Diamond Hill Small Cap Fund portfolio commentary for the fourth quarter 2014.

The Diamond Hill Small Cap Fund returned 4.86% (Class I) in 2014 compared to a 4.89% return for the Russell 2000 Index. In 2014, the small cap market’s best performing sectors were healthcare, utilities, and consumer staples. These sectors tend to be seen as relatively defensive and associated with “safe havens.” Utilities, in particular, also tend to do well when interest rates fall as many view regulated utilities as the most bond-like of equity investments. Government interest rates declined during the year, with the 10-year Treasury finishing below 2.2%, down from levels around 3% at the beginning of the year. Energy was by far the worst performing sector in 2014, as crude oil prices declined nearly 50%. The Fund’s underperformance can largely be attributed to having a larger allocation to energy stocks and a smaller allocation to healthcare stocks than the Index. In addition, while stock selection was generally good, the consumer staples sector was an exception.

Diamond Hill Small Cap Fund

Diamond Hill Small Cap Fund: Financial holdings were the largest contributors

The Fund’s financial holdings were the largest contributors in 2014. The Fund averaged roughly 27% of net assets invested in this sector, with nearly half of that amount in insurance companies. Banks and real estate investment trusts (REITs) each comprised about a fifth of the financial sector holdings. Winthrop Realty Trust, Inc. (FUR) announced a liquidation plan to sell all its assets and distribute the proceeds to shareholders within a two-year period. Thus far, asset sales have come in a bit above the mid-point of ranges that the company has used in its internal estimate of net asset value. In total, these developments led to a 65% total return for the stock in the year. Insurance or reinsurance companies including HCC Insurance Holdings, Navigators Group, Alleghany, Enstar Group, American Equity Investment Life Holding, and Reinsurance Group of America all experienced total returns between 10% and 18.5%. The largest detractors within financials were First Niagara Financial Group and Nationstar Mortgage Holdings. Nationstar is a non-bank mortgage servicer whose primary competitor, Ocwen Financial Corp., has encountered great regulatory scrutiny. We believe Nationstar may ultimately benefit from Ocwen’s problems, while thus far the market is skeptical.

Industrials were the second largest contributor to Fund performance during the year. Avis Budget Group, was the Fund’s largest holding at year-end and produced a 64% total return for the year. While fleet costs face some headwinds on lower residual values, there are signs that this will be more than offset by positive pricing action within the industry in 2015. Alaska Air Group has benefitted from favorable fundamentals for airlines, bolstered further by falling jet fuel prices. Aircastle an aircraft lessor, and Corrections Corp of America also appreciated more than 20% for the year. Hyster-Yale Materials Handling, Brink’s Co., TriMas, and Kennametal all declined for the year on lower earnings than the previous year. Finally, Trinity Industries soared during the first part of the year on continued strong fundamentals in railcar manufacturing and leasing. However, as the price of oil fell in the second half of the year, concerns about the future orders for tank cars to transport oil and a product liability lawsuit concerning the company’s highway guardrail product weighed heavily on the stock, leading to only a marginally positive return.

Diamond Hill Small Cap Fund: Decline of crude oil and natural gas prices

In energy, crude oil prices declined about 46% for the year. Natural gas prices also declined in the U.S., closing at $2.88/mcf, down from the $4.23/mcf close in 2013. Oil supply continued to grow from U.S. shales and higher production from Libya and Iraq following previous declines tied to unrest in those countries. Demand growth weakened with slower growth in China and some European economies experiencing contraction. Developed economies also continue to make efficiency gains. The result has been an oversupplied market that in previous times was balanced by OPEC, but Saudi Arabia expressed its comfort with allowing market forces to balance supply and demand and the lower oil prices that has ushered in. The fundamentals of individual companies were generally within our expectations, but the estimated intrinsic values have all been diminished by lower commodity price curves.

Historically, the Fund generally has had far less invested in health care than the Russell 2000 Index. This continues to be the case, and while stock selection was good, including Natus Medical, Lifepoint Hospitals, and health insurer Universal American Financial, the lower overall exposure meant a lesser contribution from this sector than the Index. Utility holdings, UGI, Cleco Corp and ITC Holdings performed well but totaled only about 3% of the Fund. Cleco has announced a deal to be acquired with the expected close to come in 2015.

Our consumer staples companies performed relatively poorly for the year. The largest positive contributor to the Fund in this area was Energizer Holdings. Flowers Foods and B&G Foods both had mediocre years fundamentally but have been well run companies and successful investments over longer periods. We anticipate better business results from both in the future.

Thank you for your continued interest in the Fund as we move into 2015.

Tom Schindler, CFA

Portfolio Manager

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