Small-Cap Growth Commentary – September 30, 2022
Following a tumultuous first half of 2022, our benchmark, the Russell 2000® Growth Index appreciated +0.24% in the third quarter. While the index was essentially flat for the quarter, it doesn’t even begin to tell the whole story. Optimism prevailed in the first half of the quarter and the Russell 2000 Growth appreciated +20.21%, making an intra-quarter high on August 15th. The broad-based buying of equities in the first half of the quarter quickly dried up following higher-than-expected inflation prints and persistent hawkish rhetoric from Federal Reserve governors. The corresponding rise in interest rates also dampened the rally in equities, with 10 year US treasuries rising from 2.79% on 8/15 to 3.83% at the end of the quarter – the highest level since early 2010. Needless to say, the tailwinds seen in the first half of the Q3 equity rally quickly vanished. After August 15th, the benchmark fell -16.75% through the end of Q3 2022, leaving the index up only +0.24% for the quarter and -29.28% year-to-date.
Despite the roundtrip in our benchmark during the third quarter, correlations amongst U.S. small cap growth stocks declined in the first half of the third quarter and the markets once again rewarded stock picking. For the most recent quarter, Hood River’s U.S. Small-Cap growth strategy was up +4.18% (net of fees), outperforming the Russell 2000® Growth Index by +394 basis points (“bps”). That brings Hood River’s U.S. Small Cap Growth strategy’s year-to-date and one-year performance to -27.60% and -24.15%, +168 bps and +512 bps vs. our benchmark, respectively, net of fees.
Individual security selection is at the heart of our investment process, and it is again what drove our outperformance in Q3 2022. Approximately 90% of Hood River’s outperformance for the quarter was driven by stock selection while 10% came from group weight. Sectors that contributed the most to stock selection include consumer staples (+204 bps), information technology (+145 bps), and industrials (+77 bps). Detracting sectors included consumer discretionary (-135 bps), financials (-20 bps), and real estate (-9 bps).
Our sector exposures remain relatively close to benchmark weightings, with no sector over/under by more than approximately 500 bps heading into Q4. Our largest underweighted sector is consumer discretionary, where we lightened exposure as we anticipate certain retail sub-sectors are likely to show some weakness in the coming months. On the overweight side, we have been finding good opportunities in the industrial sector (approximately +425 bps, relative to our benchmark), including companies that stand to benefit from the Inflation Reduction Act, have 10+ years of visibility on green energy spending, and have improving or stable margins. We are also overweight financials by approximately 300 bps despite an inverted yield curve. We believe our positions in the sector have conservative estimates, are trading at attractive valuations, and have contained credit issues in this environment. We are also playing offense in the technology space (+300 bps, relative) and adding exposure in areas where demand exceeds supply (e.g. networking) and where earnings estimates should increase in the coming quarters, even in a recession. While adding exposure on the broadband side, we’ve also played some defense by lightening exposure in the semi / equipment space.
While Hood River was able to successfully navigate Q3’s choppiness, macro headwinds clearly took control of the market sentiment in the second half of the quarter. Commodity prices, supply chain issues, and continued labor pressures increased concerns over persistent inflation, which in turn led to more hawkish rhetoric from the Fed and a rise in interest rates. Our recent conversations with management teams suggest that commodities and supply chain bottlenecks are improving somewhat. Cycle times, ocean shipping, and container costs have all improved as of late.
Right now, the biggest sticking point, in our view, is labor. Management teams suggest the situation is easing slightly but remains rather tight, and that it’s too early to declare victory on wage pressures or attracting/retaining the right talent. Cost of goods sold continues to pressure margins in certain industries. That said, our conversations suggest we may see an increase in layoffs during Q4 alongside a relatively soft seasonal hiring season. Many forward indicators – including commodity prices, supply chain tightness, and money supply growth – are showing signs of rolling over.
While a slowdown in interest rate hikes from the Fed would be good news for equities over the coming twelve months, we do believe the Q3 earnings season – both the print and the Q4 guide – will be rough for many companies. Q3 and Q4 may be peak pain for this cycle, which has historically been a good opportunity to selectively add exposure. Valuations also remain attractive on an absolute and relative basis: earnings-positive U.S. small cap growth stocks are trading at 12.5x 2023 earnings estimates vs. 15.3x for the S&P 500® Index. As we’ve previously stated, small cap growth stocks typically trade at a premium to their larger-cap peers.
The Hood River team has been diligent about controlling risk and creating a portfolio that we believe can outperform in a difficult tape. The second half of 2022 may be peak pain for equities in general but we are confident in the ability of our portfolio companies to weather the current economic headwinds. We greatly appreciate your partnership and continued confidence in our team and process. We look forward to speaking with many of you over the coming months and providing further insights into our thoughts on the current market environment.
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 9/30/2022 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 [email protected].. Past performance is no guarantee of future results. Not FDIC insured, no bank guarantee, may lose value.