diamond hill letters

8/9/2019 Diamond Hill Letters

http://slidepdf.com/reader/full/diamond-hill-letters 1/87

COMPILATION OF

INVESTMENT LETTERS

2001 – 2009



TABLE OF CONTENTS

PAGES

5 Year Forecast & Our Investment Approach 1 By: Ric Dillon, CFAWinter 2001

Why Does “Closet Indexing” Exist? 2-5 By: Thomas P. Schindler, CFA & William P. Zox, CFASpring 2001

How Safe Is The S & P 500? 6-7 By: Ric Dillon, CFASummer 2001

History, Probability & Statistics, and the Financial Markets 8-10 By: Thomas P. Schindler, CFADecember 31, 2002

The Meaning of Risk 11-13 By: Thomas P. Schindler, CFAJune 30, 2003

Stock Market Outlook – Forecasting the Next Decade 14-16 By: Thomas P. Schindler, CFADecember 31, 2003

The Times They Are A-Changin' 17-18

By: Charles S. Bath, CFAMarch 1, 2004

Of Models and Men 19-22 By: Thomas P. Schindler, CFAJune 30, 2004

2004 Review & 2005 Outlook for the Equity Markets 23-24 By: Ric Dillon, CFA, Charles S. Bath, CFA,Christopher M. Bingaman, CFA & Thomas P. Schindler, CFADecember 31, 2004

2004 Review & 2005 Outlook for the Fixed Income Markets 25-28 By: Kent K. Rinker, William P. Zox, CFA, & Richard W. Moore, CFADecember 31, 2004

"Inverted Thinking Leads Us To Stock-Picking" 29-31 By: Thomas P. Schindler, CFADecember 31, 2004



"In The Long Run" 32-34 By: Thomas P. Schindler, CFADecember 31, 2005

Diamond Hill Funds Discussion of Q3 2006 investment resultswith particular emphasis on energy holdings 35-44

September 30, 2006

"The Rouge et Noir Hedge Fund" 45-46 By: Charles S. Bath, CFADecember 31, 2006

Discussion of Current Fixed Income Market Environment 47-48 By: Kent K. Rinker, William P. Zox, CFA, & Richard W. Moore, CFAAugust 6, 2007

"Greed gives way to Fear" 49-50 By: William C. Dierker, CFAAugust 16, 2007

Impact of August 17 th Federal Reserve Board Action onthe Fixed Income Environment 51

By: Kent K. Rinker, William P. Zox, CFA, & Richard W. Moore, CFAAugust 21, 2007

A Discussion on the Implications of Interest Rates andthe Value of the U.S. Dollar to the investment markets 52-54

By: Charles S. Bath, CFA

November 5, 2007Update on Diamond Hill Strategic Income Fund 55-58

By: Kent K. Rinker, William P. Zox, CFA, & Richard W. Moore, CFANovember 27, 2007

Update on Diamond Hill Strategic Income Fund 59-60 By: Kent K. Rinker, William P. Zox, CFA, & Richard W. Moore, CFAMarch 17, 2008

Discussion on Recent Market Declineswith particular emphasis on Financial Services Sector 61-66

By: Christopher M. Bingaman, CFAMarch 24, 2008

"It is better to be approximately right, than precisely wrong." 67-68 By: Ric Dillon, CFAAugust 8, 2008

Historical Perspective on Bear Markets and Our Current Market Outlook 69-70 By: Ric Dillon, CFANovember 24, 2008



S&P 500 Redux 71-72 By: Tom Schindler, CFAJanuary 31, 2009

The Importance of Being Long-Term 73-80 By: Austin Hawley, CFAJune 15, 2009

Managing Risk and What We Learned from the Crisis 81-83 By: Chris Welch, CFADecember 31, 2009



Winter 2001 Quarterly Update

Diamond Hill Investments 1

5 Year Forecast & Our Investment Approach

“Market commentators and investment managers who glibly refer to “growth” and “value” styles as contrasting approaches to investment are displaying their ignorance, not their sophistication. Growth is simply a component – usually a plus, sometimes a minus – in the value equation.”

-Warren Buffett

At the time of this correspondence, the week ending March 16, 2001, the major indices showed considerable weakness.More specifically, the Dow Jones lost 7.7% for the week, its largest decline since the 7.8% loss during the week endingOctober 13, 1998. The Nasdaq fell nearly 7.9% for the week, leaving the index 62.5% below its peak of 5,049 on March10, 2000. Finally, the S&P 500 fell 6.7% for the week. It has lost a quarter of its value from its high of 1,527 last year.Suffice to say, the U.S. stock market is considered to be in “bear market” territory. Speculation as to when a bull marketenvironment will return is natural. Our view is that while a popular activity, such speculation is of little value. Moreimportant is an understanding that investing requires forecasting future economic conditions within a sound valuationframework.

Our forecast for the economy is for modest secular real growth in GDP, with inflation under control. Fiscal policy islikely to be somewhat stimulative as a result of tax cuts. Corporate profitability will likely lag due to pricing pressurefrom excess capacity in most industries. Further near-term easing by the Federal Reserve should result in interest ratesstaying within a narrow range.

Current valuations are still problematic. The mere fact that many stocks are considerably lower than they were a yearago does not necessarily make them attractive for current investment. The leading stocks in the last half of the previousdecade, namely large-cap technology and mega caps, remain expensive by most valuation metrics. For instance, despiteIntel’s stock decline of about 65% from its high, the current price is five times revenues, as compared to a valuation low in1997 of three times revenues, the latter at a time when future growth was higher than the current forecast.

The later stages of the previous bull market were characterized by investor complacency with regard to valuation, whichallowed for creation of a “bubble” that has subsequently burst. Yet an overly simplistic analysis using comparisons of stock prices from that period of “irrational exuberance” with today’s prices most likely will lead to poor investmentdecisions.

Interestingly, we are often asked whether we are “growth” or “value” managers. You need not look any further thanWarren Buffett’s comments in his annual letter to shareholders to understand that growth and value are not mutuallyexclusive. We believe the stocks we are purchasing are undervalued based upon our expectation of their businessprospects and their current valuations on an absolute basis. We first gather data we view as reliable and relevant, andthen use a sensible approach that does not require speculative, aggressive assumptions about the future being differentfrom present realities. Only then can we draw conclusions from the data in a sound valuation framework.

The present norm in our industry is for investment managers to consider relative attractiveness and benchmark weightings much more so than whether or not buying the stock will provide an acceptable return over a reasonable time

period. Not succumbing to this norm may be one of our greatest advantages.

Ric Dillon, CFA



Spring 2001 Quarterly Update

Diamond Hill Investments 2 1An interesting aside is that when an “index” approach is mentioned, the first thought is often of the S&P 500 because it is the index to whichmost dollars are indexed. However, in 1999 and 2000, there were 44 and 57, respectively, changes made to the S&P 500. Thus, there is an

active component to the S&P 500 Index that somewhat mitigates the benefits of having low turnover in an index; this is not as problematic in abroader market index such as the Wilshire 5000.

Why Does “Closet Indexing” Exist?

“The person who goes farthest is generally the one who is willing to do and dare. The sure-thing boat never gets far from shore.”

-Dale Carnegie

“Some men are born mediocre, some men achieve mediocrity, and some men have mediocrity thrust upon them.”

-Joseph Heller, “Catch 22”

If presented with the two statements above, our guess is that the vast majority of the populace aspires to the first.Yet, in investing, things are not so simple. The first quotation seemingly describes the mission of an “active”money manager: seek undervalued securities and when successful, far exceed the average return of the market.The second appears to describe a “passive” or “index” approach to investing: be perfectly content settling foraverage. However, “average” index returns are often far better than “mediocre” because index returns are notburdened by the comparatively high costs associated with an active manager. The index does not havemanagement fees, and its low turnover greatly reduces the impact of trading costs and taxes. 1 Advocates of indexing often cite statistics that the majority of actively managed funds fail to beat the return of an appropriateindex after fees and taxes. To them, striving for mediocrity is a blessing not a curse. Those “willing to do anddare” bear the burden of proof that venturing “far from shore” (the index) will not result in the financial equivalentof being swept out to sea and never heard from again.

The theoretical support for indexing comes from the efficient market hypothesis (EMH). EMH postulates thatcapital markets are so competitive that mispriced securities cannot persist for long. This competition is driven bydiligent investors, sometimes called “rational profit maximizers,” who try to ferret out the true worth of an asset.Indexers, then, are able to benefit from a free rider effect. A free rider is a person who consumes a good withouthaving to pay for it; in this case, the “good” is the assurance that the price paid for a security is “fair” because itreflects all available information.

First, we do not believe the market is that efficient. Investors are not always rational, nor do they always processinformation efficiently. But even if the market were fairly efficient, it is important to recognize the paradox thatunderlies the indexing argument. If all investors elect to index, no one will be left to set prices. An index advocatemight agree that there may be a “tipping point” when it will be worthwhile to diverge from the index and searchfor bargains, but argue that we are far from that point considering that the U.S. stock market has an aggregatemarket value of approximately $12 trillion and less than half that amount is currently indexed. But what if investors are no longer working diligently to determine the true worth of the securities in the marketplace? Whatif investors, including professional advisors, have abdicated the role of trying to determine the true value of acompany in favor of playing a game of relative performance or in some cases “closet indexing”? Closet indexersare managers who construct portfolios that align very closely with a designated benchmark, then make small “bets”by slightly over- and under-weighting index components. In our guesstimate of where that “tipping point” lay,wouldn’t we need to count both indexed assets and those managed by closet indexers?

Diamond Hill Capital Management, Inc. is an active investment manager charging active management fees. In thisregard, we are akin to the person in Carnegie’s statement. Our mission is to provide economic value to clients andfund shareholders. We cannot accomplish this goal by merely matching the performance of a passive benchmark.We must surpass this index return by an amount greater than our incremental costs. Yet, we do not view ouractivity as “daring”. We are not different for the sake of being different. We recognize that to add economic value,we must be both different and right .




Diamond Hill Investments 32 Reprinted in Classics: An Investor’s Anthology , edited by Charles D. Ellis with James R. Vertin, p. 313 (1989).

Furthermore, we do not “set out to sea” for the thrill of adventure, but with the purpose of getting somewhere.As Warren Buffett stated in a 1965 letter to limited partners of the Buffett Partnership:

It is unquestionably true that the investment companies have their money more conventionallyinvested than we do. To many people conventionality is indistinguishable from conservatism. In my view, this represents erroneous thinking. Neither a conventional nor an unconventional approach,per se, is conservative. Truly conservative actions arise from intelligent hypotheses, correct factsand sound reasoning. 2

We could not agree more with Buffett’s sentiments. We believe that all too often indexing and closet indexing arethought of as conservative. There is nothing inherently conservative about the index. It is not a birthright that theindex must provide investors with an 11% annualized return. We have analyzed the probable return from investingin a broad market index and do not believe we can meet our objectives following an index and especially a closetindex approach. An investor may remain unconvinced that an active manager can outperform the index over a longperiod after factoring in costs, or at least unconvinced that such a manager can be identified in advance. Webelieve it is possible. Yet, we believe a rational investor should consider the expected return of the index whenmaking the “active” versus “passive” decision. Diamond Hill Capital managers have significant amounts of theirpersonal net worth invested in our funds and none of us wishes to be “daring” with our money. Of course, just asBuffett conveyed in his letter, this demonstrates only the sincerity, not the validity, of our view.

While we are not unique in our approach, we believe it is far from the norm in the investment managementindustry. In particular, we believe closet indexing is more ubiquitous than investors realize. Why does closetindexing exist? The primary explanation lies in the economic incentives of the investment management industry.Investment managers charge fees based on a percentage of assets under management, rather than a percentage of the economic value added. There is some logic to this arrangement. A manager that increases the value of theportfolio stands to receive greater management fees. Thus, the interests of manager and shareholder are oftenbetter aligned than the arrangement found in commission based systems. The key to fund profitability is to garnerand then retain assets under management. Obviously, the easiest way to garner assets is to experience a period of marked outperformance, providing a “story” to tell potential investors. Additionally, sponsors of employee benefitplans are likely to take notice and include the advisor as a manager. Yet, once a fund is established, incentives oftenchange. The asset base becomes a recurring revenue stream. The upward bias of the market over time provides agrowth component. Investment advisors recognize that clients and shareholders typically will stay with a manageras long as performance is not abysmal. Thus, the fund has the allure of becoming a “cash cow” to be milked for allits worth. Plan sponsors want to avoid being in the position of having to explain why their “large cap value” fund,

which they selected as the option for that “style”, badly trailed the large cap value index. For both the manager andthe plan sponsor, then, “average” results can be perfectly acceptable.

Why is closet indexing a cause for concern? An investment advisor owes a fiduciary duty to shareholders to act intheir best interest. This fiduciary duty does not end because the manager at one time performed well forshareholders. Intentionally delivering what is for all practical purposes an index fund and charging activemanagement fees is seldom in the best interest of the client. Of course, the fund advisor has a convenient excuseto fall back upon. Namely, the advisor can claim the strategy is a diversification effort to reduce risk forshareholders. Seemingly sophisticated programs measuring “tracking error”, or how far from the benchmark theportfolio is likely to deviate, are instituted. We believe a wise shareholder should ask himself: whose risk is beingdiversified, the shareholder’s or the fund manager’s?

And yet, because of the strength of the market averages in the latter half of the 1990s and early 2000, an

environment in which many active managers had difficulty keeping up, closet indexing did not appear to be such abad investment strategy. We believe that environment is unlikely to return. Further, we think the failure to employa sensible investment strategy will likely result in disappointment for investors.

“Some men are born mediocre…

We believe that a business has an intrinsic value, equal to the present value of all future cash flows, independent of its market price. We estimate the intrinsic value and invest in a company only when the market price is significantlybelow this estimate. By doing so, we adopt the mindset of a business owner. This is the only approach that makessense to us. We believe that investors who rely on the greater fool theory, strategies such as market timing or





Fidelity Magellan Fund Position S&P 500 Index Relative Over/Under (FMAGX) (SPX) Weight in

As of 9/30/00 % Weighting Rank % Weighting Percentage Points

Cisco 2.93 (3) 3.10 -0.17EMC Corp. 1.97 (8) 1.70 0.26Intel 1.73 (11) 2.21 -0.48Microsoft 1.58 (12) 2.51 -0.93Oracle 1.50 (14) 1.76 -0.26IBM 1.38 (15) 1.57 -0.19Sun Microsystems 1.34 (16) 1.47 -0.13Nortel 0.94 (24) 1.41 -0.47

TOTALS 13.37 15.74 -2.37

Assuming Stansky felt these stocks were unattractive, has being underweight these stocks substantially rewardedMagellan’s shareholders given their precipitous price declines? Presumably, the answer is no. From 9/30/00 to3/31/01, the Magellan Fund declined 20.6% compared to the decline of 18.7% of the S&P 500 Index. Granted, weare not offering much insight into what we would do differently if we were faced with putting $86 billion to work,predominantly in the U.S. equity market and entirely in non-control positions, but that is the crux of our point.Excessive size is a debilitating factor on investment performance.

Diamond Hill Capital Management is unwavering in who we are: an active investment manager with its sights seton a course far from shore (the index) and an idea of how we intend to add economic value for clients andshareholders. While our approach does not guarantee success, we believe it certainly makes more sense than acloset indexer saying, “We have to own GE, Cisco, EMC, and Intel, regardless of price, because they are significantweightings in our benchmark.”

Thomas P. Schindler, CFA William P. Zox, CFA



Summer 2001 Quarterly Update


How Safe Is The S&P 500?

September 11, 2001 – As the following newsletter goes to press, we mourn the tragedy of the terrorist attacks that took place earlier today. The devastation to humanity and freedom is immense and enduring. Our fiduciary

responsibility requires us to contemplate the implications of these events for our clients. The weakness in our economy may be exacerbated. However, for equity investors with time horizons of five years or more, we continue tobelieve those U.S. common stocks with attractive valuations are appropriate investments. Yet today’s eventsunderscore the point of the following letter that the future is fraught with uncertainty, so investors must becompensated for committing certain dollars in exchange for an uncertain return in the future. We are always vigilant to ensure that our clients are investing at sufficiently attractive prices to compensate for such risk.

Through August our year-to-date and since inception results for clients and mutual fund shareholders are excellent onboth an absolute and relative performance basis. More importantly, we continue to believe our portfolios contain stocksthat are attractively valued.

Many investors are wondering if the bear market is near its end. At the end of August, the S&P 500 hovers around 1135,

down more than 13% year-to-date and nearly 26% from the peak in March of 2000. The frequently asked question: "Is ittime to invest?" My initial thought is always "It depends on the investment under consideration." If the S&P 500 index isthat investment, my best estimate is that it will provide a 5% annualized total return over the next decade. Our 5%forecast assumes that the S&P 500 price-earning ratio will revert to its long-run average of 14, from a level today some50% higher, primarily due to slower (but not necessarily poor) earnings growth this decade. Expressed one way,notwithstanding the 26% decline, earnings still need to "catch up" with current prices. I will leave it to the reader todecide if 5% represents a satisfactory return given the risk inherent in owning portions of some of the largest marketcapitalization corporations in the U.S. My strong suspicion, however, is that investors in general would be quitedisappointed by this result.

Fortunately for us, (1) the S&P 500 does not represent the entire U.S. stock market and (2) we do not have to own thesame stocks in the same proportion as the S&P 500. In fact, I believe the median stock in the Wilshire 5000 will return10% annually during the next decade. How can this statement be consistent with an S&P 500 return of 5%? First, the S&P500, with a total market capitalization of approximately $10.6 trillion represents about 80% of the market capitalization of the Wilshire 5000, a broader measure of the U.S. market. Second, as with many capitalization weighted indices, the S&P500 is dominated by a subset of the portfolio. Just 40 of the 500 companies in the index comprise 50% of the marketcapitalization. Therefore, the return experienced by the median stock in the index can differ greatly from that of theoverall index. Consider the results in 1999 and 2000 (two unusual years to be sure). In 1999, the index returned about20% while the majority of stocks declined. In 2000, the reverse was true, as the benchmark declined more than 9% whilethe majority of stocks in the index posted gains. To give a greatly oversimplified example, imagine this scenario:

Total MarketCap.

Current p/e 10 Yr EPSGrowth

Yield Terminal p/e 10 Yr ExpectedReturn

50% 32x 8% 0.6% 16x 1.3%50% 12x 6% 2.0% 14x 9.7%

100% 22x 7% 1.3% 15x 5.5%

In stating my belief that the p/e ratio will decline dramatically, I recognize that market commentators who sounded thealarm that valuations had risen above the historic norm spent the latter years of the 90's looking like "chicken little" as p/eratios expanded upward. So perhaps it is wise to acknowledge that no one ever knows exactly what path the "market"will take. But that does not help in formulating long run return expectations, so let's try to build a case from the groundup economically, keeping in mind that in the long run, the aggregate return of investors can only be what the businessesearn over time.

It may be helpful to consider the inverse of the price-earning ratio: the earnings yield. The inverse of a 14 p/e results in a7.1% earnings yield. Any portfolio of companies that paid out all of their earnings in dividends should expect to havegrowth only through inflation and productivity gains. If both inflation and productivity gains totaled 4%, then adding that tothe earnings yield would suggest a possible total return of about 11%, a return consistent with historical experience.



Summer 2001 Quarterly Update

Diamond Hill Investments 71The S&P 500 does benefit from changes in its composition, thus helping growth somewhat. A higher p/e could also be justified by significantly lowerinterest rates or a dramatic reduction of the risk premium required by equity investors. We feel that it is unlikely that interest rates will decline

significantly over the next decade. Also, are stocks becoming less risky than they have been historically? First, stocks remain a residual claim (versusdebt). Second, to the degree volatility is any proxy for risk, they are no less volatile now than they have been over time.

Now consider the inverse of a p/e ratio of 22 (roughly where we are today) is 4.5%. Adding the same 4% gain frominflation and productivity would result in a total return of 8.5% if, and this is a big if, you are able to sell at a similarmultiple. But as seen in the table, if the terminal p/e multiple (i.e., the p/e multiple at the end of the ten year period) ismore in line with historic averages, say 15, your total return drops from 8.5% to 5.5%. Compared to bond yields, even Ido not believe that this is an attractive risk/reward proposition.

Again, no one knows what the p/e will be in ten years or whether earnings will grow at 7% over that period, but we feelthat it is reckless to require a terminal p/e of 22 and 7% earnings growth to achieve an 8.5% total return. To defend a 22p/e ratio as continuing ad infinitum, one must believe there is something special about the S&P 500 portfolio companies,either because these companies will grow faster than the economy and/or they are less risky than history would suggest. 1 Over ten year periods, investors paying a p/e multiple as high as 22 have historically achieved below average annualreturns in a range of 5% down to negative returns. In other words, I believe that the superior returns stocks (relative tobonds) have delivered to investors were contingent upon valuations according to p/e ratios in the range of 12 to 16.

Is it possible that companies in the S&P 500 can grow earnings appreciably faster than in the past? Over long periods of time, aggregate corporate profits should parallel nominal Gross Domestic Product. Our trend line forecast for this decadeis for real GDP to grow 3% annually with inflation adding 3%, summing to 6% nominal GDP growth per year.

Any difference between corporate profits and nominal GDP can be explained by productivity gains, some foreignactivities, and any increased share of the economy these companies take from the rest. If earnings growth does exceednominal GDP growth over the next decade, the most optimistic forecast we could imagine would be an annual rate of 7%.Yet, mathematical complications arise when it is assumed that earnings growth can exceed nominal GDP indefinitely.Namely, corporate profits would capture a growing and disproportionate share of the economy, a phenomenon thatcannot be supported by empirical evidence or economic or political theory.

Despite how far our 5% forecast differs from a possible consensus of 10%, I believe that the above discussion supportsthis conclusion better than two common statements. The first is: "since 10% is the long term average, I'll use that in myforecast for the decade." The second is: "I need 10%, given a risk premium over corporate bonds." As to the first: thelong-term average return is probably indicative of a purchase price at some equilibrium, versus a presently over-valuedprice level. As for the second: what one needs (wants), is unrelated to the economics of the situation.

Ric Dillon, CFA



Excerpt from Diamond Hill Funds Annual Report December 31, 2002


History, Probability & Statistics,and the Financial Markets

The philosopher George Santayana said, "Those who cannot remember the past are condemned to repeat it." Manyinvestment "professionals" have taken this slogan to heart, spending an inordinate amount of time looking at the long agopast in an attempt to find support for predictions made about the near-term future. They have statistics pertaining to theamount of time it took for the market to eclipse the highs reached in 1929 before the Great Crash, the percentagedecline peak-to-trough in the 1973-74 bear market, and an array of other factoids at their fingertips. Admittedly, clientsand journalists often seem impressed at this type of command of market history. Precise statistics lend an aura of expertopinion. But does history have great divining power about what we should expect in the future? Paraphrasing Santayana,we would say, "Those who remember history, but are ignorant of basic probability and statistics, are condemned toerroneous forecasting."

The Gambler's Fallacy?

First, let's take the most naive error that is sometimes made by investors. Most people are painfully aware that the stock

market, as measured by popular averages such as the Dow Jones Industrials and the S&P 500, has declined in each of thepast three years. Consulting the financial history books, it is found that only once has the market declined four consecu-tive years in the last century, from 1929-1932. If four consecutive down years only happened once in I00 years, thenthere is only a I % chance 2003 will be a down year, right? We read this argument made explicitly once, but more oftenthan not, it is made implicitly in statements like "I can't imagine that we won't see stocks beat bonds and cash this year."

This argument, while cheerful, is horrendously wrong. Perhaps the easiest way to understand this is to consider thesomewhat analogous situation of coin flipping. The chance of flipping seven consecutive heads is less than I % (Fermat andPascal first worked out these probabilities). However, suppose you have just flipped six consecutive heads. Is the chancethat the next toss lands on heads less than I%? No. The probability is the same as any other flip, 50%. The mistaken notionthat the odds for something with a fixed probability increase or decrease depending upon recent occurrences is known asgambler's fallacy, and is an absolute dream for the folks who run Las Vegas casinos. The most succinct illustration of this isthe story of a casino patron who asked the pit boss, "Aren't you worried about guys who come in here with systems?"

The pit boss replied, "We send limos for guys with systems."

What Is Normal, Anyhow?

We said "somewhat analogous" above because in flipping a fair coin ("fair" means that each outcome, heads or tails, is aslikely to occur as the other), each trial is an independent event. In an independent event, the result of one trial has nobearing on the outcome of any other. In more complex situations, like the stock market, exact probabilities are not fixed,and are relatively uncertain. In addition, each trial (the return in the next year) is dependent on other variables. Thereturn for the equity market is dependent on a host of factors, including major ones like the price of stocks in relation toeconomic earnings, the level of interest rates, and the expected growth rate of corporate earnings. So what might be amore informed estimate of the probability that 2003 will be another down year? Another commentary we read asked thisquestion and solicited the opinion of a professor who surmised 16%, a figure he thought was surprisingly high. Is this areasonable estimate?

