Small-Cap Growth Commentary – September 30, 2021
With the onset of the Delta variant, COVID once again topped headlines in the third quarter. While yet another surge in case counts was indeed a cause for concern, the total U.S. trajectory has thus far followed that seen in other countries that faced Delta. That is, while there was a rapid rise in cases, in general the peak came and passed, and was for the most part lower than the heights seen in late 2020 / early 2021. Case counts remain elevated, but since the initial surges seen in the U.S., vaccination rates and natural immunity from a prior infection have increased. Thus, while case counts remain the focus of attention, it seems the majority of the U.S. is taking the latest variant in stride.
Our recent discussions with management teams confirm this view. COVID is no longer a surprise for most executive suites; companies and the U.S. economy are learning to live with the virus. Most management teams highlight this is not the same environment as March, 2020, or even January, 2021 for that matter. There are indeed lingering issues caused by the lockdowns, primarily in the labor market, which has caused subsequent bottlenecks in supply chains. With the sunsetting of enhanced unemployment benefits a few weeks ago, we expect to see labor shortage issues abate over the coming months and quarters.
While the employment picture has improved recently, the lockdowns and suppressed supply have caused an uptick in inflation. The question is, of course, whether this is transitory or will linger for some time. Based on our bottom-up research, we lean towards the ‘transitory’ camp. As an example, from our latest conversations most management teams are seeking to keep long term labor costs down by offering one-time bonuses to attract new talent. We believe companies in our portfolio can manage supply chain pressures and more than offset cost pressures with selective price increases.
These concerns have impacted the equity markets as of late, however, Hood River posted another quarter of outperformance. For Q3 2021, our U.S. Small-Cap Growth strategy fell by -1.94% on a net basis, vs. the Russell 2000® Growth Index’s -5.65% decline, resulting in 371 basis points (“bps”) of outperformance. The benchmark’s only sector posting positive returns in the quarter was utilities (+6.91%), albeit the group only has a 31 bps weighting. The sectors within the benchmark posting the most negative returns in the period were health care (-11.76%), communication services (-11.65%), and materials (-7.07%).
On a year-to-date basis, the strategy is up 18.23% (net), 1,541 bps above the benchmark’s 2.82% rise. The benchmark’s best performing sectors during the period have been energy (+73.58%, albeit there is only a 79 bps weighting), consumer discretionary (+17.46%), and consumer staples (+13.19%). Only health care (-11.17%) and communication services (-3.53%) have posted negative returns.
We communicate regularly that our stock selection process is driven by proprietary, fundamental research. It should come as no surprise, then, that excess returns are primarily driven by stock selection, as was the case yet again in the third quarter. The sectors that contributed the most through stock selection in Q3 were consumer discretionary (+63 bps), information technology (+55 bps), and consumer staples (+50 bps). Lagging sectors during the quarter were communication services (-11 bps), financials (-9 bps), and real estate (-3 bps). Going into the final quarter of 2021, sector weightings are fairly in line with that of our benchmark. All of our sector weightings are within 600 bps of the benchmark except for health care and industrials. Similar to what we stated last quarter, we have approximately 17.5% exposure to health care in the portfolio but remain about 1,100 bps underweight; this is primarily driven by our underweight to biotech. We are also overweight industrials by approximately 1,100 bps as the sector has become a ‘catch all’ for names that don’t fit neatly into one of the other sectors.
Despite some recent broader-market commentary of stretched valuations, we continue to find attractive investments that appear inexpensive to us on an earnings and EBITDA basis, which is one of the benefits of our active, in-depth, proprietary fundamental research. We seek to invest in companies growing faster than market expectations, which of course brings valuations down. Although we are satisfied with our recent performance, we are well aware things can change quickly. The investment team remains steadfast in attempting to find the best ideas and strives every day to outpace the benchmark. We appreciate everyone’s partnership with, and confidence in, Hood River and look forward to providing a year-end update in three 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, 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®) and has prepared and presented this report in compliance with the GIPS® standards. Hood River has been independently verified for the periods 01/01/13 through 12/31/20. A firm that claims compliance with the GIPS standards must establish policies and procedures for complying with all the applicable requirements of GIPS standards. Verification provides assurance on whether the firm’s policies and procedures related to composite and pooled fund maintenance, as well as the calculation, presentation, and distribution of performance, have been designed in compliance with the GIPS standards and have been implemented on a firm-wide basis. The Small-Cap Growth composite has had a performance examination for the periods 07/01/02 through 12/31/20. The verification and performance examination reports are available upon request. 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. For the entire period presented, Mr. Smoluch, Mr. Marvin and Mr. Swank have been substantially responsible for the all the investment decisions of the small-cap growth strategy. 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.
The dispersion in gross of fee composite returns shown herein was measured using an asset-weighted standard deviation formula. 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. Over a period of years, deductions for annual investment management fees will reduce the compounding effect on portfolio growth. For example, assuming 8% annual return for five years and application of the maximum annual fee of 1%, a total gross return of 46.9% and a total net return of 40.3% would be generated. 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.
Attribution information is as of 9/30/2021 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 for supplemental purposes only. Past performance is no guarantee of future results. Not FDIC insured, no bank guarantee, may lose value.