Hood River’s Small-Cap Growth strategy had a strong third quarter as we outperformed the Russell 2000® Growth Index by over 380 basis points net of fees, leaving us ahead of the index by more than 500 basis points year-to-date. As usual, our relative performance was driven by bottom-up stock picking, with technology, healthcare and industrials particularly additive this year. Also, while our bias toward higher quality companies positioned us well to weather this quarter’s choppiness in the small cap space, our stock picking has historically been effective in both good and bad markets.
The Russell 2000® Growth Index posted a loss of 6.1% for the third quarter of 2014. This marks the first negative quarter for the index in more than two years and the biggest loss since the third quarter of 2011 (-22.3%). Valuation concerns in the small cap equity market coupled with the shakier economic trajectory of Europe, Japan and the emerging markets were factors contributing to the negative quarter. Similar to what we saw in the second quarter of 2014, those companies that had the highest price-to-earnings, highest beta and lowest market capitalization were most hurt by market uncertainties. For the Russell 2000® Growth Index, the largest detractors of performance were in the technology (-5.1%), industrial (-8.1%), consumer discretionary (-8.2%) and energy (-17.2%) sectors. There was nowhere to hide in the quarter as all index sectors with the exception of consumer staples (+.5%) were in negative territory.
The Hood River Small-Cap Growth strategy was down 2.3% in the third quarter, net of fees, while the average small-cap growth manager returned a negative 5.7% for the quarter. Healthcare (+4.1%), industrials (-2.7%) and consumer discretionary (-3.4%) were the strongest relative performers. Although we had minimal exposure in the outperforming biotech industry, our healthcare performance was helped by our position in Providence Service Corporation (+32.2%). Providence, which provides services to Medicaid recipients and government entities, should see margin expansion and revenue acceleration under the Affordable Care Act, and has completed two highly accretive acquisitions this year. We continue to find opportunity in industrials, and our position in Greenbrier Companies (+27.7%), a manufacturer of railroad equipment, has performed well as the company has benefited from a strong tank car replacement cycle and improving efficiencies.
Equity market valuations were a hot topic for debate amongst pundits in early 2014, with some pointing to elevated valuations. By the end of September, however, market declines have served to improve valuations in the small cap space. The Russell 2000® Growth Index has declined 4.1% year-to-date and the average small cap growth manager is down 5.4%, while Hood River has outperformed both with a positive 0.03% return, net of fees through September 30, 2014. Conversely, the large-cap Russell 1000® Growth Index is up 7.9%. This nearly 1200 basis point differential between small and large has reduced relative valuations to the levels we saw in 2011 and 2012, before small cap stocks experienced significant appreciation in 2013. With this pullback, the current small cap growth price-to-earnings ratio is at a 12.5% discount to the 20-year average P/E, while small cap value is trading at a premium to 20-year average valuations. In fact, value stocks across all market caps are trading at a premium to long-term averages while growth investors have an opportunity to invest at a discount to long-term average valuations (See figure below).
*Source: Russell Investment Group, Standard & Poors, FactSet, J.P. Morgan Asset Management
We always build our portfolios from the bottom up and we do not take positions based on macro-economic conjecture. Our original fundamental research provides unique insight into the competitive position, industry trends, and management execution that impact our portfolio companies. The recent market pullback provides us with opportunities to buy businesses at attractive valuations that we believe are executing well. Our healthcare exposure increased as we purchased companies such as Amsurg and Tandem Diabetes Care, Inc. Trucking has a strong tailwind and we have exposure with our position in Old Dominion Freight Line. In regional banks, we own companies such as Umpqua Bank that will be beneficiaries of widening interest rate spreads. Overall, we continue to be pleased with the positioning of the portfolio.
As uncertainties increase, we believe that the experience of our team and the unique insight we employ when we speak with management teams, customers, competitors and suppliers provides us with an informational advantage. On average and over time, our excess return has been attributable to superior stock selection and we feel confident that by continuing to implement our “battle-tested” philosophy and process we will continue to provide our clients with strong returns over time.
This commentary is intended for one-on-one purposes only.
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 01/01/13 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 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.
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.