Tough Quarter for the Markets, but Hood River Was Well Positioned
The market had a rough third quarter as the Russell 2000® Growth Index fell 13.1%. The Hood River Small-Cap Growth strategy outperformed the market by 193 basis points (bps), falling 11.1% net of fees in the quarter. Within the index, weak performance was driven by investor concern regarding impending Fed rate hikes and wobbly global growth. No sectors within the index were in positive territory and all of the major sectors underperformed significantly, including industrials (-14.8%), consumer discretionary (-10.7%), and technology (-10.1%). Healthcare (-17.7%) was the hardest-hit major sector, where the big story was a sharp decline in the biopharma sector (-22.8%) – a decline that was not shocking to us in light of our recent concern regarding biotech valuations which we have discussed in previous quarterly letters.
Most of our outperformance in the quarter came from our sector allocation (+170 bps), thanks in large part to our underweight in healthcare (specifically biotech), as well as some positive stock selection. The first three weeks of the quarter were difficult for our portfolio as biotech rallied, but we then outperformed the index as biotech and the broader markets declined. Healthcare was the bright spot in the quarter as we added roughly 125 bps of performance due to our underweight, as well as over 100 bps of stock selection due to good performance from companies such as AmSurg Corp. Other positive areas included industrials, with +48 bps of stock selection, and materials, with +63 bps of stock selection. Consumer discretionary was the primary sector that detracted from returns, with -100 bps of stock selection, primarily due to poor performance by LifeLock, Inc.
Drug Pricing Concern Weighs on Biotech Stocks
The biotech component of the Russell 2000® Growth Index ended the quarter down 31.0% from its July highs, but remains up 1.8% on the year. Although the group began to slide in late July, the real fireworks started in mid-September as aggressive drug pricing emerged as a hot political issue.
We have long considered drug pricing a potentially explosive issue lurking in the wings. Drugs, especially biologicals, have long been expensive, but in the past decade drug companies have finally realized – and often acted on – their substantial pricing power. A great example is Biogen’s Multiple Sclerosis drug Avonex, which has seen declining prescriptions for the past decade, yet has managed to more than double its revenues by increasing its price 16% per year. The wholesale price for a year of Avonex at the 1996 launch was $9,200, but rose to $62,000 by 2014. In general, we are big fans of the biotech industry, and we like to see innovative companies succeed financially in the course of helping the sick. However, given the significantly non-market-based structure of our current healthcare system, as well as the understandable (and occasionally deserved) perception that some companies are predatorily gaming the system, the pricing issue could linger for the industry and may eventually lead to legislation that constrains pricing to some extent.
In the near term, we do not expect legislation will pass concerning drug pricing in the next few years, but the recent spotlight on the issue will lead to slower price growth over the next 1-2 years, much as it did the first time a Clinton focused on this issue in the 1990s. In 1993, an intense push to legislate significant reductions in drug pricing ultimately failed, yet drug price inflation decreased from roughly 8-10% annually in 1985-1992 to roughly 3-5% in 1993-1996 as pharmaceutical manufacturers bowed to public perception. Recently, pricing has only had a short moment in the spotlight and it’s not clear if this issue will continue to resonate. However, the possibility that the recent decade’s exercise of pricing power may be nearing an end, combined with the threat of legislation in the next decade, may be a dark cloud that depresses investor sentiment on the space. Two decades ago the pricing discussion contributed to a brutal bear market in biotech stocks in 1992-1994 that left many companies trading at or below net cash balances; current valuations leave the typical biotech stock vulnerable if the political debate around drug prices actually gets serious. As of early October the decline in biotech has continued, but we still view valuations in the sector as high even assuming a benign pricing environment, and we remain significantly underweight the space.
Outlook and Positioning
At Hood River we are bottom-up stock pickers, so we spend our days researching companies and trying to find quality businesses at attractive valuations whose sales and earnings will favorably surprise other investors. We don’t spend much time theorizing about macro events. With that backdrop, we continue to be pleased with our portfolio of companies and have been finding attractive opportunities to add new companies to the portfolio as well.
One of the most gratifying components of our job is finding small companies that are undiscovered by Wall Street and are doing a great job adding value for their customers, providing strong prospects for future growth. One such company that we are currently excited about is Barrett Business Services Inc. (BBSI), which provides human resources outsourcing and business consulting services to small- and mid-sized employers. With a market cap of roughly $300mm, it is not on many investors’ radar screens and few analysts cover it. It has recently grown revenues organically by at least a high-teens rate, and we expect it can continue to do so for the next few years due to a strong pipeline of new business and strong word-of-mouth referrals. It should also enjoy expanding margins due to operating leverage as its sales grow, leading to 25%+ annual EPS growth over several years. It is currently trading for roughly 10.5x analyst estimates of 2016 EPS, and we suspect those estimates will prove conservative. Few other companies in the business services space offer such high growth, and those that do typically trade at 20x or more forward EPS estimates. We look forward to owning Barrett stock as the company continues to execute in coming periods.
In terms of portfolio positioning, we anticipate that our market exposure will be similar to or slightly less than that of the index. On a macro level, our portfolio’s biggest difference from the benchmark is our continued underweight in the biopharma group. We continue to look for ideas in that space, but we will not buy stocks that we cannot justify. Our weighted average market cap has come down significantly from earlier in the year to a more normal level, and as of 9/30/15 was $2.1b, or an 8% premium to that of the index, while maintaining a good level of liquidity.
This is an exciting time for us at Hood River. We believe we have the right team and the right process, and we are executing that process well. While we enjoy our recent external recognition in the form of awards and top ratings, we are most gratified when we make a positive impact in helping our clients achieve their financial goals. We look forward to continuing to execute our process and build the organization, and ultimately extend our history of doing right by our clients. Thank you all very much 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.
Attribution information is as of 9/30/15 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.