Diamond Hill Small Cap Fund Q2 2023 Market Commentary


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Market Commentary

Markets were positive in Q2 2023, with US stocks rising over 8% (as measured by the Russell 3000 Index), bringing YTD gains to roughly 16%. Continuing the YTD trend, large-cap stocks led in Q2, rising almost 9%, while mid-cap stocks rose nearly 5% and small-cap stocks rose just over 5% (as measured by the Russell indices).

Also continuing from Q1, growth stocks outperformed their value counterparts across the cap spectrum. The Russell 1000 Value Index rose 4%, while its growth counterpart rose nearly 13%; the Russell Midcap Value Index advanced close to 4%, while the Russell

Midcap Growth Index rose over 6%. The Russell 2000 Value Index added a little over 3%, and the Russell 2000 Growth Index rose just over 7%.

From a sector perspective, health care led (up over 11%) in Q2, followed by industrials (10%) and technology (9%). Utilities (down nearly -4%) were the index’s worst performing sector in Q2 as energy prices have largely remained reined in, despite the ongoing war in Ukraine. Financials (-1%) and communication services (-1%) were also down modestly in the quarter.

2Q23 Russell 2000 Index Sector Returns (%)

2Q23 Russell 2000 Index Sector Returns (%)

Source: FactSet, as of 30 Jun 2023.

The macro picture has also been consistent in 2023, with inflation, central bank policy and ongoing geopolitical tensions dominating headlines. In early May, JP Morgan agreed to acquire most of First Republic Bank’s operations after the failed institution was seized by regulators. It marked the second-largest bank failure in US history (after Washington Mutual’s 2008 collapse), followed by Silicon Valley Bank and Signature Bank, both of which failed late in Q1 2023. While we remain vigilant in assessing the fundamental health of all our portfolio holdings, we believe the worst is behind us on this front for the time being.

Many point to the recent failures as signs monetary policy has gotten sufficiently (if not overly) tight — and investors consequently anticipated a slowdown or pause in rate hikes. Indeed, though the Federal Reserve did raise the benchmark rate 25 basis points (bps) in May to a range of 5.00% – 5.25%, it also tentatively hinted the current rate hike cycle (which has included 10 hikes in just over a year) was nearing its conclusion and didn’t raise rates in June.

Outside the US, global monetary policy is a more mixed bag. The UK faces ongoing stubborn inflation, seemingly decreasing the likelihood it is as close to the end of its hiking cycle as the US may be. Similarly, the European Central Bank likely has a way to go as inflation has proven sticky in major economies like Germany’s. In contrast, many emerging markets economies seem on the cusp of considering pausing rate hikes, if not beginning to cut.

For example, Hungary trimmed rates (which remain high) during the quarter as it struggles to rein in inflation while not hampering too much economic activity. A notable exception is Turkey, which significantly raised rates (650 bps) following President Erdogan’s May reelection — presumably in a bid to convince markets the country will begin seriously addressing its economic challenges. Whether investors find the effort credible naturally remains to be seen.

Meanwhile, markets seem to continue climbing the proverbial wall of worry — likely aided by relatively resilient economic data and corporate earnings in the US (and, selectively, beyond). Inflation, though effectively a global concern, has yet to meaningfully dampen hiring in the US. Stocks have rallied — especially growth stocks, where prices have increased significantly — which could be reflective of the fact that markets have discounted an impending recession several times over the last couple years, each time getting a little more comfortable with the economy’s and corporate earnings’ resilience.

That said, we don’t believe now is the time to get complacent about the environment. As we saw in March this year with the first of the aforementioned bank failures, unexpected events could rattle markets periodically — and that is particularly the case given all the macroeconomic headwinds we currently see. Further, there is still a possibility we see a recession in the next three to nine months, given the 10-year/3-month yield curve remains inverted and has historically been a decent predictor of recession.

However, we believe our philosophy and approach are well-suited to just such an environment — in which higher rates, higher inflation and possibly higher volatility than we’ve seen over the last decade or so are likely — as value and cyclically oriented stocks are likely to become more attractive to investors as they are well-positioned to produce abundant, consistent cash flows in the near and intermediate terms.

