2023-08-23 10:55:00 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.
- Our portfolio rose in Q2, outperforming the Russell 3000Index.
- Technology, consumer discretionary, and communication services sectors performed well, while energy and utilities sectors struggled.
- 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.
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, technology continued its strong YTD performance in Q2, rising nearly 17%, while consumer discretionary (13%) and communication services (12%) were also nicely positive. Conversely, energy (-1%) and utilities (-3%) were in the red in Q2 as oil prices have defied expectations they would rise given the ongoing Russia Ukraine war. Relatively moderate winter temperatures combined with increased production (and, therefore, increased supply), helped rein prices in — but consequently pressured returns in the relevant energy and utilities sectors.
2Q23 Russell 3000 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 when the banking crisis began, 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 rose in Q2, outperforming the Russell 3000 Index. Relative strength was concentrated among our industrials and health care holdings. Our discretionary and financials holdings were also tailwinds to relative performance in the quarter. Conversely, our underweight to and holdings within technology were a headwind in the quarter. Our materials holdings also trailed benchmark peers and weighed on relative returns.
Among our top individual contributors in Q2 were Mr. Cooper Group ( COOP ) and WESCO International ( WCC ). Mr. Cooper Group, the largest non-bank residential mortgage services provider 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.
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 in Q2 included Cimpress ( CMPR ), CarMax ( KMX ) and Amazon ( AMZN ). Cimpress is a provider of mass customized print and related products. We like its Vistaprint business, which has scale advantages and dominant market share. Further, the company is well-run by a management team with a record of effective capital allocation and cost base and debt reduction, which resulted in a healthier balance sheet than before the pandemic. In Q2, the company continued making progress toward its earnings growth goal and announced a debt repurchase at a meaningful discount to par value.
CarMax’s fundamentals sequentially improved despite a challenging near-term environment for used car demand. It has been encouraging to see management’s focus on consistently profitable sales, returning to market share gains following a temporary spike in competitor discounts, and taking steps to reset cost structures. We believe CarMax is a well-run industry leader and should strengthen its competitive positioning during this softer industry sales period.
Amazon’s management team has been working to improve retail profitability, and Q1 results showed progress. In the case of Amazon’s web services (AWS), the market has shifted its focus from where growth will bottom in the near term to how AI can help accelerate the adoption of public cloud services in the future. We believe Amazon’s competitive advantages will continue to grow and that the business has the potential to grow faster than the overall economy in the coming years.
Among our bottom Q2 individual contributors were Ashland ( ASH ) and Truist Financial ( TFC ). 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.
Truist, while not considered a “money center,” is a large, super-regional bank with an attractive Southeastern US footprint that has added value to the communities it serves via its extensive branch network and lending franchises. Truist also owns the fifth-largest insurance brokerage in the US, which it recently sold a portion of for roughly $3 billion. Truist’s share price remained under pressure during the quarter as the market continued to be concerned with lower values of longer-duration assets and increasing deposit costs. That said, we remain comfortable with our current position in Truist and believe a significant amount of pessimism is baked into its current share price.
Other bottom contributors included SunOpta ( STKL ), Bank of America Corporation ( BAC ) and Texas Instruments ( TXN ). Shares of SunOpta, a leading co-manufacturer and private label provider for non-dairy beverages and frozen fruit offerings, were pressured in Q2 as the consumer environment has moderated given higher inflation and concerns about an economic downturn. Bank of America (which we added to the portfolio in Q2) is among the US’s largest banks. Shares were pressured during the quarter against a still-challenging backdrop for banks, particularly as investors fret about rising deposit costs and the values of some longer-duration assets in a rising-rates environment. Texas Instruments’ end markets are facing some near-term headwinds where demand is concerned. We expect these trends to be transitory and continue to have a favorable view of the company’s long-term prospects and superior competitive positioning.
Portfolio Activity
In addition to the aforementioned Bank of America, we also initiated a new position in Target, the US-based mass retailer. The company has experienced strong traffic growth over the past several years but was disproportionally impacted by poor internal inventory forecasting in 2022, which caused near-term profitability to be negatively impacted. As near-term headwinds subside, we believe Target can restore its margin profile on a sales base that has seen a significant increase since the beginning of the pandemic. The recent stock price sell-off related to near term controversy concerns allowed us to initiate a position at an attractive discount to our estimate of intrinsic value. Looking past the next couple of quarters, we believe Target is well positioned to gain share longer-term due to its merchandising acumen, real estate locations, and omnichannel capabilities.
Conversely, we exited our position in regional bank Cadence Bank in favor of more compelling opportunities elsewhere. We also exited IT services provider Microsoft as its discount to our estimate of intrinsic value has narrowed.
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, with the Russell 3000 Growth Index outperforming the Russell 3000 Value Index by 23 percentage points year to date.
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.
Period and Annualized Total Returns (%) | Since Inception (30 Dec 2005) | 15Y | 10Y | 5Y | 3Y | 1Y | YTD | 2Q23 | Expense Ratio (%) |
Class I ( DHLTX ) | 9.29 | 10.23 | 11.30 | 11.18 | 21.97 | 20.69 | 17.65 | 10.37 | 0.87 |
Russell 3000 Index | 9.53 | 10.61 | 12.34 | 11.39 | 13.89 | 18.95 | 16.17 | 8.39 | — |
Russell 3000 Value Index | 7.40 | 8.33 | 9.09 | 7.79 | 14.38 | 11.22 | 4.98 | 4.03 | — |
Click here for holdings as of 30 June 2023. Risk disclosure: Because the portfolio holds a limited number of securities, a decline in the value of these investments may affect overall performance to a greater degree than a less concentrated portfolio. Small- and mid-capitalization issues tend to be more volatile and less liquid than large-capitalization issues. The views expressed are those of Diamond Hill as of 30 June 2023 and are subject to change without notice. These opinions are not intended to be a forecast of future events, a guarantee of future results or investment advice. Investing involves risk, including the possible loss of principal. Past performance is not indicative of future results. Investment returns and principal values 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 quoted. For current to most recent month end performance, visit Diamond Hill. Performance assumes reinvestment of all distributions. Returns for periods less than one year are not annualized. 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. Class I shares include Investor share performance achieved prior to the creation of Class I shares. Fund holdings subject to change without notice. Index data source: London Stock Exchange Group PLC. See Diamond Hill - Disclosures for a full copy of the disclaimer. Securities referenced may not be representative of all portfolio holdings. Contribution to return is not indicative of whether an investment was or will be profitable. To obtain contribution calculation methodology and a complete list of every holding’s contribution to return during the period, contact 855.255.8955 or info@diamond-hill.com. Carefully consider the Fund’s investment objectives, risks and expenses. This and other important information are contained in the Fund’s prospectus and summary prospectus, which are available at Diamond Hill or calling 888.226.5595. Read carefully before investing. The Diamond Hill Funds are distributed by Foreside Financial Services, LLC (Member FINRA). Diamond Hill Capital Management, Inc., a registered investment adviser, serves as Investment Adviser to the Diamond Hill Funds and is paid a fee for its services. Not FDIC insured | No bank guarantee | May lose value |
Editor's Note: The summary bullets for this article were chosen by Seeking Alpha editors.
For further details see:
Diamond Hill Select Fund Q2 2023 Market Commentary