Diamond Hill Investment Group, Inc. (NASDAQ:DHIL)
Q2 2013 Portfolio Manager Conference Call
July 17, 2013 02:00 PM ET
Julie McConnell - Director, Business Development Marketing
Bill Zox - Portfolio Manager
Tom Schindler - Portfolio Manager
Chuck Bath - MD, Investments
Rick Snowdon - Co-Director of Research
Ric Dillon - Corporate CEO
Chris Bingaman - Co-Chief Investment Officer
Austin Hawley - Co-Director of Research
Hello and welcome to the Diamond Hill Q2 2013 Portfolio Manager Conference Call and Webinar. My name is Maisha, and I will be your operator for today's call. At this time, all participants are in a listen-only mode. Later we will conduct a question-and-answer session. Please note this conference is being recorded.
I would now turn the call over to Ms. Julie McConnell. You may begin.
Great. Thank you. Good afternoon everyone and welcome to the Diamond Hill second quarter portfolio manager conference call. We certainly thank you for joining us this afternoon. Like Maisha mentioned, my name is Julie McConnell and I will be moderating the call today.
To start our call this afternoon, Bill Zox, who is Portfolio Manager of our Strategic Income Strategy, will provide an update on deleveraging in the United States. Then after Bill's comments, we will be followed by our portfolio manager reviews of all of our strategies. After our portfolio managers review their strategies, we will open the call for a question-and-answer session. At that time the operator will provide instructions. [Operator Instructions].
As always, there are a few important compliance statements to go over before we begin. The opinions expressed by portfolio managers are their own, and are subject to change at any time as circumstances change. Any discussion of specific portfolio holdings will be as of June 30. Portfolio holdings are subject to change without notice; and finally, a complete list of portfolio holdings as of June 30 is available on our website.
The next two slides provide additional important disclosures and we would just ask that you review these at a later time.
So with that, I will go ahead and turn the call over to Bill to get us started, who again is going to provide an update on deleveraging in the United States. Bill?
Thanks Julie. Before I start, I want to emphasize that the core of Diamond Hill is company-by-company, industry-by-industry research, like the piece that was sent out today by Austin Hawley, in the property and casualty insurance industry. But we are not oblivious to macroeconomic issues, and that's what I will talk about today. I also want to say that we don't have a [house view], these are my thoughts, as they pertain to what I do with the strategic income fund.
I believe that deleveraging in the U.S. has been the dominant macroeconomic issue for us over the last five years, and I expect it will be for many years to come. The bottom line of these slides is that we continue to progress on the path of a successful deleveraging, and we are getting close to an important transition, where the deleveraging moves from the private sector to the government sector, and at that point, there is reason to believe that economic growth can kick up.
On the first page, I show you the outside resources that I found most helpful on debt and deleveraging. I also want to thank Alice Gartner and Jack Parker for putting these slides together.
Turning to the next page, we update the chart from last year that shows the private sector debt has declined more than government debt has increased. In the middle column on the table on the right, you will see that while government debt has increased 28 percentage points GDP from the fourth quarter of 2008, through the fourth quarter of 2012, the private sector deleveraging in the financial sector and the household sector has been 37 percentage points. So we have had nine percentage points of deleveraging since the fourth quarter of 2008 after something like 50 plus years of pretty much constant increase in total debt in the economy.
I also think that it is very important that you look at all of these sectors together, it's dangerous to isolate one sector and draw conclusions. Then in the last column of the table, it shows what happened in 2012. In 2012, there was no net deleveraging, but a government sector and then for the first time since 2008, the non-financial corporate sector leverage increased 6 percentage points of GDP, while the financial sector deleveraged 2 percentage points, and the household sectors deleveraged four percentage points.
Turning the page, we show successful, this is a slide from McKinsey, showing successful deleveragings in Sweden and Finland in the 1990s, and you will see that you have these three stages, with the first stage being a very rapid deleveraging, which was the financial crisis. Then, you have a period of time when the private sector is deleveraging and the government sector is offsetting that with an increase in leverage, and the average of these two episodes of private sector, deleveraged 26 percentage points of GDP, whereas in the U.S. it has been 37 percentage points, the public sector increased leverage 21 percentage points of GDP and in the U.S. it has been 28 percentage points of GDP, but it does seem like we were getting close to this transition from private sector deleveraging, to public sector deleveraging, and you will see that GDP growth increased from 1% annually to 3% annually, and I think there is reason to believe that GDP growth could accelerate in the U.S., once we transition to public sector deleveraging from private sector.
