Diamond Hill Small-Mid Cap Fund Market Commentary Q1 2022

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Market Commentary

A wild quarter in equity markets ended in the worst returns since the first quarter of 2020. Rising inflation prompted the Federal Reserve to begin its rate hike cycle, while Putin’s invasion of Ukraine sent commodity prices soaring (read more about the agricultural impact of the war in Ukraine). our recent podcast) and an already-challenged supply chain system in further disarray. After the Fed hiked rates in March, some optimism crept back into the markets as investors saw the sell-off as an opportunity to gobble up stocks that sold sharply in January and February.

The Russell 1000 Index ended the quarter at -5.13%. Returns were weaker across the market cap spectrum as the Russell Midcap Index fell -5.68% and the Russell 2000 Index fell -7.53%. Across the cap spectrum, stocks in the value indices held up much better than their competitors in the growth index. The Russell 1000 Value Index outperformed its growth counterparts by 830 basis points (bps), while the Russell Midcap Value and Russell 2000 Value Indexes outperformed their growth counterparts by more than 1,000 bps each.

In the Russell 2500 Index, the energy sector rose 40% as the war between Russia and Ukraine and sanctions against the Russian energy sector rocketed oil and gas prices in the first quarter. Brent oil reached a high of $140 a barrel in early March, a level not seen since the global financial crisis in 2008. In the US, gasoline prices soared to more than $4 a gallon, with prices expected to rise in the next six months. months could reach $5. (Read more about the state of energy markets in our latest sector perspective.) Materials were up 7% and utilities posted a small gain of 2% in the first quarter.

Consumer discretionary and healthcare led the rest of the field down, losing -15% each. Technology and industrials and services followed the index with losses of -10% and -7%. The other sectors outperformed the index in single-digit declines.

1Q22 Russell 2500 Index Sector Returns (%)

chart: 1Q22 Russell 2500 Index Sector Returns (%)

Source: FactSet, as of March 31, 2022.

Performance Discussion

In the midst of a generally rocky market quarter, our portfolio’s negative returns in the first quarter still outperformed the Russell 2500 Index by a healthy margin. Our significant underweight in healthcare provided a relative boost, with our holdings also outperforming index peers. The strength of our positions in consumer staples and financials also contributed to results, as did our underweight exposure to technology, which was dented in the first half of the quarter. Our consumer discretionary investments were our main source of relative weakness as economic uncertainty resurfaced amid higher inflation expectations. Our underweights in the materials and energy sectors, which beat the index, were additional headwinds.

Based on individual investments, Cal-Maine Foods (CALM), South Jersey Industries (SJI), Alleghany Corporation (Y) and Kirby Corporation (KEX) were the largest contributors to Q1 returns. Fresh egg producer Cal-Maine has benefited from its significant advanced investment in cage-free facilities as some states have begun the transition to providing only cage-free eggs, most notably California. In addition, a number of competitors experienced avian flu outbreaks at their facilities, driving up egg prices and highlighting the quality of CalMaine’s manufacturing capabilities.

Natural gas company South Jersey Industries got a boost when it accepted an offer from a private infrastructure fund to buy the company at a 53% premium from its previous shutdown. The price offered was in line with our own long-term vision of the company. Similarly, property and casualty insurance company Alleghany announced during the first quarter that it would be acquired by Berkshire Hathaway (BRK.A, BRK.B) for a 25% premium over its prior market value.

Kirby Corporation, a US-based tanker carrier of bulk liquid products, benefited as the retreating microwave wave in North America contributed to increased demand for hydrocarbon distillates and generally improved industrial activity.

One of our key contributors in the first quarter was Coterra Energy (CTRA), energy exploration and production company. Energy demand rose as COVID-related economic restrictions eased, along with concerns about supply disruptions related to Russia’s invasion of Ukraine.

The lowest contributions in the first quarter were NVR Inc. (NVR), PROG Holdings (PRG) and Colfax Corporation. Housing builder NVR, along with other housing companies, was under pressure in the first quarter, mainly due to concerns that rising mortgage rates will dampen demand for new homes. We recognize the challenges posed by a rising interest rate environment in the near term. In the longer term, the secular outlook for housing construction is positive, as the US continues to face a material housing shortage. We also like NVR’s approach, where it has an option on land rather than owning it in full, reducing the risk of the business from falling land prices.

