UGIC - Diamond Hill Mid Cap Fund Q2 2023 Market Commentary

2023-08-23 10:05:00 ET

Summary

• Diamond Hill invests on behalf of clients through a shared commitment to its valuation-driven investment principles, long-term perspective, capacity discipline and client alignment.
• US stocks rose over 8% in Q2 2023, bringing YTD gains to roughly 16%, with large-cap stocks leading the way.
• Growth stocks outperformed value stocks across the cap spectrum.
• Industrials were the top-performing sector in Q2, while utilities were the only negative sector.

Market Commentary

Markets were positive in Q2 2023, with US stocks rising over 8% (as measured by the Russell 3000 Index), bringing YTD gains to roughly 16%. Continuing the YTD trend, large-cap stocks led in Q2, rising almost 9%, while mid-cap stocks rose nearly 5% and small-cap stocks rose just over 5% (as measured by the Russell indices). Also continuing from Q1, growth stocks outperformed their value counterparts across the cap spectrum.

The Russell 1000 Value Index rose 4%, while its growth counterpart rose nearly 13%; the Russell Midcap Value Index advanced close to 4%, while the Russell Midcap Growth Index rose over 6%. The Russell 2000 Value Index added a little over 3%, and the Russell 2000 Growth Index rose just over 7%.

From a sector perspective, industrials led in Q2, rising north of 11%. Consumer discretionary (7%) and information technology (7%) were also positive. Utilities was the only negative sector (-2%) as relatively moderate winter temperatures reduced heating demand, consequently pressuring the sector’s returns.

2Q23 Russell MidcapIndex Sector Returns (%)

The macro picture has also been consistent in 2023, with inflation, central bank policy and ongoing geopolitical tensions dominating headlines. In early May, JP Morgan agreed to acquire most of First Republic Bank’s operations after the failed institution was seized by regulators. It marked the second-largest bank failure in US history (after Washington Mutual’s 2008 collapse), followed by Silicon Valley Bank and Signature Bank, both of which failed late in Q1 2023. While we remain vigilant in assessing the fundamental health of all our portfolio holdings, we believe the worst is behind us on this front for the time being.

Many point to the recent failures as signs monetary policy has gotten sufficiently (if not overly) tight — and investors consequently anticipated a slowdown or pause in rate hikes. Indeed, though the Federal Reserve did raise the benchmark rate 25 basis points (bps) in May to a range of 5.00% - 5.25%, it also tentatively hinted the current rate hike cycle (which has included 10 hikes in just over a year) was nearing its conclusion and didn’t raise rates in June.

Outside the US, global monetary policy is a more mixed bag. The UK faces ongoing stubborn inflation, seemingly decreasing the likelihood it is as close to the end of its hiking cycle as the US may be. Similarly, the European Central Bank likely has a way to go as inflation has proven sticky in major economies like Germany’s. In contrast, many emerging markets economies seem on the cusp of considering pausing rate hikes, if not beginning to cut.

For example, Hungary trimmed rates (which remain high) during the quarter as it struggles to rein in inflation while not hampering too much economic activity. A notable exception is Turkey, which significantly raised rates (650 bps) following President Erdogan’s May reelection — presumably in a bid to convince markets the country will begin seriously addressing its economic challenges. Whether investors find the effort credible naturally remains to be seen.

Meanwhile, markets seem to continue climbing the proverbial wall of worry — likely aided by relatively resilient economic data and corporate earnings in the US (and, selectively, beyond). Inflation, though effectively a global concern, has yet to meaningfully dampen hiring in the US. Stocks have rallied — especially growth stocks, where prices have increased significantly — which could be reflective of the fact that markets have discounted an impending recession several times over the last couple years, each time getting a little more comfortable with the economy’s and corporate earnings’ resilience.

That said, we don’t believe now is the time to get complacent about the environment. As we saw in March this year with the first of the aforementioned bank failures, unexpected events could rattle markets periodically — and that is particularly the case given all the macroeconomic headwinds we currently see. Further, there is still a possibility we see a recession in the next three to nine months, given the 10-year/3-month yield curve remains inverted and has historically been a decent predictor of recession.

However, we believe our philosophy and approach are well-suited to just such an environment — in which higher rates, higher inflation and possibly higher volatility than we’ve seen over the last decade or so are likely — as value and cyclically oriented stocks are likely to become more attractive to investors as they are well-positioned to produce abundant, consistent cash flows in the near and intermediate terms.

Performance Discussion

Our portfolio returns were positive but modestly trailed the Russell Midcap Index in Q2, tied primarily to our information technology and materials holdings, which trailed benchmark peers. Conversely, our health care holdings were a source of relative strength. Our above-benchmark exposure to and holdings in industrials were also additive to relative performance in Q2.

On an individual holdings basis, among our bottom contributors in Q2 were Ashland ( ASH ) and UGI Corp. Ashland is a high-quality, specialty ingredients company providing both natural and synthetic ingredients to customers in the pharmaceuticals, home and personal care, and coatings industries. During Q2, Ashland’s customers — primarily distributors — destocked, which in turn led management to lower full-year guidance and pressured shares. However, in our view, destocking tends to exaggerate any end-market weakness, and we anticipate any effects will be transitory and minimally impact the company’s intrinsic value.

Propane distributor UGI has struggled to stem customer churn and consequently had to infuse a small amount of equity into the business in Q2 to meet its debt covenants — in turn pressuring shares. However, we anticipate UGI will be able to remain in compliance with its debt covenants over the next 12 months, giving management time to take further corrective action. In the interim, we will monitor the position closely for signs of change in either direction.

