Editor’s Note: In this recurring section, I’ll highlight two timely “best buys” in the small-cap sector, one based on value and the other on momentum. This inaugural issue looks at two Frontrunner stocks that I’m also adding to my portfolios. – JF

Value Play: Diamond Hill Investment Group (Nasdaq: DHIL)

Investing in great investors has always been one of my favorite themes. Who better knows how to make money than those whose livelihood is investing?

Everybody has heard of Warren Buffett and his investment vehicle Berkshire Hathaway (NYSE: BRK-B), which has trounced the S&P 500 for more than 40 years. In fact, Berkshire Hathaway was the very first trade recommendation I made in my Options for Income service.

However, Berkshire Hathaway has a $200 billion-plus market cap, which doesn’t qualify for inclusion in Roadrunner Stocks’ small- and mid-cap stock universe under $10 billion. Just as well, because Berkshire has gotten so large that “the law of large numbers” makes Berkshire’s ability to generate outsized returns a thing of the past.

Fortunately, I have found a small-cap money manager that shares Warren Buffett’s value-investing philosophy. Diamond Hill Investment Group (Nasdaq: DHIL) is located in Columbus, Ohio and has $9.4 billion in assets under management divided between retail and institutional accounts.

Warren Buffett wannabes are a dime-a-dozen, so regurgitating Buffett/Graham value-investing shibboleths is not enough to garner my investment dollars—the rubber hits the road with actual performance.

Does the manager simply talk the talk or does he also walk the walk? Fortunately, investors in Diamond Hill have done very well over the past decade. In fact, they have done better than investors in large-cap investment firms Berkshire or Loews (NYSE: L) over each of the past 3-, 5-, and 10- year periods:

Diamond Hill Outperforms . . . Until Recently

Source: Morningstar

If you were to measure performance from 9 ½ years ago instead of 10, Diamond Hill’s relative performance would look even better because it was on July 22, 2003 that the investment firm issued a private placement of stock to its employees that transformed them into owner-operators of a 15 percent stake, whose personal financial incentives were perfectly aligned with the average shareholder.

Since that private placement 9 ½ years ago, the total return on Diamond Hill stock has been an astounding 3,111 percent (44.1 percent annualized):

Source: Bloomberg

A reasonable question is why has the stock uncharacteristically underperformed during the past year? It may be a delayed reaction to the poor performance of the company’s nine strategic portfolios, almost all of which have underperformed their benchmarks for the past three years.

Perhaps this underperformance contributed to a management reorganization in December 2011. Whatever the case, the company’s value-based investment process makes such innate good sense to me, I’m willing to give its portfolio managers the benefit of the doubt.

The stock market is a fickle beast where different investment styles rotate in and out of favor. Academic studies have proven value-based investing strategies outperform over the long run, but anything can happen in the short run. In a January 2011 shareholder letter, then chief investment officer Ric Dillon explained the investment underperformance this way:

We are never happy when we experience a ‘slump’ during a season, and we are ‘studying the film’ to see what we may need to adjust. Our fundamental intrinsic value investment philosophy will not and has not changed since our firm’s inception.

We continually try to improve our decision-making and learn from our mistakes through an ex-post analysis and review of our investment decisions. During this process, we challenge our assumptions and analysis of the market environment, which could potentially lead to refining certain aspects of our investment process. We will not change the investment process solely based on a short-term period of underperformance.

Importantly, we are not disheartened. We believe the results for the next five year period will be better, in part due to our adjustments but also due to the return of valuation sensitivity. We also believe that our absolute return focus, lack of benchmark sensitivity and five year time horizon add value for investors in our strategies. Finally, we have significant personal investment in our strategies. As a result, we experience the same investment returns, good or bad, as our clients.

I respect Mr. Dillon’s commitment to value investing and not panicking because of short-term underperformance. I also like the fact that insiders own 31 percent of the company (page 5), which ensures that portfolio managers have every incentive to turn things around.

In addition, the company adjusts its management fees based on its funds’ investment performance (pp. 112-13), which further incents good performance. The Diamond Hill website is a treasure trove of information, and I recommend that you read through the twelve years of shareholder letters provided. And if you’re looking for a stock-valuation calculator based on discounted-cash-flow analysis, the good folks at Diamond Hill offer one up free of charge. Now that’s customer service!