Rental and leasing services company PROG Holdings saw declining lease-to-own applications in January, while PRG’s retail partners struggled with store traffic and store staff due to the ommicron variant. Furthermore, the near-term view of the lease-to-own consumer is cloudy as the industry begins to reap the stimulus benefits of the previous year. In our view, the results should improve as the retail environment opens up further. Because PRG offers flexible lease purchase solutions to help more customers with credit problems gain product ownership, a recessionary environment could emphasize the strength of PRG’s business model. We continue to be attracted to PRG’s relatively high-quality cash generation and low-asset business model. There are also opportunities for the company to expand its relatively tacky retail partner base and expand into e-commerce and direct-to-consumer channels.

Diversified technology company Colfax Corporation underperformed, largely due to concerns about the company’s exposure to Russia in its manufacturing technology business, which generated approximately 7% of that business line’s revenue. Just after the end of the quarter, the company completed a planned split: the manufacturing technology business became ESAB (ESAB) and the medical technology business organized as Enovis (ENOV). ESAB has removed Russia from its 2022 guidance, and now that the split has been completed, we both continue to hold on to the belief that the two new companies are in an excellent position to leverage their business systems to continuously operate operations over time. and make value-creating acquisitions in their respective industries.

Other bottom contributors were UGI Corporation (UGI) and Sensata Technologies (ST). Based on Europe’s energy crisis, investors are wondering whether UGI Corporation, a natural gas and electric utility, is mismanaging commodity risk or facing demand destruction. We believe that these risks are transient and manageable. In addition, UGI has made significant investments in its renewable fuels business, including renewable natural gas (RNG) and bioLPG propane, produced from renewable resources such as plant and vegetable waste. Sensata Technologies, a developer of industrial sensors, is facing lingering uncertainty in the automotive industry related to supply chain disruptions and shortages of semiconductor chips.

Portfolio Activity

New holdings in the first quarter included Civitas Resources (CIVI) and Live Oak Bancshares (LOB). Energy exploration and product company Civitas presented an opportunity for exposure to what we believe are excellent long-term assets that can benefit from higher energy prices.

The fundamentals of regional bank Live Oak remain strong, although shares were sold in the first quarter out of sympathy with other bank names. Short-term weakness presented an opportunity to gain a foothold in a company that we know well, one that we believe is uniquely positioned as a small investment bank that is also a technology leader.

Webster Financial Corporation (WBS) is also a new name in the portfolio, having completed the merger with our previous holding company, Sterling Bank. The combination means that Webster’s large health savings account (HSA) platform, which is a good source of low-cost deposits, will be combined with Sterling’s organic loan generation engine.

We left the Reinsurance Group of America (RGA) and Molson Coors (TAP) and chose names with a higher conviction.

Market Outlook

After a strong recovery in 2021, global GDP growth is expected to moderate in 2022, with possible additional pressures from ongoing supply chain disruptions, higher oil prices and other consequences of the Russian invasion of Ukraine. Despite these headwinds, corporate earnings are expected to continue to hit new highs in 2022.

The sharp economic recovery in the US, together with unprecedented fiscal and monetary stimulus, a pick-up in wage growth and moments of tightness between supply and demand, have led to high levels of inflation. The Federal Reserve has begun raising interest rates and ending quantitative easing, but may need to be more aggressive if inflation continues at high levels, which could be a headwind for equity markets.

The Russian invasion of Ukraine has the potential to disrupt the flow of exports from these countries, impacting global supply and prices for many different end markets. The potential impact on individual companies varies and we monitor these risks closely.

While the downturn in stock markets has created some investment opportunities so far, broad market valuations remain above historical averages. From current levels, equity market returns are likely to be below historical averages over the next five years.

Our primary focus has always been on delivering 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.

Mentioned effects and respective weights (%)

Alleghany Corp.

2.5

NVR, Inc.

2.4

Cal Maine Foods, Inc.

3.4

PROG Holdings, Inc.

1.1

Community Resources, Inc.

0.6

Sensata Technologies Holding PLC

2.4

Colfax Corp.

4.1

South Jersey Industries, Inc.

2.1

Coterra Energy, Inc.

2.4

UGI Corp.

2.1

Kirby Corp.

2.1

Webster Financial Corp.

3.8

Live Oak Bancshares, Inc.

0.5

Period and annualized total return (%)

Since inception (December 30, 2005) 15Y 10Y 5Y 3Y 1Y YTD 1Q22 Expense ratio (%) Gross

Expense ratio (%) Net1

Class I (DHMIX) 9.32 9.35 11.51 8.79 13.08 11 -3.07 -3.07 0.93 0.92
Russell 2500 Index 9.50 8.98 12.09 11.57 13.79 0 -5.82 -5.82
Russell 2500 Value Index 8.40 7.59 11.04 9.19 12.98 8 -1.5 -1.5


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Editor’s Note: The summary bullet points for this article were chosen by the editors of Seeking Alpha.

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