Diamond Hill Funds Q3 Market Review and Large-Cap Fund Commentary
After a difficult start to the third quarter for the bond markets, fixed income investors were given a reprieve when the Federal Reserve again surprised the markets with an announcement related to its bond buying program (QE). After prepping the global capital markets in May for a 'tapering' of QE, Chairman Bernanke announced in September that the committee had decided to continue purchasing securities at the same pace and pledged to keep interest rates low for the foreseeable future. The bond market reacted positively to the announcement pushing interest rates back down. The 10-Year U.S. Treasury yield began the quarter at 2.49%, touched 3% on September 5, and then ended the quarter at 2.63%.
Third Quarter Results
Cyclical stocks led the way again this quarter with the materials (+10.3%), industrials (+8.9%), consumer discretionary (+7.8%), health care (+6.8%), technology (+6.6%), and energy (+5.2%) sectors all beating the S&P 500 Index. Only the telecommunications sector posted negative returns for the quarter.
Real economic growth around the world continued at a generally modest pace in the third quarter. The domestic picture also looks to be one of slow but positive economic growth as housing and automobile production provided key areas of strength, balanced by a difficult fiscal situation and still high aggregate debt levels. In the first two quarters of 2013, the U.S. economy rose 1.1% and 2.5%, respectively; however, the jobless rate remains stuck above 7%.
Against this backdrop, corporate revenue growth has slowed and margins remain near historical highs, making it difficult for companies to post higher profits. In addition, market valuations, as measured by the trailing twelve month price/earnings multiple, have moved above long-term averages. The combination of these factors presents potential headwinds for stocks.
As we have highlighted over the past couple of quarters, consumer debt- service burdens have improved significantly in the past few years and are now at relatively low levels by historical standards. However, total household debt, when compared to asset levels and disposable income, remains above long-term averages. Consequently, the healthy debt service picture remains closely linked to very low interest rates and low mortgage rates which have clearly moved higher since May and may present a meaningful risk to growth if we experience further increases in those rates. We continue to believe that the U.S. economy will be challenged for many years by financial deleveraging and the ultimate withdrawal of fiscal and monetary stimulus.
We believe the Fed is likely to maintain a very accommodative overall monetary stance for the foreseeable future. Despite the increase in yields during the last few months, we remain cautious on the Treasury markets when using a long time horizon. In addition, given the combination of modest economic growth, very strong corporate profit margins, and above average price/earnings multiples, we now expect positive but below average equity market returns over the next five years.
The Fund increased 5.42% (Class A, without sales charge) during the quarter, compared to a 6.02% increase in the Russell 1000 Index.
During the quarter, the Fund's holdings in the industrials, energy, and financials sectors provided the largest positive contribution to return. Holdings in the consumer staples sector detracted from return.
The Fund's underperformance relative to the Russell 1000 Index was primarily driven by security selection in the information technology sector, as well as security selection and an overweight position in the consumer staples sector. Security selection in the energy and industrials sectors contributed to relative return.
• Exploration and production company EOG Resources, Inc. (EOG) continues to be a leader in the horizontal development of oil plays in the U.S. Results continued to improve and exceed expectations as productivity increased and costs are managed.
• Building and aerospace technology conglomerate United Technologies Corp. (UTX) experienced surprisingly strong order growth in the Otis, Carrier, and Pratt & Whitney segments. Lower pension costs and synergies from the Goodrich acquisition bode well for future financial performance.
• Boston Scientific Corp. (BSX), a medical device manufacturer, recently reported its first quarter of growth in more than three years, while also raising its earnings outlook. An emerging pipeline of new products offers the potential for continued improvement and the potential to return to mid-single digit revenue growth.
• Exploration and production company Cimarex Energy Co. (XEC) benefited from improving well results in the Delaware Basin in West Texas. Cimarex has a sizeable acreage position in the Wolfcamp Shale which we believe can help sustain strong production growth at very good economics if the development is successful.
• Diversified machinery manufacturer Dover Corp. (DOV) responded favorably to renewed organic sales growth, improving margins, and an improved outlook for its Communications Technologies business.
• ConAgra Foods, Inc. (CAG), a packaged food manufacturer, fell as it reported volume declines in its branded foods businesses and higher-promotional spending.
• Sysco Corp. (SYY), a food distributor, announced disappointing earnings as weakness in its end markets has made it difficult to achieve anticipated revenue growth targets.
• Software provider Microsoft Corp. (MSFT) reported a number of noteworthy events during the quarter. Investors reacted positively to the announcement that Microsoft will appoint a new CEO within the next 12 months to replace Steve Ballmer. However, shares retreated after the company announced the purchase of Nokia's phone business along with certain patent rights for $7.2 billion as many investors question whether that market will ever prove profitable.
• Drug manufacturer Abbott Laboratories (ABT) reported revenue growth that was below expectations due to its exposure to the slower growth economies in Europe and the emerging markets. Despite the recent weakness, Abbott is a high-quality company with shares that we believe to be attractively priced. In addition, its management team has a strong record of investing capital prudently.
• Baxter International, Inc. (BAX), a medical supply manufacturer, declined during the quarter due to concerns that it could lose more market share than expected in the hemophilia market.
We initiated a new position in office products retailer Staples, Inc. Our view is that the company has a market leading position, the ability to generate strong free cash flow, and a strong balance sheet. Additionally, strategic initiatives to close stores and focus efforts on driving sales online and industry consolidation further support our thesis.
There were no positions eliminated during the third quarter.
The views expressed are those of the portfolio managers as of September 30, 2013, are subject to change and may differ from the views of other portfolio managers or the fi rm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of results, or investment advice.
The Russell 1000 Index is a market capitalization-weighted index measuring performance of the largest 1,000 companies, on a market capitalization basis, in the Russell 3000 Index, a market-capitalization weighted index measuring the performance of the 3,000 largest U.S. companies based on total market capitalization. One cannot invest directly in an index. Unlike mutual funds, the index does not incur expenses. If expenses were deducted, the actual returns of this index would be lower.
Performance is not guaranteed. Performance returns assume reinvestment of all distributions. Returns for the periods less than one year are not annualized. Class I and Class Y shares include performance based on Class A shares, which was achieved prior to the creation of Class I shares and Class Y shares. These total return fi gures may refl ect the waiver of a portion of a Fund's advisory or administrative fees for certain periods. In such instances, and without such waiver of fees, the total returns would have been lower. The total return fi gures refl ect the maximum sales charge applicable to each class. The maximum sales charge for A shares is 5.00%; C shares have a maximum contingent deferred sales charge (CDSC) of 1.00% for redemptions within the fi rst year of purchase; I shares and Y shares have no sales charge. Average annual total returns illustrate the annual compounded returns that would have produced the cumulative total return if the Fund's performance had remained constant throughout the period indicated. Fund holdings and sector allocations are subject to change without notice.
The Large Cap Fund carries risks associated with stock market volatility.
An investor should consider the Fund's investment objectives, risks, and charges and expenses carefully before investing or sending any money. This and other important information about the Fund(s) can be found in the Fund's(s) prospectus or summary prospectus which can be obtained at www.diamond-hill.com or by calling 888-226-5595. Please read the prospectus or summary prospectus carefully before investing. The Diamond Hill Funds are distributed by BHIL Distributors, Inc. (Member FINRA), an affi liated company. 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. Like all mutual funds, Diamond Hill Funds are not FDIC insured, may lose value, and have no bank guarantee.
The performance data quoted represents past performance; past performance does not guarantee future results. The investment return and principal value of an investment 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 data quoted. Investors may obtain performance information current to the most recent month-end, within 7 business days, at www.diamond-hill.com.