Small-Cap Growth Commentary – March 31, 2023
While larger-cap equity indices closed out March higher than their February-end levels, the collapse of Silicon Valley Bank and Signature Bank disproportionately impacted smaller-cap indices. Broader implications in the regional bank sector appear to be contained for now, but some damage was certainly felt in the Russell 2000® Growth Index, which fell 2.47% during March. Exposure to regional banks was fairly low within the index at 1.4%, however, many of their depositors consisted of start-ups and smaller sized companies. The uncertainty around deposit insurance and the degree of federal intervention had an indiscriminate impact on many companies within our investible universe. We have long been proponents of select regional bank names but proactively managed the portfolio to quickly exit our exposure, which limited the fallout’s impact and allowed us to enter more attractive opportunities. For the month of March Hood River’s US Small-Cap Growth strategy outperformed the Russell 2000® Growth Index by +165 basis points (“bps”) net of fees, putting the strategy +19 bps ahead of the benchmark YTD.
As most of our readers are aware, proprietary fundamental research is at the heart of Hood River’s investment process. Thus, as is typically the case, the majority of the strategy’s outperformance was driven by stock selection. For Q1 2023, stock selection added +55 bps of outperformance, largely driven by industrials (+275 bps), financials (+51 bps), and consumer discretionary (+29 bps). Detractors during the quarter included information technology (-136 bps), consumer staples (-97 bps), and materials (-22 bps).
While the strategy ended the quarter on a positive note, the first two months proved to be a headwind for our approach. Investors tended to reward non-positive-earning stocks, which are more sensitive to interest rates. As the market gained additional clarity on the Fed’s rate-hike cycle, these names tended to outperform. Hood River is very selective when investing in companies that have yet to achieve positive earnings given the uncertainties in longer-term guidance and trajectories. Despite this underweight, our active portfolio management led to a slight outperformance for the quarter.
The most topical portfolio management discussion in Q1 centers on the regional bank sector. Heading into the Silicon Valley Bank turmoil, Hood River’s US Small Cap Growth strategy had approximately 350 bps of regional bank exposure, largely from a roughly 180 bps position in Western Alliance. The investment team proactively exited our positions in the sector due to longer-term concerns about consumer confidence, deposit costs, and loan books. Despite the investment in Western Alliance heading into the Silicon Valley Bank news, the position only impacted our portfolio by approximately -15 bps in stock selection due to our sell discipline and the swift action taken by the investment team.
While financials was the worst performing sector during March, active portfolio management decisions across other sectors and names also added to positive alpha for the quarter. Over the course of Q1 2023 we added to position sizes and/or found new opportunities in industrials, information technology, and consumer discretionary while lightening up in energy, consumer staples, and of course, financials.
Heading into Q2, all sector weights are within + / – 550 bps of the benchmark except for industrials, which we are overweight by approximately +900 bps. This is not an allocation decision but rather simply an area in which we are finding stocks with attractive valuations, improving fundamentals, and solid growth opportunities. Further, ‘industrials’ is to some extent a catch-all industry that houses companies that don’t fit neatly into another sector. Our largest sector underweight is energy (-535 bps), which overall helped during the quarter despite the rise in crude prices in late March. We are typically underweight the sector as it is difficult to add value through fundamental research when commodity prices are one of the largest determinates of stock performance. We also anticipate energy’s weight within the benchmark will come down when the index is rebalanced in May.
Our recent calls with management teams and channel checks suggest that overall guidance is conservative across small caps. While C-Suites may be somewhat uncertain about the next 6 to 12 months, most have seemingly baked in significant potential headwinds that have yet to actually appear. Inflation has become increasingly more manageable outside of labor costs, which are still rising 4-6%. Again, while a headwind, we believe most of these outcomes are already reflected in guidance. One positive aspect of the labor situation is employment, which has become stickier as fewer individuals are leaving jobs while open positions are easier to fill.
In addition to generally conservative guidance, US small cap growth valuations continue to be attractive. The Russell 2000® Growth Index is trading at 16.3x 2024 earnings (for positive-earning companies) vs. the S&P 500® Index’s 18.1x. As mentioned earlier, we also believe the earnings estimates – at least for the companies we own – are conservative, making valuations even more attractive.
Today, economic uncertainties consume headlines and remain on the forefront of investors’ minds. At Hood River, we continuously focus on the real-time fundamentals fueling earnings and dislocations relative to Wall Street estimates. This approach allows our strategy to be nimble and fluid throughout a full market-cycle, which has benefited our clients in variety of environments. Regardless of outcomes surrounding the broader economy, we’re encouraged by current valuations and opportunity set within the small cap growth space. While timing can be unpredictable, a new growth cycle begins without forewarning, drastically altering the outlook on markets – particularly within small-caps. To diverge from a quarterly staple, Cardi B, we’d like to reference a similarly gifted wordsmith, “Better three hours too soon than a minute too late” – Shakespeare. 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 December 31, 2022-March 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 3/31/23. 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.