Diamond Hill Capital market review for the fourth quarter ended December 31, 2014.

Driven by an expanding economy, growing corporate profits, and persistently low interest rates, the broad U.S. equity market posted its sixth consecutive annual gain in 2014. The S&P 500 Index finished the year with a 13.7% total return (including dividends), and the Federal Reserve signaled its belief in the economy’s ability to grow without assistance by concluding its bond purchasing program known as Quantitative Easing, or QE, in October 2014. Although investors expect the Fed to raise interest rates sometime in 2015, its overall monetary policy remains accommodative, encouraging equity investors.

In the U.S., unemployment fell as a result of the best hiring stretch since the late 1990s. The U.S. consumer benefited from a steep decline in gasoline prices to the lowest levels in five years, adding more buying power beyond modest wage gains. The sharp decline in the price of oil over the past few months is likely to improve household budgets. Globally, central banks remained extraordinarily accommodative in an attempt to provide a backdrop for increased economic growth. Europe, which has been a clear economic laggard over the past few years, was still only showing modest signs of improvement. Meanwhile, China and India continued to grow at healthy mid-single digit rates, but many other emerging economies around the world are seeing decelerating growth rates. The U.S. dollar ended the year strong relative to other currencies as investors were confident that stronger economic growth in the U.S. will lead the Fed to raise rates in 2015 for the first time since before the financial crisis.

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Diamond Hill Capital – Fourth Quarter Results

The S&P 500 Index posted a 4.9% total return in the 2014 fourth quarter led by the utilities sector (+13%). Investors reacted to an unexpected decline in bond yields by seeking income in high dividend-yielding stocks like utilities. In contrast, the energy sector was the worst performing sector during the quarter (-11%) as oil prices plunged by nearly 50% in the second half of 2014. A combination of domestic oil production growth, an increase in the supply of oil from Libya, weakening demand trends in Europe and Asia, and OPEC’s unwillingness to reduce output to mitigate anticipated over-supply led to a significant decline in oil prices as well as a decline in the oil price outlook over the next few years.

Although the decline in the energy sector hurt our portfolio returns in 2014, the downside was mitigated by good stock selection. Most of our energy holdings have some of the strongest balance sheets in the industry along with some of the highest quality prospective inventories relative to the global industry. While we have reduced our estimates of intrinsic value, we believe these companies will manage this industry cycle very well and are positioned to emerge even stronger as the industry rebounds. As a result of their strong competitive positioning, many of our energy holdings declined less than the overall energy sector.

Mitigating downside risk through good security selection is one of the benefits of active portfolio management. However, 2014 was a difficult year for active managers in large part due to lower volatility and lower dispersion.

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Volatility provides opportunities for active managers to identify mispricings in the market and take advantage of those mispricings. When volatility is low, there are fewer opportunities. Similarly, when dispersion is low, the spread between winners and losers is narrow, making it more difficult to stand out from the crowd.

Diamond Hill Capital – Market Outlook

Despite the end of the Federal Reserve’s Quantitative Easing, we continue to believe the Fed is likely to maintain a very accommodative overall monetary stance well into next year as the domestic economy is lacking signs of robust growth, while inflation expectations have again turned lower. The recent strength of the U.S. dollar is now playing a key role in these developments as its relative appreciation has created a new headwind for growth while also pushing down commodity prices. The modest deleveraging of the U.S. household sector over the past few years continues to be a positive story. These lower debt levels combined with very low interest rates have allowed consumer debt-service burdens to improve to very low levels by historical standards. This healthy debt service picture remains very much tied to historically low interest/mortgage rates, and any sharp, meaningful increase in those rates is likely to present an important headwind for growth.

Although the U.S. economy appears to be healing at a steady pace and set to maintain its 2% – 3% growth heading into next year, we continue to expect positive but below average equity market returns over the next five years. Our conclusion is primarily based on above average price/earnings multiples applied to already very strong levels of corporate profit margins, which in combination, likely tempers prospective returns. This outlook also seems consistent with the current interest rate environment.

We believe that we can achieve better than market returns over the next five years through active portfolio management and stock selection independent of benchmark weights.

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