's how we build up the portfolio. However, having said that, Rick and I actually spent quite a bit of time talking about macro and issues from the election to geopolitics to inflation and interest rates. And what we are always trying to do is be open-minded and just think about the potential scenarios and the way the environment might look over the next five years. And we're not trying to let the macro guide us and point us towards where we should look for investment ideas, but it is the backdrop for which we evaluate all the individual companies. And what we want to do is we want to try to be as prepared as possible because we know there's a lot of uncertainties in the world and we want to just be open-minded and think about all those different scenarios and how they might impact both the companies we own and also any companies we're looking at.
And so, when I think about the world today, and I think undoubtedly there's more uncertainty on the political side and geopolitical risks than we've had in a number of years. And when I think about that, there's a couple of things that we try to do. The first is, like I said, we just try to be prepared and think about all those different scenarios. The second is we do think about the portfolio and the balance of exposures we have in the portfolio. And part of that exercise of talking about the macro is to walk through all the different scenarios for the names we own and make sure we are maintaining a reasonable balance of both cyclical and non-cyclical but also different business models that we have in the portfolio. The other thing that really helps with is, like I said, it makes us prepared for whatever scenario unfolds in the future and we can take advantage of those opportunities if we get some periods of volatility.
And when I look at the markets today and when I look out over the next 5, 10 years, I do think we're at a starting point with pretty high valuations, if you look across the markets in the United States, and a lot of uncertainties in terms of politics and geopolitics. And that leads me to a conclusion that we're likely to have some bouts of real volatility over the next several years in the markets. And what we saw in early August might be pretty mild compared to what we could see over the coming years.
And I think that's good news for a strategy like Select where we have tried to be very opportunistic, we have a wide opportunity set that we can try to capitalize on. It is our job as portfolio managers to keep having those conversations and be prepared to act. And I go all the way back to that first question you asked about early August, and I am happy that we were prepared, but it was a short window and sometimes those windows will be short, and you really have to know and be confident to act during those periods of time. I think the good news is I think this is a strategy that's really well prepared to act during those periods of time. The volatility is going to be stressful, it's always stressful, it was stressful in August, but if you are confident and can act and are prepared, you can compound returns over the longer term, over periods of years, at higher rates. And that's what I'm hopeful we'll be able to continue to do looking forward.
Kristen Sheffield (15:23)
Well, I think that's a great place to wrap up. Austin, Rick, thanks again for joining me today. I appreciate the time and insights as always.