The bright side of the temporary investment underperformance is that the stock is now inexpensively priced at only 13 times earnings, which is near the lowest price-to-earnings (P/E) level it has been at any time over the past decade.

Regardless of underperformance, the key to profitability is assets under management (AUM) and assets continue to pour into the firm. As of September 30^th, year-over-year growth in AUM was a very strong 25 percent (page 17). The return on invested capital is sky-high at 48.5 percent and revenues are growing double-digits annualized over all time periods from 1 to 10 years. And the company’s shareholder-friendly behavior includes paying out sizeable special dividends in cash in each of the past five years:

 Five Years of Special Dividends

The company cautions that it offers no guarantees that such special dividends will be paid in the future, but it’s hard for me to believe that dividends will stop as long as the firm’s AUM continue to increase and its corporate debt remains at zero. With the stock currently trading at $70, even the lowest special dividend of $5 equals an annual yield of 7 percent.

One of my favorite investment managers is Chuck Akre and he started buying Diamond Hill stock in the second quarter of 2011. He continued buying more Diamond Hill stock in each of the next four quarters and now holds a total of 145,000 shares at an average cost of $75.74, representing 1 percent of his portfolio worth. 

Long-term Buffett-beating stock outperformance, high insider ownership, no debt, assets under management that are increasing combined with a proven value-investing investment process, five consecutive years of special dividends equaling a minimum annual yield of 7 percent, and a strong return on invested capital all spell future success. Buy Diamond Hill Investment Group up to $80; I’m also adding the stock to my Value Portfolio.

Momentum Play: SolarWinds (NYSE: SWI)

Despite its name, this company has nothing to do with uneconomic forms of renewable green energy such as solar or wind. The name is the brainchild of co-founders Donald and David Yonce, who were outer-space buffs and wanted a name for their computer network services company that emphasized the increased speed their software products and selling platform could provide to information technology (IT) professionals.

The Yonce brothers decided that the name SolarWinds—which refers to extremely high-velocity projectiles ejected from the sun—vividly demonstrated the speed motif.

SolarWinds is an innovative company that is disrupting the status quo of computer network services, but the disruption reminds me more of Dell (Nasdaq: DELL) than Intel (Nasdaq: INTC).

Unlike Intel, which became a leader in personal computers (PCs) via its invention of the microprocessor, Dell’s leadership status in PCs focused on its innovative disruption of the sales distribution channel.

Figuring out that consumers wanted to bypass the retail middleman and purchase custom-built PCs directly from the manufacturer enabled Dell to become the best-performing stock of the 1990s.

Similar cost-reducing sales innovations occurred in both the airline industry with Southwest (NYSE: LUV) and in personal finance software with Intuit (Nasdaq: INTU). All three of these disrupters currently sport sizeable market caps—$8.3 billion (LUV), $18.9 billion (INTU), and $22.3 billion (DELL).

SolarWinds offers a similar sales-distribution innovation in the computer network software space. Yet it remains in the early stages of its growth curve and its market cap is only $4.1 billion.

SolarWinds focuses on IT professionals who are responsible for maintaining corporate computer networks. These geeks of the corporate world spend a lot of money. According to technology research firm Gartner, the enterprise software market is larger than the consumer software market—$278 billion per year ($120 billion in apps alone) vs. $100 billion.

Even better than the larger market size is the fact that corporate enterprise revenues are sticky and stable (because of high switching costs once a computer system is in place), compared to the constant churn of fickle retail customers.

In its November Investor Presentation (slide no. 13), SolarWinds noted that its target market opportunity is $65 billion. Given that the company’s latest 12-month revenue equals only $251 million, the growth potential is huge and undeniable, especially when you consider the international opportunity.

Right now, the company’s non-U.S. sales comprise only 24 percent of total corporate revenues (slide no. 23) whereas the industry average is more than double that figure at 56 percent.

Traditionally, corporations have purchased all of their computer hardware and software from one or two full-service companies like IBM (NYSE: IBM) or Hewlett-Packard (NYSE: HPQ). Because the transaction is all-inclusive, the price tag is huge and corporate executives who don’t even know how to use email negotiate the deal over a sumptuous dinner with computer salesmen wearing Brioni suits and Ferragamo ties.

The result is a high-cost computer network using proprietary software technology that can’t be easily modified or matched with best-of-breed components from other software developers.

