Small-Cap Growth Commentary – December 31, 2021
The Hood River Capital team hopes this year-end commentary finds you happy and healthy as we wrap up yet another year. 2021 was marked by uncertainty and volatility for equity indices. Hood River’s U.S. Small Cap Growth strategy outperformed its benchmark for the quarter and for the full year ending December 31, 2021. The fourth quarter began on a positive note for equity indices, with the Russell 2000® Growth Index rising +11.33% through November 8th. The index subsequently fell -14.34% through December 16th as fears of the Omicron variant and continued inflationary pressure captured headlines. A broader risk-on mentality returned late in the year: from the December nadir through year-end, the Russell 2000® Growth Index rose +4.75%, ending the year up +2.84%. While still in positive territory, 2021 marks the lowest return for the index since 2018’s -9.93% return.
The volatility throughout 2021 created many opportunities identified by Hood River’s proactive, bottom-up research, and the investment process once again generated positive alpha for the full year. On a net basis the U.S. Small Cap Growth strategy rose +23.86%, outpacing the Russell 2000® Growth Index by 2,102 basis points (“bps”). For the twelve months ending 12/31/21 the benchmark’s best performing sectors were industrials (+2.79%), information technology (+2.59%), and consumer discretionary (+1.66%). Sectors that lagged for the full year included health care (-6.15%) and communication services (-0.33%).
Focusing in on the final three months of the year, our U.S. Small Cap Growth strategy gained +4.76% (net), outpacing the benchmark by 475 basis points (“bps”). The benchmark’s best performing sectors in the fourth quarter included industrials (+1.19%), information technology (+1.06%), and financials (+0.41%). On the other hand, health care (-2.89%), communication services (-0.25%), and consumer discretionary (-0.19%) were the three laggards for the period.
As you are aware, Hood River’s investment process is driven by fundamental research, and thus stock selection is typically the driver of our outperformance instead of sector allocation. The fourth quarter of 2021 was no different, as 290 bps of our 475 bps of outperformance was driven by stock selection. The sectors contributing most to stock selection outperformance were health care (+249 bps), information technology (+194 bps), and consumer discretionary (+121 bps). Industrials (-212 bps), financials (-43 bps), and communication services (-38 bps) were the three sectors with the least contribution from stock selection.
Entering 2022, all sector weightings are within approximately 600 bps of benchmark weightings apart from industrials and health care. Regarding the former, we are approximately 700 bps overweight, largely due to the fact that the industrial sector serves as a catch-all for many companies that don’t fit neatly into other sectors. Regarding health care, we are approximately 1,100 bps underweight, largely due to our approximately 825 bps underweighting of the biotech subsector.
It is no surprise that our recent conversations with management teams and industry contacts point to inflation and Covid as two of the most prevalent concerns companies face today. Regarding inflation, most contacts have suggested the fourth quarter was similar to the third but the upward pricing pressures were a bit more pronounced and persistent. However, management teams at the companies in our portfolio remain confident in their ability to pass increased prices on to end consumers and keep their margins intact or rising. This raises the question of continued inflationary pressures at the consumer level, which may play out over the coming quarters.
Management teams are also seeing various levels of supply-chain and labor market issues, two of the root causes of inflation during periods of high demand. Procuring enough material on time to meet demand remains a pinch point for some companies, especially those that rely on semiconductors as an input. We believe the semi space will continue to have supply issues through at least the second half of 2022, but may last longer depending on demand. Regarding labor supply, management teams have staved off permanent wage increases at the lower end of the spectrum by offering one-time bonuses; higher-skilled positions are more difficult to fill, and management teams have often turned to overall salary increases to attract and retain talent. We believe these increased costs will percolate through cost structures over the coming quarters, but higher income levels could also keep demand running strong.
The final topic involving inflation is of course the Federal Reserve’s response and a more-aggressive taper to their asset purchase program. It’s also worth noting the Fed has limited room to move on interest rate policy before inverting the curve. Commentary and action from the Fed indeed changed the daily standard deviation of our benchmark, creating some of the most volatility we have seen all year. Higher-valuation stocks in general pulled back more sharply than their relatively less-expensive peers, creating an opportunity for us to put greater weightings on our higher-conviction names as we head into 2022.
Lastly, Omicron: it is too early to tell what the longer term impact may be from the variant. However, the 1,000s of flight cancellations over the Christmas weekend demonstrated the impact another surge could have on industries and the supply chain. Thus far the symptoms fortunately appear to be less severe than prior variants, but lockdown and / or quarantine policies could still disrupt the economy in the coming months. If Omicron is indeed as mild as most of the data thus far shows, Covid may fade into the background and become one less concern that raises questions about growth.
As we enter a new year we feel very good about the names in our portfolio and the prospects ahead. The market is rewarding stock selection as investors care once again about valuation from an absolute standpoint. Further, Russell 2000® Growth Index valuations have come down in the past year and we continue to find many attractive entry points. This backdrop, coupled with our proprietary fundamental research and active portfolio management, should bode well for Hood River; especially as we expect a few months of volatility as the impacts from Omicron pan out. We greatly appreciate everyone’s confidence in Hood River and your continued support.