In the manner of economists, let's assume that the market return is normally (bell-shaped) distributed and, based on pastexperience, has a mean (average) of 10% and a standard deviation ( σ ) of 18%. Standard deviation is a measure of variationor dispersion of results around the mean. Does this offer any insight? To see, we'll briefly review some statistics, but tryto be general and brief (in the interest of space, and because we could get out of our league). Exhibit A shows this normaldistribution. The entire area under the curve is equal to 100%. There is an equal probability that the return is above andbelow the mean of 10%. Further, we should expect the yearly return to fall within one o approximately 68% of the timeand within two σ approximately 95% of the time. This would mean that we should expect the return to fall within therange of -8% and 28% (which is the mean of 10% ± the standard deviation of 18%) more than two thirds of the time andwithin the range of -26% and 46% around 95% of the time. If the area under the curve between -8% and 28% is 68%





(shown in white), then the area outside that range must be 32% (all the shaded area with 16% of the area less than -8%the other 16% more than 28%). Thus, if returns are normally distributed with a mean of 10% and σ of 18%, the probabilitythat the market returns less than -8% is 16%. The probability that the market is less than 0% is even greater, and can becalculated as a little less than 30%. These results would be generally consistent with the history of U.S. equity markets in

the past century in that roughly one out of every three years has been negative.

(As an aside, experience in the capital markets has shown that financial market returns exhibit “fat tails”- meaningseemingly low probability events have occurred with much greater frequency than predicted by the normal curve giventhe historic mean and standard deviation of the U.S. equity market. This is one of the important lessons RogerLowenstein illustrates in When Genius Failed , his book on Long Term Capital Management. Thus, the assumption of normally distributed returns is questionable. However, this should not dramatically affect our example since the"surprises" could be both positive and negative.)

So How About A Conclusion Already, Will the Market Be Up or Down in 2003?

Several conclusions might be drawn from our discussion above. The first is an explanation of why we might be logicallyreluctant to make short-term market predictions. Simply stated, in situations other than extreme conditions, chance

variation plays too great a role on the ultimate outcome of any short-term market forecast for us to feel very confident init. Imagine if someone asked a doctor his professional opinion and he responded, "l believe X, but I think there is a 30% ormore chance it could be wrong." It is doubtful that the response would inspire confidence. However, with forecastingequity markets, this is the inescapable nature of the problem.

We deal with this problem in several ways. First, we look for situations that we believe are extreme situations. In mostscenarios, we simply concentrate on individual stocks where we believe the price is significantly below what we believe itis worth, while remaining agnostic about the "market". If correct in our analysis, this will provide a margin of safety, whichBenjamin Graham described as the three most important words in investing. Second, we use a fairly long time horizon. Bydoing so, short term "noise" is largely cancelled out. Finally, we do our best to remain objective and rational. People oftenseek out the advice they want to hear. This might mean looking for a doctor who will declare them healthy or a moneymanager who will tell them the market will be up huge. Our preferred characteristic in professional counsel is realism(e.g. the doctor who says. "I have thought long and hard and called upon my training. I believe X, but I will continually be

looking for evidence that I am wrong, and the diagnosis should instead be Y.")A second conclusion is that we believe assigning a 16% probability that the market could be down this year is far too low.If we had to guess if the market will be up or down, we would guess up, just as we would whenever we believed theexpected return is positive. However, assigning a 16% probability is the equivalent of declaring that 5.25-to-I odds that themarket will be down is a ”fair" bet. It is always insightful to invert, and consider the case that might be made that theperson offering 5.25-to-I odds is making a wise bet. Perhaps the professor analyzed the situation in the same manner asabove, but used a higher expected (mean) return and/or a lower standard deviation, such as a 15% expected return and15% σ . In previous reports, we've talked about the major variables (price in relation to earnings, interest rates, andearnings growth) and expressed the opinion that we have a difficult time justifying an expected return for the market





much above 8%. We rarely have much of an opinion on the expected σ , (having written before about why we believe it isa poor measure of true risk), remembering the wise man whom when asked what he thought the market would dodeadpanned, “It will fluctuate." We would, however, observe that (I) strange things happen and (2) humans often behaveemotionally rather than rationally. We would have no basis to predict that volatility will suddenly ameliorate from levelsexperienced in the past. Thus, if a mean of higher than 10% and/or a σ less than 18% were used, it would simply reflect arosier viewpoint than ours. There is also the possibility that the professor analyzed the question in a completely differentand better manner than using a normal curve (no model is likely ever perfect). Suffice it to say, if we were offered thoseodds, we would accept the bet confident that we had succeeded in gaining an edge. We would not, however, bet ourentire net worth because there is the real possibility of losing. If we were to lose the bet and the same conditionsprevailed, we would not hesitate to make the same bet again if we were confident in our analysis and the odds favoredsuccess.

And Is History Just a Waste of Time?

In high school, I had a history teacher who on the first day of class asked why we should even bother studying history. Heproposed that if no one could come up with a valid reason, we would just use the class as a study hall. A fellow studentsubmitted Santayana's adage almost verbatim. The teacher dismissed this reason immediately, arguing that people havebeen doing the same stupid things since the beginning of time and would almost assuredly keep doing them. Alas, we didhave history class that year. The reason we should study history, according to this teacher, was for appreciation. Thisviewpoint, in my opinion is much too cynical. (A college professor of mine observed that most people tend to becomemore conservative and/or cynical as they age. He then advised to begin life with some level of idealism because if youstarted out cynical, imagine your worldview by the time you reach retirement age.) We believe studying history is veryhelpful in learning lessons and timeless principles. The key, however, is to learn the right lessons and be able to apply theprinciples to current problems.

Charlie Munger has vehemently stressed his belief that in approaching complex problems such as stock picking, one musthave multiple models to use as tools. The basic mathematics involved in probability is one important model. If you do nothave it and other models, he warns that "you will become the man with a hammer, to whom every problem looks like anail." Relying too heavily on financial history runs the risk of this man-with-hammer syndrome. Consider this example.Suppose the market tripled in 2003 without a large increase in corporate profits or a decrease in interest rates. Relyingsolely on historical results, you might raise the expected return and σ , and judge conditions to be "normal". However,considering this new development (a higher price), we would argue the only correct judgment after consideringfundamentals is to expect a much lower, probably negative, expected return. A detailed knowledge of financial history isfine, both for learning and appreciation, but for experience to be beneficial, critical thinking must be present. Otherwise,one can become like the gentleman Warren Buffet once described. A man interviews for a prospective opportunity andleft a resume referencing "twenty years of experience." When the interviewer contacted the former employer for areference, he quickly corrected the man's resume to read, "one year of experience, twenty times."

Thomas P. Schindler, CFA



Excerpt from Diamond Hill Funds Semi-Annual Report June 30, 2003


The Meaning of Risk Webster’s dictionary defines risk as the possibility of suffering harm or loss. While Webster’s is not infallible, we believethis definition is reasonably close to a common sense definition of the term. Thus, financial risk is the possibility themoney (or at least enough of it) is not there when you need it. This is different from the academic finance definition inwhich risk is defined as the volatility of returns of one stock or portfolio as compared to a larger universe of stocks. Thefollowing is not meant to be a treatise on the topic, as entire books can be and have been written on the subject. It ismeant to illustrate a few of the important ways we think about the risks in your portfolio, how our thoughts differ fromsome conventional views, and perhaps most importantly addresses our expectations (or more specifically, our lack thereof) about the future volatility of portfolios we manage.

For a businessperson, the word "risk" usually requires an adjective to specify which type of risk is being considered. Forinstance, when a banker makes a loan, the primary concern is whether the borrower will pay back principal and interest(with the rate of interest set to compensate for the pure time value of money, expected inflation, and an appropriatepremium reflecting the probability the borrower may default). Also of concern is the collateral that serves to limit loanlosses should the borrower default. These considerations are termed credit risk. Furthermore, the banker often holds aportfolio of loans with fixed long-term rates, while the funding for these loans is typically short-term in nature. Thus,there is exposure to interest rate risk should short-term rates rise significantly. At other times, the banker may havebought a pool of loans, determining the price by making certain assumptions about the credit quality as well as theduration of the portfolio. Should interest rates fall significantly, the portfolio’s value could be subject to prepayment risk .Not surprisingly, the banker will often attempt to mitigate certain risks by entering into derivative contracts. However, itis very hard if not impossible to be completely hedged. It is difficult to control one variable without affecting another. Forinstance, in hedging interest rate risk, it is very likely the banker has introduced counterparty risk, the possibility that theother party to the derivative transaction will be unable to perform its obligation. Other businesses have different risks,and a businessperson often must choose which risks are acceptable and those that are unacceptable. When we analyze acompany, we want to understand to the best of our ability the various risks to which our business is exposed, and howmanagement deals with them.

In contrast, academicians have sought a single statistic to measure risk that encompasses all the myriad risks abusinessperson would consider. Using past price data, the standard deviation of returns is calculated in the belief that thisreflects the risk that was taken, and presumably is reflective of the risk that exists in the future. The theory that isproposed about why all this makes sense ties in with the efficient market hypothesis. Supposedly, "rational profitmaximizers" quickly impound new information into stock prices such that, at any point in time, the market price is the

single best estimate of the value of an enterprise. Because news, by definition, arrives randomly, stock prices will follow a"random walk" and the price movements effected by the rational trading on news will reflect the inherent risk. Logicianand philosopher Bertrand Russell once said, "It has been said that man is a rational animal. All my life I have beensearching for evidence which could support this." Like Russell, our observations of human behavior (including our ownupon self reflection) indicate that while humans would like to maximize their wealth, the assumptions they are alwaysinformed and rational recalls the saying, "Grant me three assumptions and I’ll prove to you the moon is made of bleucheese."

Modern portfolio theory (MPT) does not stop with applying standard deviation to a single stock. MPT contends whatmatters is not the volatility of any single stock, but also how each stock correlates with others. If the correlation is lessthan perfect, investors can eliminate stock specific risk by holding a diversified portfolio, leaving only "market risk". Takingthe argument to its logical conclusion, MPT contends that investors should combine a portfolio consisting of all riskyassets with a risk-free asset according to their own tolerance for risk. Einstein said, "While all models are wrong, someare useful." In our opinion, the academic model for risk certainly qualifies for the former, but not the latter. Furthermore,we believe the cause for this error in human judgment is man-with-hammer syndrome, "To a man with a hammer, everyproblem looks like a nail." Having acquired the mathematical skills necessary to perform such statistical analyses, it feels ashame not to use them, irrespective of the utility.

We realize discussions of modern portfolio theory and standard deviation might seem esoteric. Before moving to howsome of this affects how we "manage risk" in your portfolio, I’d like to relate an experience of mine. A human resourceprofessor gave our class a list of fifteen everyday items such as a bottle of water, a mirror, a whistle, etc. and asked us toindividually rank each item in order of importance if we were stranded in the desert. The class was then divided intogroups of five, told to first discuss each item, then as a group, re-rank the list. After all groups had done so, we comparedindividual and group rankings to a list prepared by Joe Outdoorsman (not his actual name), a survival expert. The point of





the experiment was to examine whether group discussion and decision-making would improve a desired end result, in thiscase the chance for survival. As I recall, this was the outcome in our class (and I’m confident it is in a great many cases,otherwise human resource professors wouldn’t still be doing it). Each group list was "better" than the average of theindividual member lists in that group and in some groups may have even been better than all the individual member lists, afairly eye-opening result. While the intention was to examine organizational behavior in management, it could easily berelevant to the stock market as well. It describes how a group (stock market participants interacting to find the "correct"price) might come to a better decision than the average of the individual members in the group. The stock market iscompetitive–investors seek new information that might provide an edge–and the experiment certainly seems to lendempirical support to why markets are often relatively efficient.

But I could not help wondering: What if the survival expert himself had been in our class. Would he have been able topersuade the other members of his group of his expertise? Would his list have been "dumbed down" by compromisingwith other group members? What if there had been no "expert" to consult? What if two "experts" had been consulted,and their rank orders differed significantly (the expert’s order was not based on any immutable laws of the universe;rather, it involved subjective judgments such as whether a mirror would be more helpful in signaling help than a bottle of water would help stave off dehydration)? The important question in market efficiency is not whether it is sometimesefficient, but whether it is always efficient. If you have expertise superior to the market (either current knowledge or amore accurate prediction of the future), there is no reason to need an opinion poll to judge a correct course of action.

We’ll try to relate some of these concepts to how we’ve managed your portfolio. When we originally bought PacifiCarein the Focus Fund in November 2000, we viewed it as a risky situation. After reporting a severe earnings shortfall, thestock price had dropped to under $11 per share from over $60 per share months before. Here lies the seductiveness of measuring risk by stock price volatility. Volatility sometimes appears to be a reasonable proxy for risk. A newsannouncement occurred, and investors clearly were reacting and attempting to impound the information in the price.The open question is whether the new price was a correct assessment, an overreaction, or perhaps even anunderreaction. A momentum investor would sell the stock immediately, regardless of price, assuming the market getsthese things right. A value investor assumes nothing. There is an unknown probability that the downside risk is just asgreat at $11 per share as it was at $60 per share: 100%. The challenge is to decide whether an approximate value of thebusiness, given the present facts and assumptions about the future, can be ascertained. We felt there was considerablebusiness risk, as management did not appear to have a complete handle on its medical costs, a dangerous position for aHMO transitioning from capitated contracts, and maturing debt created some liquidity concerns. These judgments weremade in a manner as divorced as possible from the stock price action. If we had no idea what the business might beworth, we simply would have passed. In this case, with the aid of a contact closely following the industry, we concludedthat weighted for (subjective) probabilities, the potential reward exceeded the downside risk substantially. We wouldn’thave had a clue what the future volatility of the stock price might be. If we were forced to guess, we probably would have

assumed it would continue to be quite volatile.PacifiCare’s stock price recovered into the high 30’s and we sold some of our position. Of course, we may have beenmore in harm’s way than we realized, but it is impossible to prove either in the positive or negative. Moving forward intime, PacifiCare’s stock once again (more gradually this time) declined to about $15 per share. Emulating Charles Darwin,we sought information that would contradict our belief PacifiCare was still worth at least $30 per share. We were unableto find anything of substantive concern, and in fact the liquidity concerns had lessened and profitability appeared to beimproving. If asked why PacifiCare had traded lower, our most honest response would have been "you’d have to ask thepeople involved in the transactions how each arrived at the price." This is impractical of course, but if sellers were asked,I’m confident many of the reasons offered would have put a lot of arrows in the quiver of Bertrand Russell. Importantly,this illustrates how the academic definition of risk produces absurdities. Had PacifiCare just continued at $30 a share,academic definitions would have seen it as less risky at $30 than it is for the knowledgeable buyer who could now own itat $15!

A more recent purchase is Johnson and Johnson. It appears to possess low business risk (although there are manyexamples of great companies that don’t stay great, evoking the question of whether they were truly great in the firstplace), has a AAA balance sheet, and a price we believe is below its value. Yet, if you were to measure the historical beta(how the stock price has moved relative to the market), J&J has probably exhibited no less risk than the average company.If we had to guess volatility going forward, we suppose it would be less volatile than average. However, given we believe itis worth more than the current price, should we be surprised if it suddenly became volatile to the upside (which is alsocounted in academic notion of risk)? At any point in time, we might ow n a portfolio whose characteristics more closelyresemble PacifiCare, Johnson & Johnson, or most likely something in the middle. What matters most is valuing businesseswell enough that averaged out, we should produce attractive returns. If done well, this is the best protection against yourfinancial risk.





Several implications follow from the above discussion:

Implication #1: It is dangerous to assume that results achieved under one set of circumstances in the past have anybearing on future results, especially if given a different set of circumstances. Sometimes the past should be a very goodindicator of the future. In other cases, there is likely reason to believe the future will look nothing like the past. One mustfigure out the important factors to consider when assigning ex ante (before the fact) probabilities.

Implication #2: Diversification is necessary, but the required amount depends on the certainty (properly assigned) youhave regarding an investment and on its relative superiority to the next available alternatives. It might appear, then, thatwe are in partial agreement with modern portfolio theory on diversification. Alas, we believe it is more akin to a patientfor whom the prescribed medicine is working even though the diagnosis is completely wrong. If we found an opportunitywe felt was a near certainty, and that opportunity stood out as dramatically better than any other with which we wereaware, we would want to be decidedly non-diversified. In practice, there are degrees of certainty, and it will not be oftenthat we think we have found a Michael Jordan lay-up when everything else appears to be a full court heave.

Implication #3: Risk is inextricably linked to your time horizon. Short-term price movements are not predictable.However, for the buyer of a business whose intrinsic value far exceeds the purchase price, the underlying economics of the business will be the ultimate arbiter of value. As Benjamin Graham famously said, "In the short term the market is avoting machine; in the long term it is a weighing machine."

(There are financial economists who have argued time diversification is fallacious. Relying on a few assumptions (theaccuracy or relevance of which we would question), it can be shown mathematically that "risk" actually increases over timebecause the dispersion of possible terminal wealth diverges from the expected terminal wealth as the investment horizonexpands. This is beyond the scope of this piece, but those interested should feel free to contact us for more information.)

Implication #4: When evaluating prospective managers, it is most productive to spend time thinking about whether theyhave the ability to value businesses and judge managements, the temperament to think independently, remain open-minded enough to recognize new information and reconsider original hypotheses, especially when the new information isdiscordant, the integrity to truly act as a fiduciary, and are free of conflicts of interest. Less useful is applying arcaneformulae to past pricing data in an ex post (after the fact) attempt to measure "risk".

Implication #5: In the business world, exact probabilities of future events are not given; thus, be wary of those who tryto measure it with great precision. While it is not necessary or even possible to come up with exact figures, thinking interms of general probabilities and the potential downside is very likely the most effective way to "manage risk". Business

risk (the certainty of the cash flows produced by the underlying business), mismanagement (a sound business is operatedpoorly, capital is allocated foolishly, or the business rewards are "skimmed off the top" and not channeled to owners),financial risk (how the business is financed and whether an exogenous shock could put the equity holder in jeopardy),and liquidity risk(the ability to convert the investment to cash) are the primary risks to consider. In addition, the purchaseprice must be sensible to avoid valuation risk. Years of economic progress can go unrewarded for an investor paying too high an initial price for even a great business .

Implication #6: Volatility in your portfolio can provide a test of mettle. We hope to pass these tests. It is sometimesuncomfortable to have a former fellow shareholder sell out at a price that is not consonant with what you believe it isworth (especially when your cost basis is significantly higher). If someone does not know the business well, it isunderstandable they might wonder what the seller knows that he does not. But as Benjamin Graham stated, "You areneither right nor wrong because the crowd disagrees with you. You are right because your data and reasoning are right."Some people seem to like to look back at portfolio returns and exam ine how they bounced around in an effort to see

what risk was taken. What risk the portfolio did take is likely an entirely different, unknowable question. We recognizethis view might be considered unconventional. Still, we believe the operative phrase is "it’s alright to look foolish, as longas you aren’t being foolish."






Stock Market Outlook – Forecastingthe Next Decade “It is dangerous to apply to the future inductive arguments based on past experience, unless one can distinguish the broad reasons

why past experience was what it was.” — John Maynard Keynes

Applying Keynes statement to the S&P 500, the strong returns of the past are likely to be replicated in the future only if similar conditions—most importantly the starting valuation—exist. This is a key contingency. To understand why the pastunfolded as it did, historic stock returns must be related to two economic building blocks, earnings (and the dividendspaid from earnings) and interest rates.

Before analyzing the current outlook for the S&P 500 (which comprises more than 80% of the total U.S. marketcapitalization), a few comments might lend context. First, our forecast hasn’t changed much over the past three and a half years. At Diamond Hill’s inception in May of 2000, we felt investors should expect no more than a 5% annualized returnfor the decade 2000-2009. We thought it could easily be lower, and after a negative 5.3% annualized return during thefirst four years, the S&P 500 must return 12.5% per annum in the years 2004-2009 in order for the decade’s annualizedreturn to reach 5%. Yet, our primary message then was that while market capitalization weighted indices were decidedlyunattractive, plenty of investment opportunities existed outside technology and very large capitalization companies. As theS&P 500 index decreased, perhaps surprisingly, our updated forecasted return only improved marginally. This either lendscredence to our statement that we believed it could easily be lower or simply an acknowledgment that we were too

optimistic (read wrong), even at 5%.Because we are active managers, we don’t necessarily care what the S&P 500 does, so long as we like what we own andhave some concept of what constitutes a satisfactory return given a suitable time horizon. In other words, an outlook forthe S&P 500 only tangentially affects what we do. This mindset has served us well in the past, and we believe it will in thefuture. Today, we still believe the market cap weighted indices are unattractive. While it is more difficult to find attractiveopportunities, this remains our charge. While we hope we can achieve real returns that exceed historic market averagesover the coming decade, our foremost concern is maintaining the margin of safety in your portfolio.

One final note of clarification: annualized returns here refer to compound average (geometric) rather than an arithmeticaverage. To illustrate the difference, consider the simple example of a manager who returns positive 100% in the firstyear and negative 50% in the second. The geometric average is 0% (If you start with $100, it doubles to $200 in the firstyear, then declines to $100 in the second year, leaving you exactly where you started). The arithmetic average is 25%(100% + -50% / 2 = 25%). As long as returns are volatile, the arithmetic average will always exceed the geometric average.

If someone guessing the return for any single year wanted the prediction to reflect the “average”, then the arithmeticaverage is relevant. We hope you agree that for long-term investors, as far as enhancing wealth is concerned, thecompound return should be the focal point.

The Macro Analysis

The total return of the S&P 500 can be expressed as the sum of the dividend yield and growth, R = Dividend / Price +Growth. Long-term studies that have decomposed the sources of return in U.S. stocks have found that of the historic 6.5- 7 % annual real (inflation-adjusted) returns, dividends have provided 4.2%, expansion of the price-to-earnings (P/E) ratio1.2%, and real earnings growth 1.5% (varying some depending on the study and time period).

Dividend Yields

The current S&P 500 dividend yield is just 1.5%, so it is apparent that “growth” needs to carry a heavier load in the futureto achieve similar returns. Some market observers have pointed to low dividend yields as a cause for concern in the past.In fact, stocks at one time in our country’s history yielded more than bonds. This situation, at the time, was viewed as aperfectly natural state of affairs. Since stocks were riskier than bonds, why shouldn’t they yield more? When the yield onstocks dropped below that of bonds, warnings arose. This “market call” has been wrong for about the last 50 years (orperhaps it was just too early; some might argue it will prove correct “in the fullness of time”!). Both dividend yields andthe payout ratio, the percentage of earnings paid out as dividends, have been declining for some time and stocks havemanaged just fine. The reason frequently professed for the handsome returns stocks have earned over bonds, the so-called equity risk premium puzzle, is that stocks had been undervalued historically, because there was either a lack of understanding or skepticism of the “growth component” of stocks. As growth ensued, not only did equity investors get aboost from growing real dividends paid out of growing real earnings, but also an increase in the amount the market waswilling to pay through expanding multiples.





Not only did strong returns allow investors to “see it with their own eyes,” theoretical support was lent by Nobel Prizewinners Modigliani and Miller who proposed that, all else equal, dividend policy is irrelevant. A corporation paying adividend to its owners is akin to the owners moving money from their right pocket to their left, they argued.Furthermore, corporations contended it was more tax efficient to return capital to owners through stock repurchases,because dividends were taxed at marginal ordinary income rates, which frequently exceeded the long-term capital gainrate. We are not in the camp that worries excessively about low dividend yields, taking a cue from Phil Fisher whoentitled a chapter “The Hullabaloo about Dividends” in Common Stocks and Uncommon Profits. In our evaluation of individual companies, the ability to pay dividends is often more important than whether the company actually pays thedividends. When the company retains the earnings, it places an additional burden on us to ascertain whether thecompany is reinvesting wisely. At any rate, the tax disincentive to paying dividends has been greatly reduced (for now), sowe may see the dividend payout ratio on the rise. If stock prices don’t accelerate faster than dividends, yields will rise aswell. Still, we believe the expectation for the dividend yield component of return is best estimated as the current yield.Bottom Line: Dividend Yield of 1.5%.

Earnings Growth

Can growth pick up the slack? At first blush, it seems reasonable. A calculation for a company’s growth rate is its returnon equity multiplied by the earnings retention rate (1- payout ratio). The return on equity reported by corporateAmerica has been high in recent years (at least based on operating earnings), and earnings retention has increased. Bothfactors would seemingly point to future growth in excess of historic norms. Yet, a recent study by Robert Arnott andClifford Asness published in the Financial Analyst Journal (2003) found that the historical empirical evidence refutes this,finding that expected earnings growth is fastest when current payout ratios are high and slowest when low. Perhapsthere is some time dependent factor or alternative explanation for this finding. One might think growth will be faster inthe future, and that might prove correct. Historic precedent, however, will not be the reason.

Can we at least get faster earnings growth from share repurchases? Again, the historical empirical evidence does little tobolster the case. The relevant factor under consideration is net share issuance, and studies have found that sharerepurchases have not even offset the dilution from new shares issued through initial public offerings, secondary offerings,debt convertible into equity, and options. In summary, while U.S. real GDP growth has been remarkable in the pastcentury, real corporate profit growth is the concern of stock investors. While it may be initially tempting to believe thatcorporate profits can grow faster than GDP, available evidence is to the contrary. Bottom Line: Real EarningsGrowth of 2.0%.

P/E Expansion

How about P/E expansion? There has been much debate about the “correct” earnings of the S&P 500. For the sake of

argument, let’s agree that the current P/E ratio on forward year earnings is 20. When interest rates are low, a higher P/Eratio is justifiable. This argument can be taken too far, however. At a minimum, stocks should require a higher return thanlong-term investment grade corporate bonds. After all, bonds hold a legal claim to company assets that is senior to theequity. While the cost of debt is explicit and the cost of equity is “unseen” (both in an accounting sense and,unfortunately in the eyes of many corporate managements), how could it make sense to be otherwise? Arguments thatrely strictly on a historic record can fall into circular reasoning, whereby the better stocks do, the “cheaper” the cost of equity capital. Once the constraint of a required return for equity in excess of the yield on corporate bonds is introduced,arguments for still higher P/E multiples are difficult to justify.

