COOP - Diamond Hill Small-Mid Cap Fund Q2 2023 Market Commentary

2023-08-23 09:50:00 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%.
• Large-cap stocks led the market in Q2, while growth stocks outperformed value stocks.
• Industrials, information technology, and healthcare were the top-performing sectors in Q2.

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 (up nearly 11%) in Q2, followed by information technology (8%) and health care (7%). Utilities (down just over -3%) were the index’s worst performing sector in Q2 as relatively moderate winter temperatures reduced heating demand, consequently pressuring the sector’s returns. Materials were just barely in the red in the quarter.

2Q23 Russell 2500 Index 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 re-election — 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 trailed the Russell 2500 Index in Q2. Relative weakness was concentrated among our consumer staples and information technology holdings. Conversely, our financials holdings were a source of relative strength during the quarter — a noteworthy reversal from Q1. Our consumer discretionary holdings also provided a modest boost to relative returns.

On an individual holdings’ basis, top contributors to return in Q2 included Enovis ( ENOV ) and WESCO International ( WCC ). 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.

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.

Other top contributors included NVR , Mr. Cooper Group ( COOP ) and Allegiant Travel ( ALGT ). 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.

Mr. Cooper Group, the largest non-bank residential mortgage services in the US, continues executing at a high level in a challenging mortgage environment and is using its strong balance sheet to enhance its market position. 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.

Among our bottom contributors in Q2 were Ashland ( ASH ) and Cal-Maine Foods ( CALM ). 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.

Cal-Maine Foods is the largest producer and marketer of shell eggs in the US. During Q2, wholesale commodities and caged egg prices normalized in the US, helped by the country having seemingly averted an avian flu outbreak — a combination which, though positive for the industry, pressured shares during the quarter. We maintain our positive outlook on Cal-Maine given the company’s significant investment in specialty and cage-free egg production, which we expect will benefit from a secular tailwind in the period ahead.

Other bottom contributors included Ciena ( CIEN ), UGI Corp and WNS (Holdings) Limited. 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 web scale — 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 favourable, and we anticipate it will work through these near-term issues.

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.

India-based business process management (BPM) services company WNS weakened as investors contemplated whether artificial intelligence ((AI)) could disrupt the company’s BPM solutions. However, we do not believe AI will be a major threat to the company’s value proposition given its BPM expertise — on the contrary, we anticipate AI may present opportunities for WNS to implement AI-related solutions on its clients’ and prospects’ behalf.

Portfolio Activity

As markets have risen, we have been cautious about deploying cash and consequently entered just one new position in Q2: Lear Corporation ( LEA ). 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.

Conversely, we exited our positions in PROG Holdings ( PRG ) and Integer Holdings ( ITGR ) in Q2. Virtual lease-to-own (VLTO) provider PROG Holdings serves customers at the lower end of the credit spectrum, who tend to be more sensitive to the economy and inflation. We capitalized on shares’ recent rebound to exit our position. Similarly, we are concerned medical device outsource manufacturer Integer will continue struggling to pass inflation on to customers — and that the issue will not prove transient — and chose to exit. We also sold Advance Auto Parts 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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