Diamond Hill Small Cap Fund Q1 2022 Market Commentary

Market Commentary

A wild quarter in fairness markets ended within the worst returns since Q1 2020. Rising inflation drove the Federal Reserve to start its price climbing cycle, whereas Putin’s invasion of Ukraine despatched commodity costs surging (study extra concerning the warfare’s agricultural impression in our current podcast) and an already challenged provide chain system into additional disarray. After the Fed raised charges in March, some optimism crept again into markets as buyers considered the sell-off as a chance to gobble up shares that bought off sharply in January and February.

The Russell 1000 Index closed the quarter down -5.13%. Returns had been weaker down the market-cap spectrum because the Russell Midcap Index fell -5.68% and the Russell 2000 Index declined -7.53%. Throughout the cap spectrum, shares within the worth indexes held up much better than their progress index friends. The Russell 1000 Worth Index outpaced its progress counterpart by 830 foundation factors (bps), whereas the Russell Midcap Worth and Russell 2000 Worth Indexes outpaced their progress counterparts by greater than 1,000 bps every.

Within the Russell 2000 Index, the vitality sector superior 42% because the Russia/Ukraine warfare and sanctions on the Russian vitality sector despatched oil and gasoline costs skyrocketing in Q1. Brent crude reached a excessive of $140 per barrel in early March, a degree not seen because the international monetary disaster in 2008. Within the US, gasoline costs jumped previous $4 per gallon, with expectations that costs might attain $5 over the following six months. (Study extra concerning the state of vitality markets in our newest trade perspective.) Utilities posted a small constructive return in Q1.

Client discretionary, well being care and know-how trailed the index, down -17%, -15% and -14%, respectively. The remaining sectors outpaced the index with single digit declines.

1Q22 Russell 2000 Index Sector Returns (%)

Efficiency Dialogue

Amid a rocky market setting, our portfolio’s adverse returns nonetheless outpaced the Russell 2000 Index by a wholesome margin in Q1. Relative efficiency was aided by power amongst our shopper staples holdings — in combination, their constructive returns outpaced the market. We had been additional aided by our above-benchmark publicity. Our well being care holdings buoyed outcomes, as did our underweight publicity to know-how, which took a beating within the first half of the quarter. Our vitality holdings, although constructive, trailed index friends, weighing on outcomes, and our below-benchmark publicity was a further headwind. Our shopper discretionary holdings had been one other supply of relative weak point as financial uncertainty re-emerged tied to increased inflation expectations.

On a person holdings’ foundation, prime contributors to return in Q1 included Cal-Maine Meals (CALM), Rimini Road (RMNI) and South Jersey Industries (SJI). Contemporary egg producer Cal-Maine benefited from its vital superior funding in cage-free amenities as some states have begun their transition to offering solely cage-free eggs, most particularly California. Moreover, various rivals contended with chook flu outbreaks of their amenities, driving up egg costs and shining a lightweight on the standard of Cal-Maine’s manufacturing capabilities.

IT companies supplier Rimini Road — a brand new holding in Q1 — reported strong fundamentals and is making progress on rectifying current challenges with its US gross sales group. The corporate stays worthwhile and is producing strong money ranges contributing to internet money on its stability sheet. What’s extra, the elimination of most well-liked inventory in 2021 demonstrates a administration group that’s aligned with widespread shareholders.

Pure gasoline utility South Jersey Industries obtained a lift when it accepted a proposal from a privately held infrastructure fund to buy the corporate at a 53% premium to its prior shut. The value provided was according to our personal long-term view of the corporate.

Different prime contributors included oil and gasoline exploration and manufacturing firm Civitas Sources (CIVI) and copper miner Taseko Mines (TGB). Each noticed shares rise as commodities costs generally spiked on provide considerations associated to Russia’s invasion of Ukraine.

Backside contributors in Q1 included Inexperienced Brick Companions (GRBK), PROG Holdings (PRG) and Vail Resorts (MTN). Homebuilder Inexperienced Brick, together with different housing firms, was pressured in Q1 totally on considerations that rising mortgage charges will dampen new dwelling demand. We acknowledge the challenges introduced by a rising rate of interest setting within the close to time period. Long term, the secular outlook on housing building is constructive, as there stays a fabric scarcity of housing inventory within the US. We consider Inexperienced Brick stays top-of-the-line positioned small-cap housing firms, with engaging actual property, a robust stability sheet and a strong, shareholder-aligned administration group that has been a sensible allocator of capital.