If inflation remains near 2% or trends lower, the current P/E ratio may be in a justifiable range. However, in our opinion,there is as reasonable chance that inflation could move closer to the 1926-2003 geometric average of 3%. In this scenario,P/E contraction is more likely. For a graphical representation of the historic experience relating beginning P/E ratios withsubsequent real returns, we have borrowed a chart from Robert Shiller’s book Irrational Exuberance (updated with dataavailable on his website for returns through 2003).The chart illustrates the point made in the opening of this article:stocks can only be expected to achieve returns similar to the past if the starting valuation is similar. Bottom Line:Return from P/E expansion of 0%.





The Bottom Line

To summarize, a 1.5% yield and 2% real growth would provide a real return of 3.5%. Include an inflation estimate of 2.5%,and the nominal return would be 6%. In our opinion, that is not enough compensation for equity investors (even allowingthat the equity risk premium in the past was abnormally high) and thus, the S&P 500 is overvalued. If the market isovervalued, does that mean it will go down in 2004? Surprisingly, that is nearly impossible to predict. The following tableillustrates why.

Year Scenario 1 Scenario 22004 6% -17.5%2005 6% 9%2006 6% 9%2007 6% 9%2008 6% 9%2009 6% 9%2010 6% 9%2011 6% 9%2012 6% 9%2013 6% 9%

AnnualizedReturn 6.00% 6.01%

Notice that each scenario ends with the same annualized return. While we believe 6% is a reasonable estimate for thereturn of the S&P 500 in the coming decade, it is a safe bet the interim will contain up and down years. We have no idea,however, of the sequence in which these might occur.




March 1, 2004 Market Commentary


The Times They Are A-Changin'

"The line it is drawn the curse it is cast The slow one now will later be fast

As the present now will later be past The order is rapidly fadin'

And the first one now will later be last For the times they are a-changin'."

Bob Dylan, “The Times They Are A-Changin'” (1963)

Bob Dylan's song about the inevitability of change continues to resonate today, 40 years after it was written. Throughoutmy career in the financial services industry, I have witnessed my fair share of change. As many of you know, I began mycareer in investing in 1982 -- an important time in the history of the financial markets. Secular changes in the economicenvironment at that time led to a bull market in stocks and bonds that did not end for almost 20 years.

The early 1980's was a period of:

♦ high but declining interest rates,♦ high but declining inflation,♦ low equity valuations,♦ high dividend yields,♦ high real interest rates,♦ falling commodity prices, and♦ a strengthening dollar.

These characteristics were important not just for the opportunity they presented in the equity markets, but they alsohelped explain which sectors of the market would provide the highest returns. For example, many consumer companieswere purchasers of commodities, which were falling in price. This allowed margins on many consumer products toexpand and earnings growth to accelerate. As a result, the consumer companies were some of the most successfulinvestments of the bull market.

As I look at the investment environment of today, it looks nothing like it did in 1982. We now have:

♦ low interest rates,♦ low but rising inflation,♦ high equity valuations,♦ low dividend yields,♦ low real interest rates,♦ rising commodity prices, and♦ a falling dollar.

Yet with all these differences, investors are approaching this market as if it were 1982 all over again and nothing has

changed. How else can we explain the strong rise in the price of many high-profile technology stocks in the recent equitymarket rally? Investors are reflexively buying the stocks that performed so well in the last bull market without realizingthe environment has changed.

A Secular Change Has Come

I mention this in part to help explain recent market action, but also to highlight some very important points to investors.Market convulsions like we experienced in the 2000-2002 bear market are often important indicators of secular changesin market dynamics. Simply purchasing the stocks of the last bull market will not be a successful strategy in this marketenvironment. Just as the1980-1982 bear market marked the end of the bull market in energy stocks and the beginning of a bull market in other sectors, I believe we are in the process of a secular change in the current equity market as well. As



March 1, 2004 Market Commentary


I noted previously, there are simply too many differences in the current economic environment to return to theinvestment logic of the last bull market. I believe that investors who are paying too much now for the winners of the lastbull market are about to be gravely disappointed.

This does not mean there are not opportunities in the market. Rather, the opportunities are different than our mostrecent experience. In fact, if I look at the market today, the dynamics remind me very much of the 1970's. Following thecollapse of the "Nifty 50" bull market of the early 70's, we faced rising inflation, a falling dollar, rising commodity pricesand a recovery from a swift equity bear market. Many investors remember the 1970's as a poor equities market, and inmany cases it was. But it was also an excellent time to be an investor in certain sectors of the market. For example,small capitalization and commodity stocks performed very well in that period.

As I look at the market today, I see opportunities in many of the same sectors that performed well in the 1970's. Forexample, low real interest rates, rising commodity prices, and a falling dollar should be beneficial for many smallcapitalization and commodity stocks. More importantly, following a 20-year bear market, the commodity sector (an areaoften ignored by investors) is attractively valued at present. This is an opportunity. Similarly, the small capitalizationsector is often ignored but should benefit from low real interest rates and rising commodity prices, since many of thesestocks are more cyclical in nature than the large capitalization indices.

Earnings Growth: Not the Same Picture

Another vestige of the bull market of the 1980's and 1990's was the market's fixation with consistent earnings growth. Imust admit as an investor in that era, I was also very focused on consistent earnings growth. However, one lesson welearned from the accounting scandals of the recent past was that earnings consistency was often a reflection of creativeaccounting rather than a true picture of a consistently growing company. If companies are working this diligently tocreate the appearance of consistent earnings growth, it must be because Wall Street and investors are overpaying for thisattribute.

At Diamond Hill, we are focused on 5-year earnings growth as just one part of our valuation equation. Long-termearnings growth is much more important to us than the consistency with which it is achieved. I suspect the market willalso move toward this line of reasoning as consistent quarterly earnings growth simply becomes too difficult to achieve inthe real business world. In the meantime, we will avoid companies we feel are overvalued due to investors overpaying forconsistent earnings growth.

Finding Opportunities in the Market

Finally, I want to emphasize to investors that the investment landscape has changed. Importantly, that should provideopportunity for investors who are vigilant in searching for the best opportunities in the market. The 2000-2002 bearmarket signals a secular change in the market, and it is important that investors are aware of this change. We are veryconfident that purchasing overvalued technology stocks just because they were successful in the last bull market is exactlythe wrong strategy to adopt in this new market environment. We are focused on where we think the futureopportunities are in today's markets. That helps explain our large exposure to energy, commodities, and smallcapitalization stocks.

As always, we want to thank you for your support. It is our responsibility to inform you of the manner in which we aremanaging your money. I hope this helps you better understand our current thinking in the market.

Charles S. Bath, CFA





Of Models and Men

Financial models are often used to quantify return and risk expectations. The purpose of these models is tocapture complex realities in a form useful for decision-making. At Diamond Hill, the principal model weemploy for evaluating equities was first proposed by Benjamin Graham- independently appraising the value of a business, and only committing capital at a market price below that value in order to obtain a margin of safety. The value of a business, in theory, is the present value of the company’s future cash flows. We believeother models, such as trading rules involving monetary policy, provide interesting historical information, but donot capture accurately enough the complex reality. We believe conclusions reached with other models, such asthose that believe that the standard deviation of returns necessarily captures the risk that was actually taken,can be faulty.

While the title of this article may sound like an episode of Sex & the City or a book review of a John Steinbeck novel witha typo, the impetus came while reflecting upon some recent professional and leisure reading. The 2003 book In AnUncertain World: Tough Choices from Wall Street to Washington by Robert E. Rubin and Jacob Weisberg served as both.Rubin left his position as Co-Chairman at Goldman Sachs to serve in the Clinton administration, first as head of the newlycreated National Economic Council and later as the Secretary of the Treasury, and now is an executive at Citigroup. Thebook provides an insider’s perspective on decision-making in wide-ranging matters, mostly concerning financial markets,politics, and management. Much further down on the best-seller list, I also recently re-read The Role of Monetary Policy in

Investment Management , coauthored by Gerald R. Jensen, Robert R. Johnson, CFA, and Jeffrey M. Mercer and published in2000 by The Research Foundation of the Association for Investment Management & Research (AIMR), which recentlybecame CFA Institute. Passages in each of these brought additional thoughts about certain models.

Einstein once said, "All models are wrong, but some are useful." Rubin, who first worked in Goldman Sachs’ risk arbitragedepartment, had this to say in his book when commenting on Goldman’s initial foray into options trading, "The nowfamous Black-Scholes formula was my first experience with the application of mathematical models to trading, and Iformed both an appreciation for and a skepticism about models that I have to this day. Financial models are useful tools.But they can also be dangerous because reality is always more complex than models. Models necessarily makeassumptions… but a trader could easily lose sight of the limitations. Entranced by the model, a trader could easily forgetthat assumptions are involved and treat it as definitive." Yet, as financial analysts, we are continually using models, whosebasic purpose is to quantify, even if in a limited way, forecasts about returns and risks that form the basis for ourinvestment decisions.

"Trite is right" only some of the time

Wall Street produces an abundance of clichés, many of which can be summarized by the saying, "Conventional wisdom isoften long on convention and short on wisdom." Consider a particular favorite - "You can’t go broke taking a profit."True enough, but it doesn’t speak to the possibility of becoming much poorer by doing something stupid with theproceeds of said sale or whether the investment, even at a substantial profit, remains an attractive use of funds. A basicidea in finance is that sunk costs, in this case the prices paid for investments, are irrelevant. What matters is the expectedvalue today based on forecasts about the future. Rubin addresses this idea indirectly when he writes, "Looking back atthat episode [trading losses during the 1973-74 slump], I realized that we hadn’t really been reevaluating our positions asthe economic and market outlook changed. Holding an existing investment is the same as making it again. When marketsturn sour, you have to forget your losses to date and do a fresh expected-value analysis based on the changed facts." AtDiamond Hill, we are always comparing price (the current market quote) and value (our independent appraisal of business

worth).





Should We Ever Fight the Fed?

A more substantive aphorism on Wall Street is "Don’t fight the Fed." The authors of The Role of Monetary Policy inInvestment Management researched and presented a rigorous statistical analysis of the validity of this adage. The authorsinvestigated the difference in returns between expansive and restrictive monetary periods. A monetary period wasdefined as either expansive or restrictive according to the most recent Fed discount rate change, and remained classifiedas such until the discount rate change in the opposite direction. For example, in December 1974, the Fed lowered thediscount rate from 8.00% to 7.75%, marking the beginning of an expansive monetary policy period. This initial decreasewas followed by six more rate decreases to a 5.25% in November 1976. In August 1977, the discount rate was increasedfrom 5.25% to 5.75% signaling the end of the expansive and the beginning of a restrictive monetary policy period.Additional tests verified that these classifications coincided with growth of the money supply, measured in various ways,that was significantly higher in expansive periods than in restrictive periods. Months in which the direction changedcontain both expansive and restrictive periods, so returns in those months were excluded. Real stock returns were foundby subtracting the monthly change in CPI from the monthly mean return for the CRSP value-weighted NYSE, Amex, andNASDAQ index including dividends. The findings for monthly mean (presumably the arithmetic mean of the monthlyreturns in that period) stock returns for each period are presented as follows:

Real Stock Returns by Monetary Environment, 1960-1998

Expansive Monetary Periods Restrictive Monetary PeriodsNumber of

MonthsMean Real

ReturnStart of Series

Number of Months

Mean RealReturn

Start of Series

36 0.7800% Jun-60 44 0.8157% Jul-636 0.3223% Apr-67 8 0.5929% Nov-673 3.3538% Aug-68 22 -1.3505% Dec-687 2.1357% Nov-70 3 -0.2698% Jul-71

13 1.6615% Nov-71 22 -2.8478% Jan-7331 1.2747% Dec-74 32 0.1902% Aug-77

3 3.7471% May-80 13 -0.5009% Sep-8028 0.9203% Nov-81 6 0.7136% Apr-8433 2.1098% Nov-84 38 -0.0762% Sep-8740 0.9454% Dec-90 19 1.5189% May-9435 1.7725% Jan-96

The authors noted, "the evidence presented throughout this analysis is necessarily derived by examining historical returns.Thus, its relevance for future security returns should be interpreted with some caution." Still, the implications are clear.Historically, stocks have provided very attractive real returns when the Fed has been lowering rates, with every expansiveperiod in the study providing a positive real return. When the Fed has been raising rates, real returns have been subdued,providing positive real returns in only half of the periods under study. When analyzing bonds, they found that the 5, 10,and 30-year Treasury bonds have provided slightly higher returns during expansive periods than restrictive periods, while1-year Treasury bonds and 30 and 90-day Treasury bills have had higher returns during restrictive periods. None of thedifferences for bonds were statistically significant, however. The finding that stocks provide such superior returns (and theauthors contend the returns are even better on a risk-adjusted basis based on a lower standard deviation of returnsduring expansive periods), when following a trading rule based on a readily available variable such as the directionalchange in the Fed discount rate is an anomaly so far as the efficient market hypothesis is concerned. An anomaly issomething that is inconsistent with a model or theory that cannot be, or at least has not yet been, explained.

On June 30, the Fed raised the Fed Funds target and the primary credit rate, signaling a change in the direction of Fedmonetary policy (the discount rate series was discontinued in January 2003). I went back and updated where the authorsleft off at the end of 1998. Instead of the CRSP value-weighted index, the mean real monthly return is the arithmeticreturn of the S&P 500, which should not provide materially different results. Again, the return in the month in which thedirectional change occurred was excluded. The following table summarizes the findings:

Expansive Monetary Periods Restrictive Monetary PeriodsNumber of

MonthsMean Real

ReturnStart of Series

Number of Months

Mean RealReturn

Start of Series

42 1.8412% Jan-96 16 -0.0521% Aug-9940 -0.4152% Jan-01 ? ? Jun-04





The results seem to show a certain law at work: Murphy’s Law. The first post-study restrictive period followed form inthat mean returns were subpar, but in the first full expansive monetary period since the study ended, stocks provided anegative real return during Fed easing. Buying stocks when the Fed began lowering rates in January 2001 would havefailed.

What caused the failure? First, in fairness, the main purpose of the monograph was to present evidence and quantificationon the role monetary policy has played on historic returns, not to present a tool for forecasting future returns.Additionally, one can argue the overall record is still quite strong and that no forecasting tool in the social sciences islikely to have a perfect record. The failure could simply be due to random chance. Second, academicians seem toreflexively explain outcomes that differ from discovered anomalies by guessing that the opportunity has now beenrecognized and competed away. I have not seen an update of this study by the authors, but my own view is that neither of these explanations is convincing. Rather, when forecasting something as multi-factor and complex as future stock marketreturns, you have to do your best to identify and consider all the important variables. Interest rates are certainly animportant variable, but not the only one. Thus, research such as that presented in The Role of Monetary Policy in Investment

Management may serve as interesting tidbits, but are not major investment decision-making tools.

Risk Models

Henry Kaufman, formerly vice chairman of Salomon Brothers and in the early 1980s the most prominent Wall Streeteconomist and market strategist, commented in a speech that "The trouble with this phrase, ‘risk management’- which isvery fashionable in modern business parlance – is that it creates the impression that the risk is actually being managed."Risk, of course, is of great importance in making investment decisions and evaluating performance. Academic models of risk focus on forecasts of the standard deviation of returns. The models frequently review historic standard deviations of returns in the belief that they provide an indication of the future risk, acknowledging that future volatility might differ fromhistoric volatility. For instance, in my college textbook Principles of Corporate Finance, Richard Brealey and Stewart Myerspresent this table of standard deviations based on Ibbotson Associates’ data for common stocks (as measured by the S&PComposite which is currently the S&P 500 and prior to March 1957, the S&P 90) for successive 10-year periods startingin 1926:

PeriodMarket Standard

Deviation σ m 1926-1939 31.91940-1949 16.51950-1959 19.81960-1969 14.41970-1979 19.21980-1988 12.5

Brealey & Myers write the following: "We should be cautious about reading too much into standard deviations calculatedfrom 10 or so annual returns. However, these figures do not support the widespread impression of especially volatilestock prices during the 1980s. Overall the 1980s were below average on the volatility front.

However, there were brief episodes of extremely high volatility. On Black Monday, October 19, 1987, the market indexfell by 23% on a single day . The standard deviation of the index for the week surrounding Black Monday was equivalent to89 percent per year. Fortunately, volatility dropped back to normal levels within a few weeks after the crash."





For clarification, Brealey & Myers base their statements on the annual standard deviation of common stock returns.Ibbotson also provides monthly return information for common stocks. What if instead of measuring the annual standarddeviations, the monthly standard deviations for these exact time periods are examined? The results are summarized in thefollowing table:

Period

MonthlyMarket Standard

Deviation σ m

Annualized Monthly Market Standard

Deviation _ mMonthly σ m X (SQRT 12)

1926-1939 9.7 33.71940-1949 4.6 15.91950-1959 3.4 11.81960-1969 3.5 12.11970-1979 4.6 15.91980-1988 4.9 16.8

Thus, when looking at the standard deviation of monthly returns, Brealey and Myers statements are no longer valid.Market returns in the 1980s were slightly more volatile than any period since the 1920-30s. Conclusions drawn frommodels that quantify risk based on historic standard deviations can change depending on the frequency with which thereturns, which are the only data manipulated to find the variance and thus standard deviation of those returns, are

measured. I encountered similar circumstances upon examining the returns for the Diamond Hill Small Cap Fund. Thestandard deviation of monthly returns has been higher compared to the Russell 2000, but lower than the Russell 2000when each is calculated on a daily basis. The potential volatility of returns is likely an important factor to consider whenspecific near-term liabilities must be met. However, when analyzing long-term returns, I do not believe that standarddeviation risk models necessarily capture the risk that was actually taken.

Diamond Hill Models

So what are some models Diamond Hill does frequently use? In his book, Rubin commented on his early interest in thestock market, spurred on by his father, who analyzed stocks based on methods laid out by Benjamin Graham in Security

Analysis, who believed in investing only when an independent appraisal of business value produced a worth significantlyabove the current price. Rubin writes, "Today I believe even more strongly that this is the only sensible approach toinvesting in stocks. You should analyze the economic value of a share of stock the same way you would think about theeconomic value of the whole business. A stock, whether in a steel plant or in a high-tech firm, is worth the present valueof the company’s expected future earnings, adjusted for risk and for other fundamental factors such as hidden assets onthe balance sheet. Over the long run, the price of a stock will reflect this economic value, although the price can deviatedramatically from it for an extended period." This model is both simple in concept and difficult in practice. Obviously, themodel requires estimates of future earnings, and thus will be governed by GIGO (Garbage In – Garbage Out). Still,Graham’s value investing methods have been practiced quite successfully over the years. Like Rubin, we believe it is theonly sensible approach.




December 31, 2004 Market Commentary


2004 Review & 2005 Outlook for the Equity Markets

S&P 500 Index Forecast Reviewed

Last year in our 2003 Review and 2004 Outlook, we presented a forecast for the S&P 500 for the next decade. Tosummarize, we forecasted an S&P 500 nominal total return of 6% per year over the following decade. The components of this return consisted of a beginning dividend yield of 1.5%, 2.0% real earnings growth (providing a real return of 3.5%), andan estimate of 2.5% inflation. Furthermore, we forecast that price/earnings multiple expansion would be a neutral factor,but expressed some concern that the multiple could contract if inflation accelerated, pushing up interest rates.

In addition to possible forecasting errors for the component variables, we offered two general disclaimers regarding theentire analysis. First, because we are active managers, our outlook for the “market” only tangentially relates to what wedo. Provided we like what we own and have a reasonable expectation of satisfactory returns, the “market” is of lesserimportance. The second disclaimer goes to the heart of why the forecast was for the next decade and not just 2004. AtDiamond Hill, we believe short-term market movements are often driven by emotions, while long-term movements(greater than 5 years) are driven largely by economics. We are reluctant to forecast market psychology. Thus, ourforecasts generally involve longer periods of time.

John Kenneth Galbraith, in remarking on the tendency for selective memory, said, “Nothing more deeply characterizesthe financial mind than its ability to forget the last disaster and move confidently to the next.” This serves as a usefulreminder to revisit past forecasts in the spirit of self-examination. There is also a story about economist and investor

John Maynard Keynes. While getting the third degree from a man because he offered an opinion on a matter that wasradically different than one he made only the previous year, Keynes acidly replied, “When the facts change, I change mymind. What do you do, sir?” There are still nine years to go before time reveals the accuracy of the original forecast, butit is always useful to update facts, revisit the forecast and make changes where appropriate.

2004 Earnings

Standard & Poor's reports operating earnings, earnings as reported (which include write-offs), and core earnings that areadjusted for other items. However it is measured, 2004 was a very solid year with corporate profits, with year-over-yeargrowth in the mid-teens. Arguably, some of this profit recovery represents a continued rebound from the profit slump in

2001 and 2002, such that looking backward, the five year compound growth rate moderates to a mid single digit rate.Corporate profits as a percentage of GDP (hence, profit margins) are at all-time highs. Perhaps this can continue givenour economy's shift away from lower margin industries such as manufacturing toward the higher margin service- andknowledge-based industries. Earnings also benefited from the weaker dollar, as profits earned overseas became evenlarger when translated back into U.S. dollars. Dividend yields remain approximately the same as dividend increases rosein tandem with market prices.




2004 Interest Rates

Interest rates affect financial assets as gravity acts on matter -- the pull is always there. The higher the rate, the greaterthe downward pull. Changes in inflation rates are the primary driver of changes in interest rates. In 2004, headline CPIaccelerated from 1.9% in January to 3.5% in November. In addition, the Federal Reserve began an expected campaign toreduce the level of accommodation of monetary policy, raising the Federal Funds target rate 25 basis points per meetingbetween June and December, from a target of 1.00% to 2.25%. In perhaps the year's biggest surprise, the 10-yearTreasury yield ended 2004 at 4.22%, virtually unchanged from the beginning of the year. The market seemed to shrug off the headline CPI number in favor of the Federal Reserve's preferred measure of inflation, the Core PersonalConsumption Expenditure Deflator (disregarding food and energy), which accelerated only modestly from 1.2% in Januaryto 1.5% in November. Thus, the yield curve flattened considerably, with the difference between 10-year and 2-year yieldsdeclining from 243 basis points at the beginning of the year to 115 basis points at the end.

2005 Outlook

In 2005, we expect economic growth will be somewhat slower than 2004, but still strong at perhaps 3.5%. Corporateprofit growth, which has been slowing on a quarter-over-quarter basis, should also slow but will likely exceed our 2% realand 4.5% nominal long-range forecast. We are even more concerned about the potential for higher long-term interestrates. A negative impact on p/e multiples caused in part by higher rates could easily offset the upside from strongerearnings growth in our forecast. All in all, we see no reason to fundamentally change our outlook for the S&P 500. Giventhe 10.9% increase in 2004, this implies a slightly lower expected return for the balance of the decade.

Last year, we said that to do better than 6% over the coming decade, investors would need to find a market moreattractively priced than the S&P 500 or attain superior security selection. Two examples that we offered on how wesought to do this -- PacifiCare and a variety of investments in energy and basic materials -- proved fruitful last year. Oneother market we have sought to exploit over the past four years has been smaller capitalization stocks. As small-capstocks have outperformed large caps by enormous amounts, we have over time moderated our expectation for this tocontinue. Today, from our perspective, it is an even proposition whether small-caps will outperform as the valuation gaphas been closed.

We continue to find the energy sector attractive. While commodity prices backed off October highs in the last twomonths of the year, crude oil and natural gas are still substantially higher year-over-year. Some speculative activity mayhave been present. Also, the widely held belief that spot market prices exceeded the price that fundamentals alone woulddictate due to concern for supply disruptions (a so-called “terrorism premium”) may be true in part. Still, we believe long-term supply issues exist such that in the interaction between supply and demand, prices being maintained at a level farabove that experienced in the latter half of the 90's are likely to result.

We will continue to use the same investment discipline that has brought us success in the past. As always, we thank youfor your trust and confidence in Diamond Hill, and we look forward to helping you achieve your investment goals in thefuture.

by the Diamond Hill Equity Team

Ric Dillon, CFA Charles S. Bath, CFA

Christopher M. Bingaman, CFA Thomas P. Schindler, CFA



December 31, 2004 Market Commentary


2004 Review & 2005 Outlook for the Fixed Income Markets Coming into 2004, we expected the following:

♦ The Fed would focus on inflation rather than deflation. During late 2002 through much of 2003, theFederal Reserve began to speak about deflation after a 22-year war against inflation. We expected thefocus to return to inflation in 2004 because of historic levels of monetary and fiscal stimulus in aneconomy that had returned to above-trend growth.

♦ Interest rates would rise. We expected that the Federal Reserve would begin to raise the Federal Fundsrate from 1% to a more normal level, and that interest rates at the longer end of the yield curve wouldincrease as well, perhaps by 1-1.5%.

♦ Economic strength would continue and credit spreads would remain narrow. We expected that theeconomy would continue to grow at about a 4% rate, that corporate profitability would continue toimprove, and that credit spreads would remain at narrow levels.

Our forecast largely came to pass, except that interest rates at the longer end of the yield curve did not increase.

♦ Economic Growth. GDP growth was 4.5% in the first quarter, 3.3% in the second quarter, and 4.0% inthe third quarter. The median forecast for fourth quarter GDP growth is 3.8% (Source: BloombergMonthly Survey).

♦ Corporate Profitability. On a year-over-year basis corporate profits from current production rose32.30% in the first quarter and 19.00% in the second quarter. However, the pace of growth has slowed asthe quarter-over-quarter growth was 3.68% in the first quarter, -.70% in the second quarter, and –1.97%in the third quarter.