The next page, this is from Ray Dalio of Bridgewater, this is from the Spring of 2012, but I think these comments are every bit as relevant today, that the U.S. continues to do a good job of delevering, and the key according to Dalio, the key nominal interest rates below the nominal growth rate in the economy, and we have continued to do that, even a nominal growth has been well, of course nominal interest rates have been even lower, and to do that, you have to print money -- the Central Bank has to print money, but not so much that inflation gets out of control, and you have to combine that with austerity and debt restructurings, and the bottom line is that I believe the U.S. has gotten the mix pretty well, and we continue down this path of a successful deleveraging.
On the next slide, McKinsey, points to six indicators of progress on deleveraging, before the economic recovery becomes self-sustaining, and over the next six slides, I will address these indicators.
The first slide after this financial sector stabilized and lending volumes are rising, I think this slide speaks for itself. On the next slide, this is the one area where we still have more work to do, but the picture is I think better than many here, and this is on the structural reforms and credible medium term public deficit reduction plans are in place. We have made progress. This shows you the CBO deficit projections, which over the next nine years or so, look reasonably good. Of course, it probably becomes much worse in the out years after this period, and clearly, we need to do work on tax reform, and entitlement reform and certain other areas, but if we can muster up the political will to address those issues, I think that these two important factors will be in good shape on these factors.
The next slide, exports are growing, again, I think this speaks for itself. As does the next one, private investment has resumed and then finally, the housing market has stabilized, with residential construction reviving. I think everyone is aware of the stabilization and the improvement in home prices. It's important that we get to the point, where we are once again building 1 million plus homes a year, as we did for many years prior to the housing crisis. I think this slide which shows, it's a survey of expected single family sales, but there is a lot of confidence in that community, and it does seem to track reasonably well single family starts, so I think that it's very likely that over the next year, year and a half, we will get back to that point where we are building 1 million plus homes per year, which is very important for economic growth and I think that inventories are in a situation where that won't do any damage to pricing.
Then finally, on the last slide, this shows the U.S. compared to other mature economics. Of course it does not reflect unfunded entitlements and each country tends to have its own issues, that aren't reflected on the balance sheet. But as I said before, if we muster up the political world to address entitlements, as financial markets seem to assume that we will, the U.S. will be in much better shape than other mature economies, and I think it's important to think about where we go from here in the private sector. If you went back to the slide that shows Sweden and Finland, the private sector leverage once again, after their deleveraging was over, but that was a very different environment in the 1990s, and they were relatively small countries.
So I think, an important factor to consider going forward is, what will the private sector do in terms of leverage, going forward, I think this chart helps you to put the U.S. into the global context considering that issue.
That's all I have, thanks.
Great, thanks Bill. We will now turn to our strategy update. I will mention that Chris Welch, who many of you know, is Portfolio Manager for our small mid-cap strategy is not available to join us this afternoon. So to get us started, Tom Schindler is going to provide an update on both the small cap strategy, and also the small midcap strategy.
Thank you, Julie. The Diamond Hill Small Cap Fund Class I returned 3.61% in the second quarter, compared to 3.08% for the Russell 2000 index. Together with the first quarter outperformance, this brings the year-to-date to 20.75%, about 490 basis points ahead of the Russell 2000. The five year trailing return is about in line with the index, while the since inception results exceed the index by over 440 basis points per annum.
Looking at the five year risk statistics that continues to show a relatively lower volatility than the index. Looking at portfolio statistics, the fund is now approaching $1 billion in assets. The turnover rate has ticked up as a result of sales and replacement to those sales, as many more companies have met or are near their intrinsic value, but the 37% is still within expected range.
Looking at the sector allocations, all sectors have been fairly stable throughout this year. During the quarter, all sectors, with the exception of energy, contributed positively to returns.
Looking at the top 10 holdings, an assured guarantee drop down from the first and third largest holdings at 331 to be now the eighth and ninth largest holdings. New to the list would be Rosetta Resources, Avis Budget Group and Popular. Dropping out of the top 10 were Whiting, Cimarex and Trinity, as a result of either relative performance or these new shares in these new top 10 holdings being purchased.
