Small-Cap Growth Commentary – June 30, 2022
It’s difficult to overstate the challenges the markets have faced thus far in 2022. Concerns over inflation, a slowing/stalling economy, and the Fed’s rate hike cycle have persisted for some time now but came to a head in the second quarter, particularly in the final month of the quarter. Not only did the June selloff push the S&P 500® Index down -16.10% for the three months ending 6/30/2022, it etched Q2 2022 as the worst quarter since the pandemic-related selloff of Q1 2020. Furthermore, the S&P’s year-to-date decline of -19.96% decline was the worst six month start to the year since 1970 and worst half since the second half of 2008. The risk-off environment impacted U.S. small-cap growth stocks to an even greater extent: the Russell 2000® Growth Index fell -19.26% for the quarter and is now down -29.45% YTD, not far off the -34.78% decline during the financial crisis in the second half of 2008. Fixed income was not spared either, with the Bloomberg U.S. Aggregate Index down just over 10% in the first half, by far the worst start to a year since that index’s inception in 1976. And of course, adjusted for inflation, real returns are even worse. So it’s fair to say this was a bad start to the year.
As outlined in the first paragraph, the second quarter and first half of 2022 have been challenging, to say the least. Our nine-quarter streak of outperformance has, unfortunately, come to an end – for the most recent quarter, Hood River’s U.S. Small-Cap Growth strategy trailed the Russell 2000® Growth Index by -239 basis points (“bps”) net of fees. Year-to-date, the strategy is now down -105 bps vs. the benchmark; on a one-year basis it is up +481 bps net of fees.
The strategy’s underperformance for the quarter was primarily driven by negative stock selection in consumer discretionary (-217 bps), industrials (-124 bps), and information technology (-47 bps). On the other hand, the sectors with the most positive stock selection were health care (+149 bps), consumer staples (+43 bps), and financials (+21 bps). The broad negative sentiment across the market meant positive fundamentals and underlying trends in individual companies were largely overlooked. Although 75 of our portfolio companies had a positive earnings surprise, only 17 posted a positive price change during the period.
The difficult macro environment in the second quarter created a rotating bear market through all facets of the U.S. economy – no sector in the Russell 2000® Growth Index posted positive performance in the second quarter. The sectors with the worst performance were communication services (-25.98%), real estate (-24.48%), and information technology (-23.13%).
To expand on the macro headwinds, the ubiquitous fear of a recession is reflected in concerns voiced by distinguished economists ranging from Larry Summers to Cardi B. While we agree a recession is likely, and we may already be in one, this is not a secret among investors and stocks prices reflect this concern. Consumers are already being pressured by inflation and rate hikes are already impacting housing as well other debt-financed spending (credit cards, auto loans, etc.). Supply chain issues are less of a concern but a weakening demand side is now impacting outlooks. Recent conversations with management teams suggest visibility on demand has become increasingly cloudy as sales cycles are extended and budgets questioned.
Regarding rising prices, we suspect there is little appetite for an 8% inflation rate and that some of the inflationary pressures will be reduced by improving supply chain issues over the coming year, combined with softer demand in the face of an economic slowdown. Copper, steel, oil, and wheat have all pulled back meaningfully in recent weeks. The M2 growth rate has also fallen from the mid +20s% a year ago to roughly 6-7% for the past handful of weeks – a much more normal range consistent with lower levels of inflation, though it may take time to get there. Conversely, the long-term trend of globalization that helped hold down U.S. inflation in the past few decades may no longer be a tailwind. Lastly, we still believe the Fed is behind the curve with respect to raising rates – we certainly do not believe this to be an out-of-consensus statement.
While the first half of 2022 has been brutal for U.S. small-cap growth stocks, the selloff has brought valuations down dramatically. The Russell 2000® Growth Index is trading at 12.4x for positive forward earnings estimates – compared to year-end closes since 2000, that’s cheaper than all but year-end 2008, with which it is tied. It’s also cheap on a relative basis as the current level represents a 19% discount to the S&P 500® Index. Although we think earnings estimates are suspect for both indices, that’s a very cheap reading vs. the average premium of roughly 18% since 2020. The Russell 2000® Growth Index is also trading at a 16% premium to its Value counterpart, which is the smallest premium than any year-end since 2000.
Regarding earnings estimates, the Russell 2000® Growth Index’s valuation embeds 18% growth in 2022 and 7% in 2023. If instead we hold earnings flat with 2021 through 2023, positive forward P/E would be 15.6x, which is cheaper than any year-end other than 2008 and 2009 (12.4x and 15.4x, respectively). So, while earnings estimates likely need to be cut, valuations look fairly attractive – of course there’s always room for further multiple compression, and if we face a serious recession, earnings estimates may have further to fall.
The first half of 2022 was historic in many respects, and in choppy markets like these we are hopeful to minimize macro factor exposure and stock-pick our way through the downturn. Our sector weightings are relatively tight to the Russell 2000® Growth Index, with every sector ending within 400 bps of the benchmark. Our holdings also screen well on several quality measures: versus the benchmark, our portfolio has a lower P/E, higher market cap, higher dividend yield, and lower debt/equity. We have historically added value through building a portfolio through our process of rigorous, fundamental research. While in the second quarter the market balked at its typical practice of rewarding companies with positive surprises/revisions, we are optimistic the market will emerge from this period of indiscriminate selloffs and high correlations. Regardless, we continue to find good opportunities and, in our view, own companies that can best navigate the uncertainties confronting the economy. We look forward to connecting with many of you over the coming months and wish everyone a good start to the second half of the year.
Brian Smoluch & David Swank
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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.
Sector attribution information is as of 6/30/2022 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 firstname.lastname@example.org.. Past performance is no guarantee of future results. Not FDIC insured, no bank guarantee, may lose value.