♦ Inflation. Headline Consumer Price Inflation accelerated from 1.9% in January to 3.5% in November.However, the market seemed to shrug off the headline number in favor of the Federal Reserve’spreferred measure of inflation, the Core Personal Consumption Expenditure Deflator (disregarding foodand energy), which accelerated modestly from 1.2% in January to 1.5% in November.

♦ Interest Rates and Credit Spreads. The yield of the 10-year Treasury peaked at 4.89% in June. The spikein interest rates followed a sharp increase in non-farm payrolls which averaged 295,000 per monthbetween March and May in contrast to the 185,500 average for the first eleven months of 2004.

On June 30, the Federal Reserve began a very well telegraphed campaign to reduce the level of accommodation of monetary policy. The Fed raised the Federal Funds target rate 25 basis points permeeting between June and December raising the target from 1.00% to 2.25%.

Notwithstanding the Fed’s campaign, the 10-year Treasury yield was 4.22% at the end of 2004, virtually

unchanged from the beginning of the year. The 2-year Treasury yield increased from 1.82% to 3.07%. Theyield curve flattened as the difference between the 10-year and 2-year yields declined from 243 basispoints at the beginning of the year to 115 basis points at the end.




Credit-sensitive securities such as corporate bonds are priced to yield a margin over similar maturityTreasury securities. These credit spreads narrowed from 130 basis points to 113 basis points for BBBcorporate bonds and from 253 basis points to 202 basis points for BB corporate bonds. (Both measuresare the option adjusted spread on the corresponding Merrill Lynch index.) (See Chart 1 below.)

Interest rates at the longer end of the yield curve did not increase for several reasons. First, foreign purchases of U.S.

securities have continued at unprecedented levels as China and Japan in particular have been willing to finance our currentaccount deficit (currently, about 5.6% of GDP) to support the dollar vis-à-vis the Asian currencies. (See Charts 2 & 3below.) We agree with Bank Credit Analyst estimates that the entire yield curve is 40 to 100 basis points lower than itotherwise would be because of this currency intervention.

Second, while headline CPI inflation accelerated about 1.6 percentage points in 2004, the market seemed to follow theFed’s lead to focus on the core PCE deflator which only accelerated about 30 basis points. We consider increasing energyand food prices as inflation that should be reflected in interest rates unless those increases prove transitory.

Finally, the economy slowed dramatically in the second quarter in response to higher energy prices, a brief spike ininterest rates at the long end of the curve, and the prospect of higher short-term interest rates as the Fed began itscampaign to raise rates. There is a great deal of leverage in our economy, particularly at the consumer level, and thesecond quarter slow down suggests that disinflationary forces may follow rather quickly from rising interest rates.

We were pleased that we were able to achieve the objectives of the Strategic Income portfolios in 2004. During thecourse of the year, we maintained a 20% plus position in short-term securities and kept the maturities of our corporatebonds short. While we gave up some yield to protect us against a risk that did not materialize, we made up that foregoneyield with market appreciation.




2005 Fixed Income Outlook

As always, the more important question is where do we go from here. Let’s start with the consensus and then turn ourfocus to where the consensus may be wrong.

The Consensus Forecast

Economic growth will be somewhat slower but still strong at perhaps 3.5%. The U.S. consumer will hang in there andcorporate hiring and investment will continue to accelerate. Headline CPI inflation will moderate to the 2.5% range. TheFederal Funds target rate will increase from 2.25% to 3.50% and the 10-year Treasury yield will end the year up about 75basis points to 5%. While foreign demand for U.S. securities cannot grow forever, it will remain strong enough in 2005 toavert a dollar crash and dramatically higher interest rates. Any widening of credit spreads is likely to be modest.

Where the Consensus May Be Wrong

A Return of Disinflationary Forces. It is possible that U.S. economic growth will slow much more than the consensusanticipates. Disinflationary forces surface again as they did in 2001-2002. Monetary stimulus would be less effective thistime because asset prices have already ballooned after the 2003-2004 run and consumption was brought forward over thesame time period. In addition, there would be less room for fiscal stimulus because we would be starting from a point of large budget deficits rather than surpluses.

In this scenario, interest rates would surprise to the downside with the yield curve looking like it did in the spring of 2003, steep at historically low levels. As securities either mature or are called, we would be reinvesting at lower yields.The risk in this scenario is most likely underperformance (i.e., leaving money on the table) rather than a meaningfuldecline in market values.

We are more concerned about a scenario in which interest rates rise far more than the consensus expects as a decline inmarket values would then be likely. Accelerating inflation and a disorderly decline in the dollar could both lead tosignificantly higher interest rates.

Accelerating Inflation. As discussed above, headline CPI inflation accelerated from 1.9% to 3.5% over the course of 2004while the Federal Reserve’s preferred measure of inflation, the core PCE deflator, only accelerated from 1.2% to 1.5%.The longer that headline CPI accelerates faster and at a higher level, the more likely it is that the core PCE measure willlose credibility. In particular, if energy prices continue to increase, the market may shift its focus to the headline CPI

measure.

At its December 14th meeting, the Federal Reserve sounded more hawkish on inflation than it has in recent years. Thismay mean that the Fed raises the Federal Funds target rate far more than the market anticipates with interest rates at thelonger end of the yield curve increasing as much or even more as those at the short end. The Fed has spent the last 25years building its inflation-fighting credibility, and it may need to shock the market to preserve that credibility after severalyears of extremely low interest rates.

A Disorderly Decline in the Dollar. In 2004, the budget deficit was about 3.6% of GDP while the current account deficit(the largest component of which is the trade deficit, imports minus exports) was about 5.6% of GDP. Alan Greenspanrecently warned that foreign investors will not finance unlimited growth in our trade deficit. As the economist HerbertStein used to say, “If something cannot go on forever, it will stop.”

There is no reason that the twin deficits or other market forces have to cause a disorderly decline in the dollar in thenear term. However, as another year passes with even larger imbalances, the probability – however low it may be – increases. Perhaps, 2005 is the year that China will begin to revalue its currency against the dollar and foreign investorswill slow down their purchases of (or even sell) U.S. securities. This could also lead to accelerating inflation and muchhigher interest rates than the market anticipates.




Current Structure of our Strategic Income Portfolios

While we believe that the consensus forecast is reasonable, it is prudent to structure portfolios on the premise that theconsensus turns out to be wrong. Most assets are in a state of equilibrium with low yields and high prices. Volatility is lowand no asset class stands out as being particularly attractive relative to other asset classes. As a result, there is littlemargin for error if the consensus forecast is wrong.

Our baseline target portfolio allocation for Strategic Income portfolios is as follows:

♦ Corporate Bonds – (average duration of 3 years) – 15%

♦ REIT and Trust Preferreds – (average coupon of 8.15%) – 30%

♦ Income Generating Growth (MLP’s, REIT commons, etc.) – 20%

♦ Short-Term, Floating Rate, and Inflation-Indexed Securities and Cash – 35%

This allocation is more defensive than one year ago as the allocation to corporate bonds has declined by 15 percentagepoints and the allocation to short-term securities has increased by 15 percentage points.

In any of the scenarios that deviate from the consensus, credit spreads could begin to widen. We have mitigated this risk with a lower allocation to corporate bonds and an even shorter duration. We are bearing more risk of marketdepreciation in our preferred and income generating growth allocations. If interest rates rise and/or credit spreads widento a material extent, the duration of the preferred portfolio would extend and market prices would decline. However,with average coupons over 8%, we would still expect to earn an attractive real yield which should outweigh a decline inmarket price in due time. Master limited partnerships (MLP’s) and REIT’s could also suffer declining market prices. Butwith current yields above those of corporate bonds and reasonable opportunities for growth, we still believe that incomegenerating growth securities make sense over the next three to five years.

Finally, we maintain an allocation of 30% to the most defensive securities – short-term bonds, preferreds that have beencalled or that almost certainly will be called over the next year or two, floating-rate securities, and cash – so that we willhave the liquidity to take advantage of better opportunities when they arise.

We thank you for your trust and confidence in Diamond Hill, and look forward to helping you achieve your investmentgoals in the future.

by the Diamond Hill Fixed Income Team

Kent K. Rinker Richard W. Moore, CFA William P. Zox, CFA





"Inverted Thinking Leads Us To Stock-Picking"

The efficient market theory suggests that while investors are not clairvoyant, they are rational, informed, and unbiased. Based on these conditions, one can expect that the current stock price is the best estimate of the truevalue for a security. However, studies in behavioral finance confirm that these assumptions frequently do not coincidewith reality. Furthermore, a recent book gives a different set of organizational criteria that must be present in order for a group, such as the investors that form the stock market as a whole, to make wise decisions. We have never ascribed to the efficient market theory in its stronger forms. We believe there are select opportunities to add valuethrough active investing.

Life can only be understood backwards, but it must be lived forwards.

-Soren Kierkegaard

The great mathematician Carl Jacobi, after a long struggle with a problem, changed his approach and soon found hisanswer. Having seen the power of this thought process, he often advised, "when in trouble, invert, always invert." Onecommencement speaker picked up on this mental trick, and told the graduating class how to have a miserable life. Forinstance, he advised that if they wanted to be unsuccessful, they should never try to learn from great thinkers that have

come before; they should try to discover everything themselves. The audience soon understood the types of behaviorthe speaker believed they should avoid, and were easily able to invert, and "back into" the types of behavior he believedwould prove rewarding in life. Jacobi’s mental habit of thinking problems through forward and backward should be usefulfor everyone.

The Efficient Market Theory Stated

In the 1960s,building on the work of Harry Markowitz and others, Eugene Fama proposed the efficient market theory.Since competition in the stock market is so intense, "rational profit maximizers" will quickly impound new informationinto stock prices such that, at any point in time, the market price is the single best estimate of the value of an enterprise.Because news arrives randomly, stock prices will follow a "random walk." Investors, therefore, should utilize an indexapproach and forgo trying to beat the market. This theory rests on a circular argument. Only through the efforts of active investors can market efficiency be expected. But as long as some investors seek opportunities and bring aboutefficiency, others can "free ride" and still trust that market prices are unbiased.

In addition, efficient market theory believed that since investors are risk-averse, they must receive a premium to rewardthem for bearing greater risk (uncertainty). Vast amounts of data have been collected that seemingly support the efficientmarket theory. The records of professional managers, on average, have failed to beat the market. Furthermore, overlong periods of time, stocks have outperformed corporate bonds, which have outperformed government bonds andinflation, but each has only done so with more volatility.

Here Come the Behavioralists

The ethos of hard science dictates that a theory that has been tested, supported by evidence and seems to explain anobserved phenomenon be upheld until a competing theory either disproves the original theory or better explains thephenomenon. Some researchers, unconvinced by the correctness of the efficient market theory, began delving on theborder between economics and psychology, a field that came to be termed "behavioral finance." Thinking through the

problem backwards using cleverly designed experiments, they found evidence refuting the validity of many of the assump-tions on which the efficient market theory rests, and proposed different descriptions of reality. Amos Tversky and DanielKahneman (Kahneman shared the 2002 Nobel Prize in Economics for this work, which Tversky surely would have sharedhad he not passed away in 1996) found that people demonstrate the following:

Loss Aversion – People are not always risk averse. In the realm of losses, they exhibit risk-seeking behavior. For instance,in experiments, when people were offered a sure $85,000 or an 85% chance of $100,000 or a 15% chance of receivingnothing, the majority of respondents chose the sure $85,000 even though each has the same expected value. This isconsistent with risk aversion. But when the same people were offered the choice between a certain loss of $85,000 andan 85% chance of losing $100,000 and a 15% chance of losing nothing, the majority chose the gamble rather than thecertain loss, exhibiting risk-seeking behavior. It is often said that the market hates uncertainty. However, the finding





above recalls Mark Twain’s comment "a wife does not so much object to her husband gambling, she mostly objects to himlosing."

Mental Accounting – People tend to organize their decisions in separate mental accounts. For instance, researchersconstructed the following two scenarios:

Scenario 1: You have paid $20 for a play ticket. Upon arriving at the theatre you discover that you have lost theticket. Would you pay $20 for another ticket?

Scenario 2: You have decided to see a play that costs $20 per ticket. Upon arriving at the theatre you discoverthat you have lost a $20 bill. Would you still pay $20 for a ticket?

In one study, only 46% of respondents answered yes in scenario 1,while 88% of those same respondents answered yes toscenario 2.That people construct "mental accounts," whereby the account for a theatre ticket is down $20 in scenario 1but not in scenario 2, is the most likely explanation.

Overconfidence – Numerous studies have shown people are overconfident in their predictions. Furthermore, predictionsoften are not well calibrated. For instance, when people were asked how confident they were in a certain prediction,respondents who replied 80% or greater were often in error more than 50% of the time. As Herbert Simon declared,humans are only boundedly rational.

Conducting studies involving the U.S. stock market, Werner De Bondt and Richard Thaler published an article in 1985

entitled "Does the stock market overreact?" in which they reported findings that stocks that were the subject of recentbad news were, on average, systematically mispriced as they subsequently outperformed market averages. "Value"investors jumped on this and other studies as justification for their investment approach. Other studies looked at pos-itive earnings "surprises" and relative price strength and concluded the market under-reacts to good news given thesestocks outperformance over a 6-12 month time frame. Momentum and some quantitative investors hold up these stud-ies to justify their investment approaches. This might strike some as frustrating and even further proof of efficient mar-kets - sometimes the market overreacts and sometimes it under-reacts (not to mention the possibility that the conclu-sions in these studies might depend on the time frame over which the analysis was conducted). From our viewpoint, thefindings from behavioral finance do produce a more complete picture of reality and can be synthesized with the otherfindings. Succinctly, we believe that while markets are fairly efficient, they are far from always efficient.

A Mental Checklist

Thoughts on some of these topics were refreshed after reading The Wisdom of Crowds: Why the Many are Smarter than he Few and How Collective Wisdom Shapes Business, Economies, Societies, and Nationsby James Surowiecki. The basic premise of the book is that under the right circumstances, groups are remarkably intelligent, and are often smarter than the smartestperson in them. Instinctively, most people have trouble accepting this thesis, as unruly mobs and other mass hysteriasreadily come to mind. This doubt is acknowledged upfront in the liner notes to the book, with H. L. Mencken’s quote"No one in this world, so far as I know, has ever lost money by underestimating the intelligence of the great masses of theplain people." Surowiecki, however, maintains that Mencken is wrong. He has collected some wonderful examples of groups making extraordinarily accurate predictions under uncertainty, and working together to solve problems of cognition, coordination, and cooperation. He also presents examples of groups making dysfunctional decisions, but is notnecessarily troubled by this, wisely pointing out that this is the way the world works. What he does propose, however, isthat for a crowd to make wise decisions, it must possess the following characteristics:

• Diverse - because it adds perspectives that would otherwise be absent and because it takes away, or at leastweakens, some of the destructive characteristics of group decision making such as groupthink and conformity.

• Independent - because it keeps the mistakes that people make from being correlated and makes it more likelyto have new information rather than the same data with which everyone is already familiar.

• Decentralized – because it fosters diversity, encourages independence, and brings specialized knowledge,including what economist Friedrich Hayek termed tacit knowledge, that knowledge which cannot be easilysummarized or conveyed.

• Aggregation – because some mechanism, such as market prices, must exist to reflect the thinking of the groupas a whole, typically through averaging.

Just as an airline pilot uses checklists to ensure a safe takeoff, flight, and landing, we believe this can serve as an effectivechecklist for an individual to use to gauge the appropriate level of trust to have in the wisdom of crowds.





The Conceit of Stock-Picking

Referring back to the commencement speaker, being conceited would have made his list of behaviors to avoid in life. Sowe acknowledge that there is a certain conceit in selecting individual stocks and trying to beat the market, and recognizethat outperforming the market, after considering all costs, is a formidable challenge. We also believe free markets are thebest mechanism available for setting the price of capital and eventually sorting out the truth. Yet, when we applySurowiecki’s pre-conditions for wise crowds to the stock market, we remain skeptical of placing complete trust in stock market prices, and are hesitant to follow a passive index strategy.

Consider the condition of independence. Investors would meet this test if they independently appraise the value of abusiness based upon their own expectations for the future cash flows of the business and a reasonable required return,and buy or sell only when they spot a compelling investment opportunity. However, if investors engage in the practice of trying to predict what other investors might pay in the near future for a given security (in a process that John MaynardKeynes described as analogous to a beauty contest where the contest winner would be based not on some objectivestandard of beauty, but on whose picks most closely correspond to the average picks of all competitors), prices canbecome unhinged from reality. In reality, it is never exclusively one or the other. However we see signs of the latterreflected in very high turnover portfolios. Also, we frequently observe managers "closet indexing," by starting with thecurrent stock price (and by extension the market capitalization) to formulate portfolio position sizes based on smalldeviations from the index weight. These observations curtail our confidence in perfectly efficient markets, and lend usconfidence there will be select opportunities to add value.






"In The Long Run"

At Diamond Hill, our core investment tenets encourage independent, businesslike, and long-term thinking. This piecediscusses our thoughts on what constitutes the long-term and some of its practical effects on our investment approach.

The Eagles wrote a song about it. Every first year economics student learns to define it. And investment organizationsespouse it often enough that it might be regarded as a cliché. “It” is the long run. In certain contexts, the long runcannot be defined as a specific time frame. For instance, the economics student learns that in the short run at least somecosts are fixed, while in the long run all costs are variable. Neither should self-interest be allowed to influence anobjective definition of long-term. Fund companies have an incentive to define long-term as a very long time, perhapsforever. However, a skeptical mutual fund observer could become downright cynical when considering the hypocrisy of fund companies preaching long-term investing on the part of their shareholders, while the fund managers themselves playa distinctly short-term game as evidenced by portfolio turnover rates easily exceeding 100%. In the end, we may be ableto do no better than Supreme Court Justice Potter Stewart, who in writing a concurring opinion in an early obscenitycase refrained from giving specific definitions, but stated, “I know it when I see it.” Legal scholars among you might knowthat Stewart himself later recognized that the vagueness of his earlier opinion made it untenable in a legal context. If, likePotter, we are too vague in our definition of long-term, check back with us when we are represented on the SupremeCourt. In the meantime, hopefully this shares some thoughts on what long-term investing means to us.

Classical Economics vs. Keynesian Economics

Debates about long-term and short-term are not new in the sphere of economic policy and investing. Henry Hazlitt, inEconomics in One Lesson, wrote “the art of economics consists in looking not merely at the immediate but at the longereffects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for allgroups.” While Hazlitt thought some might find this obvious, he assured readers that it was anything but orthodoxy:

Yet when we enter the field of public economics, these elementary truths are ignored. There are menregarded today as brilliant economists, who deprecate saving and recommend squandering on a nationalscale as the way of economic salvation; and when anyone points to what the consequences of these policies

will be in the long run, they reply flippantly, as might the prodigal son of a warning father: “In the long runwe are all dead.” And such shallow wisecracks pass as devastating epigrams and the ripest wisdom.

Here, the object of Hazlitt’s disdain is John Maynard Keynes, who wrote, “But this long run is a misleading guide tocurrent affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuousseasons they can only tell us that when the storm is long past the ocean is flat again.” Keynes had a very successfulinvestment record and wrote insightfully and eloquently about investor psychology. Also, his often quoted “in the longrun we are all dead” might be better kept in context as a reminder that we must also live in the short term. Yet, insetting economic policy, Keynes believed in government intervention to solve short-term “disequilibriums,” distrustingfree markets and the price mechanism to do their work. In short, if “problems” [lack of aggregate demand] were everencountered, somebody [the government] should DO SOMETHING. While a full discussion of classical and Keynesianeconomics is well beyond the scope of this piece, we think it is appropriate to keep in mind the seemingly trite Latinsaying- primum non nocere – “First, do no harm.”

One story to place this in an investment perspective involves Diamond Hill’s Chuck Bath. In the 1990’s, Chuck wasinterviewing with a Fund organization, now part of a major multinational bank. As part of an idle conversation with amanager in that organization, Chuck mentioned that the mutual fund he was then managing had underperformed theprevious week. That manager’s immediate question, “What are you going to do about it?” The answer, in deed if notwords, was nothing. Our approach is much the same today. Given that we believe short-term stock price movementsare as much a reflection of investor psychology, we would not expect to engage in major portfolio overhauls in reactionto such fluctuations.





A Short-Term Investment Approach

Some might point out that the long-term is actually a series of short-terms. This fact is explicit in fixed income markets,where investors might attempt to predict the theoretical term structures of interest rates by considering a series of forward zero-coupon curves in a process called bootstrapping. But is there something to be gained in equity investing bypredicting a series of short-term events? Perhaps it would be useful to consider a short-term investment approach, suchas earnings surprises. This approach might best be described as attempting to choose stocks that the manager believes

will surpass the “consensus estimate” in the next reported quarter. This approach has logical aspects. If a stock isreasonably efficiently priced, then it should respond to the marginal piece of news.

There are a few major drawbacks to this approach, however, in our view. First, if a stock is inefficiently priced, whyshould it necessarily respond to marginal news in the direction anticipated – higher if the news is good and lower if bad?Second, there is great risk in concluding that the earnings estimates of a few sell-side analysts are the actual expectationsembedded in a stock price. In his book Wall Street Meat , Andy Kessler relates a story from a Microsoft analyst meeting in1991. Kessler worked at Morgan Stanley covering companies such as Intel, but did not cover PC software, so he wasthere only as an interested observer. Amid presentations about Microsoft products, Microsoft President Jon Shirleyspoke:

“I want to comment about your earnings estimates. There are certain analysts out there, and you knowwho you are, whose numbers are just TOO HIGH. They have got to come down.” One-by-one, each of the sell-side analysts left the room, went outside, pulled out their cell phones and called their trading desksto tell them that Microsoft was talking down numbers. John Shirley finished his presentation to two people,Chip Morris, a buy-side analyst from T. Rowe Price and me. Analysts started filing back into the room, andword spread quickly that Microsoft’s stock was down 4½ points…as I stepped out of the presentationroom, there were Bill Gates and Jon Shirley standing there laughing as hard as they could. I heard Gates say,“What suckers, this is too much fun.” Microsoft was probably pricing their employee stock options thenext week, and the timing of the analyst meeting was a fortuitous bang to the stock.

And if Kessler is accurate, this is an example of a company who sought a lower stock price. One can imagine thesandbagging, whisper numbers, pro forma earnings, and other games that developed in the corporate dance with WallStreet analysts from companies who sought higher prices for their stocks in the 1990’s.

With the major qualifications above, we would concede that there could be some efficacy to an approach such as earningssurprises. Yet, it’s simply not our approach. It is important to point out however, that it is likely a costly approach.

Trading costs, short-term capital gains taxes, and the cost of attempting to acquire superior short-term information allwill likely be high. Our own approach involves estimating the long-term value of a business based on the present value of its expected future cash flows. Then we look to the market price to discover whether an investment opportunity exists.If we worked backward, we would attempt to infer the long-term consensus expectations embedded in the current stock price, and find opportunity only when our expectations were more favorable than consensus.

An Example of Our Approach

In an early 2001 letter to shareholders of what was then the Diamond Hill Focus Fund, we reviewed a successfulinvestment in Electronics For Imaging (EFII). To summarize, we bought in October 2000 at $11.50 per share, when thecompany held $8 per share of net cash and short-term marketable securities, and estimated potential “normalized”earnings of as much as $1 per share. In January of 2001, we sold our stake at a price of roughly $18.50. In that letter, wewrote:

So how do we know if we were “lucky” or “skilled”? Our answer is that right now, we’re not sure. Butafter we sell a stock, we continue to keep tabs on the company. If in two years time, we find that EFII hasburned through all their cash and has little economic earnings power, we’d likely agree “lucky” and thatthe perceived value was ephemeral. In other words, if we find ourselves consistently selling things “at thetop” only to watch them crash after a sale, the relief we will feel as fellow shareholders will be greatlytempered by concern that we are making mistakes in the beginning.





Let’s update for subsequent events in regards to both the price and value of EFII. The first critical point is to understandthe concept of a required rate of return, which is akin to an opportunity cost. If the stock was indeed worth $18.50 pershare in early 2001, it should sell for a higher price today. Using required rates of return between 8% and 10% wouldyield an “appropriate” price for EFII of $27 - $30 per share today, which is approximately the price EFII has been tradingat the past few months. Measured by today’s price alone, selling in early 2001 was a “push,” as we would have receivedan approximate fair return on the stock over the subsequent holding period (EFII has not paid any dividends over thisperiod). In terms of subsequent fundamental value, EFII now has $5.60 per share in net cash and marketable securitiesafter making a $280 million acquisition in 2005 (the share count is up just slightly from five years ago, and the companymight have $10.50 per share cash without the acquisition). Including 2005, EFII will have averaged approximately $.75 pershare in earnings over the last five years, short of our expectation of $1 in “normalized” earnings which we would haveassumed would have grown closer to $1.50 by now. Thus, we would conclude EFII today is fairly valued today if it canachieve “normalized” earnings of $1.50, growing at least at a high single digit rate. From today’s vantage point, thebottom line would seem that at a price of $11.50 in early 2001, EFII offered a margin of safety whereas at $18.50 it didnot.

There are a couple points worth making here. When analyzing the value of EFII, we used a long-term horizon. Earningsand dividends were estimated over an assumed five-year holding period, with a terminal value, or target price, assigned atthe end of the fifth year. This terminal value is based in part on assumptions concerning growth and risk in years six andbeyond, so the horizon theoretically extends forever, although the mathematics of present value render cash flowsreceived in the very distant future inconsequential. Note, however, that we were short-term owners of the stock. The

decision-making process was completely driven by price-value considerations. The goal of our approach is to achieve anattractive, risk-adjusted after-tax return. Low portfolio turnover is often a means to achieve that end, but should not beconfused with the objective. We anticipate that our portfolio turnover will be lower than many of our peers, based onour approach. However, a finding of both high returns and portfolio turnover would not necessarily contradict a long-term investment approach. If, however, our returns are low and portfolio turnover is high, it would indicate either adeviation from the approach or evidence of mistakes in our initial analysis and purchase that then caused us to reversecourse.