Turning to new positions, Avis Budget Group is the third largest rental car agency behind Hertz and the privately held enterprise. Enstar Group buys and manages run-off insurance businesses. Endurance Specialty Holdings is half, a primarily specialty lines insurance company, with over half of that being cross insurance, the other half being reinsurance; and Nationstar Mortgage Holdings is a non-bank mortgage servicer.
Contango and Crimson will become one company, pending the shareholder approval this quarter, and then Pacer International is an intermodal marketing and logistics company. We also own Hub Group in this industry.
Eliminated positions generally were all successful investments, nearing their estimates of intrinsic value. The one exception to this was K-Swiss. K-Swiss completed an acquisition by E-Land and that closed out an unsuccessful investment. Radian Group was held for a very short period of time, but increased considerably, so it was sold.
Turning to best and worst performers; Warner Chilcott is being bought by Actavis in a stock deal. Live Nation has favorable arbitration ruling, which denied a claim made by CTS Eventim. The others follow either positive earnings or better market sentiment.
On the worst performers, the only one in my opinion that had a fundamental disappointment was Orthofix. It had a very disappointing quarter. Revenues were down high single digits, but that was exacerbated by lack of cost containment in that weaker revenue environment. They do have a new CEO, who will hopefully address some of those cost issues.
Turning now to the SMID Cap Fund, the Diamond Hill Small Mid Cap Fund I returned 4.03% compared to 2.27% for the Russell 2500 Index. This brings the year-to-date return to 21.2%, about 580 basis points ahead of the index. The trailing five year return of 10.6% is 140 basis points ahead of the index, and then since inception, results are 109 basis points ahead of the index. For the quarter, stock selection in both the financials and the healthcare were the main drivers to that outperformance.
Turning to the sector allocation, sector rates were stable for the most part in the quarter from the first quarter. Energy Holdings were down 330 basis points, while cash was up 320 basis points. It has been somewhat of a challenging environment to come up with new ideas.
Turning to the Top 10 holdings; Assured Guaranty and Excel Capital dropped out of the top 10 on share reductions. Noble Energy's position was reduced, also Hartford Insurance Group, which was just outside of the top 10, was also reduced during the quarter. New to the top 10 were Broadridge Financial and the Reinsurance Group of America.
New positions, Willis Group Holdings is among the three largest insurance brokers, along with AON and Marsh Mac. Greenlight Capital is a reinsurer, whose investments are handled by David Einhorn's Greenlight Capital. Whirlpool has strong franchises in both North America and Brazil and we believe has the opportunity for earnings improvement through further cost initiatives. Endurance Specialty and Nationstar and Contango were all mentioned in the Small Cap.
Eliminated from the portfolio, Myriad Genetics, Radian Group and Selective Insurance Group all were near estimates of intrinsic value. Myriad Genetics during the quarter had their Supreme Court case decided. It was a mixed decision. At first in the days following the decision, Myriad traded down meaningfully, but has since recovered a lot of that.
Looking at best and worst performers; Boston Scientific was amongst the best performers. It showed improved results from core business segments. More enthusiasm around product pipeline, and a still attractive discount to IV.
Hartford Insurance is successfully executing on a strategy to sell off non-core assets, pay down debts and repurchase shares; and Reinsurance Group of America saw favorable mortality results in the U.S. and Australia, and increased the share repurchase authorization.
Orthofix as I mentioned was the one negative fundamental development. In addition, Southwest Airlines saw a softer (inaudible) than expected, but is still showing solid profitability.
With that, I will turn it back to Julie.
Great, thanks Tom. Next I will turn the call to Chuck Bath for an update on the large cap strategy.
Thanks Julie. For the large cap funds, for the second quarter, the fund was up a little over 6% versus 2.65% for the Russell 1000 Index and year-to-date 18.42% versus just under 14% for the index. So we are pleased with the performance for 2013 year-to-date. You see some other and more important performance numbers as well for three, five and 10 years, and since inception, as you know, we always focus on the long term performance numbers, and while we are slightly lagged and still in three years, our five number is now ahead and our 10 year numbers and since inception numbers are comfortably ahead of the market, and we are pleased with that.
