The Diamond Hill Small Cap Fund returned 4.86% (Class I) in 2014 compared to a 4.89% return for the Russell 2000 Index. In 2014, the small cap market’s best performing sectors were healthcare, utilities, and consumer staples. These sectors tend to be seen as relatively defensive and associated with “safe havens.” Utilities, in particular, also tend to do well when interest rates fall as many view regulated utilities as the most bond-like of equity investments. Government interest rates declined during the year, with the 10-year Treasury finishing below 2.2%, down from levels around 3% at the beginning of the year. Energy was by far the worst performing sector in 2014, as crude oil prices declined nearly 50%. The Fund’s underperformance can largely be attributed to having a larger allocation to energy stocks and a smaller allocation to healthcare stocks than the Index. In addition, while stock selection was generally good, the consumer staples sector was an exception.
The Fund’s financial holdings were the largest contributors in 2014. The Fund averaged roughly 27% of net assets invested in this sector, with nearly half of that amount in insurance companies. Banks and real estate investment trusts (REITs) each comprised about a fifth of the financial sector holdings. Winthrop Realty Trust, Inc. (FUR) announced a liquidation plan to sell all its assets and distribute the proceeds to shareholders within a two-year period. Thus far, asset sales have come in a bit above the mid-point of ranges that the company has used in its internal estimate of net asset value. In total, these developments led to a 65% total return for the stock in the year. Insurance or reinsurance companies including HCC Insurance Holdings, Inc. (HCC), Navigators Group, Inc. (NAVG), Alleghany Corp. (Y), Enstar Group Ltd. (ESGR), American Equity Investment Life Holding Co. (AEL), and Reinsurance Group of America (RGA) all experienced total returns between 10% and 18.5%. The largest detractors within financials were First Niagara Financial Group, Inc. (FNFG) and Nationstar Mortgage Holdings, Inc (NSM). Nationstar is a non-bank mortgage servicer whose primary competitor, Ocwen Financial Corp., has encountered great regulatory scrutiny. We believe Nationstar may ultimately benefit from Ocwen’s problems, while thus far the market is skeptical. Continue Reading »