Conclusion

Equity investing is an activity that lends itself to a long-term horizon. In the past, we have suggested five years as theminimum amount of time over which to analyze the value of a business, as well as to measure the progress of an equity

manager. Even five years could prove too brief if the end points reflect extremes in market psychology. As ever, we arereminded of Benjamin Graham’s quotation that, “In the short run the stock market is a voting machine; in the long run itis a weighing machine.”




September 30, 2006


Diamond Hill FundsDiscussion of Q3 2006 investment results withparticular emphasis on energy holdings

Our pledge to investors includes the following statement “We will communicate with our clients about our investment performance in a manner that will allow them to properlyassess whether we are deserving of their trust.” In general, the performance of our diversifiedstock funds in the third quarter of 2006 was not good and we want to discuss why and explain ourcurrent assessment of your portfolios, particularly the large energy exposure.

In addition we want to re-emphasize that our approach to investing is long-term in nature asevidenced by our relatively low turnover. One of our equity investment principles states that “Over short periods of time the stock market price is heavily influenced by the emotions of market participants, which are far more difficult to predict than intrinsic value. Whilestock market prices may experience extreme fluctuations we believe intrinsic value isfar less volatile. ”

Furthermore, while stock market volatility can be unsettling, we note in our equity investmentprinciples “ We do not define risk by price volatility. We define risk as the possibility that

we are unable to obtain the return of the capital that we invest as well as a reasonablereturn on that capital when you need the capital for other purposes. If you will need thecapital that you entrust to us in less than five years, then you should not invest thatcapital in the stock market.”

(Exhibit A illustrates the performance of the Diamond Hill Funds for various periods since inception.)

Performance Discussion and Outlook

Diamond Hill’s diversified equity Funds had poor relative investment performance in the quarterending September 30, 2006. As you may be aware, Diamond Hill has had significant energyrepresentation in its portfolios dating back to 2004. After a significant positive contribution torelative performance in both 2004 and 2005, energy stocks have experienced negative total returnsthus far in 2006, especially in August and September. In our diversified equity portfolios, energyrelated stocks currently comprise a range of 20 – 25% of net assets. Thus, while the energy sector isnot the only factor explaining overall performance during any given quarter in the past 2+ years, ithas often been the largest single explanatory factor of the many factors – sector or stock specific.

For a variety of reasons discussed below, we will distinguish between the markets for crude oil andnatural gas in our remarks. The following table illustrates the relative importance of either oil or gasproduction among the exploration and production companies owned in the Diamond Hill Long-ShortFund and in the Diamond Hill Small Cap Fund. (The energy contribution of the Large Cap Fund wassubstantially similar to the Long Short Fund). In addition to these E&P companies, the Small Cap Fundalso holds positions in several energy service companies including Helmerich & Payne, Tidewater,Lufkin, Helix Energy Solutions, and Hornbeck Offshore Services. See Exhibit B for a complete list of energy holdings for each Fund.



September 30, 2006


2005 Revenues 2006E Production

Crude Oiland NaturalGas Liquids

NaturalGas Other

Crude Oiland NaturalGas Liquids

NaturalGas

L o n g / S

h o r t F u n d Anadarko Petroleum 46% 52% 2% 46% 54%

Apache 60% 39% 1% 48% 52%Cimarex Energy 24% 74% 2% 22% 78%

ConocoPhillips 27% 12% 61% 64% 36%

Devon Energy 30% 54% 16% 38% 62%

S m

a l l C a p

F u n d Berry Petroleum 71% 15% 14% 77% 23%

Cimarex Energy 24% 74% 2% 22% 78%

Encore Acquisition 67% 33% 0% 65% 35%

Southwestern Energy 4% 55% 41% 7% 93%

Whiting Petroleum 63% 37% 0% 64% 36%

Stock Performance

Long Short Ene rgy Holdings

-15%

-10%

-5%

0%

5%

10%

15%

D ec- 0 5 Jan- 0 6 Feb- 0 6 M ar- 0 6 A p r- 0 6 M ay- 0 6 Jun- 0 6 Jul- 0 6 A ug- 0 6 Sep- 0 6

% C h a n g e

Y T D

*The chart represents a custom index of the following securities with the respective beginning weights: Anadarko (20%) Apache (20%), Cimarex (20%),ConocoPhillips (20%) and Devon Energy (20%).



September 30, 2006


Small Cap Energy Holdings

-20%

-15%

-10%

-5%

0%

5%

10%

15%

20%

25%

Dec -05 Jan-06 Feb-06 Mar-06 A pr-06 May -06 Jun-06 Jul-06 A ug-06 Sep-06

% C h a n g e

Y T D

*The chart represents a custom index of the following securities with their respective beginning weights: Cimarex (20%), Encore Acquisition (20%),Berry Petroleum (10%), Helmerich & Payne (10%), Remington Oil & Gas/Helix (10%), Tidewater (10%), Whiting Petroleum 10%, Lufkin Industries(5%), and Southwestern Energy (5%).

These indices do not exactly measure energy stocks’ contribution since security weights havechanged over the course of the year. For instance the energy sector comprised 18.4% of assets inthe Small Cap Fund at the beginning of the year, 22.9% at the end of July, and 20.9% as of September30, 2006. The Long-Short Fund weighting has ranged between 25% and 22.4%. The charts should,however, give a close approximation of the performance of energy in the portfolio.



September 30, 2006


Oil Markets

As a globally traded commodity, worldwide oil consumers and producers compete with one anotherin order to consume or supply the natural resource. The International Energy Agency (IEA) pegsworldwide demand for 2006 at 84.7 million barrels per day. If that estimate proves correct, demandin 2006 will have grown by 1.3% from 2005 estimated demand. The upward pressure on oil pricesover the past 5 years is seen in the following chart:

Weekly Closing Price of Crude Oil

$15

$25

$35

$45

$55

$65

$75

Oct-01

Jan-02

Apr-02

Jul-02

Oct-02

Jan-03

Apr-03

Jul-03

Oct-03

Jan-04

Apr-04

Jul-04

Oct-04

Jan-05

Apr-05

Jul-05

Oct-05

Jan-06

Apr-06

Jul-06

We believe the major factors contributing to rising crude oil prices this decade include:• Steadily increasing demand, driven largely but not exclusively by emerging market economies

(most notably China), on the order of 1.8% per annum.• Declining production from countries in the Organization for Economic Co-operation and

Development (OECD) in combination with rising global demand has led to a decline in thespare capacity of countries in the Organization of Petroleum Exporting Countries (OPEC). TheIEA recently estimated OPEC spare capacity at just 2 million barrels per day (which equates toapproximately 2.3% of total demand), down considerably from levels seen during the 1990s andearly in this decade.

• Previous multi-year underinvestment in new oil projects, either because the low commodity

price led to unattractive prospective returns and/or political instability in regions holding muchof the worlds undeveloped proved reserves made undertaking projects too risky.• Supply interruptions or the perceived threat of supply disruptions mostly stemming from

political instability. The possible premium in market prices for potential supply disruptions - a“terror premium” – is not necessarily irrational in our view. It may represent the market’s bestestimate of the probability of an actual supply disruption. Nevertheless, it will fluctuate,sometimes dramatically, much like market psychology.



September 30, 2006


Higher oil prices have tempered, but not reversed demand growth. Demand for crude oil has grownat a lower rate in comparison with past periods of similar rates of global GDP growth. However,given the dramatic increase in crude oil prices, volume demand for crude oil has recently provedrelatively inelastic. Near-term oil supply has proved more than adequate. Forecasts from the IEAindicate that OPEC spare capacity will build once again. Also, in the U.S., inventories have wellexceeded 5-year averages despite domestic supply having been slowed by the partial shutdown of Prudhoe Bay following pipeline leaks. Oil is once again trading at similar levels to the beginning of the year, but has averaged about $68 per barrel for the year-to-date. Thus, companies orientedmore toward oil production have not faced headwinds from the commodity price with year-over-year earnings comparisons.

Daily Closing Price of Crude Oil

$50

$55

$60

$65

$70

$75

$80

$85

Oct-05

Nov-05

Dec-05

Jan-06

Feb-06

Mar-06

Apr-06

May-06

Jun-06

Jul-06

Aug-06

Sep-06

Predicated on continued, albeit slower global GDP growth, our estimates of intrinsicvalue are based on a $55 price per barrel. Strong demand should continue from developingcountries requiring greater amounts of energy as their economies and standards of living grow. Toillustrate, compare the current per capita energy use of the U.S. and China. The average Americanconsumes 25.1 barrels of oil per annum, thirteen times greater than the 1.9 barrel the averageChinese person consumes. Higher prices have stirred efforts to bring new supply. These efforts,however, take time and large amounts of capital.



September 30, 2006


Natural Gas MarketsSomewhat in contrast to the oil market, natural gas prices are more dependent on local conditions,mainly due to the expense and difficulty of transporting natural gas. In the past 12 months,Department of Energy data indicates that the U.S. has consumed about 58.3 Billion cubic feet (Bcf)per day (which is down from about 60.4 Bcf per day at this time last year, with much of the declinedue to warm winter weather) while producing approximately 49.6 Bcf per day. The difference islargely made up with imports coming via pipeline from Canada. Liquid natural gas (LNG) imports,which have been an anticipated source of additional supply, are a less important factor. This lesserreliance on foreign sources is in contrast to the crude oil markets. The U.S. consumes more than20.5 million barrels of oil per day, yet produces only about one-third of that amount. The rest isimported, mainly from countries in South & Central America or the Middle East. While worldwidedemand growth for natural gas has rivaled or even exceeded that for crude oil, U.S. demand has beenrelatively static the past decade.

The following illustrates NYMEX Henry Hub forward month natural gas price:

Weekly Natural Gas Prices (Front Month Contract)

$0

$2

$4

$6

$8

$10

$12

$14

$16

Oct -01 A pr-02 Oct -02 A pr-03 Oct -03 A pr-04 Oct -04 A pr-05 Oct -05 A pr-0 6

P r i c e

( $ M c f )

We believe the major factors contributing to rising natural gas prices this decade include:• Declining U.S. production from the Gulf of Mexico shelf that has been offset only by

unconventional gas plays (tight gas, shale, and coal bed methane) which require higher prices tobecome economic. Unconventional gas production as a percentage of the total has increasedmarkedly the past decade to approximately 40% currently.

• Steep production decline curves in natural gas wells require greater drilling activity which facedconstraints with respect to rig and crew availability.

• The hurricane season of 2005 led to the loss of 8 rigs and production shut-ins in the Gulf Coastregion resulting in the price spike in the second half of 2005.



September 30, 2006


The downward pressure on gas prices this year has been largely driven by plentiful supply after arecord warm winter in many parts of the U.S. At Christmas 2005, storage levels approximatedprevious averages. In the U.S., January was the warmest on record, which led to a much lowerinventory drawdown than typical. By the end of the winter heating season in late March, there was650 Bcf more than the 5-year average in storage. A hot July led to a briefly improving storagesituation, but a return to normal weather patterns combined with the absence of supply disruptionsfrom hurricane activity have us on an apparent course to full storage capacity of an estimated 3,500Bcf before the winter heating season begins anew.

U.S. Natural Gas Storage Levels

1,000

1,500

2,000

2,500

3,000

3,500

Sep-05 Nov-05 Jan-06 M ar-06 M ay-06 Jul-06 Sep-06

S t o r a g e

( B c f )

Storage Level Previous 5-Year Average Storage Level

The U.S. natural gas market has a near-term storage overhang. The cycle for natural gas is muchshorter than oil, and weather introduces a more important “wild card” into the market. In addition,seasonality in demand leads to significant volatility in the commodity price. Our current estimatesof intrinsic value assume an average of $8.00 over the next 5 years for the Henry Hubnatural gas price. Recent commodity price declines coupled with the prospect of forced

production shut-ins due to full storage have led a few producers (primarily those that have hedged athigher prices) to curtail higher cost production. While on-shore supply has come online faster thandemand, remember that much of the increase comes from unconventional production that requireshigher prices (in certain cases at least $6.50 Mcf) to remain economic. Thus, if lower prices lead to adecrease in drilling activity, and demand remains constant, a tight supply-demand situation wouldreturn quickly.



September 30, 2006


SummaryWhile the recent declines in the commodity prices for oil and natural gas, and the accompanyingdeclines in the equity prices of energy related companies, have been a detriment to performance, ourlong-term outlook remains intact. We believe current equity prices embed long-termcommodity prices on the order of $35 - 45 per barrel of oil and $5 – 6 per Mcf for naturalgas, whereas we believe probabilities favor higher average prices. In 2004 and 2005, sell-side analysts’ estimates badly lagged the actual earnings generated as commodity price assumptionswere slow to be adjusted upward to those being realized in the marketplace. This year, analysts’commodity price assumptions have largely caught up, so there may be some need to reduceestimates if there are further declines in 4 th quarter commodity prices. However, if our commodityprice assumptions prove reasonably accurate, and the individual companies execute well in increasingproduction without allowing costs to outpace revenue increases, these companies should havematerially higher earnings five years from now. From our standpoint, the marketplace has alreadyanticipated at least some of these reductions, as evidenced by the current multiples.

Consensus P/EFY 2006 EPS Based on 2006

9/29/06Price Estimates Consensus EPS

Anadarko 43.83 $5.60 7.8Apache 63.20 $8.00 7.9ConocoPhilips 59.53 $10.25 5.8Devon 63.15 $6.50 9.7Cimarex 35.19 $4.00 8.8Berry Petroleum 28.16 $2.80 10.1Encore Acquisition 24.34 $1.80 13.5Helmerich&Payne (Sep '06) 23.03 $2.50 9.2Helix Energy 33.40 $3.00 11.1Hornbeck Offshore 33.50 $2.70 12.4Lufkin Industries 52.92 $4.60 11.5Southwestern 29.87 $1.00 29.9Tidewater (Mar '07) 44.19 $5.30 8.3Whiting Petroleum 40.10 $4.15 9.7

We are sometimes asked: What would make you change your mind? Our answer is thatwe are always comparing price and our estimate of value. If we interpreted new demand and supplydata such that we no longer felt our commodity price assumptions were valid, or if at the companylevel, there were production or cost issues, this would lead us to adjust our estimates of value.



September 30, 2006


EXHIBIT A

The table below includes the historical returns for each of the Diamond Hill Funds.

Returns as of 9/30/2006

Fund / Benchmark 3

Months1

Year 3

Years5

YearsLife of

FundInception

Date

Small Cap Fund – ANAV -4.69% 0.71% 18.33% 20.16% 17.14% 12/29/2000POP -9.44% -4.31% 16.33% 18.94% 16.10%

Russell 2000 Index 0.44% 9.92% 15.48% 13.78% 8.68%

Small-Mid Cap Fund – ANAV -3.15% -- -- -- 1.50%

12/30/2005POP -7.98% -- -- -- -3.61%Russell 2500 Index 0.52% -- -- -- 6.87%

Large Cap Fund – ANAV 1.32% 8.50% 19.97% 11.96% 9.04% 6/29/2001POP -3.76% 3.07% 17.96% 10.82% 7.98%

Russell 1000 Index 5.06% 10.25% 12.79% 7.64% 3.94%

Select Fund – ANAV -0.86% -- -- -- 3.90% 12/30/2005POP -5.80% -- -- -- -1.33%

Russell 3000 Index 4.64% -- -- -- 8.02%

Long-Short Fund – ANAV -0.06% 10.85% 18.94% 15.02% 10.05%

6/30/2000POP -5.05% 5.28% 16.93% 13.83% 9.15%Russell 3000 Index 4.64% 10.22% 13.00% 8.08% 1.10%

Financial Long-Short Fund – ANAV 5.04% 15.49% 14.51% 15.80% 13.16% 8/1/1997POP -0.20% 9.74% 12.56% 14.63% 12.52%

S&P 1500 SuperComposite Financials Index 7.53% 19.96% 14.15% 10.04% 7.94%NASDAQ Bank Index 3.12% 11.04% 10.78% 12.39% 9.73%

Strategic Income Fund – ANAV 3.15% 5.61% 6.98% -- 10.19% 9/30/2002POP -0.47% 1.88% 5.72% -- 9.22%

Merrill Lynch Domestic Master Index 3.87% 3.66% 3.41% -- 3.92%

The performance data quoted represents past performance; past performance does not guarantee future results. Theinvestment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worthmore or less than their original cost. Investors should consider the investment objectives, risks, and charges and expenses of theDiamond Hill Funds carefully before investing. This and other information about the Funds is in the prospectus, which can beobtained at www.diamond-hill.com. Read the prospectus carefully before you invest. The Funds’ current performance may belower or higher than the performance data quoted.

Performance is not guaranteed. Performance returns assume reinvestment of all distributions.Average annual total returns illustrate the annual compounded returns that would have produced thecumulative total return if the Fund’s performance had remained constant throughout the periodindicated. Returns for the periods less than one year are not annualized. These total return figuresmay reflect the waiver of a portion of a Fund’s advisory or administrative fees for certain periods. Insuch instances, and without such waiver of fees, the total returns would have been lower. Themaximum sales charge is 5.00%. The investment return and net asset value will fluctuate, so that aninvestor’s shares, when redeemed, may be worth more or less than the original purchase price.



September 30, 2006


EXHIBIT B

Following is a list of securities mentioned in the above analysis and the percent each represents of therespective Diamond Hill mutual funds as of September 30, 2006. Portfolio holdings are subject tochange without notice.

Portfolio Weight as of 9/30/2006

Ticker Company Name

Long-ShortFund

LargeCap Fund

SmallCap Fund

APA Apache Corp. 4.7% 4.7% --APC Anadarko Petroleum Corp. 4.6% 4.5% --COP ConocoPhillips 4.3% 4.3% --DVN Devon Energy Corp. 5.1% 5.1% --XTO XTO Energy Inc. -- 2.7% --BRY Berry Petroleum Co. -- -- 3.0%

XEC Cimarex Energy Co. 3.7% -- 4.0%EAC Encore Acquisition Co -- -- 4.0%HLX Helix Energy Solutions -- -- 0.7%HP Helmerich & Payne Inc. -- -- 2.1%HOS Hornbeck Offshore Services -- -- 1.2%LUFK Lufkin Inds Inc. -- -- 0.8%SWN Southwestern Energy Co. -- -- 0.8%TDW Tidewater Incorporated -- -- 1.3%WLL Whiting Petroleum Corporation -- -- 3.5%

Total Energy Sector Weight 22.4% 21.3% 21.4%





Of course, the agency risk is not limited to hedge funds; it is an important concern for mutual fundinvestors as well. The roulette example is, in my mind, also analogous to the momentum market soprevalent in the late 1990’s. Investors made large investments when price became separated fromvalue, in an attempt to keep pace with the momentum market. They did not realize they were takingever larger risks for ever smaller incremental returns because, for a while, the strategy worked.However, eventually value prevailed and prices plummeted. In many ways, this is the risk we see withmomentum investing, and why our investment decisions are always grounded in our valuation-basedapproach. Momentum investing can work for a long period of time and may fool investors intobelieving the strategy is generating excess returns. The problem is, when momentum investing stopsworking, the losses can be substantial. To us, it makes no sense to make any investment without firstcomparing price to value.

As always, our valuation driven approach requires a long-term perspective, and that is a point we areconstantly emphasizing to our clients. In the short term, our approach may be to avoid what appearto be exciting areas of investment, because we see the risks as too great compared to the returnopportunities. Those time periods are never fun, but they have happened in the past and will happenagain in the future. But that is the nature of long-term valuation-based investing. We are constantlyevaluating not just the potential return but the risk as well. Some risks are obvious. Hopefully thisdiscussion helps investors to understand that other risks are difficult to discern but are still very real.

At Diamond Hill Investments, we are very focused on the risk/reward tradeoff in our investmentdecisions, and, while we will make mistakes, it will not be due to perverse incentives to takeunwarranted risks. We manage our portfolios with the shareholders perspective, so we will not putbusiness decisions ahead of fiduciary decisions.

Charles S. (Chuck) Bath, CFA



Discussion of Current Fixed Income Market Environment – August 6, 2007


Discussion of Current Fixed Income Market

Environment

We are currently in the midst of the most difficult investment environment that we have faced for the Diamond HillStrategic Income Fund since its inception. In fact, the credit and market liquidity conditions today are quite similar towhen we started the fund in 2002. The difference, of course, is that in 2002 we were on the tail end of a credit cycle andtoday we are at the beginning of a credit cycle. The purpose of this letter is to describe what is currently going on in thefixed income markets and to detail what we are doing with the portfolio, in response to these conditions.

Over the past six months or so, we have discussed the persistent narrowing of credit spreads (i.e., narrowing of theadditional yield of credit sensitive securities over U.S. Treasury securities). While credit spreads have narrowed forvarious reasons – strength of corporate balance sheets and profitability, lower volatility of economic growth, and inflation

– one significant contributing factor was a global glut of capital that was chasing yield wherever it could be found. In lateFebruary, the deterioration of subprime mortgage credit scared the markets, but confidence was quickly restored andcredit spreads continued to narrow in many markets until early June. At that time, we learned of large (and ultimatelyfatal) losses in two Bear Stearns hedge funds that were heavily invested in subprime mortgage backed and structured

finance securities. Risk aversion began to increase and, in particular, demand for structured finance securities such ascollateralized debt obligations (“CDOs”) and collateralized loan obligations (“CLOs”) began to evaporate.

At the same time, mergers and acquisitions (“M&A”) reached a frenzied peak with transaction sizes ever increasing.Coming in to July, it was estimated that investment banks had over $300 billion of high yield debt to place, much of whichwas to fund buyout activity. Subprime credit issues finally spread to other markets as they led to a loss of confidence inCDOs and CLOs, which were the leading buyers of high yield debt at a time when there was this huge supply of debt inthe pipeline. In many cases, banks and investment banks are obligated to provide the high yield financing if it cannot beplaced with investors. Thus, subprime mortgage issues have spread to all structured finance markets (e.g., CDOs, CLOs,commercial mortgage backed securities), then to all of the primary markets (e.g., corporate debt, commercial real estatedebt, emerging markets debt), and now to the banking system.

These events have led to a seizing up of the credit markets and a rapid unwinding of leverage. Broker-dealers are

reluctant to bid for securities, resulting in much wider bid-ask spreads and fewer trades (if a trade can even be done).This, in turn, has caused declines in market prices and margin calls for leveraged investors. Margin calls have lead toforced selling into an illiquid market, causing even lower prices. In addition, distressed investors are selling whatever theycan regardless of price or quality. Investment banks are selling short (whatever can be sold short) to offset theirunwanted credit exposure (i.e., investment banks purportedly bet against GM debt to offset their exposure to a difficultChrysler financing).

At the beginning of July, our allocation to high yielding equity securities was about 13% compared to 17% at the end of thefirst quarter and 20% for much of our history. Also, at the beginning of July, our corporate bond weighting was about20%, which is about half of where we would like that position to be in a normal environment, and our allocation to agencybonds and cash was about 20%. As of July 20, 2007, our allocation to high yielding equity securities and corporate bondswas slightly lower; and agency bonds, Treasuries (7.3% position), and cash were over 22% of the portfolio.

Our large position in agencies, Treasuries, and cash has not been sufficient, in the short term, to shield us from ourexposure to real estate finance. Approximately 60% of the decline in the value of our portfolio since July 20th can beattributed to 11.6% of our portfolio that was exposed to real estate finance. The remaining 40% of the decline can, in ourview, be attributed primarily to the absence of liquidity as opposed to a reevaluation of credit risk.



Discussion of Current Fixed Income Market Environment – August 6, 2007


Investors should consider the investment objectives, risks, charges, fees and expenses of the Diamond Hill Funds carefully beforeinvesting; this and other information including fund performance and a prospectus can be obtained at www.diamond-hill.com . Read theprospectus carefully before you invest. Fund Holdings are subject to change without notice. The value of fixed-income securities variesinversely with interest rates; that is, as interest rates rise, the market value of fixed-income securities will decline. Lower quality debtsecurities involve greater risk of default or price changes due to potential changes in the credit quality of the issuer. Diamond Hill fundsare not FDIC insured, may lose value, and have no bank guarantee. Distributed by IFS Fund Distributors, Inc., Member FINRA/SIPC,303 Broadway, Suite 1100, Cincinnati, Ohio 45202.

As of April 30, 2009, BHIL Distributors, Inc. (Member FINRA) became distributor for its affiliate, the Diamond Hill Funds.

Information contained herein is intended as a snapshot as of the date of this investment letter and is retained for historical reference onlyand should not be relied upon for current information. For current fund information, please go to www.diamond-hill.com.

