Diamond Hill Small Cap Fund Commentary – First Quarter 2014
During the quarter, the Fund’s holdings in the industrials and energy sectors provided the largest contribution to absolute return. Holdings in the consumer staples and financials sectors detracted from return.
The Fund’s outperformance relative to the Russell 2000 Index was primarily the result of security selection in the consumer discretionary and industrials sectors. Security selection in the financials and consumer staples sectors detracted modestly from relative return.
• Auto rental company Avis Budget Group, Inc. (CAR) outperformed for the quarter in response to the positive free cash flow outlook provided by management in a meeting with investors. In addition, the announcement that competitor Hertz Global Holdings, Inc. would separate its equipment rental business indicated the potential for more rational competition and upward pricing in the car rental business.
• Railroad service company Trinity Industries, Inc. (TRN) reported strong revenue and margins in addition to a significant two-year purchase agreement in its Rail segment, which continues to benefit from an increase in car demand for transporting oil.
• Oil and gas exploration and production company Cimarex Energy Co. (XEC) outperformed reflecting stronger commodity prices and an improving growth outlook based on favorable results in the Delaware Basin.
• Pharmaceutical company Actavis, Inc. PLC (ACT) announced the acquisition of drug manufacturer Forest Laboratories, Inc. during the quarter for a combination of cash and stock. Investors viewed this as a positive for Actavis due to expected synergies and an increase in the branded drug business as a percent of revenues.
• Shares of infant medical device manufacturer Natus Medical, Inc. (BABY) rose as the company reported strong quarterly earnings, continued margin improvement, and a promising outlook for the year.
• Machine tool manufacturer Kennametal, Inc. (KMT) disappointed investors by reporting lackluster revenue growth and lower operating margins, questioning the ability of the company to achieve its already reduced operating targets for the year.
• Diversified industrial company TriMas Corp. (TRS) underperformed as a result of weak earnings during the previous quarter.
• Life insurer American Equity Investment Life Holding Co. (AEL) reported disappointing results due to a mismatch in their hedge position. We believe the company will continue to benefit from the growing demand for indexed annuities and from any increase in long-term rates.
• Battery manufacturer Energizer Holdings, Inc. (ENR) underperformed as a result of weakness in battery and personal care sales.
• Processed and packaged goods manufacturer B&G Foods, Inc. (BGS) reported earnings and provided guidance that were below expectations. The food industry dynamics remain challenging for many packaged food companies.
We initiated new positions in several companies during the quarter. Brown & Brown, Inc. (BRO) is a mid-sized insurance broker. We view the insurance brokerage industry as highly attractive with good secular growth prospects, low capital requirements, and the ability to generate high free cash flow. In addition, the management team has been successful purchasing smaller brokers and operating within a highly decentralized business model. Investor skepticism related to recent large acquisitions, which we believe will prove unfounded, created an attractive valuation.
First Horizon National Corp. (FHN) is a Tennessee-based bank whose stock underperformed peers in 2013 due to lingering litigation concerns and continued sluggish performance within its fixed income trading business. The bank has the highest market share in Tennessee, and as one of the more asset-sensitive banks, we believe earnings should increase more quickly in a rising interest rate environment.
Electric utility provider ITC Holdings Corp. (ITC) is the only pure play independent electricity transmission company in the country. The company has a strong management team and is able to earn a high return on investment due to the federal government’s interest in promoting investment in electricity transmission following years of underinvestment.
Ski resort owner and operator Vail Resorts, Inc.’s (MTN) marquee properties in Colorado enable the company to generate a substantial season pass business that offers quality and value to customers. Smaller lodging and real estate divisions complement the company’s core ski business.
Grocery store chain Harris Teeter Supermarkets, Inc. (HTSI) was eliminated as its acquisition by The Kroger Co. was completed. Additionally, we eliminated accident and health insurance company Assurant, Inc. (AIZ) and trucking company Saia, Inc. (SAIA) as these companies’ share prices approached our estimates of intrinsic value.
Tom Schindler, CFA
Chris Welch, CFA
Asst. Portfolio Manager
Jason Downey, CFA
Asst. Portfolio Manager
There are specialized risks associated with small capitalization issues, such as market illiquidity and greater market volatility, than large capitalization issues.
The views expressed are those of the portfolio managers as of March 31, 2014, are subject to change and may differ from the views of other portfolio managers or the firm as a whole. These opinions are not intended to be a forecast of future events, a guarantee of results, or investment advice.
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 diamond-hill.com.
Performance returns assume reinvestment of all distributions. Returns for periods less than one year are not annualized. Class C, Class I and Class Y shares include Class A share performance achieved prior to the creation of Class C, Class I and Class Y shares. These total return figures may reflect the waiver of a portion of a Fund’s advisory or administrative fees for certain periods. Without such waiver of fees, the total returns would have been lower. The total return figures reflect the maximum sales charge applicable to each class. The maximum sales charge for A shares is 5.00%; C shares have a maximum contingent defer red sales charge of (CDSC) of 1.00% for redemptions with the first year of purchase; I shares and Y shares have no sales charge.
Fund holdings subject to change without notice.
The Russell 2000 Index is an unmanaged market capitalization-weighted index comprised of the smallest 2,000 companies by market capitalization in the Russell 3000 Index, which is comprised of the 3,000 largest U.S. companies by total market capitalization. This index does not incur fees and expenses (which would lower the return) and is not available for direct investment.
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 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 affiliated company. Diamond Hill Capital (Trades, Portfolio) 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.