Diamond Hill Mid Cap Fund Q2 2023 Market Commentary

Market Commentary

Markets have been optimistic in Q2 2023, with US shares rising over 8% (as measured by the Russell 3000 Index), bringing YTD beneficial properties to roughly 16%. Persevering with the YTD pattern, large-cap shares led in Q2, rising virtually 9%, whereas mid-cap shares rose almost 5% and small-cap shares rose simply over 5% (as measured by the Russell indices). Additionally persevering with from Q1, development shares outperformed their worth counterparts throughout the cap spectrum.

The Russell 1000 Worth Index rose 4%, whereas its development counterpart rose almost 13%; the Russell Midcap Worth Index superior near 4%, whereas the Russell Midcap Progress Index rose over 6%. The Russell 2000 Worth Index added a bit of over 3%, and the Russell 2000 Progress Index rose simply over 7%.

From a sector perspective, industrials led in Q2, rising north of 11%. Client discretionary (7%) and data expertise (7%) have been additionally optimistic. Utilities was the one detrimental sector (-2%) as comparatively average winter temperatures diminished heating demand, consequently pressuring the sector’s returns.

2Q23 Russell MidcapIndex Sector Returns (%)

The macro image has additionally been constant in 2023, with inflation, central financial institution coverage and ongoing geopolitical tensions dominating headlines. In early Might, JP Morgan agreed to accumulate most of First Republic Financial institution’s operations after the failed establishment was seized by regulators. It marked the second-largest financial institution failure in US historical past (after Washington Mutual’s 2008 collapse), adopted by Silicon Valley Financial institution and Signature Financial institution, each of which failed late in Q1 2023. Whereas we stay vigilant in assessing the basic well being of all our portfolio holdings, we consider the worst is behind us on this entrance in the interim.

Many level to the latest failures as indicators financial coverage has gotten sufficiently (if not overly) tight — and traders consequently anticipated a slowdown or pause in price hikes. Certainly, although the Federal Reserve did increase the benchmark price 25 foundation factors (bps) in Might to a variety of 5.00% – 5.25%, it additionally tentatively hinted the present price hike cycle (which has included 10 hikes in simply over a yr) was nearing its conclusion and didn’t increase charges in June.

Exterior the US, world financial coverage is a extra blended bag. The UK faces ongoing cussed inflation, seemingly reducing the chance it’s as near the top of its mountaineering cycle because the US could also be. Equally, the European Central Financial institution seemingly has a approach to go as inflation has confirmed sticky in main economies like Germany’s. In distinction, many rising markets economies appear on the cusp of contemplating pausing price hikes, if not starting to chop.

For instance, Hungary trimmed charges (which stay excessive) throughout the quarter because it struggles to rein in inflation whereas not hampering an excessive amount of financial exercise. A notable exception is Turkey, which considerably raised charges (650 bps) following President Erdogan’s Might reelection — presumably in a bid to persuade markets the nation will start severely addressing its financial challenges. Whether or not traders discover the trouble credible naturally stays to be seen.

In the meantime, markets appear to proceed climbing the proverbial wall of fear — seemingly aided by comparatively resilient financial knowledge and company earnings within the US (and, selectively, past). Inflation, although successfully a worldwide concern, has but to meaningfully dampen hiring within the US. Shares have rallied — particularly development shares, the place costs have elevated considerably — which might be reflective of the truth that markets have discounted an impending recession a number of instances over the past couple years, every time getting a bit of extra snug with the financial system’s and company earnings’ resilience.

That mentioned, we don’t consider now’s the time to get complacent in regards to the setting. As we noticed in March this yr with the primary of the aforementioned financial institution failures, surprising occasions might rattle markets periodically — and that’s significantly the case given all of the macroeconomic headwinds we at the moment see. Additional, there may be nonetheless a chance we see a recession within the subsequent three to 9 months, given the 10-year/3-month yield curve stays inverted and has traditionally been a good predictor of recession.

Nonetheless, we consider our philosophy and method are well-suited to only such an setting — by which larger charges, larger inflation and probably larger volatility than we’ve seen over the past decade or so are seemingly — as worth and cyclically oriented shares are prone to develop into extra engaging to traders as they’re well-positioned to provide considerable, constant money flows within the close to and intermediate phrases.

Efficiency Dialogue

Our portfolio returns have been optimistic however modestly trailed the Russell Midcap Index in Q2, tied primarily to our data expertise and supplies holdings, which trailed benchmark friends. Conversely, our well being care holdings have been a supply of relative energy. Our above-benchmark publicity to and holdings in industrials have been additionally additive to relative efficiency in Q2.

On a person holdings foundation, amongst our backside contributors in Q2 have been Ashland (ASH) and UGI Corp. Ashland is a high-quality, specialty substances firm offering each pure and artificial substances to clients within the prescribed drugs, dwelling and private care, and coatings industries. Throughout Q2, Ashland’s clients — primarily distributors — destocked, which in flip led administration to decrease full-year steerage and pressured shares. Nonetheless, in our view, destocking tends to magnify any end-market weak spot, and we anticipate any results might be transitory and minimally impression the corporate’s intrinsic worth.

Propane distributor UGI has struggled to stem buyer churn and consequently needed to infuse a small quantity of fairness into the enterprise in Q2 to satisfy its debt covenants — in flip pressuring shares. Nonetheless, we anticipate UGI will be capable of stay in compliance with its debt covenants over the following 12 months, giving administration time to take additional corrective motion. Within the interim, we’ll monitor the place intently for indicators of change in both path.

