Small-cap growth stocks jumped a robust 9.2% in the third quarter as investors moved past fears of Brexit-induced economic weakness and contemplated the current very low-rate environment potentially persisting. Hood River’s Small-Cap Growth Strategy posted a 15.2% net of fees return in the quarter, beating the Russell 2000® Growth Index by 594 basis points. Within the index, the sectors contributing the most to returns were information technology, up 15.4%, and healthcare, up 13.3%.
Most of our outperformance versus the index was due to stock selection (440 basis points) rather than sector allocation (150 basis points). Our stock picking in the technology sector drove Hood River’s outperformance this quarter, contributing 480 basis points of performance. As we highlighted in our 2Q16 letter, we were hurt earlier this year by the performance of our optical stocks, such as Oclaro, Finisar, and Lumentum, which cost us roughly 85 basis points in the second quarter, but we stuck with our positions based on our conviction that investor concerns around near-term order patterns were overblown and that other investors were missing the importance of the industry’s 100g upgrade cycle. One quarter later, we are happy to report that these three stocks were among our largest positive contributors for the past three months, as well as year-to-date. Beyond technology, other sectors that contributed significantly to our quarterly return included industrials and materials.
Healthcare was our weakest sector, costing us roughly 200 basis points of total attribution. In previous letters over the past year, we have written that we are underweight biotechnology and pharmaceutical stocks and overweight healthcare services stocks based on where we are currently finding value. Pharmaceuticals and biotechnology stocks, which made up more than half of the index’s healthcare weighting, returned 18.1%, compared to the more meager 7.1% return for the index’s healthcare equipment and services stocks. Beyond our industry-level positioning, we were also hurt by individual stocks such as Ligand Pharmaceuticals, which suffered as a drug on which it receives a royalty failed to show superiority to a competitor in a clinical trial, and Diplomat Pharmacy, which was weak on continued fears around the sustainability of pharmaceutical price inflation.
Although we posted very strong relative performance in a quarter in which our benchmark was also up significantly, it is important to note that our market exposure was very similar to that of the index, as we had suggested in our 2Q16 letter. In fact, the “beta” of our portfolio versus the Russell 2000® Growth Index, calculated on a daily basis, was 1.00 for the quarter, indicating that all of the outperformance came from alpha, not beta.
As we enter the fourth quarter, we estimate that the market exposure of our portfolio continues to be similar to that of our benchmark. Our sector weightings are all within 700 basis points of the benchmark, except for technology, where we are 720 basis points overweight. While we are overweight healthcare overall, we continue to be underweight biotechnology. Our liquidity remains good. We feel as though our opportunity set remains large, despite the recent run in the portfolio. Finally, as of September 30, we crossed $1 billion in assets under management after we received funding from two Fortune 500 companies.
All the best,
The Investment Team
Rob Marvin, Brian Smoluch, David Swank
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 has an arms-length service level agreement with mar Vista Investment Partners, a registered investment adviser, to provide back and middle office 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 9/30/16 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.