Rental and leasing companies firm PROG Holdings (PRG) noticed declining lease-to-own functions in January whereas PRG’s retail companions struggled with retail site visitors and retailer staffing because of the omicron variant. Additional, visibility into the lease-to-own shopper is cloudy within the near-term, because the trade begins lapping the prior 12 months’s stimulus advantages. In our view, outcomes ought to enhance because the retail setting continues opening up. As a result of PRG affords versatile lease buy options to assist extra credit-challenged clients towards product possession, a recessionary setting might spotlight the power of PRG’s enterprise mannequin. We proceed to be drawn to PRG’s comparatively high-quality money era and its asset-light enterprise mannequin. There are additionally alternatives for the corporate to develop its comparatively sticky retail associate base and develop into e-commerce and direct-to-consumer channels.

Regardless of file move gross sales, Vail Resorts had a tough 2021-2022 ski season which is being mirrored in share costs. Early season lack of snow led to issue opening terrain. Issues had been compounded by challenges hiring seasonal labor assembly an abundance of skier demand. Disappointment within the shopper expertise was properly publicized on social media. Administration has addressed these points with a major funding in personnel.

Different detractors in Q1 included Stay Oak Bancshares (LOB) and Crimson Rock Resorts (RRR). Regional financial institution Stay Oak’s fundamentals stay sturdy, although shares bought off in sympathy with different financial institution names. Following a robust end to 2021, Las Vegas locals’ on line casino operator Crimson Rock Resorts pulled backed on omicron considerations in addition to inflationary dangers associated to the corporate’s Durango improvement.

Portfolio Exercise

As talked about, we initiated a holding in Rimini Road in Q1, an IT companies supplier specializing in enterprise help and upkeep primarily for Oracle (ORCL) and SAP (SAP) merchandise. Current challenges with its US gross sales group quickly obscured its income progress profile, giving us a chance to buy shares at what we consider is a pretty low cost to our estimate of intrinsic worth.

Webster Monetary Company (WBS) can be a brand new title within the portfolio, having accomplished its merger of our prior holding Sterling Financial institution. The mix signifies that Webster’s massive well being care financial savings (HSA) account platform, which is an efficient supply of low-cost deposits, might be paired with Sterling’s natural mortgage era engine.

We exited Coterra Vitality (CTRA), benefiting from increased share costs in response to the run-up in commodities to reallocate to different alternatives. We exited regional financial institution Glacier Bancorp (GBCI) in favor of upper conviction names. We bought pumping gear producer SPX Move (SPXC) prematurely of its acquisition by Lone Star as shares had been buying and selling above the takeout value. Broadridge Monetary Options (BR) and specialty meals producer Flowers Meals (FLO) had been bought as they approached our estimates of intrinsic worth.

Market Outlook

After a robust rebound in 2021, international GDP progress is anticipated to reasonable in 2022, with the potential for extra strain from lingering provide chain disruptions, increased oil costs and different impacts from Russia’s invasion of Ukraine. Regardless of these headwinds, company earnings are anticipated to proceed making new highs in 2022.

The sharp financial rebound within the US, together with unprecedented fiscal and financial stimulus, an uptick in wage progress and situations of provide/demand tightness, has resulted in elevated inflation ranges. The Federal Reserve has began to lift rates of interest and finish quantitative easing however might must be extra aggressive if inflation persists at elevated ranges, which could possibly be a headwind for fairness markets.

Russia’s invasion of Ukraine has the potential to disrupt the circulation of exports from these nations, which can impression international provides and costs for all kinds of finish markets. The potential impression to particular person companies varies, and we’re monitoring these dangers carefully.

Whereas the year-to-date pullback in fairness markets has created some funding alternatives, broad market valuations stay above historic averages. From present ranges, fairness market returns over the following 5 years are prone to be under historic averages.

Our major focus is at all times on attaining value-added outcomes for our present purchasers, and we consider we are able to obtain better-than-market returns over the following 5 years by means of energetic portfolio administration.

Talked about Securities and Respective Weights (%)

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Editor’s Notice: The abstract bullets for this text had been chosen by Looking for Alpha editors.