The Russell 2000® Growth Index returned 3.6% during a seemingly quiet fourth quarter. However, the quarter was bisected into clear pre- and post-election periods. Prior to the U.S. election, the index had been on a downward trajectory as investors were growing increasingly concerned regarding economic growth prospects, with the index down 6.0% for the quarter through the election. Post-election, stocks jumped 10.0% as investors generally came to view Mr. Trump’s win and the GOP sweep as likely to usher in a more globally competitive lower corporate tax rate, a friendlier regulatory environment, and a focus on getting the domestic economy going. Small-cap stocks did relatively better in the quarter given their greater focus on the domestic economy, more exposure to full corporate tax rates, and relatively little exposure to the negative effects of any possible trade disruptions.
Specific sector returns were generally explained by investors speculating which areas would do better under a federal government controlled by Mr. Trump and the GOP. The best sectors for the index were financials (+19.6%), telecommunications (+12.4%), industrials, (+11.2%), utilities (+9.0%), and materials (+7.9%). Financials could benefit from deregulation and tax cuts while materials will likely benefit from infrastructure spending. Healthcare was by far the worst performing sector in the quarter (-6.9%), as biotech sold-off on continued concerns around pricing pressure, and providers such as hospitals sold-off on concerns that the repeal of Obamacare might weigh on patient volumes.
The Hood River Small-Cap Growth portfolio underperformed the benchmark by 93 basis points net of fees (2.64% versus 3.57%) in the fourth quarter and ended the year outperforming the benchmark by 239 basis points net of fees (13.71% versus 11.32%). We had an outstanding earnings season during the fourth quarter, which is the focus of our bottom-up stock selection process. However, like most people, we were surprised by the GOP electoral sweep, and our portfolio was not optimally set-up for the actual outcome. We were hurt by our overweight in stocks with exposure to Medicaid, which sold-off after the election as investors anticipated the repeal of Obamacare would weigh on volumes. Healthcare hurt us by 81 basis points overall in the quarter, mainly due to our overweight in the sector. We also gave up 80 basis points in consumer discretionary, as companies like Sportsman’s Warehouse and American Outdoor Brands fell as investors assumed a Trump administration’s Second Amendment friendliness would reduce consumers’ urgency to acquire guns. Strong earnings drove positive stock selection in technology (+64 basis points), industrials (+42 basis points) and materials (+21 basis points). Within technology we were helped by continued positive performance in our optical names including Oclaro and Finisar, and also by Advanced Micro Devices, Inc., which performed well as investors gained confidence in the sales potential of its new Zen architecture.
As we frequently remind our clients, we are bottom-up stock pickers and that is how we add value in the investment process. With the new GOP government moving into Washington later this month, it is likely that changes in the political landscape may at times be more important than company-specific fundamentals and may drive tracking error versus the benchmark to the extent that portfolios have factor exposure different than the benchmark. In some cases, these factors may be somewhat esoteric, such as tax rate, percent of cost structure imported from other countries, or debt levels. Some cut of the corporate tax rate is already built into prices, but not a cut to the mid-20s rates that are most often talked about by Republicans, and certainly not to the lower rates that are included in some GOP plans. While we are optimistic that companies will see some tax rate relief, the ultimate outcome is uncertain, and risk exists in either direction. Similar risks and opportunities abound for trade and energy policy. There will continue to be a large research gap that Hood River can capitalize on regardless of how politics play out over the next twelve months.
As of early January, our portfolio is positioned fairly normally, with market exposure (beta) roughly in-line with the benchmark. Our sector weights are slightly tighter to the index than usual, with no sector more than 500 basis points different than the index. Currently, our biggest overweight is financials, at 10% versus 5% for the index, due to adding to positions like Bank of the Ozarks in the quarter. We have trimmed our technology overweight to in-line as we sold some names, such as Gigamon, on earnings concerns. Technology does have more trade and international exposure than other sectors, as well as lower tax rates, so we will consider these factors in our bottom-up stock picking. Liquidity remains good.
As of December 31, 2016, our weighted average market cap had drifted up slightly to about $3b, placing us roughly at median with other small-cap managers, but above our normal market cap premium to the benchmark as a result of a number of well-performing stocks that we’ve continued to hold. One of these stocks, Advanced Micro Devices (“AMD”), is our biggest position and, having appreciated to a $10b market cap, is contributing significantly to our higher market capitalization. Our research indicates AMD’s new Zen architecture is likely to be well received in the marketplace, and we expect the stock to perform well as that sentiment becomes further built into its valuation. We anticipate that our average cap will drift back down to a normal level over the next quarter or two, as has happened in similar instances in the past. While we are committed to running a portfolio that is both small-cap and growth focused, we are not index huggers, and when we see mispriced opportunities we want to take advantage of them.
There were no changes to the team or organization in the quarter.
We are delighted that in 2016 we outperformed our benchmark for the fifth year in a row. As we enter 2017, we have our noses to the grindstone – or more precisely, our ears to our telephones – and are excited to build on our track record of creating value for our clients through our original research. Thank you for your continued support,
All the best,
The Investment Team
David Swank, Brian Smoluch, Rob Marvin
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 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 12/31/16. 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 12/31/16. 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. 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 compliant presentations are available upon request. Past performance is no guarantee of future results.
Attribution information is as of 12/31/16 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.