Performance Discussion

Our portfolio outperformed the Russell 2000 Index in Q2, adding to YTD outperformance. Our financials holdings were a sizeable source of relative strength in the quarter — a noteworthy reversal from Q1. Our consumer discretionary holdings were also a relative tailwind. Conversely, relative weakness among our consumer staples holdings weighed on returns, as did our below-benchmark exposure to the information technology sector, though our holdings there outpaced index peers.

On an individual holdings’ basis, top contributors to return in Q2 included Green Brick Partners (GRBK) and UFP Technologies (UFPT). Green Brick Partners is a homebuilder operating primarily in Atlanta and Dallas. Homebuilders have had a solid start to 2023, and Green Brick has performed especially well — its low land basis and strong fundamentals in its main Dallas Fort Worth market have contributed to strong earnings and underlying metrics relative to competitors. We like Green Brick Partners for its solid balance sheet, which should allow it to navigate any impending cyclicality and survive a downturn. Further, its management team is long-term oriented and well-aligned with shareholders — attributes we like.

UFP Technologies is an innovative designer and custom manufacturer of components, subassemblies, products and packaging primarily for the medical market. Its medical technology business (MedTech) has become the company’s dominant business driver, now accounting for roughly 85% of revenues. As management adds capacity in lower-cost regions like the Dominican Republic, Mexico and Ireland, we expect gross margins to continue expanding. Free cash flow should also be helped as the company recently completed its new facility in Tijuana, Mexico. Combined, these developments speak to UFPT’s ability to execute on its two-pronged growth strategy, which targets 10%-15% annual revenue growth and margin expansion via organic growth and acquisitions.

Other top contributors included Allegiant Travel (ALGT), Bank OZK (OZK) and Mr. Cooper Group (COOP). Leisure-focused low-cost airline Allegiant Travel has a unique business model, contributing to being among the highest margins versus competitors. As travel demand has normalized against a post-pandemic backdrop, Allegiant has benefited from strong pricing. Arkansas-based regional bank Bank OZK has weathered a challenging environment well despite fears around commercial real estate.

Further, with its conservative approach, the bank was positioned to opportunistically deploy capital during the banking crisis. Mr. Cooper Group, the largest non-bank residential mortgage services in the US, continues executing at a high level in a challenging mortgage environment and is using its strong balance sheet to enhance its market position.

Our bottom contributors in Q2 included Ashland (ASH) and Cal-Maine Foods (CALM). Ashland is a high-quality, specialty ingredients company providing both natural and synthetic ingredients to customers in the pharmaceuticals, home and personal care, and coatings industries. During Q2, Ashland’s customers — primarily distributors — destocked, which in turn led management to lower full-year guidance and pressured shares. However, in our view, destocking tends to exaggerate any end-market weakness, and we anticipate any effects should be transitory and minimally impact the company’s intrinsic value.

Cal-Maine Foods is the largest producer and marketer of shell eggs in the US. During Q2, wholesale commodities and caged egg prices normalized in the US, helped by the country having seemingly averted an avian flu outbreak — a combination which, though positive for the industry, pressured shares during the quarter. We maintain our positive outlook on Cal-Maine given the company’s significant investment in specialty and cage-free egg production, which we expect should benefit from a secular tailwind in the period ahead.

Other bottom contributors in Q2 included First Interstate BancSystem (FIBK), Taseko Mines (TGB) and WNS (Holdings) Limited. Regional bank First Interstate is struggling with the ongoing challenging backdrop for banks and has lowered revenue guidance twice, dampening the market’s confidence in its ability to weather the downturn. Shares of Canada-based mining company Taseko Mines were pressured as copper prices weakened modestly and the Florence copper mine’s final permit remains in the works with the Environmental Protection Agency.

India-based business process management (BPM) services company WNS weakened as investors contemplated whether artificial intelligence (AI) could disrupt the company’s BPM solutions. However, we do not believe AI will be a major threat to the company’s value proposition given its BPM expertise. On the contrary, we anticipate AI may present opportunities for WNS to implement AI-related solutions on behalf of its clients and prospects.

