Small-Cap Growth Commentary – June 30, 2023
Investors had faced a wall of worry in 2022 as companies attempted to navigate inflationary pressures, rising interest rates, and a potential slowdown in the economy. We believe investors discounted these factors into small cap stock prices in 2022, and additional downside macro risks are largely offset by attractive stock valuations. We continue to get closer to peak rates, and while the risk of the Fed overshooting expectations still looms, many of the fundamental pressures companies faced are winding down.
This backdrop, along with the expectations for a soft landing, prevailed through most of Q2 2023, paving the path of least resistance as up and to the right for equities. The Russell 2000® Growth Index (the benchmark) rose +7.05% during the second quarter and is now up +13.55% for the year. Hood River’s US Small-Cap Growth strategy rose +8.16% in the second quarter of 2023, outperforming the benchmark by +111 basis points (“bps”) net of fees. This puts the strategy up +138 bps YTD and +78 bps on a one-year basis net of fees vs. the benchmark.
Our team’s proprietary fundamental research was yet again the primary driver of our outperformance, with stock selection adding +72 bps of alpha for the quarter and now +136 bps YTD. Sectors contributing most to the second quarter’s performance were consumer staples (+75 bps), information technology (+72 bps), and materials (+70 bps). Consumer discretionary (-90 bps), industrials (-66 bps), and health care (-54 bps) were detractors over the last three months. The largest contributors YTD include industrials (+224 bps), financials (+94 bps), and materials (+51 bps), slightly offset by information technology (-68 bps), consumer discretionary (-65 bps), and health care (-51 bps).
Outside of corporate earnings announcements, the trajectory of the Fed tends to be one of the largest concerns for investors. Although the “expectation” for a soft landing strengthened during Q2, there is downside risk across equities if the Fed bounces the economy on the runway – and while each quarter puts us closer to peak rates, the risk remains that rates go beyond expectations. Prices continue to rise, albeit at a slower pace, but if the Fed executes on its 2% target we believe it will result in a relative slowdown within certain parts of the economy. However, we believe a broad-based slowdown is already baked into prices at this point. Recent conversations with management teams suggests demand is in fact slowing in several areas – primarily in the consumer and software spaces. That said, we continue to find pockets of strength and are investing accordingly.
One of these pockets is artificial intelligence (“AI”), which is indeed a growing trend. We are hearing and seeing real demand for generative AI solutions, especially – but not surprisingly – in the technology space. We believe the interest in AI solutions will only continue to increase and have found a number of opportunities in the semi, semi-cap equipment, and data center spaces.
Additionally, in our conversations with management, we sense the stiff labor headwinds of 2022 have since eased. Wages are flattish and there are fewer departures – especially within the healthcare space, which saw a surge in hiring earlier this year. Workers have burned through their stimulus checks and are returning to work, so the overall cost to attract and retain talent has improved. In addition to our channel checks, this is supported by 14 straight nonfarm payroll beats – despite the streak ending with June’s print.
Heading into Q3 the portfolio is positioned fairly agnostically with respect to sector weightings. The largest overweight is industrials (+450 bps), which, in addition to us finding a lot of good opportunities, is fairly common given the ‘catch all’ nature of the categorization of many companies. Our largest underweight is energy (-250 bps) – the sector’s weighting within the benchmark was revised down approximately 200 bps on the last rebalancing.
We remain constructive on the market in the back half of 2023 and continue to find opportunities with solid bottom-up stories and the likelihood for positive revisions. As we mentioned, demand is slowing in pockets of the economy and we expect many companies see top line pressures – and in typical fashion, we’ve positioned away from these names in the portfolio. Due to these pressures, we anticipate a higher percentage of companies to post in-line numbers over the coming earnings season. This will likely be sufficient to support small cap equity prices at their current valuations, as evidenced by the Russell 2000® Growth Index is trading at 19x 2024 earnings, which is roughly at parity with the S&P 500® Index despite typically trading at an approximately 20% premium.
In closing, we would like to express our gratitude, and appreciate your continued confidence in the Hood River team. We look forward to connecting with many of you over the coming 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 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.
Chart information is gathered from sources that are considered reliable, however its accuracy cannot be guaranteed. Sector attribution information is as of 6/30/23 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.