Other bottom contributors included Ciena ( CIEN ), Sensata Technologies ( ST ) and POST Holdings. Networking systems company Ciena has faced a significant orders backlog given ongoing supply chain constraints. With those now easing, Ciena has begun fulfilling orders, generating strong fundamentals. However, two of its largest segments — telecommunications and webscale — have begun pushing out orders, leading to concerns those orders could ultimately be cancelled and weighing on shares. However, our long-term fundamental outlook on the company remains favorable, and we anticipate it will work through these nearterm issues.

Shares of automotive component manufacturer Sensata were pressured in Q2 as its progress toward pivoting its business toward higher-growth businesses like electric vehicles and electrification infrastructure slowed, weighing on revenue growth and margins. Growing investor concerns about a weakening consumer environment weighed on diversified consumer products group Post Holdings in the quarter.

Among our top contributors in Q2 were WESCO International ( WCC ) and Enovis ( ENOV ). WESCO International is a leading distributor of electrical, industrial and communications materials. Its recent acquisition of Anixter is generating better revenue and cost synergies than anticipated, giving a boost to shares. Further, easing supply chain constraints should enable WESCO to generate significant free cash flow in 2023’s second half — which should also bolster the company’s ability to weather any impending macroeconomic weakness. Looking forward, we believe the Anixter merger presents a meaningful value creation opportunity and are encouraged by the company’s overall approach to bolt-on acquisitions.

Medical technology company Enovis continues taking share in its reconstructive business, while its prevention and recovery segment has rebounded nicely following COVID induced weakness. This combination resulted in better-than expected revenue growth and margin expansion during the quarter. We maintain our conviction in our thesis that Enovis can capitalize on its continuous improvement-focused business system to drive above-market organic growth and margin expansion.

Other top contributors included Parker-Hannifin Corporation ( PH ), Allegiant Travel ( ALGT ) and NVR . Shares of global leader in motion and control technologies and solutions Parker Hannifin rose alongside improving investor sentiment about global industrial activity — a meaningful majority of Parker Hannifin’s revenues are derived from industrial businesses. Leisure-focused low-cost airline Allegiant Travel has a unique business model, contributing to among the highest margins versus competitors. As travel demand has normalized against a post-pandemic backdrop, Allegiant has benefited from strong pricing. Homebuilder NVR has benefited from a solid start to 2023 as its core mid-Atlantic markets have remained strong despite higher interest rates — a combination which is allowing NVR to generate solid earnings and some of the best operational performance among its peers.

Portfolio Activity

As markets have risen, we have been cautious about deploying cash. That said, we are still finding attractive values in the market and capitalized on attractive entry points to initiate three new positions in Q2: Ferguson ( FERG ), SBA Communications Corp ( SBAC ) and Lear Corp ( LEA ).

Ferguson is a leading US distributor of plumbing, waterworks, HVAC and related products. In an industry where scale is key, Ferguson is a high-quality market leader, which has resulted in a virtuous cycle of share gains and margin expansion that remains in its early innings given a still-fragmented industry. Further, we believe any concerns about a softening macroeconomic environment and its potential impacts on Ferguson are largely reflected in the share price, giving us an attractive entry point.

SBA Communications is a leading independent owner and operator of wireless communications infrastructure, including towers. We believe towers is a high-quality business that is central to the wireless economy and stands to benefit from the rollout of 5G technology. Though recent concerns around slowing 5G growth — and, in turn, tower leasing — have weighed on shares, we capitalized on the weakness to initiate a position in what we anticipate will be a growing business.

Lear is a leading manufacturer of global automotive seating and is end-market agnostic to the ICE/EV (internal combustion engine to electric vehicles) secular shift. Lear has a stable business with attractive cash-generation capabilities. A recent market selloff allowed us to establish a market position at an attractive discount to our estimate of intrinsic value.

We sold Advance Auto Parts in the quarter in favor of more compelling opportunities elsewhere.

Market Outlook

Despite equity markets’ positive returns in Q2 and 2023 to date, it has been among the narrowest markets in history, with just seven stocks — Meta Platforms, Apple, NVIDIA, Alphabet, Microsoft, Amazon and Tesla — contributing a large majority of the market’s return. These stocks collectively have increased 61% year to date, although the other 493 stocks in the S&P 500 Index increased a respectable 6%.

Market participants have seemingly moved past the recent failures of SVB Financial, First Republic and Signature Bank; however, the full effects of these failures have not yet been felt. For example, if banks pull back on lending to improve their capital positions, it could negatively impact economic growth. Balancing the potential economic impact of higher interest rates with still-elevated inflation levels continues to complicate the Fed’s monetary policy decision-making process.

Corporate earnings growth is expected to slow in 2023, weighed down partly by a decline in energy sector earnings due to commodities prices well below their mid-2022 peaks. However, the decline in this year’s earnings estimates seems to have bottomed.

Given the very aggressive monetary policy and much higher interest rates, we have been surprised many of the more speculative growth stocks have been leading the market thus far in 2023. Growth stocks more broadly have regained a vast majority of their 2022 underperformance versus value stocks.

Meanwhile, equity markets are trading at elevated valuations compared to history; however, this is somewhat misleading given the market’s narrowness. While the S&P 500 Index trades around 20X earnings per share ((EPS)), the median stock trades at a more reasonable ~17X EPS. So, while it may be difficult for equity markets to generate returns that match historical averages over the next five years, there are still attractive opportunities with the potential to generate above-average returns over that period.

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

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