Small-Cap Growth Commentary – December 31, 2022
We hope everyone had a happy and healthy holiday season. 2022 was certainly a rough year for equities, and for small-cap growth stocks in particular. While a majority of the decline in the Russell 2000® Growth Index (our benchmark) was seen in the first half of the year, the second half ended up approximately where we were on June 30th despite some impressive rallies. Our benchmark fell by -32.85% in the first six months of 2022 and gained +5.96% over the next six months. For the full year, the index was down -26.36%, which marks the largest decline since 2008. Large-caps and small-cap value stocks fared somewhat better, with the S&P 500® Index falling by “only” -18.11% and the Russell 2000® Value index declining -14.48%.
Needless to say, ‘small’ and ‘growth’ were out of favor given inflation concerns and the rising interest rate environment. A recent analysis of our portfolio showed the three largest factor exposures in 2022 were small-cap, growth, and earnings momentum/revisions. Earnings momentum stocks faced headwinds throughout the year, particularly those with positive 12-month earnings revisions — impacting our philosophy of identifying businesses with a high likelihood of a positive earnings surprise. Investors chose to view these revisions through a ‘glass half empty’ lens, by ignoring fundamentals and instead focusing on the uncertain environment ahead. Fortunately, we mitigated a bulk of these factor exposures for 2022 through stock selection.
For the full year ending 12/31/2022, Hood River’s U.S. Small Cap Growth strategy fell by -27.86%, underperforming the benchmark by -150 basis points (“bps”) net of fees. While the full-year was somewhat close to a push, the most recent quarter was not. In Q4, Hood River’s U.S. Small-Cap growth strategy fell by -0.36% (net of fees), underperforming the Russell 2000® Growth Index by -449 bps.
The underperformance in Q4 masked the broader strength in our portfolio, however, as one holding in particular had an outsized negative impact due to a large, ill-advised acquisition. We had long been a fan of Chart Industries (GTLS) due to the positive fundamentals and long-term opportunities for the company. In fact, the company reported what we viewed as good quarterly numbers in late October, sending shares up +4.81% and up +50% YTD prior to the acquisition. However, on 11/9/22 management announced a $4.4BN acquisition that sent shares down by a total of -57.99% over the seven trading days following the announcement. We were overweight GTLS going into the news but the acquisition undoubtedly took us — and the market — by surprise. Management had long discussed the potential for ‘tuck-in’ acquisitions but nothing similar to a merger-of-equals. Despite management touting the long-term positives of the acquisition, we decided to fully exit the position at approximately $147 per share – GTLS ended the year at $115.28. Although GTLS alone had a -200 bps impact post acquisition announcement, the position had long driven positive alpha and, in fact, still had a 12 bps positive impact for 2022.
Due in part to GTLS, approximately 80% of Hood River’s underperformance for the quarter was driven by stock selection, with the remaining coming from group weighting. Sectors that contributed the most to stock selection for the fourth quarter include financials (+33 bps), materials (+27 bps), and consumer staples (+24 bps). Detracting sectors included health care (-120 bps), industrials (-81 bps, GTLS’s GICS classification), and communication services (-78 bps). For the full year, stock selection had a neutral impact on performance — thus, the vast majority of underperformance came from sector weightings.
From our recent conversations with management teams, although we may or may not be in a ‘technical’ recession, most companies are seeing a slowdown in fundamentals. Consumer demand for big ticket items (e.g. housing, RVs, and boats) are being impacted by a reduced propensity to spend alongside higher interest rates, so it is not shocking to see a slowdown in these areas. Our fundamental research suggests software, semi-conductors, energy, and consumer discretionary are also seeing general weakness. On the positive side, we believe industrials and financials are two areas with relatively fewer headwinds heading into 2023.
With that in mind, as we head into 2023 we remain somewhat neutral versus the benchmark with no sector being over- or under-exposed by more than approximately 400 bps. Given our comments in the prior paragraph, it is no surprise our largest exposures are industrials (+373 bps), financials (+339 bps), and, due to selective investments, information technology (+333 bps). Our largest underweights are — again, not surprisingly — consumer discretionary (-423 bps), energy (-258 bps), and real estate (-223 bps).
To expand a bit on the broader market environment, inflation and the Fed’s next few rate decisions remain top of mind amongst investors. Indeed, it was the +7.1% year-over-year CPI print on 12/13/22 vs. the roughly 7.4% expectation that reversed a short-term rally in equities as concerns about inflation shifted to concerns about growth. Contrary to another round of inflation-lamenting Cardi B videos, recent calls with C-Suites reinforce the view that inflation has indeed improved, primarily on the commodity / input cost side. Labor remains the last sticking point and, while things remain difficult, the situation has improved from six months ago. Money supply growth as measured by M2 has also turned negative on a year-over-year basis, marking the first time since 1995, and only the second time in the series, it has been negative. Thus, this is the slowest monetary growth environment we’ve recently seen, which should aid in dampening inflationary pressures.
The question now, in our minds, is what does growth look like in the near-term. With the broad perception the Fed missed the signs of the monetary situation becoming untenable a few years ago, even if inflation rolls over we believe the Fed may need to ensure it is squashed in order to maintain (or rather, regain) credibility. We believe the market is currently pricing in a 4-5% range for the Fed funds rate through 2023.
Despite the recent slowdown in fundamentals and the potential for a Fed over-correction, we believe the risk / reward in the US small cap space is fairly attractive — even if we have a ‘regular’ recession. Valuations remain relatively inexpensive: on a P/E basis, positive-earning companies in the Russell 2000® Growth Index are trading at 13.8x 2023 and 12.9x 2024 vs. the S&P 500® Index’s 16.7x 2023 and 15.3x 2024. We also continue to find attractive investment opportunities through our fundamental research that have durable earnings growth potential and inexpensive valuations. The current backdrop is somewhat tricky in that you don’t want to over-index to names where earnings revisions are improving but the improvement is already priced in. We believe this is a good setup for proactive, fundamental stock picking.
We’ve consistently opined that investing is a humbling endeavor. While 2020 and 2021 were two years of gratifying outperformance, the fourth quarter of 2022 indeed proved to be humbling. Fortunately, the underperformance was not due to something systematically wrong with the portfolio or our process. Our conviction to adhere to our philosophy has never wavered, and we look forward to opportunities that lie ahead. Thank you all for your time and confidence in the Hood River team – we look forward to connecting with you in the coming weeks and months.
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 and a list of broadly distributed pooled funds, 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®). 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. 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.
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. 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.
A complete list of portfolio holdings and specific securities transactions for the investment strategy during the preceding 12 months, the top contributors and underperformers calculation methodology and a list of every holding’s contribution to the overall performance during the period is available upon request. The securities mentioned in this letter were held in the account of a Small-Cap Growth client that Hood River believes to be representative of the accounts that Hood River manages for this investment strategy during the period from September 30, 2022-December 31, 2022. Other Hood River clients managed with different investment objectives may hold different securities than those listed. The securities listed in this letter should not be considered a recommendation to purchase or sell any particular security. The reader should not assume that investments in the specific securities identified herein were or will be profitable. Sector attribution information is as of 12/31/2022. Information is provided as supplemental to the Small-Cap Growth GIPS® Composite Report. A Small-Cap Growth GIPS® Composite Report is available upon request by contacting Hood River directly at 561-484-5699 or via email at [email protected].. Past performance is no guarantee of future results. Not FDIC insured, no bank guarantee, may lose value.