Stocks capped off a strong 2019 with an excellent fourth quarter, and small-cap growth stocks were among the best performers as investors shifted back to a “risk on” positioning. The Russell 2000® Growth index returned +11.4% in the quarter, and finished the year up an impressive +28.5%. The Hood River Small-Cap Growth strategy returned +9.7% net of fees in the quarter, underperforming the benchmark by 170 basis points. For the year, Hood River’s Small-Cap Growth strategy returned +24.1%, lagging the benchmark by 440 basis points.
The key drivers behind this surge in the benchmark’s price were the same variables that were on investors’ minds for the past year: The Federal Reserve’s outlook for rates, and trade relations between the U.S. and China. The Federal Reserve cut rates by a quarter point in late October, its third cut of the year after reversing its hawkish positioning at the start of 2019, sparking the rally. By the December meeting the Federal Reserve was on hold, and its dot plots signaled no hikes through 2020. With Federal Reserve Chairman Jerome Powell pointing to inflation still below the desired 2% level and perhaps even in need of overshooting to make up for inflation that has been, in his opinion, too low for too long, the Federal Reserve basically gave stock investors the green light to go into “risk on” mode.
By mid-December, the U.S. and China had agreed in principal to a “Phase One” trade deal, which in addition to China increasing agricultural purchases from the U.S. and the U.S. suspending new tariffs that were to be implemented imminently, seemingly signaled a general de-escalation of the trade war. These developments at the Federal Reserve and on trade, as well as an economy that seems healthy for the moment, led investors to take a more optimistic view of the economic future. As a result, the yield curve steepened by the end of the year, with the 10-year Treasury yielding 34 basis points over the 2-year, the highest since October of 2018, and after being inverted as recently as the beginning of September. Taken as a whole, this environment set the stage for the fourth quarter’s strong rally and left investors with a hearty appetite for risk near year-end.
Within the Russell 2000® Growth Index, all sectors were up for the quarter with the exception of utilities. The best performing sector was healthcare, +23.0%, which was driven by a surging biotech industry. Other strong sectors included consumer discretionary (+9.3%), information technology (+7.1%), and financials (+7.1%). For the year, all sectors in the index were up with the exception of energy. Information technology was the strongest (+35.4%), but industrials (+31.9%) and healthcare (+31.2%) were also up significantly.
Hood River’s stock selection within healthcare accounted for more than 100% of the underperformance during the quarter and the year. Our healthcare underperformance was impacted by being underweight a very strong biotech industry. Biopharma, which makes up about half the healthcare sector’s weight, was up 32.2% in the fourth quarter. In addition, we were underweight novel drugs by approximately 700 basis points and overweight non-biopharma healthcare by a similar amount, and we estimate this weighting cost us approximately 130 basis points in the quarter. Our usual conservative positioning and bias toward profitable companies in healthcare did not fare well in a quarter within a “risk on” environment where investors pushed up the most volatile industry and companies.
Beyond industry exposures, our healthcare stocks had an eventful quarter from a bottom-up basis. Our biggest winner within healthcare was The Medicines Company, which reported good phase 3 data for Inclisiran, its drug for treating high cholesterol, and also subsequently announced it would be acquired by Novartis. Amarin Corp. was another winner for us, as it received a unanimous FDA advisory panel vote in favor of label expansion for its drug Vascepa in treating high triglycerides, followed by the actual label expansion. Sage Therapeutics offset those two winners when it reported data from a Phase 3 trial of its antidepressant, SAGE-217, that fell short of expectations and missed its primary endpoint. In two prior Phase 2 & 3 trials for depression, Sage-217 had shown significant benefit after 15 days with p-values <0.01, meaning that in each of those two trials there was less than a 1% chance that the observed drug effect was random. Our conversations with doctors suggested that the drug had a highly differentiated profile with rapid action, and that analyst estimates for peak sales were dramatically underestimated, thus the stock was inexpensive. Unfortunately, patients were unusually bad about taking their medicine in the trial, and this adversely effected the trial’s outcome. Sage Therapeutics cost us over 115 basis points in the quarter. Another stock that hurt us in the quarter and the year was Merit Medical, which missed earnings and guided down due to softness in recently acquired products, currency headwinds, and tariffs. Other weak healthcare stocks in the quarter included Integra Lifesciences, Tabula Rasa, Macrogenics Inc., and Coherus Biosciences.
The bright spot in the quarter and the year was information technology, which added over 200 basis points of stock selection in the quarter and 388 basis points for the year. Strength was broad-based in the quarter and the year, with Lumentum, Limelight, Rapid7, and Paylocity strong during both periods. These companies continue to report strong quarters and give solid guidance, causing analyst numbers to rise, and the stocks to follow. Technology also had very limited detractors for the year and quarter. Only one stock cost us more than 20 basis points of stock selection for the quarter and only three did so for the year. Generally, we are finding more names with an information gap in technology, leading to our current overweight there.
As we enter the first quarter, our portfolio is positioned relatively tightly against the benchmark, with no sectors more than 400 basis points over- or underweight versus the index, with the exception of information technology, which is nearly ten percentage points over weight. However, we believe our effective technology overweight is closer to 700 basis points as two securities, Anixter and KBR, officially classified as information technology, in our opinion are much better classified as industrials. We remain underweight biotech. As of early January, we estimate our current portfolio’s beta is similar to that of the Russell 2000® Growth Index.
In early January we announced that Rob Marvin will be retiring on April 30, 2020 to spend more time with his family. We appreciate his contributions to the firm and wish him the best of luck as he enters this new chapter of his life. The unique structure of the firm ensures that there will be no loss of institutional knowledge on the portfolio due to any one individual’s departure. We have invested in four analysts over the last four years, so we are having more conversations than ever with small-cap companies. Hood River’s research depth and breadth is the best it has ever been, and we are excited about our prospective returns in 2020.
While Hood River ended the year up 24.1% net of fees in absolute terms, we underperformed our benchmark, and we are not satisfied with that outcome. We continue to believe that this relative drawdown represents an attractive opportunity to add, as such periods have represented in the past, and the portfolio managers are continuing to add to our own holdings in the strategy. Ultimately what drives longer-term performance is finding and capitalizing on the information gap in small-cap securities. That gap and its corresponding opportunity set is as big as it has ever been. We are sticking to our discipline, staying focused on doing good research, and are excited to generate strong returns in the future.
Thank you for your ongoing support,
David Swank, Brian Smoluch & 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 12/31/18. 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 12/31/18. 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.
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. 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 compliant presentations are available upon request.
Attribution information is as of 12/31/2019 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.