At the end of 2012, despite having outperformed the Russell 2000® Growth Index by more than 800 basis points, net of fees, we concluded that the Roxbury/Hood River Small Cap Growth portfolio was still undervalued relative to the index. In 2013, the index performed very well, up 43.3%, and the Roxbury/Hood River Small Cap Growth strategy outperformed again, by more than 100 basis points, net of fees. As we look at the portfolio today, we again see it as undervalued relative to the index and continue to believe that the portfolio is poised to outperform the index in 2014.
Investor concerns that the Fed may “taper” its accommodative policies caused some market volatility during the year, but by the time the Fed initiated a minor tapering of $10b and indicated that more would come in 2014, the markets shrugged it off. As the Fed balances what is probably its most accommodative monetary stance since 1982 with the potential for further “tapering,” a continued slow growth economy seems likely for 2014. What does that mean for small cap stocks, in general? Over the last 80 years, the GDP of the US has grown less than 3.5% during 42 calendar years and during those years, small cap stocks have outperformed large cap stocks by nearly 800 basis points. Interestingly, during the faster GDP growth years, large cap has outperformed small cap by about 200 basis points. Thus, if history is a guide, small caps should outperform in a slower growth economy.
During 2013, the strongest relative stock selection for our strategy was in consumer discretionary, where we added over 500 basis points of relative performance. The strongest performers included Conns, Inc., a retailer of consumer electronics and home furnishings, and Hanesbrands, a manufacturer of cotton-based apparel. The performance in consumer discretionary was not only driven by a number of strong performers, it was also positively impacted by a lack of significant underperformers: Our worst performing stock in the sector cost us less than 50 basis points relative to the index. We were also able to find solid performers in the industrials sector, where stock selection added over 150 basis points. Our best performers, Barrett Business Services and Trex, added about 100 basis points each in relative stock selection. Similar to consumer discretionary, our worst performer in industrials cost us less than 40 basis points versus the benchmark.
After several years of very strong performance in healthcare, our 2013 stock selection detracted from returns relative to the Russell 2000® Growth Index. Stock selection in the sector cost us 214 basis points, with nearly half of the variation due to our significant underweight to biotech and specialty pharmaceutical companies. We continue to evaluate opportunities in biotech, but will maintain our underweight exposure if we are unable to identify stocks that meet our fundamental and valuation criteria. In addition, our portfolio was overweight services and managed care companies which underperformed throughout the year as more speculative industries outperformed.
Assets finally seem to be flowing back into equities with equity mutual funds receiving more cash flows than bond funds consistently since June. Earnings yields continue to make equities cheap relative to bonds and earnings growth has remained solidly positive since 2010. We believe that cash will continue to move back into equities and that small cap has several advantages relative to large cap. Relative valuations between large and small are currently in-line with where they have been over the last ten years. The balance sheet of the average small cap company has improved significantly more than that of the average large cap company in terms of the percent of the balance sheet in cash and debt relative to total assets. Finally, operating margins at the average small cap company have not recovered nearly as much as the average large cap company, leaving substantial room for relative improvement.
The Roxbury/Hood River strategy focuses on investing in the best companies in small cap, and the portfolio tends to have a weighted average market cap above that of the Russell 2000® Growth Index and tends to have a significantly lower weighting of non-earnings companies than that of the index. The lowest market cap companies in the index and non-earnings companies significantly outperformed in 2013. Despite those headwinds, our portfolio was able to outperform. Further, we still see the portfolio as undervalued. By continuing to implement our investment philosophy and process, we are confident that we will be able to reward our clients with strong returns over the long run.
We recognize that our investors want us to beat our benchmark in absolute terms. But in a year when our benchmark was up 43% and we had an observed daily beta of roughly 0.89, we are proud that our alpha is significantly greater than our absolute outperformance. We look forward to that alpha shining through more brightly in years in which there are fewer fireworks in the general market.
Hood River Capital Management LLC (“Hood River”) is an investment adviser registered with the SEC. Performance presentations compliant with the requirements of GIPS standards can be obtained by calling 877-725-4432. 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 the 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 12/31/13. The Small-Cap Growth composite has been examined for the periods 6/30/02 through 12/31/13. The verification and performance examination reports are available upon request. . 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 014/01/13 meets GIPS® portability requirements.
The Small-Cap Growth composite was created in 2002 with an inception date of 06/30/02. 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 end 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.
Net Net performance is net of any applicable performance fees and net of transaction costs 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.
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. Risk data is being provided as supplemental to the Small Cap Growth GIPS compliant presentation. Past performance is no guarantee of future results. Not FDIC insured, no bank guarantee, may lose value.