Small-Cap Growth Commentary – December 31, 2023
The fourth quarter of 2023 was a wild ride for US small caps, as the Russell 2000® Growth Index (the benchmark) hit both its annual nadir and peak during the final three months of the year. The benchmark hit its 2023 low of 1,037 on 10/27/23 before rallying to nearly 1,310 on 12/27/2023. Non-coincidentally, US Treasury 10yr rates hit their peak of near 5% in late October before subsequently falling to below 4% by year-end. As we have previously written, small caps have an inverse correlation to interest rates, and the fourth quarter underscored that relationship. More on the macro and ‘Fed Pivot’ later, but first a quick recap of performance. Despite hitting intra-year lows, the Russell 2000® Growth Index rose +12.75% for the quarter, ending 2023 +18.66%. The Hood River investment team is consistently looking for inefficiencies in the market, and 2023 was no different: the US Small-Cap Growth strategy outperformed the benchmark by +300 basis points (“bps”) for the quarter net of fees, placing it +302 bps ahead for the year (net).
The strategy’s outperformance for the quarter was entirely driven by stock selection, which is to be expected given Hood River’s proprietary, bottom-up research process. Sectors contributing the most to stock selection included health care (+146 bps), industrials (+114 bps), and materials (+53 bps), which was slightly offset by consumer staples (-53 bps) and consumer discretionary (-12 bps). Group weight was largely flat for Q4 (+3 bps). Stock selection was also positive for the full-year ending 12/31/2023 — industrials (+434 bps), health care (+152 bps), and financials (+101 bps) were the largest contributors while consumer discretionary (-163 bps), information technology (-158 bps), and utilities (-54 bps) were the largest detractors. Group weight added +48 bps to the strategy’s 2023 outperformance.
Moving to the macro, higher interest rates have been a headwind for the small cap asset class for several years. The setup changed — at least for now — in late October, as the US Treasury 10yr hit its peak of near 5% and afterwards retreated. That move served as a catalyst for US small caps to rally, helping boost the asset class off YTD lows to its YTD highs.
That said, in our view US small cap valuations remain very attractive. Despite the recent rally across all market caps, small caps have lagged their larger-cap peers since 2000 and have lagged the S&P 500 ETF for all of 2023. We believe this continues to provide an attractive entry point and set-up for the asset class.
From our hundreds of conversations during the quarter with management teams, suppliers, customers, etc., we are able to build a macro picture from the ground up, so to speak. We believe the US economy continues to chug along, labor markets are cooling slowly yet still tight, and inflation is ebbing, thanks in part to money supply growth — which went negative in November of 2022 and remains negative today. In our view, the largest risk to small caps as a whole is if the Fed broadcasted their intentions too quickly or if there are indications of a subsequent pause in rate cuts. The argument now surrounds the timing and slope of rate cuts. Regardless, it does not impact what Hood River has focused on for the past twenty years, which is finding investment opportunities through proprietary, fundamental research in any market environment.
Even though the asset class gained ground in 4Q, it wasn’t all smooth sailing for our US small cap growth portfolio. The strategy was up approximately +550 bps versus the benchmark going into the “Fed Pivot” in mid-December, when the governors signaled a more dovish approach to rates than previously expected. Following the release of the minutes, ‘lower quality’ small cap names — i.e. those that are more-rate sensitive, have high debt, are non-earners, and/or have high short interest — rallied. These are names that Hood River has historically avoided.
Still, our strategy held its own and outperformed for the quarter. Over longer-term rallies, Hood River’s US Small Cap Growth strategy has historically outperformed the benchmark. We would point to 2003, 2009, 2012, the Euro Crisis, and even post-Covid as examples of longer-term outperformance. Our work is to ensure we are right on the fundamentals in each name we own — and if we are correct on the majority of our holdings, we believe we should outperform over the long term.
We have remained quite active over the past few months and made some changes within the portfolio that reflect where we are finding the best ideas. However, our portfolio remains fairly close to the Russell 2000® Growth Index as it relates to sector weightings. Going into Q1 2024, no sector is more than 600 bps different than the benchmark. Information technology is the most overweight sector (approx. +600 bps) while consumer discretionary is the most underweight (approx. -400 bps).
As always, we greatly appreciate everyone’s partnership and confidence in the Hood River team. We hope everyone had a safe and healthy holiday season and wish you all the best in 2024. We’ll be in touch with many of you in the coming months, but please reach out if you have any questions or need anything from the team.
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 Capital Management, LLC 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.
Information has been gathered from sources that are considered reliable, however its accuracy cannot be guaranteed. The security mentioned in this letter was 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, 202-December 31, 2023. 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 12/31/23 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 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.