The fund's sector allocation which you see before you, nothing has changed too much in this quarter, but it has marked the evolution of the portfolio, as financials over the last year become a bigger portion of the portfolio. They still remain the largest weighting in the portfolio. Consumer staples and healthcare are second and third respectively. Healthcare has declined due to weighting in the portfolio, mostly because many of our names reached our estimates intrinsic value, and were removed from the portfolio for that reason. But nonetheless, replacement for those holdings were often found in other areas of the market.
You see, our total portfolio turnover rate was (inaudible) around 25%. That is typical and normal for this portfolio. Number of securities, 49, also under 50 is quite typical. I don't think we have been over 50 for quite some time, if that were so, that is more typical in terms of the holdings in the portfolio.
You will see in the top 10 holdings list; Occidental and Medtronic, depending on short term performance, may or maybe top one or two, but those are intended to be the largest holdings. Occidental has been a large holding for a while. A name like Prudential, which is our third largest holding, was (inaudible) increased the weighting, and recently due to opportunities we felt we saw in the inexpensive valuation.
(inaudible) I think what comes out and strikes to you, perhaps more so than in the past is though, financial services, top 10 holdings; Morgan Stanley, AIG, Citigroup, JPMorgan, Prudential. Five of the top 10 are financial services, and a name like Wells Fargo, that used to be a top 10 holding, is no longer a top 10, simply because we found the others that are more attractive. But I think that they reflect a common opportunity, which occurred and we felt in many of the capital markets, names like Morgan Stanley and Citigroup that were under-recognized values in the marketplace; six to nine months ago, and that encourages to make those large holdings in the portfolio. Since then, the stocks have performed fairly well, and that's helped to maintain their large weighting, but they are also relatively new as the large holdings in the portfolio.
In terms of names that were eliminated; Chubb reached our intrinsic value and the stock, in its higher position was sold. Merck is a name that in the portfolio was very close to intrinsic value, and we became concerned about some fundamental weakness in one of their important new drugs, and so therefore when -- we took advantage of the opportunity to eliminate that name, to provide capital for other new names in the portfolio.
In terms of new names, Southwest Airlines was a name that we owned in the past in other portfolios. We find that the fundamentals in the airlines industry are the best they have been in quite some time, and we view that as an opportunity to establish a position there. Then there are a couple of other names, which are also smaller large cap names, Whirlpool and Cimarex, where we find attractive opportunities for earnings growth, due to margin expansion opportunities and at Cimarex, because they bought an unusual asset base.
The best performers were some of the financial services names, ones which I had mentioned earlier, Prudential, Hartford and AIG. Prudential was the best performing stock in the quarter and was a large weighting, so that was very helpful. Microsoft, the stock performed very well, which was kind of nice, considering it's a reasonably controversial name, simply because from time to time, the focus becomes on consumer aspects of its Microsoft business, people who cited the enterprise business as the most valuable.
Perhaps the most interesting was Occidental Petroleum, which we had mentioned is the largest holding. It was unusual in the sense that there was a proxy battle at the most recent annual meeting, and the Chairman of the Board was [eluded] off of the Board of Occidental, and the CEO who was on his way out, will remain as CEO for a period of time. The CEO has pursued a strategy, which we are glad he has agreed to stay and hopefully through improved cost management, Occidental's return on capital and therefore profitability, should improve meaningfully.
The worst performers are IBM, it leads the list. It was a little bit disappointing quarter, in the second quarter. The first time they have had a disappointment in quite some time. And then Apple Computer, which is -- I think it's well known with the controversy surrounding that name. But the valuation is unusually attractive, so we are quite comfortable holding that name. A name like Southwest shows as a negative contributor, was owned in the portfolio for such a short period of time, is relatively inconsequential. Then Philip Morris International, I think people are concerned about the impact of the dollar appreciation on its almost entirely international businesses.
That's the large cap portfolio. I'm certainly available to answer any questions you might have at the end of the presentation, but for now, I will turn the call over to Julie.
Great, thanks Chuck. Next, Rick Snowdon will provide an update on the Select strategy.