Portfolio Activity

We exited our positions in global basic apparel manufacturer Hanesbrands (HBI) and BankUnited (BKU) in order to redeploy our capital into current holdings where we have higher conviction. We also exited virtual lease-to-own (VLTO) provider PROG Holdings (PRG). The company serves customers at the lower end of the credit spectrum, who tend to be more sensitive to the economy and inflation. We capitalized on shares’ recent rebound to exit our position.

Market Outlook

Despite equity markets’ positive returns in Q2 and 2023 to date, it has been among the narrowest markets in history, with just seven stocks — META Platforms, Apple (AAPL), NVIDIA (NVDA), Alphabet (GOOG,GOOGL), Microsoft (MSFT), Amazon (AMZN) and Tesla (TSLA) — contributing a large majority of the market’s return. These stocks collectively have increased 61% year to date, although the other 493 stocks in the S&P 500 Index increased a respectable 6%.

Market participants have seemingly moved past the recent failures of SVB Financial (OTCPK:SIVBQ), First Republic (OTCPK:FRCB) and Signature Bank (OTCPK:SBNY); however, the full effects of these failures have not yet been felt. For example, if banks pull back on lending to improve their capital positions, it could negatively impact economic growth. Balancing the potential economic impact of higher interest rates with still-elevated inflation levels continues to complicate the Fed’s monetary policy decision-making process.

Corporate earnings growth is expected to slow in 2023, weighed down partly by a decline in energy sector earnings due to commodities prices well below their mid-2022 peaks. However, the decline in this year’s earnings estimates seems to have bottomed.

Meanwhile, equity markets are trading at elevated valuations compared to history; however, this is somewhat misleading given the market’s narrowness. While the S&P 500 Index trades around 20X earnings per share (EPS), the median stock trades at a more reasonable ~17X EPS. So, while it may be difficult for equity markets to generate returns that match historical averages over the next five years, there are still attractive opportunities with the potential to generate above-average returns over that period.

Our primary focus is always on achieving value-added results for our existing clients, and we believe we can achieve better-than-market returns over the next five years through active portfolio management.


Period and Annualized Total Returns (%)

Since Inception (29 Dec 2000)

20Y

15Y

10Y

5Y

3Y

1Y

YTD

2Q23

Expense Ratio (%)

Class I (MUTF:DHSIX)

9.57

9.19

7.63

7.03

5.62

19.76

19.03

13.05

6.34

0.97

Russell 2000 Index (RTY)

7.67

8.89

8.43

8.26

4.21

10.82

12.31

8.09

5.21

Russell 2000 Value Index

8.12

8.29

7.72

7.29

3.54

15.43

6.01

2.50

3.18

Click here for holdings as of 30 June 2023.

Risk disclosure: Small- and mid-capitalization issues tend to be more volatile and less liquid than large-capitalization issues.

The views expressed are those of Diamond Hill as of 30 June 2023 and are subject to change without notice. These opinions are not intended to be a forecast of future events, a guarantee of future results or investment advice. Investing involves risk, including the possible loss of principal.

Past performance is not indicative of future results. Investment returns and principal values will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. The Fund’s current performance may be lower or higher than the performance quoted. For current to most recent monthend performance, visit Diamond Hill.

Performance assumes reinvestment of all distributions. Returns for periods less than one year are not annualized. Class I shares include Investor share performance achieved prior to the creation of Class I shares.

Fund holdings subject to change without notice.

Index data source: London Stock Exchange Group PLC. SeeDiamond Hill Disclosuresfor a full copy of the disclaimer.

Securities referenced may not be representative of all portfolio holdings. Contribution to return is not indicative of whether an investment was or will be profitable. To obtain contribution calculation methodology and a complete list of every holding’s contribution to return during the period, contact 855.255.8955 or info@diamond-hill.com.

Carefully consider the Fund’s investment objectives, risks and expenses. This and other important information are contained in the Fund’s prospectus and summary prospectus, which are available at Diamond Hill or calling 888.226.5595. Read carefully before investing. The Diamond Hill Funds are distributed by Foreside Financial Services, LLC (Member FINRA). Diamond Hill Capital Management, Inc., a registered investment adviser, serves as Investment Adviser to the Diamond Hill Funds and is paid a fee for its services. Not FDIC insured | No bank guarantee | May lose value


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Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.

Editor’s Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.



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