Diamond Hill Select Fund Commentary – First Quarter 2014
During the quarter, the Fund’s holdings in the health care, information technology, and industrials sectors provided the largest contribution to absolute return. Holdings in the financials sector detracted from return.
The Fund’s outperformance relative to the Russell 3000 Index was primarily driven by security selection in the health care, energy, and industrials sectors. Security selection in the financials sector was the primary detractor from relative return.
• Generic drug manufacturer Teva Pharmaceutical Industries Ltd. (TEVA) benefitted from the addition of a well-respected CEO and the continued successful transition of patients to a new, patent-protected version of the company’s multiple sclerosis drug.
• Shares of Southwest Airlines Co. (LUV) increased as a result of strong revenue trends and moderating non-fuel costs which led to significant margin expansion.
• Medical device manufacturer Boston Scientific Corp. (BSX) benefitted from continued revenue acceleration and the launch of a new high margin stent with the potential for sizeable share gains.
• 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.
• Household durables company Whirlpool Corp. (WHR) reported strong quarterly results driven by the North America division and Brazil. The company continues to benefit from volume growth and margin expansion.
• Shares of investment manager Fortress Investment Group LLC declined during the quarter as Nationstar Mortgage Holdings, Inc. (NSM), one of the firm’s larger private equity holdings, performed poorly. In addition, the firm’s macro hedge fund has experienced disappointing near-term results.
• Rental and leasing services company Aaron’s, Inc. (AAN) declined due to recent lower traffic and weaker comparable store sales trends, which led to downward revisions in the company’s earnings outlook.
• Banking and financial services provider Citigroup, Inc. (C) continues to deal with litigation issues and a sluggish trading environment. The company’s request to increase capital return to shareholders was denied during the most recent regulatory assessment. Despite these challenges, the company continues to improve its earnings potential and balance sheet.
• Shares of oil and gas exploration and production company Apache Corp. (APA) responded to the company’s weakened competitive position relative to the domestic oil and gas industry.
• Property and casualty insurer Endurance Specialty Holdings Ltd. (ENH) reported higher than expected crop losses due to the cold weather and a decline in corn pricing. In addition, expenses continued to increase as a result of the reorganization initiated by new CEO John Charman. Over the next five years, we believe these changes will position Endurance for significant growth in premiums.
We initiated new positions in several securities 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.
Oil and gas exploration and production company EOG Resources, Inc. (EOG) is positioned to generate strong production growth over the next five years and benefits from domestic exposure to productive shale oil acreage.
Global pharmaceutical company GlaxoSmithKline PLC (GSK) has several attractive franchises and pipeline drug candidates that have the potential to add significant value.
Tobacco product manufacturer Philip Morris International, Inc. (PM) is the world’s second largest tobacco company and owns half of the leading international cigarette brands. The strength of the product portfolio enables the firm to be the price leader in many geographies.
Household durables company Whirlpool Corp. (WHR) benefits from the normalization of domestic demand and increased penetration of home appliances in developing markets.
We eliminated our positions in Southwest Airlines Co. (LUV) and medical device manufacturer Medtronic, Inc. (MDT) as these companies’ share prices approached our estimates of intrinsic value. We sold rental and leasing services company Aaron’s, Inc. (AAN) due to recent lower traffic and weaker comparable store sales trends, which led to downward revisions in the earnings outlook. We sold our position in investment manager Fortress Investment Group LLC (FIG) to redeploy funds toward other opportunities where we have a higher degree of confidence. We also eliminated oil and gas exploration and production companies Apache Corp. (APA) and Occidental Petroleum Corp. (OXY) and reinvested the proceeds into other opportunities that presented a larger discount to our estimate of intrinsic value. We closed our position in drug manufacturer Forest Laboratories, Inc. (FRX) as the market reacted positively to the news that Actavis, Inc. PLC would buy Forest Laboratories at a significant premium, and the share price approached our estimate of intrinsic value.
Austin Hawley, CFA
Rick Snowdon, CFA
Because this Fund expects to hold a concentrated portfolio of a limited number of securities, a decline in the value of these investments would cause the Fund’s value to decline to a greater degree than a less concentrated portfolio. 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 Y shares include Class A share performance achieved prior to the creation of 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 deferred 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 3000 is an unmanaged market capitalization-weighted index 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.