Small-Cap Growth Commentary – March 31, 2022
The volatility across equity markets seen in late 2021 continued into the first quarter of 2022, which had a rocky start. Concerns over Covid’s impact on the economy ebbed throughout the quarter but were quickly replaced by persistent and rising inflation, a Fed rate hike cycle, continued supply chain issues, and most recently the war in Ukraine. The Russell 2000® Growth Index had its worst January on record, falling -13.40%. Despite large swings over the next two months, the index ended off its Q1 2022 lows but still declined -12.63% for the quarter.
The selloffs in January and during the large down-days seemed almost indiscriminate within the Russell 2000® Growth Index. However, the higher growth and unprofitable companies within the index typically fared worse throughout the quarter. Since its inception, Hood River’s investment process has focused on identifying companies that possess quality growth metrics and are trading at attractive valuations — not merely investing in ‘growth at any price’. This once again benefited our U.S. Small Cap Growth strategy in Q1 2022, which outperformed the Russell 2000® Growth Index by 132 basis points (“bps”) net of fees. On a one year basis, as of 3/31/2022, the strategy is down -1.33% (net), 1,300 bps better than the benchmark.
As is typically the case, stock selection drove the majority of Hood River’s outperformance in the first quarter of 2022: 222 bps of our total outperformance was driven by stock selection. The sectors contributing most to stock selection outperformance were consumer discretionary (+197 bps), health care (+163 bps), and information technology (+28 bps). Materials (-45 bps), financials (-39 bps), and industrials (-34 bps) were the three largest detractors from the first quarter’s security selection effect.
The benchmark’s only sector posting positive performance in the first quarter was energy (+36.92%). On the other hand, consumer discretionary (-18.81%), health care (-15.24%), and information technology (-14.68%) were the sectors declining the most during the quarter. Sector weightings overall detracted from our outperformance for the quarter, primarily due the strategy’s overweight in the consumer discretionary sector and underweight in energy.
Regarding our current positioning, all sector weightings to start the second quarter, are within approximately 600 bps of benchmark weightings apart from industrials and health care. We are approximately 800 bps overweight industrials, which serves as the ‘catch all’ sector for companies that do not neatly fit into another group, and 800 bps overweight consumer discretionary. We are slightly over 600 bps underweight healthcare due to our limited exposure within biotech.
Our recent conversations with management teams have echoed many of the concerns highlighted earlier –inflation, rising rates, supply chain issues, and the war in Ukraine – and the effects of each are intertwined in several ways. First, it has become increasingly clear that inflation is not transitory. The executives we have spoken with continue to see ongoing supply chain issues, rising input costs, labor supply tightness, and continued strong demand (albeit less than what was seen in 2H 2021). Further, the war in Ukraine and sanctions on Russia are impacting commodity prices while another Covid-related shutdown in China is impacting the supply of components for various industries. It’s difficult to temper inflation when the causes are so widespread. On a more positive note, many executives see inflationary pressures easing somewhat in the second half of 2022. Indeed, over the last few months we have seen a slowdown in the rate of money supply growth from the Fed and there is a potential for an easing in the labor market tightness as Covid-era benefits wind down further. From our perspective it is difficult to get visibility on timing however, and thus we continue to invest in companies that can maintain or expand margins given the situation.
Regarding rising rates, we believe the Fed is behind the curve on combatting inflation. The market digested the initial fact that we are in a rate hike cycle, but the overall level of where the Fed ends and the pace it takes to get there are ongoing questions. Looking at the U.S. small cap space as a whole, rising rates do of course impact valuations. This ties back to our investment process, which always considers valuation and has historically allowed us to outperform our benchmark across market cycles.
Despite the headwinds listed above, we continue to find good investment opportunities and see reasons for optimism in the coming quarters. Clearly if the U.S. enters into a recession our optimism would be pushed out a few quarters, but if we avoid a downturn, we believe the prospects for U.S. small cap growth companies are quite good. To begin, the group as a whole is inexpensive as the premium over the S&P 500® Index has evaporated. On a 1-year forward P/E basis the positive-earning companies in the Russell 2000® Growth Index are trading at 18.0x vs. 20.6x for the S&P 500® Index. Small cap growth names are also cheap on an absolute basis, as the benchmark’s 5- and 10-year averages are 21.3x and 21.1x, respectively. Although rates are indeed rising, the 10-year in the U.S. ended the quarter at 2.34%, below the approximately 3.20% average going back to 2000. Next, although inflation is indeed a concern, demand across the economy remains strong and owning companies with positive earnings can be an inflation hedge if they can maintain margins. And finally, although we have historically owned companies with exposure to energy infrastructure, alternative energy, and defense, with the recent dynamics playing out in Europe we have been adding to existing positions and have found additional opportunities within these subsectors, all of which could have multi-year tailwinds.
Hood River’s investment process is built on our belief that the small cap market is inherently inefficient. The past 2+ years have not only demonstrated this but have served to exacerbate inefficiencies. We have always believed that rigorous, fundamental research is the primary catalyst for relative outperformance in the small cap space – that is especially true in today’s environment. This approach has served Hood River and our investors well across market cycles, and has again led to outperformance now for the 9th straight quarter. We are quite cognizant that investing can be a humbling business, however, and remain vigilant in our investment process every day. As always, we appreciate your confidence in Hood River and look forward to seeing you or speaking with you in the near future.
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.
Sector attribution information is as of 3/31/2022 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.