The price declines in the real estate finance sector have been steep and indiscriminate. The market has made littledistinction between residential and commercial real estate lenders, lenders who hold structured real estate debtsecurities, lenders who hold whole loans, lenders who rely on short-term financing, and lenders who have adequate long-term financing. Our principal exposure to real estate finance is as follows:

July 20, 2007 August 3, 2007

Countrywide Capital 7% Preferred 2.4% 1.8%Gramercy Capital 8.125% Preferred 1.9% 1.6%iStar Financial Common Stock 1.3% 1.1%Crystal River Capital Common Stock 1.0% 0.6%iStar Financial 7.875% Preferred 1.0% 0.9%iStar Financial 7.8% Preferred 1.0% 0.9%Northstar Realty Common Stock 0.8% 0.6%KB Home 7.75% Due 02/01/10 0.8% 0.8%Taberna I Preference Principal Protected 0.5% 0.5%Wachovia 7.25% Preferred 0.4% 0.4%Huntington 7.875% Preferred 0.3% 0.3%Beazer Homes 8.625% Due 05/15/11 0.2% 0.2%

11.6% 9.7%

The majority of this exposure is to preferred securities (senior in priority to the common stock) of real estate lenderswith leading market positions and, in our judgment, enduring franchises. While we are constantly reevaluating ourpositions, we believe that at current market prices this basket of securities should perform well over a medium to long-term investment horizon.

We have also sold all of our master limited partnership equity positions, which were 7.3% of the portfolio on July 20,2007. Additionally, while we continue to like the midstream energy business, the valuations are no longer as attractiverelative to so many other sectors that have been sharply revalued in the last several weeks.

Finally, as of August 3, 2007, our position in Treasuries, agencies, and cash is about 32% of the portfolio. An additional 5%of the portfolio is in preferred securities that we expect to be called within one year or corporate bonds that maturewithin one year. We are currently looking for opportunities in higher quality, higher yielding securities that are sufferingmore from the absence of liquidity than the reevaluation of credit risk.

While the bad news is that it will take some time for the credit markets to return to normalcy and that credit spreads canstill work their way out to wider levels, the good news is that this will create buying opportunities, the likes of which wehave not seen since 2002. We appreciate your support of the Diamond Hill Strategic Income Fund.

Kent K. Rinker William P. Zox, CFA Richard W. Moore, CFA



Greed gives way to Fear – August 16, 2007


Greed gives way to Fear:A discussion of the current investment market environment

Fear and GreedAn old adage about the financial markets is that they are driven by fear and greed. We have observed in recent periodsthat in many parts of the market it appears investors have been willing to ignore or downplay risk in the search forreturns. Recently, the worldwide equity and fixed income markets have been shaken as investors have transitioned fromgreed to fear. History is full of examples of the mercurial nature of risk appetites. In 1999 and early 2000, investors threwcaution to the wind, only to become very conservative as the tech bubble imploded.

Risk This so-called “repricing of risk” manifests itself in lower asset prices, as investors pay less for any given set of fundamentals. In many cases they also begin to question the level and direction of those same fundamentals. Thesechanges in risk appetite can often be very fast, and the effect is like a rubber band stretched too far in one direction. Thereturn journey can be very painful. We think we are in one of those periods where the excesses of recent history arebeing purged. It is a painful period, but one that we think plays to our strengths. Over the years we have seen many timeswhen those who take excessive risk are severely penalized; this appears to be one of those times.

Tighter credit conditions, housing, the economy and corporate profitsAs this risk repricing takes place, the suppliers of credit require more compensation for the credit they provide. In somecases, where creditors worry about the soundness of a business, they can decide to cut off credit entirely. We have seenthis in recent weeks, as businesses reliant on funding from the capital markets ceased certain operations, slowed theirgrowth or in some instances, filed for bankruptcy. The housing market has been particularly impacted as tighter creditconditions have taken many marginal buyers out of the market. As a result, homebuilders have been unable to sell theirinventory without significant price concessions. This impacts the pricing of existing homes for sale and the perceivedmarket value of all housing stock. Anecdotal evidence has suggested when home prices decelerate or decline, loandelinquencies increase, which ultimately may lead to a default, further increasing the supply of homes for sale.

The possible impact on the economy and profits is potentially significant for a number of reasons.♦ First, the consumer has been a big driver of economic growth. If the consumer balance sheet takes a hit from

declining home values or less access to credit, the economy would surely be impacted.♦ Second, residential construction has provided a large stimulus to the economy in recent years. That economic tail

wind is now a considerable headwind.♦ Lastly, as financial institutions take losses on consumer and mortgage lending, they are often less willing to lend,

further exacerbating the situation.

In the long term, this process is a positive. In hindsight, we can see that many people who should not have qualified forcredit or a home loan were able to qualify. Part of this is a result of the structure of the mortgage finance system.Historically, government sponsored enterprises dictated credit standards by defining what they would buy from mortgageoriginators. In recent years, the private market took over. Originators and investment banks retained little or noeconomic interest in the mortgages they originated or packaged. Like a game of hot potato, they let the next guy worryabout it. This only works so long as the ultimate holder continues to purchase the end product. The recent dislocations inthe market place are a direct result of this ultimate holder of mortgage securities going on strike as they try to come togrips with what they already own (and in many cases cannot sell).

Implications to Financial StocksThe results of these dislocations on the financial services industry may be long lasting and profound. Again, the epicenterof this storm is the residential mortgage market. The origination, funding, packaging and reselling of these loans haschanged rather dramatically in recent years. The private market’s creation of new mortgage products (ARM’s, optionARM’s, piggyback’s, etc.) and new structured finance products (CDO’s, CMO’s, CLO’s) has driven more complexity intothe system and an ever wider gap between the borrower and the ultimate lender.



Greed gives way to Fear – August 16, 2007


Moving forward, we believe this further pressures specialty lenders lacking strong funding sources as well as those capitalmarkets firms heavily leveraged to the packaging and distribution of structured products. We have already witnessednumerous specialty mortgage REITs disappear and the secondary market for most types of structured product isretrenching radically. On the flip side, these abrupt changes have reduced competition in many areas of the mortgagefinance market and clearly risk-adjusted pricing on almost all types of credit extension has improved recently. Longerterm, this re-pricing of risk along with a meaningful reduction in capacity in certain areas should bode well for thosedisciplined lenders that have exercised prudent standards in the past and continue to enjoy stable funding sources going

forward.

Our Approach to InvestingAt Diamond Hill we define risk as the probability of a permanent loss of capital or an inadequate long-term investmentreturn on that capital. Our investment philosophy is grounded in forecasting the fundamentals for the businesses weinvest in, making reasonable estimates of what those fundamentals are worth, and properly accounting for the risk inthese investments. These inputs are reflected in our calculation of intrinsic value. When the markets lose a sense of risk,or when investors are more focused on “what’s working” rather than on what is undervalued, our investment approachcan lose some of its effectiveness. In the short term, our absolute returns could suffer if the market experiences a furthercorrection. However, because we have been more price and risk sensitive, as the market focuses more on fundamentals,risk, and margin of safety, we expect to outperform.

In general, we are underweighted in financial stocks, which have been impacted significantly as investors try to figure out

who is holding the sub-prime bag. Market environments like this are opportunities for investors with long time horizons.In times of market chaos, investors tend to “throw the baby out with the bathwater.” We are prepared to take advantageof the opportunities that are thus created.

Focus on the Long TermAs volatile as recent weeks have been, the correction we have experienced has been relatively mild. (As of the date of this letter, the large cap Russell 1000 is down 9.7% from its peak and the small cap Russell 2000 is down 12.3%.) We think it is important to remember that in the short term, the market is often driven more by emotion than fundamental value.This is very true today, as investors’ time horizons have dramatically shortened in recent years. When “investors” have ashort time horizon, their decisions are generally poor decisions. It would be safe to say that if investors find the recentmarket volatility very stressful, they should consider if their equity exposure is too great.

We are long term investors, and we always recommend that our shareholders share our perspective. We remember the

market crash of 1987, the 1998 collapse of LTCM, and the 2000-2002 implosion of the tech bubble. Many individualinvestors dramatically reduce their exposure when the market experiences periods like these. In general, these actionsare as detrimental to long-term returns as is buying when the market is euphoric. To paraphrase Warren Buffett,investors should try to be fearful when others are greedy and greedy when others are fearful. As fellow shareholders, wetry to exhibit this temperament on your behalf through market cycles. While we cannot predict with any certainty whatthe market will do over the near term, we do think that over the long term we will be able to deliver absolute returnsthat will compensate you for the risk of the asset class while outperforming our peers.

As we always remain focused on the long term, we strive to have our decisions driven by our analysis, and not by ouremotions. For a perspective on recent market developments from a fixed income perspective, please see “Discussion of Current Fixed Income Market Environment,” which is available on our web site at www.diamond-hill.com .

William C. Dierker, CFA




Impact of August 17th Federal Reserve Board Actionon the Fixed Income Environment

August 21, 2007

On the morning of Friday, August 17, 2007, the Federal Reserve Board reduced the discount rate from 6.25% to 5.75% andallowed financing for as long as 30 days, renewable by the borrower, rather than overnight financing. Further, Fedrepresentatives arranged a conference call with leading commercial and investment banks urging them to use the Fed’s discountwindow as a sign of strength rather than the stigma that would normally be associated with such a move. Finally, the FederalReserve’s Open Market Committee, which is responsible for setting the more important federal funds rate, changed its risk assessment from its August 7 meeting stating, in part, that the “Committee is monitoring the situation and is prepared to act asneeded to mitigate the adverse effects on the economy arising from the disruptions in financial markets.”

We believe that these actions by the Fed are an important first step in the restoration of liquidity to the credit-sensitive fixedincome markets. The conditions that we described in our August 6, 2007 update on the fixed income markets continued todeteriorate prompting the Fed action. As an example, the yield on one-month Treasury Bills was 4.83% on August 6 compared

to the fed funds rate of 5.25%. Last week, the yield on one-month Treasury Bills declined from 4.62% to 2.96% and it was wellbelow 2% on the morning of August 21st.

Kent and Rick have been in the fixed income markets for 35 years each and have seen conditions like this only a couple of times.However, on each occasion liquidity was restored, and our markets functioned efficiently once again. More action may well beneeded, but we believe that the Fed and the federal government will do what is necessary to see that liquidity is in fact restored.

As significant investors, we share your anxiety, but we remind ourselves that the information imparted from market prices insuch an extreme environment is limited.


Diamond Hill Capital Management, Inc.



November 5, 2007


A Discussion on the Implications of Interest Rates and theValue of the U.S. Dollar to the investment markets

As we mark the 20 year anniversary of the market decline of 1987, I am reminded of the events of that day and their effects on the market. I was in my third year of managing an equity mutual fundand I remember it like it was yesterday. The declines were severe and the fear in the marketplacewas more extreme than I have experienced since that date. Yet, the effects were transitory and thedecline was brief. People forget the market finished up for the year and the bull market continueduntil the technology bubble finally burst in 2000. This bull market was aided, in part, by what becameknown as the Greenspan put, and it was first used following the steep decline of October 1987.

What do we mean by the Greenspan put? Following the market decline of 1987, the U.S. FederalReserve lowered interest rates and provided considerable liquidity to the markets to help investorsrecover from the effects of the equity decline. In many ways this helped lay the foundation for the

subsequent bull market. There were subsequently other occasions where Federal Reserve easinghelped to maintain the bull market.

I am reminded of these events by the recent action in the U.S. equity markets. The markets sold off severely as investors became concerned about the effects of the troubles in the subprime mortgagemarket. The response of the Federal Reserve was to lower rates quickly and decisively. The ½ pointdecline engineered by the Fed has been credited for the quick recovery of the market and itssubsequent recovery to record levels in the Dow Jones Index and the S&P 500.

The recent market action has given me reason for pause. The question I have been asking myself is,“What if there is market turmoil and the Fed does not ease?” Even worse, “What happens if they

tighten in the face of market decline?” The obvious response to that is to simply ask why would theFed do that? Clearly, it is something the Federal Reserve would not want to do but market eventscould force their hand. This is not unprecedented. In the late 1970’s and early 1980’s the centralbank was quite restrictive in the face of a weak economy due to high and rising levels of inflation.This was very painful and not something the Fed wanted to do, but was necessary to set the stage forlong-term prosperity. This also coincided with a severe bear market in equities so it is an importantfactor to monitor.

If this is not something the Fed would want to do, what is it that would cause the Fed to respond in arestrictive manner to market volatility? I have been monitoring several indicators which might leadto this response and chief among them is the value of the dollar. I have included a graph showing the

long-term decline in the value of the dollar at the end of this letter. The U.S. currency has been in amulti-year bear market and the latest Fed easing only accelerated the decline. If the Fed perceivedfurther easing would exacerbate the dollar’s decline, it may be restrained in responding to marketdeclines. The dollar’s value is especially important because the U.S. is an importer of capital. Foreigninvestors may be reluctant to continue investing if the market decline continues.



November 5, 2007


We are also monitoring inflation indicators in case rising inflation could create a cautious FederalReserve. Right now those indicators are mixed. Inflation, as measured by the CPI, is relatively tame.However, PPI inflation is more troubling. The PPI is impacted much more severely by risingcommodity prices. To date, we have seen significant increases in commodity prices with very littleincrease in inflation. If this acceleration in the PPI inflation measure is a precursor to future increases

in inflation, then the Fed’s job becomes more difficult.While we have been monitoring these indicators for some time, this issue is much more topical asthe recent Fed ease triggered a significant market rally. We are concerned that investors arebecoming complacent and we wanted to highlight these important issues to our shareholders. Wewill continue to monitor these indicators, but we wanted to inform you of these important concernsregarding the opportunities in the equities markets. Currently, these are only concerns. However, if these currency or inflation indicators become more problematic it could create difficulties for theequity market.

U.S. DOLLAR INDEX FROM DECEMBER 1999 THROUGH OCTOBER 2007

Charles S. Bath, CFA



November 5, 2007


PORTFOLIO HOLDINGS @ 9.30.2007 of APA, DVN and COP in Large Cap Fund (5.8%, 5.5%, 5.3%), Long-Short Fund

(5.8%, 5.4%, 5.4%) and Select Fund (5.9%, 5.7%, 5.2%), respectively.

An Update – One Year Later

A year ago, we communicated our thesis and reasoning for continuing to hold a large percentage of our portfolio in energy related businesses. At the time, crude oil and natural gas prices had fallen torecent lows and our investments had followed. Our decision to continue holding our positions (and

subsequently adding to them) may have seemed controversial at the time; however, as we explainedin our letter last October, we were simply following our investment discipline. Upon re-assessingour estimates of intrinsic value, we concluded that our stakes were trading at larger discounts tointrinsic value.

Over the past year, energy market fundamentals have tightened and commodity and stock prices haverebounded. As a result, our energy holdings have been a significant contributor to positiveperformance in our funds. For example, the three largest energy holdings in many of our funds areDevon Energy, Apache Corp., and ConocoPhillips. The 12-month total return (9/29/2006 thru9/28/2007) for these three stocks is shown in the chart below:

-10%

0%

10%

20%

30%

40%

50%

60%

9 / 2 9 / 2 0 0 6

1 0 / 1 3 / 2 0 0 6

1 0 / 2 7 / 2 0 0 6

1 1 / 1 0 / 2 0 0 6

1 1 / 2 4 / 2 0 0 6

1 2 / 8 / 2 0 0 6

1 2 / 2 2 / 2 0 0 6

1 / 5 / 2 0 0 7

1 / 1 9 / 2 0 0 7

2 / 2 / 2 0 0 7

2 / 1 6 / 2 0 0 7

3 / 2 / 2 0 0 7

3 / 1 6 / 2 0 0 7

3 / 3 0 / 2 0 0 7

4 / 1 3 / 2 0 0 7

4 / 2 7 / 2 0 0 7

5 / 1 1 / 2 0 0 7

5 / 2 5 / 2 0 0 7

6 / 8 / 2 0 0 7

6 / 2 2 / 2 0 0 7

7 / 6 / 2 0 0 7

7 / 2 0 / 2 0 0 7

8 / 3 / 2 0 0 7

8 / 1 7 / 2 0 0 7

8 / 3 1 / 2 0 0 7

9 / 1 4 / 2 0 0 7

9 / 2 8 / 2 0 0 7

ConocoPhillips (CO P) Apache Corp. (APA) Devon Energy Corp. (DVN)

We have always emphasized to our clients that we follow a disciplined intrinsic value approach with a

long-term perspective and recommend that clients share our philosophy. While admittedly over ashort period of time, this is one example when our strategy was very successful. We may find itnecessary in the future to again invest in a controversial situation when the long-term opportunity

justifies the investment. Not all such investments will be this successful. However, finding true long-term value often requires we invest in areas of short-term uncertainty.

DVN

+ 32.7%

APA

+ 43.7%

COP

+ 50.8%



November 27, 2007


Update on Diamond Hill Strategic Income Fund

November has been the most difficult month in the history of the Diamond Hill Strategic IncomeFund. Much of the weakness can be explained by the performance of the preferred securities in ourportfolio. The Strategic Income Fund has long had an allocation to preferred securities (preferreds)in the 40-45% range.

After selling off in July through mid-August, the preferred market, as measured by the Merrill LynchUS Preferred Stock Fixed Rate Index, rebounded 5.4% between August 16 (the day before theFederal Reserve lowered the discount rate by 50 basis points between its regularly scheduledmeetings) and the end of October. This rally was attributable in large part to the return of liquidityto the preferred market as brokers once again committed capital after fleeing the market in August.

On October 31, the date of its last scheduled meeting, the Federal Reserve cut the Fed Funds ratefrom 4.75% to 4.5% but suggested that a cut at its December 11 meeting was unlikely unlessconditions deteriorated even more than anticipated. Since that meeting, the preferred market hasgiven back all of the post-August 16 gains and more. From October 31 through November 26, theMerrill Lynch preferred index is down 8.6% on a total return basis. On a year-to-date basis, thepreferred index is down 10.4%. After the Fed’s more hawkish statement, there has been another legdown in market expectations of residential mortgage losses and a heightened concern that thoselosses will spread to other sectors of the economy. Once again, the brokerage firms have withdrawncapital from the preferred market at least until their 2008 fiscal year, which typically begins eitherDecember 1 or January 1. While institutional participation in the preferred market has increased, themarket becomes very illiquid without the brokers’ capital and small 100 or 1,000 share retail tradeson the exchange can literally cause multi-percentage point declines in quoted prices.

In response to the deteriorating conditions in the credit markets, we raised our allocation to cashand callable agency securities to a range of 15-30% and we remain at the higher end of that range.We did, however, maintain our large preferred allocation through the summer and into the fall forseveral reasons. First, we did not believe that Treasuries offered sufficient yield to meet our incomeobjective. Second, we felt that preferreds offered attractive yields with much higher credit qualitythan high-yield bonds. Within our preferred allocation, we swapped a number of unrated REITpreferreds for preferreds issued by much larger, highly-rated financial institutions. Over the last twoquarters, this positioning has been punished in the marketplace. The Treasury market has ralliedcontinuously, there has been nowhere to hide in the preferred market, and high yield has held upmuch better. However, we do not manage the Fund on a one- or two-quarter time horizon and westill believe that the positioning will be rewarded over a longer time horizon.



November 27, 2007


To put November’s performance into perspective, the Merrill Lynch preferred index has beencalculated since April, 1989. Of the 223 months of total return data, 51 months (23%) have hadnegative total returns. Eleven of the 223 months (5%) have had negative returns worse than minus2%. Those months are as follows:

Month Ending TotalReturn (%)

1/31/1990 -5.28

4/30/2004 -4.64

4/30/1990 -4.55

3/31/1994 -4.10

12/31/1999 -3.38

7/31/2003 -2.82

3/31/2005 -2.777/31/1989 -2.77

9/30/1990 -2.42

7/31/2007 -2.06

2/28/1994 -2.02

On an annual basis, the Merrill Lynch preferred index has had two negative years since 1990. In1994, the index declined 5.7% (followed by a positive 20.4% in 1995) and in 1999 the index declined4.4% (followed by a positive 16.2% in 2000).

We do not suggest that historical returns are predictive of future returns. We mention this data onlyto place the November and year-to-date 2007 declines in context. The preferred market is a fixedincome market; it is not an equity market. Declines of this magnitude over this short a period of time are highly unusual.

To give you an example of what has happened, National City issued a preferred at 6.625% in late May,2007, at a time when the 30-year Treasury yield was about 5%. In late August, National City issued apreferred at 8% that is now trading at $24.01 for a yield of 8.5% (this security represents 2.03% of netassets at October 31, 2007). The 30-year Treasury yield is now about 4.3%. So the spread overTreasuries for National City preferred has widened from 1.625 percentage points to 4.2 percentagepoints. This kind of a move is representative of the broader preferred market.



November 27, 2007


Another way to put the preferred market into perspective is to compare the yield of a basket of preferreds issued by well-known companies to the expected return of the S&P 500. A reasonablecase can be made that the S&P 500 is priced for an annualized return of 8% over the next five years.Compare that to the following preferred securities and their strip yields:

Issue Yield (%) S&P Rating % of NetAssets @10-31-2007

Bank of America 7% 7.5 A+ 0.86

Citigroup 6.95% 8.0 A+ 1.51

Comcast 7% 7.9 BBB+ 1.87

Fifth Third 7.25% 8.6 A- 1.24

Huntington 7.875% 8.4 BBB 0.45

Kimco Realty 7.75% 8.4 BBB+ 1.99

Merrill Lynch 7.12% 8.4 A- 0.74

National City 8% 8.5 BBB+ 2.03

US Cellular 7.5% 8.6 BB+ 0.71

Wachovia 7.25% 7.7 A 1.96Equal Weighted Average 8.2

All of the preferred securities in the Strategic Income Fund are senior in priority to the commonequity. Corporate managers should now realize that their highest priority is to restore the market’sfaith in their creditworthiness. Our opinion is that over the next several years, the preferred issuerswill in fact focus on restoring their credit and spreads over Treasuries will revert back to a morenormal level closer to two percentage points. Recognizing that the Treasury yield may well be higherat that time, we expect that preferred yields for BBB and A issuers will be closer to 7% than 8% asthe environment improves. Depending on the coupon and current price level, such a decline in yieldcould result in the addition of 10 percentage points or more to total return above the 6-7% annualcash yield. Of course this is our opinion, there are no guarantees and performance could bematerially worse than our expectation.

Our confidence in the long-term from today’s levels is tempered by our concern with the marketsover the next several months and quarters. The predominant issuers of preferred securities arefinancial services companies and real estate investment trusts. The environment for these companiesis very difficult and getting worse. More write-offs will probably be announced, or preannounced, andmore bad news on the housing front awaits. Wall Street is not willing to carry positions into the endof the year, so market moves on individual securities will be exaggerated. At the same time, financialservices firms are issuing preferreds at a rapid pace to shore up their capital positions, which isfurther pressuring the secondary market. In summary, we believe that the preferred market is cheap(pricing in plenty of bad future news), but there is no telling how much cheaper it may get before itturns around.



March 17, 2008

Diamond Hill Investments 59 Investors should consider the investment objectives, risks, charges, fees and expenses of the Diamond Hill Fundscarefully before investing; this and other information including fund performance and a prospectus can be obtained atwww.diamond-hill.com . Read the prospectus carefully before you invest. Fund Holdings are subject to changewithout notice. The value of fixed-income securities varies inversely with interest rates; that is, as interest rates rise,the market value of fixed-income securities will decline. Lower quality debt securities involve greater risk of defaultor price changes due to potential changes in the credit quality of the issuer. Diamond Hill funds are not FDIC

insured, may lose value, and have no bank guarantee. Distributed by IFS Fund Distributors, Inc., MemberFINRA/SIPC, 303 Broadway, Suite 1100, Cincinnati, Ohio 45202.

Update on Diamond Hill Strategic Income Fund

The unwinding of leverage in the financial markets has accelerated dramatically in recent days culminating in theNew York Fed’s intervention on behalf of Bear Stearns (a 0.0% position as of 2/29/08) on Friday. Even firms withhigh quality assets have been brought to (and in some cases past) the brink of insolvency because their lenders haveforced the sale of assets into inhospitable markets. This has led to yet another intense wave of fear with spikingvolatility and significant declines in the prices of stocks, corporate bonds, and most other risk-based assets.

It is likely that the economy is in recession, house prices will continue to decline, and defaults on all sorts of creditinstruments will accelerate in coming months. Markets, however, are forward looking and they will almost certainlybegin to discount (not necessarily good but) better days well before the worst is over in the real economy. Webelieve that the securities that we are concentrated in – preferred securities, corporate bonds, bank stocks- will doquite well when the markets begin to look beyond the point of maximum uncertainty and fear.

Progress has been made on the factors that we have been looking for to signal a better environment. Financialinstitutions have recognized or forecasted substantial losses and raised capital to offset a good portion of thoselosses. The roughly 10% decline in home prices has improved affordability although lower prices and/or lower

interest rates will be required to return affordability to the long run average. While the Federal Reserve is facedwith an enormously complex and difficult task, it has developed several unique initiatives designed to stabilize thedebt markets and to bring down the cost of financing for home owners. Congress now seems well aware of theissues and likely to contribute to a solution if necessary. The risk-adjusted yields on many credit instruments(preferred securities, corporate bonds, leveraged loans, municipal bonds) are now well above the bogies required bymany investors with (and this is the key point) either no or very low levels of leverage. The turning point may onlyrequire a shift in psychology, the timing and proximate cause of which nobody knows.

