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Diamond Hill Finds Fewer Gems

By Richard Diennor The Diamond Hill Small-Cap Fund/A (DHSCX) usually doesn't own many stocks. And for the last year or so, portfolio managers Roderick "Ric" Dillon and Thomas Schindler say they have experienced difficulty finding any attractive investments. As a result, the $88.1 million fund's cash position has nearly reached its mandated 30% maximum after drifting around 20% on average last year, Dillon says.

Its relatively heavy weighting in cash hasn't kept the fund from outrunning its competitors, though. Diamond Hill Small-Cap, which began operating in December, 2000, returned 24.2% for the 12-month period through February of 2005, vs. a 13.2% advance for the average small-cap value fund. For the three-year period, the fund registered a 19.2% annualized return, vs. a 13.8% gain for the peer group. Based on risk and return characteristics over the last three years, Standard & Poor's has a 4 STARS ranking on the fund (5 STARS is the highest rank).

SELECTION STRATEGY. Even when investment opportunities seem more promising, the managers typically limit their number of holdings to 50. "We do want it to be a reasonably concentrated, or a focused, portfolio," Dillon says. "The idea is that the best returns will come from the best situations. We don't want to dilute those by having too many names."

In picking stocks, Dillon and Schindler look for those priced at a discount relative to their estimate of a company's

intrinsic value. They also like companies with a competitive edge, a sound balance sheet, and solid

returns on equity.

While the managers want to own profitable businesses, they're willing to bet on those currently in the red if they think the outfit is on the verge of posting earnings. Similarly, they like concerns that are generating cash, but they'll own those that aren't cash-flow-positive if they deem that the situation is poised to change. The managers hunt for companies with market caps of $50 million to $2.5 billion.

POSITIVE ENERGY. In late 2004, Dillon and Schindler bought a stake in Finish Line (FINL), a retailer of athletic footwear and apparel. The chain looked good, Dillon says, because it was drawing business away from competitor Foot Locker (FL). This, in turn, was pushing up Finish Line's margins and sales in stores open at least a year.

The fund's No. 1 stock at the end of last year: Southwestern Energy (SWN), a company that Schindler notes has benefited from increased production and higher prices for natural gas.

The fund, whose sector weights result from the managers' stock picks, had just a tad more than 20% of its assets in energy stocks at the end of December, making it the second-largest sector in the portfolio. Its biggest investments overall included Encore Acquisition (EAC), an oil and natural gas producer that Dillon says has done a good job of locating supplies and boosting production.

MAYTAG: WASHED UP? When it comes to selling, Dillon and Schindler will unload a stock if it grows pricey or if the outfit's financial fundamentals start to slide. They'll also eliminate a business to raise cash to buy a better looking investment.

Earlier this year, the managers banished appliance maker Maytag (MYG) from the fund because, they say, the company's profits were disappointing.

In addition to running the Small-Cap Fund, Dillon and Schindler own shares in it. Both have a "fairly high dollar amount" invested in the portfolio, according to Dillon.

Looking at small-cap stocks, Dillon expects them to generate positive returns this year but not as many as they did in 2004. Small-caps, which have rallied over the last five years, no longer qualify as undervalued, relative to stocks of large companies, he notes. Diennor is a reporter for Standard & Poor's Fund Advisor

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