The third quarter of 2023 was rough for equities — US Small Caps were particularly impacted as the Russell 2000® Growth Index (the benchmark) fell by -7.32% compared to the S&P 500 Index’s -3.27% decline. July began on a positive note, with the benchmark rising +4.68%; but August’s -5.21% and September’s -6.60% declines put the index in the red for the quarter. On a slightly more positive note, the Russell 2000® Growth Index remains up +5.24% for the year. For the third quarter, Hood River’s US Small Cap Growth strategy fell by -8.53% (net of fees), underperforming the benchmark by 121 basis points (“bps”). The strategy remains up +5.13% YTD (net), only slightly trailing the benchmark by -11 bps.

From an attribution standpoint for Q3, stock selection detracted -113 bps of performance, largely driven by information technology (-102 bps), consumer discretionary (-63 bps), and utilities (-39 bps). This negative selection was slightly offset by industrials (+61 bps), consumer staples (+44 bps), and health care (+37 bps). Year-to-date selection effect is basically flat, with industrials (+278 bps), financials (+81 bps), and materials (+37 bps) representing the largest contributors and information technology (-181 bps), consumer discretionary (-134 bps), and utilities (-48 bps) representing the largest detractors.

From a near-term perspective, July 31 marked the high point for Q3 2023, and despite a brief rally in late August, the trend was lower for the last two months. Correlations across stocks rose, which makes stock picking particularly difficult as solid earnings beats, guidance raises, and positive updates were not rewarded by investors. From a broader perspective, however, US small cap growth stocks have trended lower since November 2021. The general decline since then has largely been driven by a rising interest rate environment as small cap companies — and small cap growth companies, in particular — are impacted by higher rates to a greater extent than their larger-cap peers.

The disparity of performance between small caps and their larger-cap peers can be clearly evident over the last 2+ years. The S&P 500® Index, for example, has generally remained above its January 2021 starting levels while small cap growth stocks have faced persistent headwinds. This places valuations at very attractive levels for the latter group. Historically, the Russell 2000® Growth Index trades at a 20-25% premium to the S&P 500® Index — but the relative underperformance has left the small cap growth group at 18.2x forward earnings vs. the S&P’s 19.3x. This places small cap growth companies back at 2016 levels.
Interest rates, of course, remain at the forefront of investors’ minds and have been the primary culprit of the recent risk-off sentiment. Inflation is no longer a negative surprise but the Fed has, as of late, aggressively discussed raising rates once more this year and then holding them higher for longer. Although the front end of the yield curve remains inverted, over the last few weeks the 5yr/30yr has become more positive-sloping and thus healthier, albeit higher overall. While small caps typically underperform under a hawkish environment, once monetary policy turns more dovish small caps tend to lead the way higher. This eventual shift, alongside attractive valuations, creates an attractive setup for US small caps in our view.

When we spoke with management teams during Q2, most conversations left us feeling that demand was relatively stable. However, from July through August, business slowed, which generally soured guidance and turned earnings season into a knife fight in a closet. Demand issues combined with higher rates on the long end of the curve in September and the beginning of October, there is clearly less clarity for consumer, software, industrial, and renewable energy names. On the flip side, there is generally greater visibility on supply chains and costs. Our companies have not been immune from demand issues but are generally performing well fundamentally. The third quarter had several other idiosyncratic events, including multiple companies with CEO departures and merger integration issues at Mastec. Despite taking these unforeseen hits, our investment team was able to remain nimble, adapt the portfolio based on our bottom up research, and remain in the game thus far for 2023.

Heading into Q4 2023, our sector weightings are relatively tight, with Industrials at +450 bps vs. the benchmark representing the largest disparity. All other sectors are within 400 bps of benchmark weightings. We are very selective in these sectors and own names where, we believe, we have a differentiated opinion and believe Street estimates appear low.

One bright spot amongst subsectors is in the semi and semi-cap equipment area. Companies in these groups are upstream suppliers for larger companies building their artificial intelligence capabilities. We have found attractive investments trading at 15-20x earnings where we believe there will be an acceleration in 2024 — which, from our perspective, is not reflected in the current Street estimates. In the memory and advanced logic space, we are finding companies whose main business is at a trough yet there is AI optionality layered on top. We like these setups as there is somewhat of a floor for base earnings yet the companies are levered to AI and will be high beta if the market rallies. Another area of relative strength includes trucking, which has already been in an extended recession and is benefitting from a tightening market and the bankruptcy of one company with over 10% market share.

To leave this quarterly on a positive note, earnings revisions amongst small caps have improved over the last three months. High yield spreads have recently tightened, which usually leads to a rally in small caps, which we have yet to see. With the recent addition of another senior analyst, the investment team’s throughput has never been greater and we are having more touchpoints / channel checks each quarter than ever before. We made a lot of moves in the portfolio over the last three months against the dynamic market environment and, largely due to our current holdings and attractive valuations, we like the setup entering the final quarter of 2023.

We appreciate your time in reading this commentary and continued partnership with Hood River. We look forward to visiting with many of you over the coming months — please reach out if you have any questions or would like to have a more in-depth conversation.

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.
Information has been gathered from sources that are considered reliable, however its accuracy cannot be guaranteed. The security mentioned in this letter was 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 June 30, 2023-September 30, 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 9/30/23 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.