“Taper-talk” was the driver of 3rd quarter market uncertainty. The beginning of July started with 9 of the first 10 days in positive territory; however, 7 of the last 8 days of September ended with negative returns. The Fed’s comments in May that quantitative easing could be coming to an end were thrown off track in the third quarter as mixed economic data caused the Fed to postpone any reduction of its $85 billion per month bond buying program. Lack of progress between Congress and the Senate in resolving the federal budget caused concern of a government shutdown and added to market anxiety.
Nevertheless, with anemic return opportunities in fixed income, uncertain growth prospects in emerging markets, stability concerns in Europe and a domestic monetary policy that is intentionally lowering the risk premium, the Russell 2000® Growth Index has rallied 32.8% year-to-date and posted another positive return of 12.8% for the third quarter. Small caps have traditionally done better than their mid-cap or large-cap brethren when market perception is that the economy is getting stronger and this has been the case for the first three quarters of 2013. However, the conundrum lies in the fact that the current PE of 29.7x is significantly higher than the 24x of early 2011 and forward earnings growth for the index has dropped from 17% to 16.5%. This increase in valuations and slight decrease in earnings growth has caused the price-to-earnings growth ratio (PEG) to increase from 1.41 to 1.80. In other words, using PEG, valuations are now 31% higher than they were 33 months ago.
Cyclical, low-ROE, nonearning, higher valuation and high beta stocks led the way in the third quarter. When the market favors these types of attributes it is difficult for active managers to beat the index, given their biases towards higher quality businesses. According to Morningstar, the average small-cap growth manager was up 12.3% for the third quarter and only 40% of small cap growth managers beat the index for the quarter and YTD for 2013. One area with the attributes that have been working this year is in the biotechnology area within health care, which was up 19.5% for the quarter and is up over 50% for the year.
The Hood River Small-Cap Growth strategy appreciated 10.9%, net of fees, underperforming the Russell 2000® Growth Index and the average small-cap growth manager for the quarter. The factors that drove the small-cap markets were attributes that the team’s philosophy and process generally avoid: high beta, higher valuations and lower returns on equity. Strong stock selection within the technology, consumer discretionary and industrial sectors generated excess return. While a significant underweight of biotechnology within health care detracted nearly 190 basis points from performance. So far this year, our small-cap growth portfolio has gained 30.9% net of fees, slightly underperforming the Russell 2000® Growth Index but ahead of our peer group.
Although there has been a significant appreciation of the small cap markets over the last two years, we are continuing to find areas within the market that provide value and meet our fundamental criteria: strong balance sheets, expanding margins and industry leaders with best in class management. The Hood River Small Cap Growth portfolio continues to trade at a discount to the market as we are finding attractive opportunities, especially in the semiconductor, healthcare equipment & services, banking and retailing industries. Our current PEG ratio is 1.22 or a 32% discount to the Russell 2000® Growth Index. We believe the attributes that we have outlined will allow our strategy to continue to provide superior absolute, relative and risk-adjusted long-term returns for our investors.
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 9/30/13. The Small-Cap Growth composite has been examined for the periods 6/30/02 through 9/30/13. 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. Past performance is no guarantee of future results. Not FDIC insured, no bank guarantee, may lose value.