Brian Smoluch & David Swank
Investors in Hood River’s Small-Cap Growth strategy acknowledge and agree that (I) any information provided by the Firm is not a recommendation to invest in the strategy and that the Firm is not undertaking to provide any investment advice to the investor (impartial or otherwise), or to give advice to the investor in a fiduciary capacity in connection with an investment in the strategy and, accordingly, no part of any compensation received by the Firm is for the provision of investment advice to the investor and (II) Hood River has a financial interest in the investor’s investment in the strategy on account of the fees and other compensation the Firm expects to receive from the client.
Hood River Capital Management LLC, a Delaware limited liability company, is a registered investment adviser under the Investment Advisers Act of 1940. The Firm offers investment advisory services to individuals, pension and profit-sharing plans, trusts, estates, corporations, as well as other institutional clients. Hood River has an arms-length service level agreement with Mar Vista Investment Partners, a registered investment adviser, to provide back and middle office services. For purposes of compliance with GIPS®, Hood River has defined itself to not include bundled/WRAP fee accounts in the firm’s assets. Hood River maintains a complete list and description of firm composites, which is available upon request.
On 01/01/13, Brian Smoluch, Robert Marvin and David Swank formed Hood River to manage a small-cap growth strategy. Brian Smoluch, Robert Marvin and David Swank were dual employees until 05/31/13 when all of the assets under their management at Roxbury transitioned to Hood River through a sub-advisory arrangement. On 1/20/15, Hood River finalized an agreement that put 100% of its equity in the hands of Hood River’s three Principals, divided equally among them. All assets under management are managed by Hood River. Information provided for the period from June 2002 through December 2012 represents the performance of portfolios managed by Mr. Smoluch, Mr. Marvin and Mr. Swank while employed by Roxbury. Hood River claims compliance with the Global Investment Performance Standards (GIPS®) and has prepared and presented this report in compliance with the GIPS® standards. Hood River has been independently verified for the periods 01/01/13 through 12/31/20. A firm that claims compliance with the GIPS standards must establish policies and procedures for complying with all the applicable requirements of GIPS standards. Verification provides assurance on whether the firm’s policies and procedures related to composite and pooled fund maintenance, as well as the calculation, presentation, and distribution of performance, have been designed in compliance with the GIPS standards and have been implemented on a firm-wide basis. The Small-Cap Growth composite has had a performance examination for the periods 07/01/02 through 12/31/20. The verification and performance examination reports are available upon request. GIPS® is a registered trademark of the CFA Institute. CFA Institute does not endorse or promote this organization, nor does it warrant the accuracy or quality of the content contained herein. Benchmark returns are not covered by the report of independent verifiers. For the entire period presented, Mr. Smoluch, Mr. Marvin and Mr. Swank have been substantially responsible for the all the investment decisions of the small-cap growth strategy. Performance prior to 01/01/13 meets GIPS® portability requirements. ACA served as the verifier, conducted a verification and examined the composite’s performance history that was ported over to Hood River prior to 1/1/13.
The Small-Cap Growth composite was created in 2002 with an inception date of 06/30/02. On 01/01/13 the name of the composite changed from Small-Cap Growth (Portland Team) to Small-Cap Growth. All returns are based in U.S. dollars and are computed using a time-weighted total rate of return. The composite is defined to include all fully discretionary, taxable and tax-exempt portfolios with a minimum portfolio value of $500,000 managed in accordance with Hood River’s Small-Cap Growth strategy and that paid for execution on a transaction basis. Any account crossing over the composite’s minimum threshold due to contributions shall be included in the composite at the end of the month it increased in value. Any account which drops below 65% of the composite’s minimum threshold because of considerable cash withdrawals and not due to manager performance will be removed from the composite at the beginning of the month it declines in market value.
The benchmark is the Russell 2000® Growth Index, defined as an unmanaged, capitalization weighted index of those Russell 2,000 companies with higher price-to-book ratios and higher forecasted growth values. Index returns include dividends and/or interest income and do not reflect fees or expenses. In addition, unlike the composite, which periodically maintains a cash position, the Russell 2000® Growth Index is fully invested. Investors cannot directly invest in an index.
The dispersion in gross of fee composite returns shown herein was measured using an asset-weighted standard deviation formula. For returns presented gross of fees, results were calculated prior to a deduction for investment management fees. Client returns will be reduced by Hood River’s investment management fees. The fee schedule is disclosed in Part 2A of Form ADV filed with the Securities and Exchange Commission. Over a period of years, deductions for annual investment management fees will reduce the compounding effect on portfolio growth. For example, assuming 8% annual return for five years and application of the maximum annual fee of 1%, a total gross return of 46.9% and a total net return of 40.3% would be generated. Performance results presented reflect the reinvestment of dividends and other earnings. Gross performance is net of all transaction costs. Net performance is net of transaction costs, the maximum performance-based fees if applicable and actual management fees, but before any custodial fees. All returns are calculated net of withholding taxes on dividends and interest. Actual results may differ from composite results depending upon the size of the portfolio, investment objectives and restrictions, the amount of transaction and related costs, the inception date of the portfolio and other factors. Policies for valuing portfolios, calculating performance, and preparing GIPS® Composite Reports are available upon request.
Attribution information is as of 12/31/2021 in an account of a client that Hood River believes to be representative of the Small-Cap Growth accounts Hood River manages. Clients of Hood River managed with different investment objectives or restrictions may have different sector performance and daily beta than those listed. Information is provided for supplemental purposes only. Past performance is no guarantee of future results. Not FDIC insured, no bank guarantee, may lose value.