Small-Cap Growth – September 30, 2019

Small-cap growth stocks were weak in the third quarter, posting their first quarterly loss of the year. The Russell 2000® Growth Index returned -4.17% for the quarter. The Hood River Small-Cap Growth product returned -8.54% net of fees, underperforming the benchmark by 437 basis points (bps). Year-to-date the Hood River Small-Cap Growth portfolio was up +13.11% net of fees, underperforming the benchmark by 223 bps.

After a sedate July with no major surprises on trade, the economy or the Fed, August saw President Trump intensifying the trade war with China by announcing new 10% tariffs on $300 billion of Chinese goods not yet subject to U.S. tariffs. China initially responded by letting the yuan breach the seven yuan/dollar level and sparking fears of competitive currency devaluations, before reining the currency in later in the month. Small-cap stocks sold off sharply over the course of a week in early August in response to these events. After grinding back to recover most of the early August losses, stocks sold off again in the second half of September on heightened worries of an economic slowdown.

Within the Russell 2000® Growth Index, the sectors contributing most to the market’s decline included healthcare (-9.8%), consumer discretionary (-4.1%), and information technology (-2.2%). The only positive sectors within the benchmark were relatively small (combined total of approximately 10% of the benchmark), defensive or interest rate-sensitive ones: utilities (+9.2%), consumer staples (+3.6%), and real estate (+2.9%), where we believe valuations have been pushed to high levels by investors chasing “safety” or yield in an environment of fear over the economy.

Hood River’s quarterly performance was driven almost entirely by negative bottom-up stock selection, which was dramatically impacted by a shift in the market’s demand away from growth companies and toward value companies. Other factors, such as earnings revisions, also underperformed. The phenomenon began in the middle of August and then dramatically accelerated in the month of September. The portfolio lost 71 bps on a relative basis in the second half of August and then another 216 bps in September despite minimal fundamental news. Within our investment process, our companies usually grow faster than those in the index and they also typically have positive earnings revisions since they tend to beat street estimates. Additionally, our portfolio tends to be cheaper than the index, with larger market capitalizations, similar beta, and less debt. However, those factors did not matter in our portfolio in the quarter nearly as much as growth and earnings revisions did. Attribution was negative across all major sectors except materials, which is extremely rare.

During the quarter, we actually had a relatively normal amount of detraction from companies that had disappointing earnings versus the Street’s expectations. Merit Medical, Harsco, TPI Composites, Gluu Mobile, and Carbonite fall into this bucket and detracted 173 bps combined, which is within a fairly normal range. In fact, our top five stock contributors in the quarter, Mastec, CONMED, Zumiez, Integra Life Sciences and Kinsale Capital Group combined added 194 bps and approximately offset these negative contributors. It was the massive factor attribution highlighted earlier that impacted performance in the quarter rather than any wholesale fundamental misses, which is what our process is designed to capture.

There were some areas in the portfolio that amplified underperformance, despite good earnings and no fundamental concerns, and were not necessarily caught in the growth to value rotation. We currently have approximately 570 bps allocated to education stocks (Chegg, Grand Canyon Education, K12, Laureate Education). The stocks are inexpensive, growing nicely, and are not economically sensitive. However, during the last week of the quarter, they sold-off sharply due to President Trump’s impeachment inquiry and the prospects of an Elizabeth Warren nomination and victory. This is despite the fact that Chegg and Grand Canyon Education are not exposed to for-profit post-secondary education businesses. Laureate Education has some post-graduate online businesses, but those have historically not been a focus for Elizabeth Warren and the democrats. Those stocks cost the portfolio roughly 39 bps in the quarter, and even more than that from their peaks prior to the impeachment news. Another company, Innovative Industrial Properties (IIPR), cost the portfolio 37 bps despite recently raising its dividend. IIPR is a U.S.-based medical cannabis REIT with properties exclusively in the U.S. Its multiple contracted due to problems in the Canadian market that are not directly tied to IIPR’s fundamentals.

Entering the fourth quarter, our portfolio was positioned slightly tighter to the benchmark’s sector weightings than normal, with no sector more than 400 bps over- or under-weight versus the index, with the exception of information technology, which was approximately 440 bps overweight. We continue to be underweight biotech. As of early October, we estimate our current portfolio’s beta is similar to that of the Russell 2000® Growth Index, although we would caution investors that predictions regarding beta can be significantly off relative to actual outcomes.

This was the worst relative quarter we have had in over a decade, but quarters like this do happen on infrequent occasions. Over nearly two decades, relative draw-downs like these have proven to be good buying opportunities, and some of the investment professionals here used it as an opportunity to add to their Hood River holdings. Historically, in periods when we have had negative performance, we have stayed disciplined, kept our noses to the grindstone, and focused on doing excellent research. Over time, that strategy has led us back to better performance and handsomely rewarded investors. Given the large investment each of us personally has in Hood River’s portfolios, we are executing that playbook with great intensity, and are highly motivated to produce strong returns.

As always, we appreciate your ongoing support,

David Swank, Brian Smoluch & Rob Marvin

Investors in Hood River’s Small-Cap Growth strategy acknowledge and agree that (I) any information provided by the Firm is not a recommendation to invest in the strategy and that the Firm is not undertaking to provide any investment advice to the investor (impartial or otherwise), or to give advice to the investor in a fiduciary capacity in connection with an investment in the strategy and, accordingly, no part of any compensation received by the Firm is for the provision of investment advice to the investor and (II) Hood River has a financial interest in the investor’s investment in the strategy on account of the fees and other compensation the Firm expects to receive from the client.
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 12/31/18. 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 12/31/18. 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.
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. Performance results presented reflect the reinvestment of dividends and other earnings. 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.
Attribution information is as of 9/30/2019 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.