The fourth quarter of 2018 was a rough quarter for stocks in general, and the worst quarter (-21.66%) for small-cap growth stocks since 3Q 2011. The Hood River Small-Cap Growth portfolio returned -24.30% net of fees for the quarter, underperforming the benchmark by 265 basis points (bps). For the year ended 12/31/18 Hood River’s Small-Cap Growth strategy was down -6.96% net-of-fees, beating the benchmark by 235 bps. While this was a volatile quarter, we are pleased to have navigated an also-volatile full-year 2018 successfully and the strategy has now out-performed, net-of-fees, in 6 out of the last 7 years.
To put the Russell 2000® Growth Index’s quarterly decline into context, in the past 20 years there have been five other quarters in which the index was down at least 20%. The two worst of these other moves were -28.09% in 3Q 2001 and -27.46% in 4Q 2008, which in one case included both a recession and the 9/11 attacks, and in the other was the worst quarter of the financial crisis.
The sell-off in the fourth quarter was driven by a combination of concerns including the potential for overly aggressive Fed rate hikes, slowing economic and earnings growth, and escalating trade tensions with China. The initial spark that began the sell-off in earnest was Fed Chairman Jay Powell’s comments in early October stating that the Fed was willing to continue raising rates, potentially even to the point of crimping economic growth. Those comments, combined with trade tensions and concerns regarding yield-curve inversion foreshadowing a recession, led to small-cap growth stocks losing more than 12% in October. While November eked out a small gain, growing concerns drove small-cap growth stocks down another 12% in December. The December down move was accelerated when, on December 19, Chairman Powell and the Fed decided not only to hike rates again and point to another two hikes in 2019, but also to host a tone-deaf press conference suggesting an indifference to financial market distress and an “autopilot” quantitative tightening program.
Within the Russell 2000® Growth Index, the biggest performance drivers were healthcare (-25.05%), industrials (-22.45%) and consumer discretionary (-20.76%). Some of the smaller sectors in the benchmark were even worse on a percent basis, with energy down 41.33% and materials down 25.81%. The only positive sector was utilities (a mere 0.5% of the benchmark) which eked out a 1.76% gain.
Hood River’s underperformance in the quarter was driven by bottom-up stock selection. Our portfolio was fairly conservatively positioned heading into this pullback, however, we had some unusual, hard-to-predict stock specific items that hurt performance: SuperMicro fell 58% after allegedly having its hardware hacked by China; Amarin fell 21% when a different Irish-incorporated company was hit with a large retroactive tax bill; Teladoc fell 20% on its CFO resigning over an extra-marital affair with a subordinate; Lumentum fell 32% on November 12 after giving new guidance tied to an Apple slowdown. Lumentum was unusual because it had just given guidance for the December quarter one week earlier and it was solid. It was the first supplier to talk about an Apple slowdown. Combined, these four stocks cost the portfolio 120 bps of stock selection in the quarter around these select events, but for the entire quarter were not big contributors. However, in all of these cases, it took stocks that otherwise would have helped in the quarter and made them slightly negative.
Our worst sectors for stock selection in the quarter were information technology (-106 bps), communication services (-43bps) and financials (-39 bps). Within technology, our worst performers were Limelight (-44 bps) and Digimarc (-34 bps). Limelight took down fourth quarter estimates due to near-term demand issues surrounding Amazon Web Services, reaffirmed revenues for 2019, and announced incremental investments that will pressure EBITDA margins in 2019. The stock is trading at 5x 2020 EV/EBITDA and we are maintaining our position there. Digimarc was pressured as the market lost patience surrounding potential customer adoption of its “barcode of everything.” We still think it is a matter of when, not if, this technology is accepted and are remaining patient.
Our best sector in the quarter was healthcare, which generated 22 bps of stock selection on strength in companies including BioTelemetry Inc. (+66 bps) and Vocera Communications (+27 bps), which both held up well in the wake of strong third quarter numbers.
Hood River’s out-performance for the year was also driven by bottom-up stock selection. Our best stock selection sectors were healthcare (+402 bps) and industrials (+94 bps). In healthcare, Tabula Rasa, BioTelemetry, and Teladoc helped drive performance and, in industrials, Chart Industries, Costar, and Harsco were additive. Our worst stock selection sectors were information technology (-192 bps), and materials (-55 bps). Coherent, Digimarc, and Limelight were the worst performing technology names and US Concrete hurt us in materials.
As we have mentioned to clients in the past, when correlations increase, it can be harder for the portfolio to out-perform given that our process depends on investors eventually caring about differentiated fundamentals of our companies. In the fourth quarter, correlations increased, creating a slight headwind to our bottom-up fundamental investment process.
As we enter 2019, our sector weights are slightly tighter to the Russell 2000® Growth Index than normal, with no sector more than 400 bps away from the benchmark. We continue to be underweight the biotech industry and overweight non-biotech healthcare stocks. As of early January, our predicted beta is similar to that of the Russell 2000® Growth Index. Valuations appear attractive given the sharp pullback in the asset class. If we do not go into a recession, 2019 could be a really strong year for small-cap equities. If we do go into a recession, there would be downside to small-cap equities, but a lot of bad news is already priced into the stocks in our portfolio and our opportunity set.
The Small-Cap Growth portfolio started in 2002, and over that time we have seen a number of markets, both good and bad. We have found that regardless of the market environment, remaining disciplined and sticking to our process has led to good results over time. Given our recent analyst hires over the last several years, we are talking to more companies than ever and we have seen a measurable increase in the product’s research throughput as a result. We believe that we are executing our process as well as we ever have, which leaves us optimistic about future relative returns regardless of near-term market gyrations.
We are pleased to announce that in November we added another analyst to our investment team. Brennan Long joins us from Bloomberg, where he was an analyst covering biotech, and previously from Janney Montgomery Scott where he was a research associate covering biotech and specialty pharma. Beyond that addition, there were no organizational changes in the quarter.
Thank you for your ongoing support,
David Swank, Brian Smoluch and Rob Marvin
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, 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 12/31/17. 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 12/31/17. 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 12/31/18 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.