Model Portfolio teriksen:ESVF

The asset management industry is one of my favorites to invest in because the industry has attractive characteristics: high profit margins, little need for capital investment, and solid sales growth.

A favorite asset manager of mine over the last two years has been Diamond Hill Investment Group, Inc. (nasdaq: DHIL). It has grown rapidly and its share price increase reflects it. But when I look at the company, it still appears that the market is pricing DHIL as if its growth will stop. Based on past performance and current trends, I think that scenario is very unlikely. In fact, I think the shares can double in the next two years.

Diamond Hill manages mutual funds, separate accounts and two hedge funds. Management follows a value-based investment philosophy - they invest in good companies when prices are at a bargain to their assessment of intrinsic value of the business. What is most impressive is the firm’s growth. Assets under management (AUM) were $107 million at the end of 2002, $250 million at the end of 2003, $515 million at the end of 2004, $1.5 billion at the end of 2005, and $3.7 billion at the end of 2006. That’s four straight years of over 100% growth!

A number of factors have led to Diamond Hill’s tremendous asset growth but the primary factor has been the performance of its funds. The Small Cap fund (closed to new investors) and Long-Short fund have five star Morningstar ratings, while the Large Cap, Financial Long-Short, and Strategic Income funds have four star ratings. In 2006 DHIL introduced two new funds, a Small-Mid Cap fund and a Select fund, which is based on the best ideas from the Small Cap and Large Cap funds.

I believe the market is not pricing in any future growth for the company, which I think is a very unlikely scenario given its historical performance. If growth stopped and AUM leveled off at the current $3.7 billion I estimate the company would have 2006 earnings of $4 per share. Based on the average industry multiple of 20 times earnings that would support a share price of about $80, close to the end of 2006 market price. This gives us some downside protection.

While I can’t precisely estimate future asset growth, continued AUM growth is likely. If asset growth were to continue at just half of its 2006 average of $180 million per month for the next two years, I estimate annual earnings would be $7 per basic share in 2008. At the industry multiple of 20 times earnings, DHIL would be priced at $140.

If DHIL can maintain their 2006 rate of growth in 2007 and 2008, it could see earnings reach $8 to $10 per basic share. At the normal industry multiple of 20 times earnings, that would result in a stock price of $160 to $200 per share. Based on its historical growth rate, I think Diamond Hill should trade at a premium to the industry average. If I use a PE ratio of 25 to 30 due to its superior growth rate, the above scenario would result in price range of $200 to $300 per share by the end of 2008.

Diamond Hill fits the kind of stock I look for. I want to invest in good industries that are not capital intensive, that have upside potential without all the downside risk. It looks to me like a stock that can double in two years.

Note: Mr. Eriksen is a registered Investment Advisor. Both Mr. Eriksen, and funds he manages, have a position in Diamond Hill.