Thanks Julie. Short term performances just (inaudible) short term and may not prove to be meaningful over longer periods of time. However, we are certainly with the direction of the short term performance of the Select strategy; how we outperformed the benchmark for the second quarter, our year-to-date and one year periods, on a roughly 500, 900 and 1100 basis points respectively.
On a three year performance (inaudible) benchmark by roughly 125 basis points, but the strategies outperformed the benchmark by 80 to 90 basis points for too long, as to therefore significant periods shown here, five years and inception to date.
On slide 35, I would point out the trailing 12 month turnover number of 72%. This number is a residual of bottom-up stock selection, thus not something that we manage. But 72% is still higher than we would normally expect. This currently elevated number is a function of a number of stocks having approached or reach the intrinsic value recently, and is also the byproduct of some initial repositioning that occurred in the portfolio, when Austin and I first became involved with the strategy, during the first quarter.
Also on page 35, we show the sector weights. These are generally consistent with where we were last quarter. On slide 36, our top 10 holdings are shown. Changes since the last quarter include Boston Scientific, Popular, Microsoft and Forest Labs, replacing Southwest Airlines, Hartford, which was eliminated entirely from the portfolio; Medtronics and Morgan Stanley.
Positions eliminated from the portfolio include, Abbott Labs, Assured Guaranty, Schwab, McDonalds, Merck and Hartford, which I just mentioned. All of which were eliminated at prices approaching intrinsic value, and made room for the following new names; AIG, the insurance company; Warner Chilcott, a specialty pharma company. Hub Group, which is an intermodal transportation company; Willis Group, which was mentioned earlier as an insurance broker; Fortress Investment Group, which is an alternative investments manager; Juniper Networks, computer networking and that's a name that we have owned elsewhere for some time; and Endurance Specialty Holdings, which Tom mentioned earlier.
In terms of best and worst performers, many of those have been discussed with respect to other portfolios, but I will quickly hit at those, that not yet have been addressed. On the top performers, V.F. Corp I think is the only one not already mentioned, and although results were somewhat mixed for the quarter, little miss on revenue and a beat on margins. Management firm, the long term revenue growth and expectations, at an Analyst Day they had in the quarter, of 8% organic, and also 300 basis points of margin expansion, and this growth is focused on the outdoor at Asia Pacific portions of the business. So that stock did well, was up 15% in the quarter.
On the bottom side, Cimarex was a little bit weak due to weak natural gas and natural gas liquids pricing. But as Chuck mentioned, they have got a very unique set of assets, and operationally continue to perform well, and the Permian assets continue to look better and better. Baxter, lagged the market by a few points in the quarter, due likely to poor results and some Alzheimer's trials and also possibly due to some FDA warning letters they received regarding unsanitary conditions in two of their facilities. Then Fortress which was added in the quarter, was down just a little bit. No real news that appears to have affected that name.
I think that's it Julie.
Great, thanks. Next up, Ric Dillon will provide an update on the Long Short strategy.
Thank you, Julie. Clearly in an upmarket, Long Short strategy would lag our long only strategies, and as all of our long positions are held in either our large cap and/or small mid-cap strategies, you have heard about the long positions and how they have done, and that explains entirely, the good results for the quarter and for the last year, and we are glad that we are meeting our long term goals over the -- since inception and longer periods of rivaling our long only benchmark.
I want to make note of a minor change, where our secondary benchmark historically has been the 50-50 Russell 1000 and Bank of America-Merrill Lynch U.S.T. Bill Index. We are now using 60-40. The reason for that has to do with where we have tended to be. We recently have found that we are closer to that 60% versus 50 and so by using that as our second -- that minor change in our secondary benchmark, we think it should allow investors to have a better idea of what to expect over short periods of time. But again, over the long periods of time, our goal is to rival the long only benchmark, with a lot less volatility.
The second thing I want to highlight, is that we continue to do, like all of our other strategies, view the financials most positively, and we are most cautious on the consumer discretionary, the latter of which has actually hurt us in the recent periods, but we still -- and I will go into some detail at the moment on a couple of names, as to why we are continuing with those positions.
Our top holdings, not surprisingly from what you've heard earlier, are dominated by financial stocks, and with regards to our short positions, again, not surprisingly, the consumer discretionary is well represented there. You will also see in our new positions, jcpenney, which was a very successful short position for us. We covered that position, and recently reestablished that position, as many of you know, the former CEO has returned to the company, trying to stabilize that situation, and we are cautious on the ability to accomplish that.