As the managers of an unleveraged portfolio with a long-term time horizon, we can step back from the inevitableday-to-day anxiety to better position the portfolio. Since the end of the year, we have decreased our preferredexposure from 43% to 39%. More importantly, within the preferred portfolio, we have sold a number of smaller,lower quality issues and replaced them with new issues such as M&T Capital Trust IV 8.5% (a 1.5% position as of 2/29/08), Xcel Energy 7.6% (a 1.5% position as of 2/29/08), Duke Realty 8.375% (a 1.1% position as of 2/29/08), andPNC Capital Trust 7.75% (a 1.5% position as of 2/29/08). We have increased our corporate bond allocation thisyear from 26% to 35%. The option adjusted spread of the Merrill Lynch Cash Pay, BB Rated Index is currently 590basis points, up from 201 basis points one year ago and 458 basis points at the beginning of 2008. We have addedpositions in such corporate bonds as Freeport-McMoRan 8.25%, Due 04/1/2015 (a 2.7% position as of 2/29/08),Trinity Industries 6.5%, Due 3/15/2014 (a 1.2% position as of 2/29/08), and Xerox 7.625%, Due 6/15/2013 (a 1.5%position as of 2/29/08). Finally, we sold the common stocks of two commercial finance REITs early in the year andadded to our positions in the common stocks of US Bancorp (a 1.4% position as of 2/29/08), Wells Fargo (a 1.3%position as of 2/29/08), Wachovia (a 1.2% position as of 2/29/08), Huntington (a 1.4% position as of 2/29/08), andSynovus (a 1.3% position as of 2/29/08). We still have 15% in cash and two callable agency securities.

We appreciate your continued support of the Diamond Hill Strategic Income Fund.




March 17, 2008

Diamond Hill Funds 60

EXHIBIT A

The table below includes the historical returns for the Diamond Hill Strategic Income Fund.

Period & Annualized Returns as of 2/29/2008

Fund / Benchmark 1Month 1Year 3Years 5Years Life of Fund

Total

ExpenseRatioStrategic Income Fund Inception Date: 9/30/2002

Class ANAV -2.26% -4.49% 2.83% 6.64% 7.66% 1.10%POP -5.64% -7.83% 1.62% 5.89% 6.96% 1.10%

Class CNAV -2.40% -5.22% 2.06% 5.83% 6.96% 1.85%POP -3.37% -6.11% 2.06% 5.83% 6.96% 1.85%

Class I NAV -2.22% -4.10% 3.26% 6.90% 7.90% 0.71%Merrill Lynch Domestic Master Index 0.38% 7.98% 5.43% 4.65% 4.88% --

The performance data quoted represents past performance; past performance does not guarantee future results. Theinvestment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worthmore or less than their original cost. Investors should consider the investment objectives, risks, and charges and expenses of theDiamond Hill Funds carefully before investing. This and other information about the Funds is in the prospectus, which can beobtained at www.diamond-hill.com. Read the prospectus carefully before you invest. The Funds’ current performance may belower or higher than the performance data quoted. To obtain performance information current to the most recent month-end,please visit www.diamond-hill.comor call 1-888-226-5595.

Performance is not guaranteed. Performance returns assume reinvestment of all distributions.Average annual total returns illustrate the annual compounded returns that would have produced thecumulative total return if the Fund’s performance had remained constant throughout the periodindicated. Returns for the periods less than one year are not annualized. These total return figures mayreflect the waiver of a portion of a Fund’s advisory or administrative fees for certain periods. In suchinstances, and without such waiver of fees, the total returns would have been lower. The maximumsales charge is 3.50%. The investment return and net asset value will fluctuate, so that an investor’sshares, when redeemed, may be worth more or less than the original purchase price. Diamond HillFunds are distributed by IFS Fund Distributors, Inc ., Member FINRA/SIPC, 303 Broadway, Suite

1100, Cincinnati, Ohio 45202.

As of April 30, 2009, BHIL Distributors, Inc. (Member FINRA) became distributor for its affiliate, theDiamond Hill Funds.

Information contained herein is intended as a snapshot as of the date of this investment letter and isretained for historical reference only and should not be relied upon for current information. Forcurrent fund information, please go to www.diamond-hill.com.



March 24, 2008


During the last week, the crises seemed to reach new level of panic as Bear Stearns was essentially shut down by thecapital markets and forced to seek a buyer to stave off bankruptcy. One of the more interesting aspects of the BearStearns deal is the fact that the Federal Reserve is providing them (through J.P. Morgan) with a $30 billion non-recoursecredit facility. After observing this transaction, along with other unprecedented steps the Fed has recently taken, onemight readily conclude that our federal government is now paying special attention to this situation and is willing to takeextraordinary measures to return our financial system to a state of normalcy. This is extremely important for both thecredit and equity markets and in particular for the financial services sector. In short, the Federal Reserve, along withCongress and the White House, will do essentially whatever it takes to stabilize and protect our financial system. As wesaw in the case of Bear Stearns, that does not mean equity investors are without risk, but it does greatly reduce thevulnerability to a systemic meltdown and is strongly positive for those companies positioned to take advantage of opportunities as the environment improves.

With that background, we can now spend a few moments on specific areas we are investing in and those that we areavoiding. By far our largest exposure within the sector is the banking industry. We have long been biased to this industryfor many reasons, not the least of which are the stability of deposit based funding and the industry’s importance to ouroverall economic health. The banking system has been under tremendous pressure of late due to concerns over bothmargins and credit quality. Clearly, credit is now decidedly negative and remains a risk, while margins are beginning tostabilize and the yield curve is quickly becoming more favorable for the industry. On the credit front, we are still seeingdeterioration in many different loan classes. However, this industry trend has now been in place for over a year and inmost cases, the required reserving is well underway and future reserve additions are now, in our opinion, largely

discounted in the stocks. Again, with the benefit of hindsight, credit risk in general was under-priced for at least a coupleof years. However, the cost of credit has increased dramatically in last few months and should be very positive for theindustry’s risk adjusted margins going forward. In other words, the industry is currently under significant pressure and isbeing valued at depressed multiples on well below “normalized” rates of return.

Source: Factset

We also have exposures – albeit more modest – to the insurance and investment banking businesses in most strategies.Within the insurance industry, a situation worth highlighting is one of our larger holdings, American International Group(AIG). The company has an outstanding track record and an unparalleled worldwide insurance franchise. We seeexceptional value in the stock and believe that current GAAP accounting convention has created at least some of thisopportunity. The company’s stock has been under considerable pressure over the past month as its fourth quarterincome reflected several “mark to market” losses. Based upon our understanding of the exposures involved, we do not

see the bulk of these losses as economic in nature. For example, AIG experienced an $11.12b pre tax loss for valuationadjustments with respect to AIG’s super senior credit default swaps. AIG’s own stress testing indicated a $900meconomic loss potential on these swaps under a “severe stress scenario”. In other words, the economic reality, while notcompletely benign, looks much less severe than current accounting rules would suggest. And while this may be anextreme example, similar situations have occurred at many firms throughout the sector.

Areas that we continue to be especially leery of include those business models that are overly exposed to low qualitymortgages and/or capital markets based funding. We have seen numerous entities from the mostly non-regulated“specialty financial” space encounter catastrophic problems due to either poor asset quality or the lack of stable andsecure liquidity.



March 24, 2008


Again, at the center of the storm is residential real estate. It has been decades since we have experienced home pricedepreciation like we have seen in the past 18 months. The mortgage finance industry does not have enough “excessmargin” to avoid significant losses when net charge offs are rising to the levels we have seen recently. However, as wepointed out earlier, there seem to be a number of political and regulatory tail winds developing. Two more notableexamples are the newly created $200 billion Primary Dealer Credit Facility which is geared towards thebrokers/investments banks as well the recent OFHEO (the regulator of the GSE’s) actions to relax the capitalrequirements for Fannie Mae and Freddie Mac. The liquidity provided by these actions along with lower interest ratesand of course, the depreciation we have already experienced, should begin to mitigate further declines in both homeprices and many types of underlying securities.

We also do not believe that what is occurring in the residential market is likely to be repeated on the commercial side.As the residential market took off, a massive supply of new homes was built and now that demand did not keep pace, alarge inventory of unsold homes remains on the market.

Estimated Supply of Unsold Homes in Months

Source: Bloomberg

This overbuilding also occurred during the last commercial real estate cycle. However, in recent years, growth in newcommercial real estate supply has been modest due mostly to skyrocketing construction costs, investors not wanting torepeat the mistakes of the last cycle and an increasingly difficult permitting process. Also, most commercial propertieshave long-term leases that will provide some stability. One factor in the rise of commercial real estate prices in recent

years has been the ability of landlords to raise rents. Many leases signed at low rates during the last recession are due toreset in the coming years, increasing the property’s cash flow to the owner. Growth rates in rent will surely slow andvacancy rates will likely increase, but ultimately we believe that the supply/demand fundamentals in the commercial realestate space are healthier than residential real estate.

To conclude, as many of you already know, we are an intrinsic value based firm and are always comparing stock priceswith our estimates of value. The difference between price and value is often referred to as the “margin of safety” and actsas our most important risk reduction tool. At times, our philosophy leads us to areas of the market where fundamentalsare challenged and conversely we are occasionally divesting where things are rosy if the positive fundamentals are fullyreflected in a company’s valuation. In the aftermath of the Bear Stearns deal and subsequent Fed easing and market rally,many are once again asking if we have “seen the bottom”. Our response to this question is usually something along thelines of “who knows, we can’t predict short term stock price movements”. All we can do is follow our process of



March 24, 2008

Diamond Hill Investments 6 4Investors should consider the investment objectives, risks, charges, fees and expenses of the Diamond Hill Fundscarefully before investing; this and other information including fund performance and a prospectus can be obtained atwww.diamond-hill.com . Read the prospectus carefully before you invest. Fund Holdings are subject to changewithout notice. For the Small Cap Fund and Small-Mid Cap Fund, there are specialized risks associated with smallcapitalization issues, such as market illiquidity and greater market volatility than large capitalization issues. TheLong-Short Fund and Financial Long-Short Fund uses short selling which incurs significant additional risk.Theoretically, stocks sold short have unlimited risk. Diamond Hill funds are not FDIC insured, may lose value, andhave no bank guarantee. Distributed by IFS Fund Distributors, Inc., Member FINRA/SIPC, 303 Broadway, Suite1100, Cincinnati, Ohio 45202.

As of April 30, 2009, BHIL Distributors, Inc. (Member FINRA) became distributor for its affiliate, the Diamond HillFunds.

Information contained herein is intended as a snapshot as of the date of this investment letter and is retained forhistorical reference only and should not be relied upon for current information. For current fund information, pleasego to www.diamond-hill.com .

Performance data previously included in this investment letter has been removed.

estimating intrinsic values using a long time horizon and waiting for the market to give us opportunities to buy at adiscount. For a variety of reasons, many of which we have outlined above, we believe the current environment isproviding many such opportunities in the financial services sector.

As always, we would like to thank our clients and shareholders for their continued support.

Christopher M. Bingaman, CFA



March 24, 2008

Diamond Hill Investments 6 5

EXHIBIT A

Following is a list of securities in the financial services sector, some of which are mentioned in thediscussion above, and the percent each represents of the respective Diamond Hill equity mutual fundsas of February 29, 2008. Portfolio holdings are subject to change without notice.

Portfolio Weight as of 2/29/2008

Ticker Company Name

SmallCapFund

Small-Mid Cap

Fund

LargeCapFund

SelectFund

Long-ShortFund

FinancialLong-ShortFund

Long HoldingsAIG American International Group, Inc. -- -- 3.5% 4.1% 2.8% 5.2%WFC Wells Fargo & Co. -- -- 2.9% 4.4% 3.2% 4.9%USB U.S. Bancorp -- -- 3.4% 4.5% 3.4% 4.5%WB Wachovia Corp. -- -- 1.3% -- 1.3% 4.2%MER Merrill Lynch & Co., Inc. -- -- 1.7% 2.0% 1.5% 3.9%BAC Bank of America Corp. -- -- 1.2% -- -- 3.8%

HBAN Huntington Bancshares, Inc. -- 2.8%1.3%

1.6% 1.2% 3.4%BK Bank of NY Mellon Corp. -- -- 1.2% -- -- 3.4%ALL Allstate Corp. -- -- 0.5% -- -- 3.0%C Citigroup, Inc. -- -- -- -- -- 3.0%PNC PNC Financial Services Group -- -- -- -- -- 3.0%WM Washington Mutual, Inc. -- -- 0.8% -- 1.1% 2.9%SNV Synovus Financial Corp. -- 1.7% 1.5% 2.1% 1.5% 2.5%MS Morgan Stanley Co. -- -- -- -- -- 2.3%CWC.PR Countrywide Cap 7.00% Pfd -- -- -- -- -- 2.1%UFCS United Fire & Casualty Co. 1.9% 2.0% -- -- -- 2.1%PRU Prudential Financial, Inc. -- -- -- -- -- 2.0%FSNM First State Bancorp 1.6% -- -- -- -- 1.8%

MAA Mid-America Apart. Comm. 1.5% 1.6%--

-- -- 1.8%SFI Istar Financial, Inc. 0.8% 1.2% -- -- -- 1.7%THG Hanover Insurance Group 1.7% 1.4% -- -- -- 1.7%SOV Sovereign Bancorp, Inc. -- 1.2% -- -- -- 1.7%FRE Freddie Mac Corp. -- -- -- -- -- 1.5%SRCE First Source Corp. 1.3% -- -- -- -- 1.4%BANR Banner Corp. 1.2% -- -- -- -- 1.4%DFS Discover Financial Services -- -- -- -- -- 1.4%CMA Comerica, Inc. -- 1.1% -- -- -- 1.4%AIZ Assurant, Inc. -- 1.3% -- -- -- 1.3%UCBH UCBH Holdings, Inc. 1.2% 1.2% -- -- -- 1.3%CCOW Capital Corp. Of The West 0.9% -- -- -- -- 1.2%

GRNB Greene County Bancshares -- ----

-- -- 1.0%HAFC Hanmi Financial Corp. 1.2% 0.5% -- -- -- 1.0%TAYC Taylor Capital Group, Inc. 1.1% -- -- -- -- 0.9%CYN City National Corp. -- 0.9% -- -- -- 0.9%PRE Partner Re, Ltd. -- -- -- -- -- 0.9%CBHI Centennial Bank Holdings, Inc. 1.2% -- -- -- -- 0.9%IMP Imperial Capital Bancorp 0.9% -- -- -- -- 0.8%FCTR First Charter Corp. -- -- -- -- -- 0.7%

Total Long Financial Holdings 16.6% 18.3% 19.4% 18.8% 16.0% 83.0%



March 24, 2008


EXHIBIT A, continued

Short HoldingsCHCO City Holding Co. -- -- -- -- -- -2.2%KRE Kbw Regional Banking Etf -- -- -- -- -- -1.6%NTRS Northern Trust Corp. -- -- -- -- -- -1.0%

BSC Bear Stearns Co., Inc. -- -- -- -- -- -0.7%EPHC Epoch Holding Corp. -- -- -- -- -- -0.7%MTB M & T Bank Corp. -- -- -- -- -- -0.5%KBW Keefe, Bruyette And Woods -- -- -- -- -- -0.5%VCBI Virginia Commerce Bancorp -- -- -- -- -- -0.4%

Total Short Financial Holdings -- -- -- -- -- 7.7%

Total Financial Sector Weight 16.6% 18.3% 19.4% 18.8% 16.0% 75.3%



August 8, 2008


“It is better to be approximately right,than precisely wrong.”

The above quote from Warren Buffett suggests to us that if we can assess the future economic fundamentals reasonably

well and maintain our valuation discipline, we will continue to provide a value-added service to those who invest with us,which is our mission at Diamond Hill.

The first half of 2008 has been a character-building time for investors, to say the least. We certainly understand (perhapsbetter than most) that during periods like this it can be very difficult to maintain a long-term focus and ignore theconstant barrage of incoming market data and analysis which eventually may persuade some people to make irrational,short-term, adjustments to their investment portfolios. The following is an excerpt from an email that I sent to a worriedclient on July 17th which hopefully provides some insight into our perspective:

The US markets have been experiencing pressure over the past year. While we only know the end of it after-the-fact, yesterdays large advance may suggest that the worst is behind us. The combination of the energy price shockand bursting of the housing bubble has resulted in a weak economy, and this is reflected in the markets. My best

guess is that markets finish the year higher than current levels, and while we do not believe that “the next bull

market is just around the corner” we do suggest that on a five year rolling basis, we will continue to be able toprovide clients satisfactory investment returns. That being said, don’t be surprised by continued volatility, as theeconomic challenges ahead, such as inflation pressures and a weak economic growth, will exact a toll on investors’ emotions. My suggestion is to try to ignore the short term rollercoaster – thinking in a rolling five year frameworkhelps to do this. Over the past five years, returns were good. Over the next five years, returns should be sufficient.(Over the next five months – who knows?) The biggest danger is getting “whip-sawed” – changing your long terminvestment plan at the bottom of the valley due to fear (or top of the hill, circa 1999, due to irrational exuberance).

At the outset of Diamond Hill eight years ago, Tom Schindler and I suggested that the US equity market had becomebifurcated, and that Large Cap index returns would suffer as a result of extreme over-valuation for at least the totality of this decade. We positioned client portfolios accordingly, and generally our view has come to pass, even though we alsosuffered over short periods of time - especially during the 3rd quarter of 2002. Small and Mid Cap stocks have faredmuch better than Large Caps, providing long term results similar to historic norms. In a commentary (“5 Year Forecast &Our Investment Approach” - March 2001), we discussed issues surrounding a market pullback similar in magnitude towhat we recently have seen from the market levels reached again last year.

More than four years ago, Chuck Bath wrote that the era of disinflation had ended its 20 year reign, being replaced bytight supply-demand conditions that would lead to upward pressure in commodity prices, most notably energy (“TheTimes They Are A-Changin’” - March 2004). He has said that this too is a long term phenomenon - both in its makingand its ultimate resolution. Accordingly, stocks of natural resources producers have done very well, dwarfing theperformance of stocks from all other economic sectors. Yet, during various short periods over the past four years, thosesame stocks did poorly (as Tom Schindler discussed in detail in a September 2006 piece). However, keeping thosepositions intact has been important for excellent long term results.

Currently we stand in the midst of disarray amongst stocks in the financial sector. The bursting of the housing bubble hasled to record foreclosure rates and loan losses, as well as the seizing up of most of the fixed income markets. Thedramatic collapse of Bear Stearns will be remembered as an event indicative of the stress to the system, just as thecollapse of Enron recalls the excesses of the preceding decade.

In Chris Bingaman’s Commentary from the 2006 Annual Report, he commented on historically high valuations for financialstocks, which by itself is always troubling. In that year’s semi-annual report we also made mention of the narrow creditspreads, which was indicative of complacency among lenders. We kept our long positions limited to a few of the higherquality institutions, and sure enough, beginning last year revelations consistent with our view came to fore. We nowrealize that we underestimated the magnitude of the problem, and with the benefit of hindsight we should have had nolong positions at all and maintained our short positions for a longer period than we did.

Our forecast for the next five years is for broad US equity returns of 8% annualized, with the average financial stock returning something much higher. For instance, if one arrayed the stocks of the financial sector, the median annualized



August 8, 2008


return might be 12%, with stocks at the top of the list compounding over 30% and perhaps a 100% loss for stocks at thebottom of the list. In contrast, we expect energy stocks to continue to provide above average returns, and while few (if any) may have as much upside as 30% compounded, we would be surprised if most did not have positive returns frompresent levels. The consumer discretionary sector is most likely to under perform the averages, as we doubt investorshave adequately discounted the lingering effect on consumer spending from higher gasoline prices coupled with declines inhouse prices.

As we view return and risk, we are always trying to balance the long term expected return on the capital we invest withthe risk of loss of capital. Our long term forecasts of economic fundamentals will not capture the short term marketmovements caused by investor emotions, but the latter we hope to mitigate with our valuation discipline. The recentmarket declines have presented us with many attractive opportunities to pursue, and as always we will continue to investthe capital entrusted to us with the same care and diligence with which we invest our own capital.

Thank you for your continued support.

Diamond Hill Investments

Ric Dillon, CFAChief Investment Officer



November 24, 2008


Historical Perspective on Bear Markets and Our CurrentMarket Outlook

A Review of Past Bear Markets

Broad stock market declines are very disturbing. They come about as a result of stock prices climbing too high (greed) incombination with developing economic problems, and are usually exacerbated by human emotion (fear). Stock pricesexperienced a solid five year run from 2003-2007 in virtually all stock markets around the globe with the S&P 500returning 82% during the period. In 2008, the world-wide banking crisis has ushered in a recession, which very well maybe pronounced, in terms of depth and length. If so, this will rival the 1973-1974 recession as the worst since The GreatDepression. The stock market declines over the past 13 months have already approximated the 1973-1974 declines of 50%.

As another point of comparison, 2008 is on track to be the single worst year ever for the stock market and is oftencompared to the period from 1929-1932 when the market declined 88%. It should be noted that in the 1929-1932depression, unemployment reached 25% and GDP declined by 15%; we would expect worst case scenarios for the 2008-2009 recession of unemployment of 10% and a GDP decline of no more than 5%.

The actions taken by the Federal Reserve in 2008 stand in sharp contrast to policymaker actions during the depression.In the 1929-1932 depression the Fed raised the discount rate on several occasions, failed to address a shrinking moneysupply and stood by passively as countless banks failed. To deal with the current crisis the Fed has aggressively cut rates,facilitated significant growth in the money supply and pulled out all the stops in its efforts to support banks and otherfinancial institutions.

In late 1999, Warren Buffett wrote a piece for Fortune magazine, in which he said that the next 17 years would be insharp contrast to the previous 17 years from 1982-1999, primarily due to the high price level of the stock market. Hesuggested that these long periods are not unusual, mentioning 1966-1982 as a similar long period of below averagereturns. Last month Mr. Buffett wrote an op-ed piece for the New York Times, saying he was buying U.S. stocks now,relating the dictum that one should buy when people are fearful (and therefore prices are low), and sell when people aregreedy (prices are high).

Current Valuations

We agree with Mr. Buffett and we too have become much more positive on stocks, knowing that while the economy willget worse as we enter 2009 and may not notably improve for a year or more, the stock market will reach a bottom wellin advance of such a recovery. Perhaps the best valuation support is that the current dividend yield on the S&P 500 isnow greater than the yield on the US Treasury 10-year note for the first time in 50 years! If the S&P 500 only returnedto its April 2000 level in the year 2016, that appreciation, coupled with the dividend yield, would result in an annualizedtotal return of over 12%. Given today’s very low money market rates of 2%, this suggests that stock investors would benicely rewarded under that scenario.

Other asset classes such as non-US equities, as well as many fixed income securities, have similarly attractive returnprospects, as the current need for liquidity by some market participants seems acute. Corporate bonds, in particular, areat record low valuations compared to other asset classes. Stocks should benefit from lower corporate bond yields asdebt markets recover. Someday this bear market will end, but that may not be until sometime next year: the timing of such is unpredictable. Yet as long-term investors we will continue to search for attractive investments. The biggestchallenge will be our fundamental estimates of income statements, balance sheets, and cash flow statements. History maybe of limited use in those efforts.

At the bottom in August of 1982, my model forecast a 5-year annual return of 20%, driven largely by a forecast of lowerinterest rates and higher valuations, and returns ended up reasonably close to the forecast. A recent Merrill Lynch surveyof fund managers said that 80% are forecasting a world-wide recession to continue through all of next year. I think that isa reasonable forecast, but more importantly this suggests that stocks are discounting such an outlook already. A FederalReserve Governor was quoted as saying the Fed would make sure deflation would not occur. [An eventual return of problematic inflation seems a more likely risk, given the immense injection of liquidity currently ongoing.]



November 24, 2008


How we think about individual sectors and stocks

In this environment in particular, I believe it is helpful to remember Buffett’s dictum that when a good management meetsa bad industry, it is the latter whose reputation remains intact. We are concerned that areas of overcapacity like bankingand retailing may be such industries. Part of the overcapacity is a function of the Internet Revolution, analogous to theIndustrial Revolution during the 1800s. In contrast, we remain very positive on our commodity related holdings. Whilethere is little doubt that commodity demand has been reduced due to both the very high prices earlier in the year andnow the recessionary cycle, demand growth from emerging economies (such as China, India, and many others) coupledwith supply constraints puts long-term upward pressure on prices, and thus the secular case is intact. While expectationsvary by sector, we are of the belief that from current prices the market could reasonably generate a total annual return of 12% for the S&P 500 over the next five years.

In seeking out individual companies for investment we believe that, generally, good businesses with strong balance sheets(no need for financing) should generate returns that exceed the returns of the market and of companies subject todilution. Fortunately, we have consistently said that we are benchmark agnostic and so owning “growth” stocks is notproblematic, and having little or no representation in the stocks which we believe will lag has helped us in the past andshould help us continue to:

1. Achieve satisfactory returns on an absolute basis,2. Add value above passive alternatives, and

3. Rank highly among our peers.

Long Term Temperament

As you know one of the cornerstones of our investment philosophy is to have and maintain a long-term temperament. Itis difficult in any human endeavor to remain patient and think long-term when current events are so troubling; however, itis precisely times like these when we must think and act with a long-term perspective in mind.

We, at Diamond Hill, strongly encourage all of our staff to invest in the same portfolios that our clients are invested inand, as a result, we are collectively the largest shareholders in the Diamond Hill Funds. I want to thank all of our clientsas well as their advisors for investing with us and for your patience in these difficult times.

R.H. (Ric) Dillon, CFADiamond Hill Capital Management, Inc.



January 31, 2009


S&P 500 ReduxPast Predictions

At the inception of Diamond Hill in May 2000, we expected the total return of the S&P 500 to moderate to no more than5% per annum over the coming decade, considerably lower than what had been experienced in the prior decade. The

primary reason for this forecast was a starting valuation level that was simply too high. At the end of 2003, we providedan update. Despite losing more than 5% per annum through the end of 2003, we were not inclined to raise the forecastmaterially, bumping our forecast to 6% per annum for the decade ending 2013. Through August of 2008, this forecastwas faring well, as the compound return had been a bit above 5%. However, after the past four months, the trailing 5-year annualized return has dropped to a -2.2%. The S&P 500, therefore, would need to return approximately 14.9% perannum over the next five years in order to make the end of 2003 prediction of 6% per annum over the next decade cometrue. Thus far, it is shaping up to be a lost decade in terms of equity returns and even relatively downbeat forecasts haveerred on the optimistic side.

