Diamond Hill Small Cap Fund commentary for the third quarter 2014.

The Diamond Hill Small Cap Fund decreased 5.86% (Class I) during the quarter, compared to a 7.36% decrease in the Russell 2000 Index.

During the quarter, the Fund’s holdings in the energy, financials, and industrials sectors were the largest detractors from absolute return, while holdings in the health care sector contributed to return.

The Fund’s outperformance relative to the Russell 2000 Index was primarily the result of security selection in the health care and energy sectors as well as a relatively high average cash balance. An overweight position in the energy sector, security selection in the consumer staples sector, and an underweight position in the health care sector detracted from relative return.

Diamond Hill

Diamond Hill Small Cap Fund: Best Performers

  • Shares of medical device manufacturer Natus Medical Inc (NASDAQ:BABY) increased after reporting strong quarterly earnings and raising its full-year 2014 earnings guidance. While the company has shown improvement in margins for some time, this was the best quarter of organic revenue growth for Natus in years.
  • Railroad service company Trinity Industries Inc (NYSE:TRN) rose as the company continues to benefit from strong sales in its Railcar Group. In addition, investors are increasingly expecting the size and duration of the product cycle to benefit from more stringent tank car regulations, potentially requiring customers to more aggressively update their fleets.
  • Resort operator Vail Resorts, Inc. (NYSE:MTN) announced the acquisition of Park City Mountain Resort, which ends lengthy litigation against its previous owner and operator. The company also released a positive season pass sales update and issued strong earnings guidance for next fiscal year.
  • Facilities support management services company Corrections Corp Of America (NYSE:CXW) rose as the company released results above its previous earnings guidance due to elevated demand from Immigration and Customs Enforcement. The better than expected results reflected an increased focus on border patrol and immigration.
  • Shares of property and casualty insurance company Endurance Specialty Holdings Ltd. (NYSE:ENH) recovered much of its first quarter losses when it announced the termination of its contentious battle to acquire Aspen Insurance Holdings Limited (NYSE:AHL) after an AHL shareholder vote failed to provide convincing support for Endurance’s offer.

Diamond Hill Small Cap Fund: Worst Performers

  • Exploration and production company Rosetta Resources Inc. (NASDAQ:ROSE) declined during the quarter as a result of weak oil and gas prices.
  • Shares of diversified industrial company TriMas Corp (NASDAQ:TRS) fell during the quarter as it lowered earnings guidance for the remainder of the year primarily due to weakness in Cequent North America, which makes high quality, customized engineered towing, trailer and cargo management products. The company also experienced weakness in its Energy and Aerospace segments.
  • Auto parts manufacturer Tenneco Inc (NYSE:TEN) declined as investors became concerned over potential macro-economic issues related to the automotive industry.
  • Financial services company Popular Inc (NASDAQ:BPOP) the largest bank in Puerto Rico, declined in response to continued weak Puerto Rican economic data.
  • Shares of freight transportation management company Hub Group Inc (NASDAQ:HUBG) fell as slower train speeds and longer dwell times by the rails are increasing costs and impacting volumes for Hub Group. These issues are likely to persist into 2015, but the railroads are taking steps to increase capacity and improve service levels. It does not appear that lower service levels are impacting shippers’ attitudes toward longer-term conversion to intermodal.

Diamond Hill Small Cap Fund: New Positions

We took advantage of an opportunity to purchase shares in food products company Post Holdings Inc (NYSE:POST) when its stock fell sharply after the company’s quarterly earnings came in below Wall Street analysts’ estimates, and company management lowered its full-year earnings guidance. We believe the stock is attractive at current valuations and view favorably the company’s diversification away from the slow growing cereal category through acquisitions.

Diamond Hill Small Cap Fund: Eliminated Positions

We eliminated our position in internet software and services company Liquidity Services, Inc. (NASDAQ:LQDT) when company fundamentals deteriorated below our initial expectations. The company lost half of a two-part contract with the Department of Defense to a competitor at renewal. The second part of the contract was renewed, but at terms we believe will be significantly less profitable.

See full Diamond Hill Small Cap Fund 3Q14 Commentary here.