In contrast, SolarWinds has no costly exterior sales force, doesn’t cold-call potential clients trying to convince them to buy things they don’t really need, and doesn’t try to win business with expensive meals and entertainment. Rather, SolarWinds marketing efforts are “demand driven” and “web based,” which means that it only reaches out to customers after they have made the first move—e.g., by conducting a Google (Nasdaq: GOOG) search for a software fix.

Once communication is established, it is done primarily through emails/instant messaging/telephone with face-to-face meetings the exception rather than the rule. The client is almost never a top executive, but rather the jeans-wearing, pocket protector-wearing IT manager in the trenches who faces a time-sensitive problem that needs to be fixed yesterday.

These geeks don’t want any social interaction with flashy salesmen but just want to fix their problem and move on. SolarWinds is perfect for these socially awkward tech wizards because all they have to do is download the software for a free 30-day trial and purchase it at the end of the trial period if it meets their needs.

This soft sales touch works because SolarWinds only sells products that “sell themselves.” These products either fix the problem or they don’t and there is no need for a salesman to convince the client of anything. Furthermore, the company has created a social networking website—www.thwack.com—where IT professionals can discuss computer problems with each other and SolarWinds support team and find solutions.

SolarWinds offers software components for network management (50 percent) and system applications (50 percent) to more than 95,000 customers worldwide. It does not strive to compete with IBM or Hewlett-Packard to be a client’s turnkey solution or one-stop shop.

Rather, SolarWinds’ target is the 80 percent of computer software services that can be commoditized and offered piecemeal and to offer them at one-tenth of the cost charged by the big boys.

The average dollar amount of a SolarWinds sale is only $8,400 (slide no. 75). Recurring, annual maintenance services (slide nos. 64-66) comprise 50 percent of total sales and is a big growth driver, growing at a 39 percent compound annual rate which is even faster than the 33 percent compounded growth of total revenues.

Maintenance revenues are more stable than new license revenues, so SolarWinds success in winning maintenance work is a good thing. Still, CEO Kevin Thompson forecasts license revenues to grow more than 20 percent per year for the next 3-5 years.

Since its May 2009 IPO, the financial performance of SolarWinds has been phenomenal. Slide nos. 59-62 of the November Investor Presentation tells the story:

• Twelve consecutive quarters of free-cash-flow growth
• Five-year compounded annual earnings per share growth of 36 percent
• Stable operating profit margins of 55 percent
• Five-year average annual return on equity of 54 percent
• $195 million in cash and zero debt

With growth and profitability numbers like these, it is no wonder that SolarWinds is ranked No. 1 on Forbes Magazine’s list of America’s Best Small Companies. The growth story is well known, which explains why the stock has performed so well since its IPO—up 338.5 percent!

SolarWinds is a true momentum stock, trading within 10 percent of its all-time high and at sky-high valuations of 55 times earnings and 16.5 times sales. If you believe analyst estimates that the company will grow earnings only 20.5 percent annually over the next five years, then the stock appears overvalued.

However, as a I mentioned earlier, new license revenues alone are forecast to grow more than 20 percent annually and this growth figure doesn’t even include renewal maintenance revenues.

I think that SolarWinds may surprise on the upside in the coming years. Co-founder Donald Yonce still owns a 16.7 percent stake in the company (page 18) and, although he retired from the board of directors in 2010 at the age of 46, he undoubtedly still commands influence with management and has every financial incentive to keep SolarWinds’ growth coming.

A momentum stock needs to be watched closely because they are usually priced for perfection and investors punish high-valuation stocks severely if they stumble. Even market-disrupter Dell got arrogant and took its eye off of the ball. New competitors—not to mention old incumbents—never stop trying to copy and neutralize a successful disrupter’s business model. But Dell didn’t stumble until many years later in its growth cycle than SolarWinds finds itself right now.

SolarWinds’ IPO occurred on May 20, 2009 and it has been public for about 3.7 years (1,340 days). If you compare SolarWinds’ stock performance with Dell’s stock performance during the first 1,340 days of public life, the numbers are similar:

Is SolarWinds Another Dell?

Bottom line: SolarWinds’ best days may still lie ahead.

SolarWinds is a buy up to $60; I’m also adding the stock to my Momentum Portfolio.