The fourth quarter of 2014 was an exciting one for Hood River Capital Management as we entered into an agreement to gain 100% ownership of the firm, up from the 65% that our investment team currently owns. This represents the final step in the process of becoming a fully independent, employee-owned firm that is solely focused on generating strong investment returns. We are as excited as ever about our team and our strategy, and our confidence in our future prospects makes us delighted to put more of our personal capital into the business.
In the markets, the final quarter of 2014 was a strong one for small cap growth stocks, with the Russell 2000® Growth Index up 10.1%. Hood River’s Small-Cap Growth strategy underperformed in the quarter, with a net return of 8.7%, largely due to the higher quality, lower beta nature of our portfolio that has been evident historically as well as currently. These lower-risk factors are demonstrated in our portfolio’s daily beta of roughly 0.93 during 2014. Despite the soft relative-performance end to the year, the full year of 2014 was a strong one for Hood River, as we outperformed the index by 306 basis points net of fees, up 8.7% versus the Russell 2000® Growth Index, up 5.6%.
The Russell 2000® Growth Index got off to a rough start in the fourth quarter as it plunged to its lows of the year in mid-October. Fears of slowing global growth promptly abated and the markets made a V-bottom, trading mostly up through November and December. As we look at the world today, the U.S. economy appears to be in decent shape in the near-term, with low inflation and probably the best economic outlook of any major developed-world economy. Headline unemployment is back down to 5.6%, and 3Q14 GDP growth was recently revised up to 5%. Based on our numerous conversations with management teams and industry sources, certain small cap companies are finding good opportunities to grow.
With that said, the stronger dollar may increasingly weigh on exporters in 2015, and we continue to be concerned about levels of sovereign debt globally, which now leave Europe, Japan and the U.S. with record levels of total debt to GDP. In the near-term, the U.S. economy seems to be managing ok, however the level of debt in the global economy raises the risk of future crises and will impair the abilities of governments worldwide to respond to those crises.
For the Russell 2000® Growth Index, the biggest sector winners for the quarter were, health care (+17.5%), consumer discretionary (+13.6%), telecommunication services (+13.2%), and information technology (+12.0%). The biggest sector-level loser for the index was clearly energy (-35.3%) as the price of crude plunged to near $50 by year-end on fears of weaker demand and a seeming unwillingness on the part of OPEC to reduce supply. The only other sector that was down was utilities (-7.8%).
Hood River trailed the index in the quarter by roughly 120 basis points gross of fees, while the average small-cap growth fund manager trailed the index by 210 basis points. Industrials was our strongest relative sector in terms of stock selection, while our weakest sectors were health care, technology and materials. Health care was most impacted by our underweight of the strong-performing biotech industry, as well as Providence Service Corporation giving up some of its gains from last quarter as additional disclosures made a recent acquisition look less accretive than originally thought.
Our energy underweight contributed 224 basis points of positive allocation effect in the quarter, but that, along with seemingly poor stock selection in technology, fail to tell the whole story. While we are typically underweight traditional energy names, and had little exposure again this quarter, for the past year we have had meaningful positions in a number of solar stocks, which have been among our biggest winners. Historically, solar stocks have been classified in technology, but over the last couple of years the solar industry has continued to evolve and more recently has begun to trade with a high correlation to the energy sector. Based on the way the stocks trade, we ran a mock attribution that moved solar stocks from technology and placed them in the energy sector. The results are interesting and present a more accurately reflection of the stock selection skill we demonstrated throughout the year. If solar stocks had been in energy for the quarter, the portfolio would have shown +215 basis points of stock selection in energy, with -53 basis points of allocation effect; technology would have shown a -30 basis point stock selection and a -9 basis point allocation effect.
While every quarter brings with it unique geopolitical events and market twists, we remain focused on implementing our philosophy that has generated strong results for our clients since we began in 2002. We continue to believe that inefficient small-cap markets provide opportunities to capitalize on unique bottom-up insight. Our insight comes from our original research, including conversations with management teams and other industry sources, combined with our lengthy experience in small cap investing. As we look at the companies we own today, we have conviction that our research has translated into a portfolio that should generate alpha, and we remain excited to come into the office every day to find the next great stocks that will extend this success.
Hood River Capital Management LLC, a Delaware limited liability company, offers investment advisory services to individuals, pension and profit sharing plans, trusts, estates, corporations, as well as other institutional clients. Hood River also serves as a sub-adviser to Roxbury Capital Management, LLC (“Roxbury”), a Delaware limited liability company. Hood River has a contractual agreement with Roxbury through which Roxbury provides various administrative, operational, and business services, including trading, marketing, client service, compliance, and accounting. 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. 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 12/31/14. Verification assesses whether (1) the firm has complied with all the composite construction requirements of the GIPS® standards on a firm-wide basis and (2) the firm’s policies and procedures are designed to calculate and present performance in compliance with the GIPS® standards. The Small-Cap Growth composite has been examined for the periods 6/30/02 through 12/31/14. The verification and performance examination reports are available upon request. 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, fee paying, 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. One non-fee paying portfolio is included in the composite for the following period: 0.2% of the composite assets year end 12/31/03.
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 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. Gross performance is net of all transaction costs, and net performance is net of any applicable performance fees and net of transaction costs, performance-based fees 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 compliant presentations are available upon request. Past performance is no guarantee of future results. Not FDIC insured, no bank guarantee, may lose value.
Attribution and beta statistics listed are as of 12/31/14 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. 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 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. Past performance is no guarantee of future results. Not FDIC insured, no bank guarantee, may lose value.