Different backside contributors included Ciena (CIEN), Sensata Applied sciences (ST) and POST Holdings. Networking techniques firm Ciena has confronted a major orders backlog given ongoing provide chain constraints. With these now easing, Ciena has begun fulfilling orders, producing sturdy fundamentals. Nonetheless, two of its largest segments — telecommunications and webscale — have begun pushing out orders, resulting in considerations these orders might in the end be cancelled and weighing on shares. Nonetheless, our long-term basic outlook on the corporate stays favorable, and we anticipate it’s going to work by way of these nearterm points.

Shares of automotive element producer Sensata have been pressured in Q2 as its progress towards pivoting its enterprise towards higher-growth companies like electrical automobiles and electrification infrastructure slowed, weighing on income development and margins. Rising investor considerations a few weakening shopper setting weighed on diversified shopper merchandise group Put up Holdings within the quarter.

Amongst our high contributors in Q2 have been WESCO Worldwide (WCC) and Enovis (ENOV). WESCO Worldwide is a number one distributor {of electrical}, industrial and communications supplies. Its latest acquisition of Anixter is producing higher income and value synergies than anticipated, giving a lift to shares. Additional, easing provide chain constraints ought to allow WESCO to generate vital free money circulate in 2023’s second half — which must also bolster the corporate’s capacity to climate any impending macroeconomic weak spot. Wanting ahead, we consider the Anixter merger presents a significant worth creation alternative and are inspired by the corporate’s general method to bolt-on acquisitions.

Medical expertise firm Enovis continues taking share in its reconstructive enterprise, whereas its prevention and restoration section has rebounded properly following COVID induced weak spot. This mixture resulted in better-than anticipated income development and margin growth throughout the quarter. We keep our conviction in our thesis that Enovis can capitalize on its steady improvement-focused enterprise system to drive above-market natural development and margin growth.

Different high contributors included Parker-Hannifin Company (PH), Allegiant Journey (ALGT) and NVR. Shares of world chief in movement and management applied sciences and options Parker Hannifin rose alongside enhancing investor sentiment about world industrial exercise — a significant majority of Parker Hannifin’s revenues are derived from industrial companies. Leisure-focused low-cost airline Allegiant Journey has a novel enterprise mannequin, contributing to among the many highest margins versus rivals. As journey demand has normalized in opposition to a post-pandemic backdrop, Allegiant has benefited from sturdy pricing. Homebuilder NVR has benefited from a strong begin to 2023 as its core mid-Atlantic markets have remained sturdy regardless of larger rates of interest — a mixture which is permitting NVR to generate strong earnings and among the finest operational efficiency amongst its friends.

Portfolio Exercise

As markets have risen, we have now been cautious about deploying money. That mentioned, we’re nonetheless discovering engaging values out there and capitalized on engaging entry factors to provoke three new positions in Q2: Ferguson (FERG), SBA Communications Corp (SBAC) and Lear Corp (LEA).

Ferguson is a number one US distributor of plumbing, waterworks, HVAC and associated merchandise. In an trade the place scale is essential, Ferguson is a high-quality market chief, which has resulted in a virtuous cycle of share beneficial properties and margin growth that is still in its early innings given a still-fragmented trade. Additional, we consider any considerations a few softening macroeconomic setting and its potential impacts on Ferguson are largely mirrored within the share value, giving us a lovely entry level.

SBA Communications is a number one unbiased proprietor and operator of wi-fi communications infrastructure, together with towers. We consider towers is a high-quality enterprise that’s central to the wi-fi financial system and stands to learn from the rollout of 5G expertise. Although latest considerations round slowing 5G development — and, in flip, tower leasing — have weighed on shares, we capitalized on the weak spot to provoke a place in what we anticipate might be a rising enterprise.

Lear is a number one producer of world automotive seating and is end-market agnostic to the ICE/EV (inner combustion engine to electrical automobiles) secular shift. Lear has a steady enterprise with engaging cash-generation capabilities. A latest market selloff allowed us to ascertain a market place at a lovely low cost to our estimate of intrinsic worth.

We offered Advance Auto Elements within the quarter in favor of extra compelling alternatives elsewhere.

Market Outlook

Regardless of fairness markets’ optimistic returns in Q2 and 2023 to this point, it has been among the many narrowest markets in historical past, with simply seven shares — Meta Platforms, Apple, NVIDIA, Alphabet, Microsoft, Amazon and Tesla — contributing a big majority of the market’s return. These shares collectively have elevated 61% yr to this point, though the opposite 493 shares within the S&P 500 Index elevated a decent 6%.

Market contributors have seemingly moved previous the latest failures of SVB Monetary, First Republic and Signature Financial institution; nevertheless, the total results of those failures haven’t but been felt. For instance, if banks pull again on lending to enhance their capital positions, it might negatively impression financial development. Balancing the potential financial impression of upper rates of interest with still-elevated inflation ranges continues to complicate the Fed’s financial coverage decision-making course of.

Company earnings development is anticipated to sluggish in 2023, weighed down partly by a decline in vitality sector earnings attributable to commodities costs properly under their mid-2022 peaks. Nonetheless, the decline on this yr’s earnings estimates appears to have bottomed.

Given the very aggressive financial coverage and far larger rates of interest, we have now been stunned lots of the extra speculative development shares have been main the market to this point in 2023. Progress shares extra broadly have regained a overwhelming majority of their 2022 underperformance versus worth shares.

In the meantime, fairness markets are buying and selling at elevated valuations in comparison with historical past; nevertheless, that is considerably deceptive given the market’s narrowness. Whereas the S&P 500 Index trades round 20X earnings per share (EPS), the median inventory trades at a extra cheap ~17X EPS. So, whereas it might be tough for fairness markets to generate returns that match historic averages over the following 5 years, there are nonetheless engaging alternatives with the potential to generate above-average returns over that interval.

Our major focus is all the time on reaching value-added outcomes for our current shoppers, and we consider we will obtain better-than-market returns over the following 5 years by way of lively portfolio administration.

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