Small cap growth stocks were up a respectable 3.23% in the second quarter, although that number masks significant volatility in the quarter. Hood River’s Small Cap Growth strategy trailed the Russell 2000® Growth Index by 307 basis points (bps), rising 16 basis points net of fees in the quarter. Within the index, the biggest contributors to return were healthcare, which rose 5.08% in the quarter, and technology which rose 3.78% in the quarter. The biggest absolute gainers in the index were telecommunications +11.48%, consumer staples +9.03%, and energy +9.61%.
As is typical for us, most of our deviation from the index was due to stock selection. Within our portfolio, our negative stock selection in the quarter primarily came from consumer discretionary (-129 bps), information technology (-93 bps), and industrials (-74 bps). Healthcare was our best stock selection sector in the quarter, adding 41 bps. Beyond stock selection, we were hurt by being underweight a number of the slower growth sectors that were amongst the best performers in the quarter, such as consumer staples, energy, materials, and utilities.
During the second quarter, several of our optical names negatively impacted performance despite very strong results and guidance. Oclaro, Finisar, and Lumentum detracted 85bps of stock selection in total during the period. Generally, investors are concerned about near term order patterns weakening for a variety of reasons, including trade sanctions and inventory build in the channel. Contrary to these concerns, we still believe the industry’s 100g upgrade cycle will continue in the metro and data center and order patterns will remain strong, which should allow all three of these companies to beat estimates as we progress throughout the year.
In consumer, Francesca’s cost us 59 bps in the quarter. Part of our thesis involved its CEO, Mike Barnes, who had been an extremely good operator at Signet Jewelers, which was a prior holding in the fund. Mike moved from Signet to Francesca’s in December of 2014. We added Francesca’s to the portfolio in 2015 after seeing evidence of Mike’s impact. Mike unexpectedly resigned from the company in May of 2016 with very little explanation and we exited the position.
Outlook and Portfolio Positioning
Going into the third quarter, Hood River’s Small Cap Growth portfolio has a fairly normal stance, with market exposure similar to that of the benchmark. Regarding sector weights, early in the third quarter our biggest deviations from the benchmark are in information technology, where we are 600 bps overweight, and in healthcare, where we are roughly 500 bps overweight at 28% of the portfolio, despite being significantly underweight biotech. Our overweight in the healthcare equipment and services industry spans a relatively diverse group of companies, without major exposure in any one sub-industry and simply reflects a nice mix of reasonable valuations and our belief in the potential for company-specific upside. Our portfolio weightings are within 500 bps of the benchmark in all other sectors. Exiting the quarter our weighted average market cap was $2.2 billion, a 20% premium to the benchmark. We had no organizational changes in the quarter.
As we have often said, we pride ourselves on our bottom-up research, and we do not view ourselves as in the business of making macroeconomic bets. We assemble our portfolio on a bottom-up basis, and while we monitor our exposures to factors including beta, value/growth, interest rates, and major commodities, our organically-assembled portfolio normally looks sufficiently like our benchmark with respect to those factors that we don’t actively manage to risk models. While much has been written about the Brexit, for us it served as a nice stress test for our exposure to macro factors ranging from beta to interest rates to FX, and we are happy to say that from the week prior to the Brexit vote to the week following it, our portfolio performed basically in-line with the index. We want to live or die by our bottom-up stock picking, and are gratified when our relative performance is mostly independent of broader market forces.
It’s no secret that we at Hood River are fond of small cap growth stocks. It’s nice that the asset class includes some of the most exciting companies in world, but the real reason we like it on a secular basis is the inefficiency that we’ve historically found in the space – with enough digging, we’ve historically been able to uncover great stocks that lead to outperformance, and we are still excited about that opportunity. But beyond that secular case for the asset class, as we look at the investment world, we are optimistic about the current setup for U.S. small cap growth relative to much of the rest of the investment universe. A lot of the world’s sovereign debt is trading for near-zero or even negative yields, and taking on more risk brings only modest additional yield. Large cap U.S. equities are somewhat more defensible, with forward P/Es around the median seen since the turn of the current century. But small cap growth stocks are currently trading well below their median P/Es for that period, and trading at a similar P/E to the S&P 500® Index, despite having a considerably higher expected growth rate (and realized historical growth rate). We are not turning into macro traders – we are still doing this for the alpha! – but we will simply note that small cap growth stocks look pretty defensible in absolute terms, and arguably attractive relative to other major asset classes.
While we are never pleased with a quarter like the one just ended, we know that they happen from time to time, and we are staying focused on conducting great research today that we hope will translate into a portfolio of quality, attractively valued companies that will outperform other investors’ expectations in the future. We remain excited about our strategy and our team, and appreciate the opportunity to build long-run value for our clients.
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 jointly owns its back office service provider, Roxbury Capital Management, with Mar Vista Investment Partners, a registered investment advisor. Roxbury provides various administrative, operational, and business 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 12/31/15. 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 12/31/15. 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 6/30/16 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.