The next page shows our best performers and our worst performers for the quarter. Again, there is no need to talk about the long positions, but I will talk about the short positions, which were our worst performers, Boeing, Gap, and Life Time Fitness. Two of the three being consumer discretionary. But starting with Boeing, certainly has been in the press quite a lot over the past year, with some of the challenges they have had with their 787 Dreamliner Commercial Airline airplane. But the story there really has more to do with both the balance sheet and $27 billion underfunded pension liability, and this is a company that has a market cap of just under $80 billion. So that's a very large percentage that's not showing up on the balance sheet. Then secondly, the concern we have for their defense business as well as the commercial. Essentially, the company has very little top line growth, and we think there will be some margin pressure.
I must acknowledge that one thing that has been better than our expectation, is their international defense business, which has had a little stronger growth than we had forecasted, but otherwise, our thesis remains intact. Their top line is challenged, free cash flow is next to zero and their balance sheet, while it benefits of course by this upward moving stock market, at some point, we think that the stock will reflect that fairly large underfunded liability. When they report earnings in a week or two, you will see them report (inaudible) not including that pension charge, but when you include that, it's a pretty big negative.
With regard to Gap, it's a retailer that everyone knows. If you look at the most recent same store sales, you see it was driven primarily by Old Navy brand, and that tends to be a lower margin business, and so our expectation when they report in August, is that there will be some margin pressure as a result of that, primarily, as well as the result of tougher comps, with regard to cotton pricing, which had helped them a lot a year ago, but is now somewhat of a negative for them.
Finally, in the consumer area, Life Time Fitness, again a stock that in the quarter hurt us. Well note that the insider selling has been very relatively high in the most recent quarter. So whether that's coincident with their view, the stock price being maybe a little high, or something else is not knowable, but nevertheless, it is something to be concerning, if you are long in the stock. But in the short position, that gives us some comfort. Also, the attrition which has been increasing, we expect when they report in another week or so, that trend will continue. They are hoping that they will offset that, with regard to other revenues, restaurant revenues inside their stores and boost increases, but that's something that we think is a problem.
You may recall that when they reported fourth quarter, the numbers were sufficiently disappointing and the stock had a sharp selloff. It has recovered since then in this very strong upmarket, but the next quarter, which will be, as I said reported in less than two weeks, we might see something a little bit different. So that's why we continue to maintain those positions in those three shorts, and with that, I turn it back over to Julie.
Thanks Ric. Next, we will hear from Chris Bingaman, with a review of our Financial Long-Short strategy.
Thanks Julie. The Financial fund had a good second quarter, up just about 8% versus 6.3% roughly for the S&P Super Composite Financials. You can see performance over the recent periods, very-very strong on an absolute basis. Pretty pleased with the performance, absolute in recent periods, and relative shift (inaudible) over all periods.
Page 45, just some of the updates in terms of changes, statistics, and so forth. Net exposure was reasonably steady. It dipped a little bit during the middle part of the quarter, but then during the June, in particular sell-up in the market, we took the opportunity to add to some positions, so it ended up being fairly flat quarter-to-quarter. Gross exposure down a little bit from the second quarter.
In terms of industry allocations, no real big changes there. Banking and the other industries, fairly stable. Insurance is the one area we will discuss in a minute, but did see a reduction in exposure.
On Page 46, top holdings. A lot of these have been discussed in the top five; new names are AIG and Citi, strong relative performance and also adding to those on weakness, names that fell out were Hartford, which was completely sold and JPM which was trimmed during the quarter.
Short holdings, top five, nothing real meaningful there. I think one new name is BancorpSouth is the only new name there. Little bit of movement among the others, but not much. I think most of the new positions have been previously. Couple exceptions, Capital One was added during the quarter at a percent and a half position size. It's a very large credit card issuer, something it has struggled a bit over the last few years, but the industry fundamentals are very-very strong, credit profiles are very-very good across the board. Capital One is no exception, so we think that some of the fundamental issues, they have been struggling with are behind them, and the valuation still seems reasonably attractive. Bank of Marin is a very small cap bank in the Bay Area of California. Very strong franchise. So I think those are the key new positions.
