Diamond Hill Small Capital Fund Q1 2022 Market Commentary

Two businessmen with pens pointing to a graph discussing data with modern laptops on a desk.  Strategic concepts and analysis of the close working team in the office.

ArLawKa AungTun/iStock via Getty Images

market comment

The runaway quarter ended in stock markets with the worst returns since the first quarter of 2020. Rising inflation prompted the Federal Reserve to begin a rate-raising cycle, while Putin’s invasion of Ukraine sent commodity prices soaring (Learn more about the war agricultural impact In our last podcast) and the already challenged supply chain system in more chaos. After the Federal Reserve raised interest rates in March, some optimism again crept into the markets as investors viewed the sell-off as an opportunity to acquire shares that sold sharply in January and February.

The Russell 1000 Index ended the quarter down 5.13%. Returns were weaker below the market cap spectrum with the Russell Midcap down -5.68% and the Russell 2000 Index down -7.53%. Across the cap spectrum, stocks in the value indexes have held up much better than their growth index peers. The Russell 1000 Value Index outperformed its peers in growth by 830 basis points, while the Russell Midcap Value and Russell 2000 Value Indexes outperformed their peers in growth by more than 1,000 basis points each.

In the Russell 2000 Index, the energy sector advanced 42% as the Russian/Ukrainian war and sanctions on the Russian energy sector drove up oil and gas prices in the first quarter. Brent crude 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 have jumped past $4 a gallon, with expectations that prices could reach $5 on over the next six months. (Learn more about The state of energy markets In our most recent industry perspective.) Utilities posted a small positive return in the first quarter.

The Discretionary Index for Consumer, Healthcare, and Technology followed, down -17%, -15%, and -14%, respectively. The remaining sectors outperformed the index with single-digit declines.

1Q22 Russell 2000 Index Returns (%)

1Q22 Russell 2000 Index Returns (%)

Source: FactSet, as of March 31, 2022.

performance discussion

Amid a challenging market environment, our portfolio’s negative returns still outperformed the Russell 2000 Index by a healthy margin in the first quarter. The relative performance was underpinned by strength among our core consumer goods holdings – and overall, its positive returns outperformed the market. We got more help with our exposure above the standard. Healthcare holdings boosted results, as did underweight exposure to technology, which took a hit in the first half of the quarter. Our energy holdings, while positive, our lagging peers in the index, influence the results, and our below-standard exposure served as an additional headwind. Discretionary consumer holdings was another source of relative weakness as economic uncertainty linked to higher inflation expectations returned.

On an individual holdings basis, major shareholders returning in the first quarter included Cal-Maine Foods (calmRimini Street (RMNIand South Jersey Industries.SJI). Fresh egg producer Cal-Maine has benefited from its significant advanced investment in cage-free facilities as some states have begun to transition to providing cage-free eggs only, especially California. In addition, a number of competitors have encountered bird flu outbreaks in their facilities, driving up egg prices and highlighting the quality of Cal-Maine’s production capabilities.

IT provider Rimini Street — a new holding company in the first quarter — has announced strong fundamentals and is making progress in correcting recent challenges with the US sales organization. The company remains profitable and produces strong cash levels that contribute net cash to its balance sheet. Furthermore, the cancellation of preferred stock in 2021 demonstrates a management team in line with the common shareholders.

The South Jersey Industries natural gas facility received a boost when it accepted an offer from a privately owned infrastructure fund to buy the company at a 53% premium over its previous close. The price quoted was consistent with our long-term view of the company.

Other major shareholders include Civitas Resources, an oil and gas exploration and production company (CIVITaseko Mines and copper minesTGB). Both saw stocks rally as commodity prices generally rose due to supply concerns related to Russia’s invasion of Ukraine.

Among the lowest shareholders in the first quarter are Green Brick Partners (GRBK), PROG Holdings (PRGand Vail ResortsMTN). Homebuilder Green Brick, along with other housing companies, came under pressure in the first quarter primarily on concerns that higher mortgage rates would dampen demand for new homes. We are aware of the challenges posed by the near-term higher interest rate environment. In the long term, the secular view of housing construction is positive, as there is still a physical shortage of housing stock in the United States. We believe Green Brick continues to be one of the best positioned small housing companies, with attractive real estate, strong balance sheet and strong shareholder compliant management team which has been a prudent capital allocation.

