The past five years have been difficult for equity market investors and especially for active money managers. Many investors are questioning whether active portfolio management is still relevant in a period of high correlation and others are questioning whether equity market returns (1) are sufficient to compensate for the volatility risk. From the end of 2008 through June 2012, trailing five-year equity returns have been consistently subpar; total returns have not once achieved 5% and have been below 0% over 1/3 of the time. Put simply, the recent equity market returns have fallen far short of what most investors (ourselves included) consider adequate for the risks incurred. Despite recent results, we believe that the next five years will be advantageous for equity investors and for our intrinsic value focused investment philosophy and process.

Long-Term Focus and Valuations

Our studies of historical market returns suggest that investors should expect the unexpected over short time periods and focus on the long-term for more predictable results. In our most recent investment letter titled The Importance of Being Long-Term Revisited (2), we examine rolling time series of five-year returns over 100 years of market history and conclude that there are three factors that lead us to an optimistic conclusion about our ability to deliver adequate results over five-year periods despite the poor returns for equity indices over the past few years.

1. Over very long periods, deviations outside the normal return range are equally as likely to be positive as negative.
2. Over periods of five years and longer, fundamentals (dividends and earnings growth) have been predictably normal, and the compounding of returns from fundamentals begins to outweigh the impact of speculative changes in the price to earnings multiple.
3. We are active, intrinsic value based investors, and our strategies typically hold less than 5% of the companies in their respective benchmarks. In contrast, market capitalization weighted indices can become heavily skewed by large companies or sectors, with index results reflecting a minority of businesses.

Over the long-term, the fundamentals that support intrinsic values – dividends and earnings growth – have produced steady results for investors with a time horizon of five years or more. At times, excessive valuations have created headwinds, but for active investors, a five-year horizon has provided ample opportunity to add value for clients. Five years ago, we found it very difficult to find stocks selling at a significant discount to intrinsic value. Today that has changed. We are currently finding many stocks trading at substantial discounts to intrinsic value.

Economic & Market Outlook
The U.S. economy benefits from a multitude of strengths that result in a natural bias toward growth with only size acting as an anchor on the upper limit for the growth rate. Given this scenario we believe a reasonable estimate of a five-year GDP growth rate would be in a range of 1% to 4%, with the minimum and maximum determined primarily by worst or best case decisions by government policymakers. Depending on your assumptions, expected returns for the S&P 500 Index may be in the 5% to 7% range, modestly below average historical equity market returns. Assuming the mid-point of the GDP range, which is our current best estimate, we estimate a total return for the S&P 500 Index of 6%, annualized, over the next five years, based upon the following:
• S&P 500 Index price of 1379 as of August 1, 2012,
• 2.5% growth rate for real GDP, and
• trend line inflation estimate of 1.5% annually.

It is our expectation that we can achieve better than 6% market returns over the next five years through active portfolio management and stock selection. While the U.S. faces fiscal and monetary headwinds, we believe the U.S. is still well positioned relative to other countries. Equity market valuations appear reasonable, and success in North American energy production is a potentially huge positive for U.S. industrial competitiveness. However, the implications of the extreme possibilities for GDP growth are dramatic for the financial markets (not to mention society).

Macro Factors
The fact that we should choose government policies that acknowledge our competitive position in a globalized economy is elemental to U.S. economic growth. Tax policy is the easiest to assess, and nearly everyone agrees that corporate tax rates should be reduced. Most would also agree that increased trade is beneficial to our economy. However, policies surrounding the production and use of energy are among the most controversial, since these policies involve issues ranging from national security to ecological impact while simultaneously affecting costs of production and consumption.

In addition, few dispute the need to successfully address the aggregate debt burden, with federal and state government debt, including unfunded liabilities, of primary concern. The growing awareness of this problem is encouraging, despite no clear indication of how and when it will be solved.

Over the next few months, both political parties will have the opportunity to present their solutions to the aforementioned problems (and others). The election results will provide us with new information necessary to update our estimates above for the financial markets, real GDP, and inflation. We are well aware of the range of potential outcomes and the impact of the upcoming election on those outcomes. Implicitly, we factor a probability weighted estimate of outcomes in our estimates of intrinsic value. However, the market level at the time of investment tends to have a greater impact on five-year returns than the outcome of an election. For example, the pharmaceutical companies appeared headed for trouble prior to the Clinton presidency and the managed care companies appeared headed for trouble prior to the Obama presidency. In response, stocks within both industries declined significantly. With hindsight, the market overreacted and those industries enjoyed strong subsequent returns. By focusing on valuations, we seek to avoid those pitfalls and at times benefit from market overreactions.

Conclusion
Periods of high market correlation typically call into question the ability of active managers to outperform. Our strategies do not aim to achieve a specific result in the near term or utilize hedging strategies to nullify the effects of market volatility and macro uncertainty. We take a long-term view of performance and focus our research efforts on understanding and valuing businesses. In fact, we believe that taking a long-term view is perhaps our greatest competitive advantage. While the perception of near-term profit opportunities often attracts significant amounts of capital and erodes excess returns, there are far fewer investors willing to deploy capital based on an investment horizon of five years or more. At many institutions the career risk associated with being wrong in the short run is simply too great for analysts to consider investment opportunities that may play out over years instead of quarters.

Our philosophy and process has not changed since the inception of Diamond Hill in 2000, and we believe it will remain relevant and successful regardless of how the investment landscape changes in the future.

Ric Dillon, CFA, Portfolio Manager & CEO
Chris Welch, CFA, Portfolio Manager & Co-Chief Investment Officer
Chris Bingaman, CFA, Portfolio Manager & Co-Chief Investment Officer

(1) As measured by S&P 500 Index total returns.
(2) The complete letter, written by Austin Hawley, CFA, Research Analyst and Co-Director of Research, is available on our website at www.diamond-hill.com.

(c) Diamond Hill Investments

www.diamond-hill.com

             
 

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