The markets remained firm in the second quarter with the Russell 2000® Growth Index up 2.0%. The Hood River Small Cap Growth portfolio was also up during the period, but underperformed the index by 1.9% net of fees. Investor focus continued to bounce between various macro concerns, ranging from Greek debt woes, China stock market crashes, and the prospect of higher interest rates in the U.S. Despite these macro headwinds, the U.S. economy continued to chug along as consumers continued to open their wallets and the headline unemployment rate ticked down further into a respectable range.
While the overall Russell 2000® Growth Index had a solid quarter, returns were highly concentrated in specific industries. The vast majority of the returns came from healthcare, which at roughly 25% of the index posted a 6.0% return for the quarter. Of the four major sectors, technology was next best with a +2.8% return, followed by consumer discretionary +0.9%, and industrials were down 2.0%. The index’s healthcare returns were dominated by biopharma companies, which currently comprise roughly 17% of the index. Biotech was up 14.6% in the quarter and is up 35.1% year-to-date. We continue to be underweight biotech due to high valuations, making it difficult to find stocks that offer attractive future returns.
Hood River’s portfolio outperformed the index during April, when most of our holdings were reporting earnings, but we gave back a portion of that in May. June was a month in which the news headlines were flooded with reports on Greece and China as well as concerns that the U.S. economy might be slowing. The latter had a negative impact on our transportation stocks, which have been outperforming the index over the last year. While we reduced our exposure to these stocks during the quarter, the transportation companies in our portfolio hurt our stock selection by approximately 55 basis points in the quarter. Overall, stock selection across the entire portfolio accounted for approximately 140 basis points of the quarter’s underperformance with the rest due to sector allocation.
Our second-quarter performance puts us in-line with the Russell 2000® Growth Index year-to-date. A significant headwind has been the dramatic outperformance of unprofitable companies in the index, both in the first six months of the year, and in the second quarter in particular. While the Russell 2000® Growth index was up 8.7% in the first half of 2015, companies in the index with negative operating earnings were up 15.7% and those with positive operating earnings were up only 7.1%, for a more than 8% point spread. In the second quarter alone this spread was 6.1%. Hood River’s portfolio is currently, and has historically, been more focused on quality and profitable companies with lower debt, so it is not surprising that we were hurt by this “low-quality” factor outperformance in the quarter.
Looking forward, we believe our unique, proprietary fundamental research will uncover differentiated investment opportunities. For example, over the years Brian Smoluch’s own knee problems have put him in contact with many of the thought leaders in knee medical technology, and his specialized knowledge led us to recently add Conformis Inc. to our portfolio. Conformis uses three-dimensional scans of knee joints to create custom knee replacements. While the knee replacement market is $6-$7 billion, outcomes and patient satisfaction are relatively low, with approximately 25% of patients unhappy with their knee, 20% with pain more than two years post-operation, and 14% having adverse events related to the surgery. By providing the patient a better fit, Conformis patients have a 94% satisfaction rate and only 2% have adverse events. For the doctor, there is less equipment required, a shorter set up time, and lower sterilization costs. With over 400 patents, Conformis is the only company that can provide customized implants in the marketplace, and given the disruptive nature of the technology in conjunction with its tiny current market share, we think the company should be a long-term successful growth company. Revenues in 2016 should grow over 50% to at least $109mm. We believe that Conformis is a great example of how our differentiated research process can uncover investment opportunities that have the possibility of being contributors to our portfolio’s returns going forward.
The portfolio’s current positioning is a strong reflection of our time-tested investment process. As in the past, we expect the portfolio to have slightly less market exposure than the index while being comprised of higher quality companies with better earnings, lower debt and more market liquidity. It is a combination of these factors that on average and over time have allowed us to consistently generate alpha for our clients.
We are excited about the opportunities that our fundamental research continues to uncover, and look forward to speaking with many of you in the coming months. Thank you for your ongoing support.
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 information is as of 6/30/15 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.