Eliminated positions, I think most of these have been discussed, CME Group was a relatively long time holding, but a fairly small holding. Ran up quite a bit, as soon as we saw some volatility in the treasury markets. It passed our estimated intrinsic value, when we sold that name. I think the others have been mentioned. On the short side, Wesbanco and Wintrust both eliminated. Wintrust was a successful short, made a little bit of money, it came down to our IV and we covered it. Wesbanco has been in and out of the portfolio. They announced a much better quarter than I anticipated after an acquisition recently, and that position was eliminated roughly at breakeven.
On page 47, best performers; I think all of these have been generally mentioned. First American on the short side was a modest contributor, which was very nice in a strong upmarket. It's definitely tied to -- it's title insurance business was negatively affected by the rising yields. And the worst performers, Winthrop is a REIT that same thing, is considered a little bit more bond like, and all of those generally mixed up quarters, and on the short side, Home Banc Shares announced a fairly accretive end market deal, and took that stock a little bit higher.
So overall again, very-very pleased with the performance, staying ahead of the long only benchmarks again, with 70% to 75% sort of net exposure we are very pleased with. Would be glad to answer questions at the end, and I will turn it back to Julie.
Thanks Chris. Next, Austin Hawley will provide an update on the Research Opportunities fund.
Thanks Julie. In the second quarter, the Research Opportunities Fund Class I appreciated 5.06% compared to 5.06% compared to 2.69% for the Russell 3000. For the year-to-date period, the fund is up 18.68% compared to 14.06% for the Russell 3000 Benchmark. Since inception, the Research Opportunities fund has produced strong absolute returns, while trailing our long-only benchmark by a modest amount. This relative underperformance is not surprising in a sharply rising market environment. But over full market cycle, as we continue to expect positive relative returns, in addition to adequate, absolute returns.
Turning to page 51, the fund has 69 long and 23 short positions at the end of the quarter, compared to 62 long and 20 short positions at the end of the first quarter. Gross exposure increased to 90.5% from 84% at the end of the first quarter, and our next exposure increased slightly to 68% from 66.5% at the end of the first quarter.
Turnover at 40% is slightly higher than we would expect over the long term, as many of our positions increased to approach our estimates of intrinsic value. There are no significant changes during the quarter, based on a sector basis.
Turning to page 53, looking at our top 10 holdings. New to our top 10 holdings in the quarter were AIG and Willis Group. These names replaced the Hartford, which was eliminated completely from the portfolio, and also Energizer. AIG was added during the first quarter, and the position size was increased during the second quarter, moving it into the top 10.
Willis, one of the largest insurance brokers in the world is a new position during the quarter, and was added to replace the Hartford Group, which as I mentioned was eliminated.
Looking at our new positions during the quarter, we had eight new long positions, and six eliminated positions. Of note during the quarter, three of our new long positions were international names. We had two ADRs based in Britain, the pharmaceutical company GlaxoSmithKline, and the retailer, Tesco, that were added; and Canadian pharmaceutical company Valeant, which is listed on the New York Stock Exchange, was also added during the quarter. Currently we have approximately 3.5% of the Research Opportunities fund in international holdings.
Looking at the eliminated positions during the quarter; all the names with the exception of Devon, were at or nearing our estimates of intrinsic value. In the case of Devon, Devon was sold -- increased our position in Cimarex, where our analyst Suken Patel thought there was a better risk reward.
Finally, turning to page 53 and looking at our best and worst performers; there were no significant contributors or detractors that have not -- already been addressed on this call.
So at this point, I am going to go ahead and turn it back to Julie.
Thanks Austin. To wrap up our strategy update, I will turn the call back to Bill Zox for an update on the strategic income strategy.
Thanks. Starting with the five year performance; the Strategic Income Fund has generated a total return just (inaudible) 9% annually, compared to (inaudible) of 8% and just over 5% for our primary and secondary benchmarks. For the last quarter, which was a pretty good stress test for the fixed income markets, the fund was down at 66 basis points, compared to just under 300 basis points for the primary index, and 250 basis points for the secondary index; and while not (inaudible) here, the Bank of America-Merrill Lynch High Yield Index was down 1.35% during the quarter. So we feel good about how we held up, and what was I think a good stress test for the fixed income markets, of course, we don't like to lose money, but it was a very difficult quarter.