A convenient excuse might be that the unfolding credit crisis, which originated in the subprime mortgage sector and cannow be fairly characterized as broad-based, could not have been foreseen so long ago. While this is true, it ignores onereality. Easy credit, both in terms of low interest rates (spurred by central bank rate cuts in the wake of the tech andtelecom crash and the coincident mild economic recession) and lax underwriting, contributed to the strong economy and

stock market in the previous years. Without this easy credit, housing prices would not have risen as much as occurred.The portion of consumer spending that was driven by home equity extraction, made possible by the rise in home prices,would have been muted. Furthermore, the expansion of other types of consumer credit, such as revolving credit cards,has also allowed consumer spending to outpace incomes for some time. Finally, narrow spreads in various credit marketsalso led to booming environments in commercial real estate and mergers and acquisitions including highly leveraged goingprivate transaction. These were positive influences on stock prices. It would seem intellectually dishonest to accept thefavorable early benefits of these factors on the original forecast, while blaming the eventual consequences of some of theirrational behavior as being unforeseeable.

A second possible defense is far simpler. Perhaps, despite the economy facing real challenges, stock prices haveoverreacted and are now at levels implying high future returns. Many managers with stellar long-term records havepublicly called now the best ‘buying opportunity’ of their careers. Warren Buffett, who has seldom made general “marketcalls,” wrote an op-ed in The New York Times on October 17, 2008, summarizing his belief that while the economic news

will be grim for a time, it was now time to buy stocks. The S&P 500 closed at about 940 that day. We will explore thismore in a bit.

Why Bother?

Since we are active managers at Diamond Hill, we have never owned the S&P 500 Index through an index fund or ETFand more than likely will not in the future. In constructing our Fund portfolios, we have always been willing to veer farfrom the benchmark. So, our outlook only tangentially affects what we do. There are a couple reasons for our interest,however. First, although we are seldom involved in client decisions regarding asset allocation among various asset classes(equities, fixed income, and real estate with each often further subdivided into different categories), these forecasts give asense of our opinion for the general U.S. equity market. Second, it provides information in setting the discount rate touse for an individual company under analysis.

The Difficulty of Normalizing Earnings in Today’s Environment

Corporate earnings and interest rates are the two fundamental underpinnings for the long-term value of stocks. A thirdcomponent, which we’ll term investor psychology, is also very important to the short-term performance of stocks.However, this is ordinarily a less predictable component of returns that in the long-term tends to recede in importance asinvestor’s intermittent bouts of fear and greed tend to cancel one another out. Recently, however, earnings havedemonstrated great instability as well. After corporate profits (excluding write-offs, a topic for another discussion)retreated in 2001 approximately 20%, S&P 500 earnings grew steadily and briskly once again over the ensuing 5 years. Atthe onset of 2008, many strategists forecast 2008 S&P earnings to eclipse $90 per share, up from the mid to high $80’s in2006 and 2007. When companies finish reporting fourth quarter earnings this winter, S&P 500 earnings are likely to be inthe mid $60 per share range, which again excludes a heavy amount of write-offs, especially in the financial sector. Theyear 2009 is likely to be another down year for earnings, perhaps receding to the mid to high $50’s per share, a level last



January 31, 2009


seen in the year 2000. This has been a huge miss, obviously. For energy and basic materials companies, commodity priceshave undergone significant downward swings. In the financial sector, banks have had to increase provisions for loan losseswhile insurers have marked down investment portfolios. And the upheaval in the credit markets spilled into the realeconomy at an accelerated rate starting in October, leading to a rapid falloff in orders and uncertain capital spendingbudgets that is wearing on most industrials. Clearly, past income statement data may be less reliable for predicting thefuture than normal. As long-term investors, we attempt to estimate the economic earnings a company will generate overan entire economic earnings cycle. Even dividends, which have historically risen at a slow but steady pace, in part becausemanagements tend to be conservative in setting dividend policy (once instituting a dividend at a certain level, they havebeen reluctant to reduce it later), are likely to fall in 2009 as banks preserve capital needed to shore up capital ratios.Today’s economic environment presents challenges in estimating “average” earnings.

The Future Outlook

Let’s return to the premise that the steep decline in the S&P 500 might leave it unusually cheap. The S&P 500 closed atapproximately 826 on January 31. At this level, using trailing dividends and estimated earnings, the S&P 500 is trading atapproximately a 3.5% dividend yield (at a time when the 10-year Treasury bond is approximately 2.6%) and less than 13Xearnings. Provided that the economic slump does not drag on for a multi-year period and that corporate profits maintaintheir relative share of GDP, the combination of the resulting earnings growth, the current dividend yield, and a small bit of multiple expansion suggest to us that the expected return for the S&P 500 is now 10.5% – 12.5%. The bad news is thatwhile Treasuries currently offer miniscule returns, many areas of the bond market offer expected returns that approach

these same returns. The good news is that we do expect equities will once again allow investors to compound capitalcommensurate with the risk involved.

Thomas P. Schindler, CFADiamond Hill Capital Management, Inc.



June 15, 2009


The Importance of Being Long-Term

At Diamond Hill we consistently tell our clients that we aspire to achieve superior returns over periods of five years orlonger. Our dedication to a long-term investment orientation is clearly articulated in our mission statement:

Committed to the Graham-Buffett investment philosophy, with goals (over 5-year rolling periods)to outperformbenchmarks and our peers, and achieve absolute returns sufficient for risk of asset class .

Choice of time horizon is central to our culture at Diamond Hill. We evaluate and compensate our investmentprofessionals based on rolling five year performance; we focus our research efforts on estimating five year normalizedearnings and cash flows; and we try to set reasonable absolute return expectations based on a five year outlook. Webelieve that the combination of valuation discipline and long-term investment horizon gives us an edge over many of ourcompetitors, and by clearly communicating our five year time horizon to clients we align expectations with our processand incentive structure.

That all sounds good, but over the five years ended 12/31/2008 the S&P 500 achieved a negative 2% annual return, andwhile our relative performance was good, many of our strategies fell short of absolute return targets. Simply stating thatyou have a long-term investment horizon clearly doesn’t guarantee satisfactory outcomes. However, we can control our

philosophy and process so that we give ourselves the best odds of achieving our return objectives and meeting ourclients’ needs. A five year time horizon is a critical aspect of our process, and we think it helps maximize the odds of success for our clients.

We did not choose a five year time horizon arbitrarily. Historically, five years is the minimum amount of time requiredfor normal returns to be likely, and it is the minimum time required for the odds of negative returns to be remote. By“likely” we mean better than even (50/50) odds, by “normal” we mean returns that investors typically expect ascompensation for the risk of owning equities (5-15% in surveys) 1, and by “remote” we mean less than a 10% chance. Fiveyears is also what we consider the minimum time period required to have any statistical meaning when we measure ourperformance versus peers and benchmarks, and five years provides a reasonable amount of time for the gaps betweenintrinsic value and market price to narrow. Finally, a longer time horizon, perhaps 10 years, would provide moreconfidence in evaluating our results versus peers and absolute benchmarks, but we are conscious of the fact that there arelimits to our clients’ patience.

The History of Five Year Returns

There has been a great deal of academic and popular research examining the distribution of stock returns, much of itfocused on one year returns. These studies have helped popularize the notion that stocks earn superior returns relativeto bonds, and that there is an expected return on stocks equal to the yearly average of 10-11%. However, more than acursory glance at the distribution of one year returns exposes the folly of anticipating a normal outcome in any one yearperiod. Returns over a one year time horizon are highly volatile and investors who have expectations about one yearoutcomes are certain to be surprised often – both positively and negatively. Over the past 126 years realized returnshave been between 5% and 15% less than 20% of the time 2. The historical distribution of one year returns, based on datafrom Yale Professor Robert Shiller’s website, is shown in Figure 1 along with the bell-shaped Gaussian (Normal)distribution, which is often used as a model of stock returns 3.

1 www.ibefa.org/conferences/ahead2009 Presentation by Gene Amromin & Steven Sharpe, Chicago Fed and Federal Reserve Board. 2 Returns between 5 and 15% occurred 22 times in 126 years, 17.5% of the time. 3 www.econ.yale.edu/~shiller/data.htm , Data based on Robert Shiller’s book, Irrational Exuberance (Princeton University Press 2000, Broadway Books 2001, 2nd ed., 2005). The Shiller data is for the S&P 500 Composite Index, which is a proxy for large capitalization stocks.



June 15, 2009


Figure 1: 1 Year Distribution of Returns, Mean = 10.4%, Std. Deviation = 18.9%

The historical distribution of one year returns exhibits “fat tails”, with more returns greater than one standard deviation+/- the mean return, and fewer returns between +1 and -1 standard deviations of the mean compared to the Normaldistribution.

Figure 2: 1 Year Returns – Differences in frequency of observations vs. Normal distribution

There have been many attempts to better fit the historical pattern of one year returns using probability distributionsother than the Normal distribution. However, in practice many investors’ return expectations are strongly influenced bythe historical average, which in reality rarely occurs over any given one year period. Not only do normal gains of 5-15%happen infrequently over one year horizons, but the unexpected (negative returns) materializes quite often. Total returnsof less than zero were realized more than 25% of the time between 1883 and 2008 4.

4 Negative returns occurred in 36 out of 126 years, 28.6% of the time.



June 15, 2009


Fortunately the history of five year holding periods tells a different story. Investors still suffered losses in five year periods(we just lived through one of those periods) and there is still a wide range of outcomes. However, negative returnsoccurred far less frequently, and normal returns were much more likely over a five year horizon. The excess volatility of one year returns – the “fat tails” – disappear when looking at the history of five year returns, and in fact the more typical-1 to +1 standard deviation events become more likely than the Normal distribution predicts. The distribution of independent five year returns is shown in Figure 3 using the same data from Shiller.

Figure 3: Distribution of Five Year Returns, Mean = 9.1%, Std. Deviation = 8.6%

The Normal distribution does not fit the actual return pattern particularly well, which in this case is at least partly due tothe small sample size. Despite the limited size of the data set, we can observe that a much higher proportion of returnsare in the 5-15% range over five year periods, and the range of outcomes is considerably smaller, with only three negativereturns 5.

One of the appeals of looking at the one year distribution of returns is that there are ample independent (non-overlapping) observations. Using the same data to analyze the distribution of five year returns yields only 25 independentperiods (i.e., 1995-2000, 2000-2005). An aberrant five year return due to an extreme starting or ending price level has abigger impact on the distribution than an extreme one year return that is part of a 126 data point series. To try tocorrect for the inordinate impact that extreme data points might have on the five year return series, different startingdates, using September, June and March, can also be considered 6. The results are summarized in Figure 4, which showsthat normal returns, those between 5-15%, have occurred about 50% of the time, while negative returns have occurredonly 9% of the time 7

5 Annual gains of 5‐15% occurred 10 times in the 25 periods beginning and ending in December, 40% of the time. 6 The goal of this exercise is simply to check that our sample is not biased by one or two data points that were skewed by extreme starting or ending price levels. For instance the five year period beginning in December 1968 had a total return of about 1%. Starting just 9 months earlier in March the 1968 – 1973 period showed a nearly 8% annual gain. 7 These results are the sum of frequencies across four different quarterly start dates (100 total observations). There were 46 observations between +5‐15% and 9 observations less than 0%.



June 15, 2009


Figure 4: Distribution of Five Year Returns - Different Quarterly Start Dates

Based on history, five years turns out to be the minimum time horizon required for normal returns to be likely and fornegative returns to be highly unlikely. Stock investors who maintain a five year horizon have a much more reasonablebasis for anticipating 5-15% gains and also for being surprised if they achieve negative returns over any given five yearperiod. We do not like to disappoint our clients, so setting reasonable expectations is important to us, and we believethere is solid evidence to support the view that five years or longer is an appropriate horizon to evaluate our returns.

The Fundamentals of Five Year Returns

We take comfort in the history of five year returns; however, we are active, intrinsic value focused managers and do notrely on the performance of any broad index to achieve our returns. We believe that companies have an intrinsic valuebased on the assets they own and the cash they distribute to shareholders. In the short-term, speculation, behavioralbiases, and supply-demand imbalances may drive prices away from intrinsic value. In the long-run the weight of cashdistributions, asset sales, and arbitrage between the public and private markets tends to drive prices towards fundamentalvalues. As Benjamin Graham famously said, “in the short-run the market is a voting machine, but in the long-run it is aweighing machine.”

Incidentally, the history of stock returns provides empirical evidence that Graham’s weighing machine does indeedfunction better over the long-term. Over five year holding periods the fundamentals underlying business value have beenmore stable than over one year periods. Furthermore, those fundamentals have been weighed in a much more rationalway over five year periods compared to one year periods. In the long-term extremes of valuation tend to revert to morenormal levels, while in the short-term cheap (expensive) prices often become cheaper (more expensive).

Stock returns can be deconstructed into two components: 1) a fundamental return based on dividends paid and growthin normalized earnings power, and 2) a speculative return based on the change in the price-to-earnings multiple (P/E) 8.Over a one year time horizon the fundamental return is not as volatile as stock returns, but ranges widely between -10%and +25%. In contrast, the five year fundamental return usually stays between +5 and +15%. The fundamental return canbe thought of as the return that investors would earn if P/E multiples did not change over the investment horizon. If wecan imagine a world where P/E multiples remain constant, the five year fundamental return is consistent with normal, 5-15%, gains and a very low probability of negative returns.

8 As a first approximation, the stock return can be thought of as: Div/Price + Earnings Growth + P/E change. For normalized earnings we use 10yr average earnings as calculated by Shiller.



June 15, 2009


Figure 7: Five Year Return vs. P/E change

Aside from the obvious differences in volatility, there is a crucial distinction between one year and five year time horizons:over one year horizons it is difficult to foresee the direction of P/E changes, while over five year periods the direction of P/E changes, particularly at extremes (where it matters most), becomes much more predictable. Based on the last 126years of stock returns, a P/E multiple of less than 10x had a 40% chance of decreasing over the next twelve months 9. Incontrast, over a five year horizon P/E multiples of less than 10x had less than a 10% chance of decreasing. Over periodsof five years or longer the speculative component of stock returns becomes decidedly less speculative.

9 For example, a P/E of 9 going to 8.



June 15, 2009


5 Year Holding Period: Changes in P/E Multiples

Beg. P/EMonthly

Observations% of

ObservationsAnnual Change in

P/E Multiple Hit Rate>25 100 6.8% -6.57% 85.0%

20 - 25 196 13.2% -1.93% 68.4%15 - 20 498 33.6% -0.56%10 - 15 458 30.9% -0.06%5 -10 228 15.4% 10.30% 93.0%

<5 1 0.1% 18.43% 100.0%Total / Average 1,481 100.0% 0.69% 82.3%

1 Year Holding Period: Changes in P/E Multiples

Beg. P/E MonthlyObservations % of Observations Annual Change inP/E Multiple Hit Rate>25 140 9.5% -4.33% 58.6%

20 - 25 204 13.8% -4.29% 57.8%15 - 20 467 31.5% -0.26%10 - 15 441 29.8% 5.60%5 -10 228 15.4% 9.40% 62.7%

<5 1 0.1% 27.80% 100.0%Total / Average 1,481 100.0% 2.05% 60.0%

"Hit Rate" = # of times cheap (expensive) P/E multiples become more expensive (cheap)Where "cheap" = < 10x and "expensive" = >20x

Over short time horizons undervalued assets and cash flows often lose value. However, the investor who has the abilityto value assets and cash flows accurately and has a long term investment horizon can take advantage of the cheapbecoming cheaper by lowering his cost and earning even higher returns as the weight of fundamentals begin to takeprecedence over speculation.

For equity investors to consistently achieve normal absolute returns over periods of one year or less they need to havesuperior information that hasn’t been priced into the market, and they must be appropriately hedged against movementsin speculative returns ( i.e., unpredictable P/E multiples). We don’t doubt that there are individuals or institutions thathave executed on this model, but it is simply not the way we invest. The search costs associated with finding truly uniqueinformation are extremely high and the competition for such information is fierce. We are always looking for newinformation, or new ways to look at existing information, but as a part of the process of trying to understand the value of

a business -- not an end in itself. Our goal is to find businesses that we can value and buy them at a significant discount toour estimates of intrinsic value. Because we have aligned all aspects of our process with a five year time horizon we areable to take advantage of speculative short-term movements in price and wait for the market to weigh the fundamentalsof the business. By being value conscious we hope to limit downside over most time periods, but we recognize thatspeculative losses are difficult to overcome in the near-term but can be reliably defeated with patience and correctanalysis.



June 15, 2009


Conclusion

Having a five year time horizon is not a panacea – losses will still occur – but investing is a probabilistic exercise, andhaving a five year horizon substantially increases the odds of achieving normal returns while reducing the chances of losingmoney. At Diamond Hill we have thoughtfully organized ourselves with a clear focus on achieving superior long-termresults. We are not swayed by the excess volatility of stock prices in the short-run, preferring to let the weight of fundamentals determine our results over periods of five years or longer.

Austin C. Hawley, CFADiamond Hill Capital Management, Inc.



December 31, 2009


Managing Risk and What We Learned from the Crisis

With the possible exception of technology stocks around the turn of the century, the volatility we have seen in the broadstock market, and particularly in financial stocks, is unprecedented since at least the 1930s. The S&P 500 Index lost over55% of its value from the October 2007 peak to the March 2009 trough. Over the same period, the S&P 500 FinancialsIndex lost more than 80% of its value. Both indexes have rallied sharply from the market trough, with the broad S&P 500Index up more than 60% from the bottom and the Financials Index gaining over 130% through December 31, 2009.These recoveries leave the indexes well short of their prior peaks, however. The S&P 500 Index would need to see anadditional 40%+ gain to reach its former peak, while the S&P Financials Index would need to gain more than 160% toachieve new highs.

Our job at Diamond Hill is to manage whatever set of risks the market presents, while seeking to achieve superiorreturns on an absolute and relative basis over five year or longer time periods. The rest of this piece will discuss two of the most significant ways in which we attempted to manage recent market risks and opportunities, as well as some of thethings we observed and learned through the downturn.

Discount Rate

An important part of the valuation process for stocks is setting the proper discount rate, or required rate of return, foreach individual company. The value of any company is the sum of the discounted future cash flows. Forecasting the cashflows is the activity that generally receives the greatest attention, but the use of the proper discount rate is also a keypiece of the puzzle. The discount rate represents the riskiness of the forecasted cash flows – higher risk activities requirehigher returns to justify an investment. Thus, the discount rate applied to the cash flows of Procter & Gamble Co. (PG)or McDonalds Corp. (MCD) should be much lower than the discount rate used for an investment in a small airline ormining company.

A company’s balance sheet is also a factor in determining the appropriate discount rate for future cash flows. A firm withhigh levels of cash and no debt deserves a lower discount rate, all things equal, than one in the same business with roughlythe same scale but having a balance sheet with high debt levels and little cash. The latter firm may be able to meet theirdebt payments under most economic scenarios. However, in a sharp downturn, the lack of cash flow necessary to coverdebt payments may force the company to sell off assets at a low price or issue new equity at low prices to raise funds tomeet debt payments. In either case, existing investors’ equity ownership is diluted. The main point is that a weakerbalance sheet, all things equal, raises the riskiness of future expected cash streams.

How did this impact Diamond Hill strategies during the recent downturn? We have always recognized the importance of setting appropriate discount rates and have always differentiated between companies with stronger and weaker balancesheets. We also focus on the longer-term risks of a business model. By focusing long-term, we avoid placing an artificiallylow discount rate on a cyclical business that may be achieving unsustainable near-term peak operating results. However,in this downturn we discovered that for some of our holdings, what we had considered to be conservative discount rateswere not conservative enough to fully reflect the risk of dilutive capital raises and other balance sheet related moves,which reduced the future expected gains to equity holders. Some of this dilutive effect was centered on banks and otherfinancial holdings, but it also extended to industrials, technology and several other areas of the market where the sharpdownturn forced value-diluting actions in order to protect companies’ viability. After experiencing such effects for a fewof our holdings, we aggressively scoured the rest of our portfolios to make sure that we were fully incorporatingappropriate discount rates for all our investments. In limited cases, we adjusted our discount rates. This adjustment didnot necessarily lead to a change in our investment position – in some cases it simply led to a narrower, but still ample,margin of safety. We regularly review all the variables in our intrinsic value estimates and take action when warranted byany change in our estimates or market prices.



December 31, 2009


Price Volatility vs. Investment Risk

While we felt a need to reevaluate some of our discount rates, we observed many cases where we believed that other

market participants were misreading the situation based on excess fear. This fear created some extremely attractiveinvestment opportunities, as well as some short-term price volatility. However, in our opinion, the short-term pricevolatility did not always correspond equally with higher levels of long-term investment risk. To illustrate the differencebetween short-term price volatility and long-term investment risk, let’s look at our investment in Juniper Networks, Inc.(JNPR).

Juniper Networks has a strong number two position in the router market, behind Cisco Systems, Inc. (CSCO). JNPR hasachieved double-digit operating profit margins each year since 2003, excluding a goodwill impairment charge in 2006, andmanagement has shown a strong commitment to balancing growth with cost control. As of Fall 2008, the company hadbuilt a fortress balance sheet, with $2.5 billion in cash and investments, and no debt. In comparison, JNPR’s marketcapitalization fell below $10 billion in October 2008 and dipped under $7 billion in March 2009.

The demand for Juniper’s products relates to consumer and corporate Internet bandwidth usage. The growth in Internetvideo consumption is widely forecast to continue for many years, and that growth should further accelerate as highdefinition video becomes a larger portion of what is viewed online. While technological advances may lead to slowerdemand growth for JNPR’s products versus overall bandwidth usage, in our opinion it seems unlikely that the companywill fail to achieve at least a high-single-digit sales growth rate over the next 5+ years. Given JNPR’s product position andcontinued innovation, our view is that the company’s competitive position is unlikely to deteriorate significantly over thenext 5 years.

Despite the advantages of a strong competitive position, a rock solid balance sheet and an industry with dependable long-term growth characteristics, Juniper’s stock traded down aggressively with the rest of the market. JNPR fell from themid-high $30s in late 2007 to the mid-$20s by September 2008, eventually declining to the low teens near the 2009market trough. We initiated positions in multiple Diamond Hill strategies, as this quality company with favorable growthcharacteristics traded down to a level where we felt it was selling at a sizable discount to our estimate of intrinsic value.

When we made these purchases, we were aware that the fear of continued economic decline might further depress theprice, and it did. Fortunately, realization of this risk also presented an opportunity for us to enhance our returns byadding to the position at even better prices. For example, we bought more shares in the Small-Mid Cap Fund after theprice dropped 10% from our original purchase and again after the price dropped another 10%.

In this case, our views were eventually endorsed by the market. JNPR rallied strongly as the market rose, and we soldour shares in May 2009 when the price reached our intrinsic value estimate. We earned 35%-75% holding period returnson our purchases of JNPR. The stock now trades modestly above the levels at which we sold our positions, while ourestimate of intrinsic value is little changed.

Managing Portfolio Risk

One lesson from the downturn is to take advantage of especially attractive opportunities on the infrequent occasionswhen they present themselves. In our view, these opportunities often arise due to investors mistaking short-termvolatility for true investment risk. The former is driven by emotion and in some cases has little relation to the underlyingvalue of companies, which equals the sum of discounted cash flows those companies will produce over time. At DiamondHill, we define risk as the permanent loss of capital. Although future events could prove us wrong, we believe that

Juniper Networks was one of numerous investment opportunities that the market presented during the downturnentailing significantly greater likelihood of short-term price volatility than true long-term investment risk. Unfortunately,we are finding fewer of these high-reward, low-risk opportunities in the current market environment.



December 31, 2009

A major part of our job at Diamond Hill is managing portfolio risk. We pay close attention to business and balance sheetrisk to set appropriate discount rates for the companies we invest in, and we will continue to take advantage of opportunities that show disproportionate rewards relative to the level of risk. This approach has served our clients wellin both up and down markets. We remain committed to our disciplined, intrinsic value investment philosophy, and webelieve that our approach to portfolio risk management will serve our clients well in future market environments. Wethank you for your continuing support and confidence.

Christopher A. Welch, CFADiamond Hill Capital Management, Inc.

___________________________________________________________________________________________

The views expressed are those of the portfolio manager as of December 31, 2009, are subject to change, and may differfrom the views of other portfolio managers of the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of future results, or investment advice. All data referenced are from sources deemed to bereliable but cannot be guaranteed. Securities and sectors referenced should not be construed as a solicitation orrecommendation or be used as the sole basis for any investment decision.

Standard and Poor's 500 Index is a capitalization-weighted index of 500 stocks. The index is designed to measureperformance of the broad domestic economy through changes in the aggregate market value of 500 stocks representing

all major industries.

Standard and Poor's 500 Financials Index is a capitalization-weighted index, with 79 members.

Mentioned Securities and Respective Weights in the Diamond Hill Funds as of 12/31/09:

Small CapFund

Small-MidCap Fund

Large CapFund

SelectFund

Long-ShortFund

FinancialLong-Short Fund

StrategicIncome Fund

CSCO 0.0% 0.0% 2.0% 2.5% 2.3% 0.0% 0.0% JNPR 0.0% 0.0% 0.0% 0.0% 0.0% 0.0% 0.0%MCD 0.0% 0.0% 1.9% 2.5% 2.0% 0.0% 0.0%

diamond hill letters

Documents