Leasing and Leasing Services Company PROG Holdings (PRG) saw a decline in lease-to-own applications in January while PRG’s retail partners struggled with retail traffic and store employees due to the omicron variable. Moreover, the vision to the consumer through a lease to own contract is murky in the near term, as the industry begins to benefit from the stimulus benefits of the prior year. In our opinion, results should improve as the retail environment continues to open up. As PRG offers flexible rental purchasing solutions to help more credit-challenged customers towards product ownership, a slack environment can highlight the strength of PRG’s business model. We continue to be drawn to PRG’s relatively high-quality cash generation process and asset-light business model. There are also opportunities for the company to grow a relatively stable retail partner base and expand into e-commerce and direct-to-consumer channels.

Despite record pass sales, Vail Resorts had a tough 2021-2022 ski season which is reflected in stock prices. The lack of snow early in the season made the terrain difficult to open. The problems are exacerbated by the challenges of hiring seasonal workers, which meet a huge demand from skaters. The disillusionment with the consumer experience is well publicized on social media. Management has addressed these issues with a significant investment in personnel.

Other critics of Q1 Live Oak Bancshares (loband Red Rock Resorts$$$$). The fundamentals of regional bank Live Oak remain strong, although shares were sold in sympathy with other bank names. After a strong finish to 2021, Las Vegas-based local casino operator Red Rock Resorts has backed away from omicron concerns as well as inflationary risks related to the Durango development of the company.

wallet activity

As mentioned, we started a contract on Rimini Street in the first quarter, an IT services provider focused primarily on enterprise support and maintenance for Oracle (ORCL) and SAP (succulents) products. Recent challenges with the US Sales organization have temporarily withheld its revenue growth profile, giving us the opportunity to purchase stock at what we believe is an attractive discount to our intrinsic value appreciation.

Webster Financial Corporation (WBS) is also a new name in the portfolio, having completed the merger of the former Sterling Bank. This combination means that Webster’s large Health Care Savings Account (HSA) platform, which is a good source of low-cost deposits, will be paired with Sterling’s organic loan creation engine.

We exited from Coterra Energy (CTRA), and take advantage of rising stock prices in response to rising commodity prices to reallocate them to other opportunities. We exited from the regional bank Glacier Bancorp (GBCI) in favor of the names of the highest conviction. We sold the pump equipment manufacturer SPX Flow (SPXC) prior to its acquisition by Lone Star as the shares traded above the output price. Broadridge Financial Solutions (BR) and the company Flowers Foods, which specializes in food production (FL) when close to our estimate of intrinsic value.

market forecast

After a strong recovery in 2021, global GDP growth is expected to slow in 2022, with the potential for additional pressure from ongoing supply chain disruptions, higher oil prices and other impacts from the Russian invasion of Ukraine. Despite these headwinds, corporate earnings are expected to continue to reach new heights in 2022.

The sharp economic recovery in the United States, along with unprecedented fiscal and monetary stimulus, increased wage growth and supply and demand tightening, has led to higher levels of inflation. The Fed has begun raising interest rates and ending quantitative easing, but it may need to be more severe if inflation continues at elevated levels, which could be a headwind for stock markets.

The Russian invasion of Ukraine has the potential to disrupt the flow of exports from these countries, potentially affecting global supplies and prices for a wide range of end markets. The potential impact on individual companies varies, and we monitor these risks closely.

While the year-to-date decline in stock markets has created some investment opportunities, broad market valuations are still above historical averages. From current levels, stock market returns over the next five years are likely to be lower than historical averages.

Our primary focus has always been to achieve value-added results for our existing clients, and we believe we can achieve better market returns over the next five years through active portfolio management.

Listed securities and respective weights (%)

Cal-Maine Foods, Inc.

4.8

Rimini Street, Inc. (Cl A)

2.1

Civitas Resources, Inc.

2.6

South Jersey Industries, Inc.

1.1

Green Brick Partners, Inc.

1.6

TASICO MINES LIMITED.

2.3

Live Oak Bancshares, Inc.

2.2

Villa Resorts

2.3

PROG Holdings, Inc.

1.3

Webster Financial Corp.

4.6

Red Rock Resorts, Inc. (Cl A)

5.8

Period and total annual returns (%)

Since inception (December 29, 2000)

20 h

15 p

10 am

5 am

3 years

1 p

YTD

1Q22

Expense percentage (%)

first degree (MUTF:DHSIX)

10.12

8.95

7.27

9.32

7.60

11.91

9.43

-4.46

-4.46

0.97

Russell 2000 . index

8.51

8.72

7.99

11.04

9.74

11.74

-5.79

-7.53

-7.53

Russell value index 2000

9.16

8.55

6.91

10.54

8.57

12.73

3.32

-2.40

-2.40


original post

Editor’s note: The bulleted summary of this article was selected by searching for the alpha editors.