The key differentiating factor in what we do, is that we do not manage the fund against an index, and our duration has been in the two for quite some time, which we think makes the most sense, and you just won't find a fund that's managed against either a core index, or a high yield index. Typically we would fund the [duration there in the course].
Turning to page 56, we started to include the slide last quarter, because our strategy is fairly unique, it is important to evaluate our returns on a risk adjusted basis, and while we do not define risk as volatility, this is the most common way and one of the few ways to quantify risk adjusted returns, so that's why we have included that, and we do feel that the returns, risk adjusted in this manner, have been good over these periods of time.
Then finally, I am going to skip to the last slide, page 58. We were fairly active in the quarter. It was an unusual environment, where typically when interest rates increase, credit spreads will narrow. In this case, credit spreads widened, and it was also an environment where stocks continue to appreciate and have certainly done very well over the last year. So that equity cushion in our holdings was valued higher in the marketplace, yet the bonds were selling off. So we were very active towards the end of the quarter.
Two new positions that we took throughout the quarter that will highlight, because they are large positions were U.S. Airways, 6.13 of 2018 and United Continental Holdings, 6.38 of 2018. As we have already talked about the airline industry somewhat, but capacity discipline in the U.S. airline industry over the last 10 years, is leading to significant free cash flow generation, which managements are directing at debt reduction. So we think it's a fantastic point in the evolution of the airline industry to be a creditor.
The yields are still very attractive, and our view compared to what we expect the balance sheets to look like, just a couple of years from now; and we also like the structure of these two bonds, is five year non-callable bonds; which is not the typical structure in the high yield space, but one that we think is very attractive in this environment.
With that, I will turn it back to Julie.
That concludes our prepared remarks this afternoon. So Maisha, we are now ready to begin the question-and-answer segment of the call.
We do have one question that we received here for Bill Zox. Bill, over the last few years, you have kept the strategic income strategy in mostly corporate bonds, and have continued to shorten the duration. Do you expect that to continue going forward?
I do expect that the strategy would be almost entirely in corporate bonds, but the one other class of securities that we used to be involved in, getting back largely more than five years, that was preferred securities, which if they were deeply discounted as they were in the financial crisis, at $0.50 from $1, I could see maybe returning to that space to some small extent, 5% to 10% of the fund. But we are very far from that today, so for the foreseeable future, I would expect the all-in corporate bonds.
In terms of duration, our duration over the last five years or so has fluctuated between the low to mid to high threes, and that kept us below the duration of a four bond strategy, or a strategy managed against the high yield index and I would expect that it will always tend to be somewhat shorter, although not necessarily as (inaudible) we have been in the low twos, and in fact in this quarter, we are down into the mid to high twos today, compared to the low twos.
Maisha, are there any questions in the queue?
We have another question that we received for Chris Bingaman. Chris, with the strength in the financial sector stock, are you having a hard time finding attractive opportunities? And on the flipside, are you finding more short opportunities?
Yeah in general, if you look over the last year, I think the fund is up somewhere in the high 30s over the past 12 months. So no doubt, expected returns compared to a year ago are much-much less attractive on an absolute basis. It was very-very easy period of time then, and expected returns, we were modeling quite often in the mid and high teens. So today, it's much-much more difficult, but I still think, on a relative basis, the sector still seems fairly attractive, just not nearly as attractive as it was a year ago. So we have continued to sell holdings as they reach our intrinsic value estimates, net exposure in the financial long short fund is down, reflecting that. So we have built a couple of short positions, so it has become a little bit easy on the short side, a little tougher on the long side, but still think the sector is generally still relatively attractive.
Thanks Chris. We don't have any additional questions that we've received here. Are there any questions in the queue at this point?
We have no questions at this time.
Okay then, we will go ahead and wrap up the call. As a reminder, for those of you who missed parts of the call or would like to listen to it again, we will post a replay on the website, in a few days, and again, thank you for joining us today, and for your continued support of Diamond Hill, and we look forward to speaking with you again, next quarter.
Thank you ladies and gentlemen. This concludes today's conference. Thank you for participating. You may now disconnect.
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