Q: What is the history of the fund?
The Hood River Small-Cap Growth Fund was launched in 2003 and the fund’s strategy and philosophy have remained unchanged since. We seek superior long-term growth of capital by looking for quality companies under $3 billion in market capitalization that are trading at reasonable valuations, and we rely on original fundamental research to identify those that will exceed earning estimates and translate to good performance in the portfolio.
In the investment strategy itself, we manage $800 million, with about $130 million of that currently invested in the fund. We offer both institutional and retail share classes, with $25,000 and $1,000 minimum account sizes, respectively.
Because the management company is 100% owned by its three portfolio managers, its structure aligns their interests with those of their clients. Each portfolio manager has made significant investments in the fund, and has over 20 years of experience investing in small-cap stocks.
Q: What are the tenets of your investment philosophy?
We believe stocks are valued based on future cash flows, and in the short-to-intermediate term, most investors use earnings estimates to approximate these.
But Wall Street is not well-equipped to assess small companies. Larger corporations may have 50 brokerage analysts covering them while smaller ones have anywhere from none to a handful—and those tend to be more junior people.
As a result, earnings estimates for small-cap companies have more errors in them, which creates an opportunity. We use fundamental research to identify companies that are misunderstood and underappreciated by other investors.
Q: Would you describe your investment strategy and process?
In sourcing ideas, we look for quality businesses: ones that are either already growing earnings by at least 15% a year or that we anticipate will do so, and are trading below a $3-billion market cap. We try to find companies with strong cash flow, superior products, increasing market share, excellent management, and within growing industries—because even a great company can find it hard to overcome headwinds.
Q: What is your research process and how do you use it to identify opportunities?
We feel research is our biggest competitive advantage. It is easy for investment managers to sit in their offices, stare at their computer screens, and read brokerage analysts’ industry reports, but it takes more to track down the right people and ask them the right questions.
Instead, we make north of 1,000 calls a year—to management teams, customers, suppliers, and competitors—to corroborate our forecasts, so we can understand empirically what is happening with a business and determine where we think it may go.
Ultimately in our due diligence, we are looking for information gaps, which occur when our forecasts of relevant financial metrics for a company are materially better than the Street’s consensus. Big information gaps represent situations where we will consider making an investment.
After comparing our views with the Street’s, we do some basic math. We forecast earnings and the financial strength of a company, and also think about management’s ability to execute and the industry dynamics.
Valuation comes next. While it is important to find quality companies that you have unique insight into, it is equally important to pay the right price. We consider a company’s valuation versus its history, its industry, and the market, and scrutinize metrics like price-to-earnings valuations and EBITDA.
We want a minimum appreciation over 12 months of at least 15%, ideally without assuming any multiple expansion. In practice, a company that delivers a positive earnings surprise may be seeing revenue growth acceleration and often has multiple expansion—but that is icing on the cake to us.
Because risk increases when investing in companies with high valuations, we shy away from them; also, their valuations may indicate the market knows much of what we do.
Q: How do you construct your portfolio?
Portfolio construction balances risk and return, and position sizes typically reflect the size of the information gap as well as our confidence in it. We also take into account a stock’s liquidity and how it fits into our broader portfolio.
Position sizes are limited to 5% maximum to prevent a single position from blowing up a year. Though sector weights have a hard limit within 15% of the Russell 2000 Growth Index, our benchmark, we tend to be a little tighter and remain within 700 or 800 basis points of it.
Our holdings range from 75 to 95 stocks; currently we are in the low 80s. Versus the benchmark, almost the entire portfolio—92% or 93%— is an active bet.
Compared to other small-cap funds, we are more concentrated, and can still put on meaningful positions in the bigger names in which we have the most conviction.
We keep cash to between 0% and 5% of the portfolio. To us, cash is a residual; we are not timers and instead focus on bottom-up research. People hire us to get exposure to small-cap growth stocks as well as for the alpha we offer, so we never have high cash levels.
Each week we meet to rank the portfolio’s stocks by their performance over the last month and the last quarter—and we look at them in reverse order to focus on the worst underperformers instead of sweeping them under a rug. However, if a well-founded belief can be articulated that a company is going to positively surprise people, we may stick with it or even scale up our position.
The same information gaps that inform our buy decisions also drive our sell discipline; as we see a gap disappearing, we may trim companies. A good-case scenario that illustrates this is when we have gotten everything exactly right about a company and the market comes around to our way of thinking, causing a stock to appreciate. We begin selling as it approaches our price target and should be at zero by the time it hits it.
There are less optimal ways we can wind up getting out of a stock, like if our original thesis starts to deteriorate. Ideally, ongoing research should alert us to get out before a stock’s price is affected, but a stock moving against us triggers a closer examination.
A final reason a stock might be sold is if our access to an information source dries up—maybe a contact leaves a company, or management stops returning our phone calls—and our conviction level thus goes down.
Q: Does the fund ever invest in companies that exceed $3 billion in market cap?
Overall, we want the portfolio to resemble a small-cap growth portfolio, though not every single thing in it has to have capitalization lower than $3 billion.
With new companies, we generally look at only those below $3 billion. But if we are familiar with a stock and see an opportunity to make money for our clients, we may invest even if the market cap is above that range. Previously, the fund has owned companies with market caps that appreciated to as high as $10 billion or more.
In practice, it is hard to forecast the future and the further out you go the harder it is to get it right. Over the course of a three-year holding period, if a company goes from a $2-billion market cap to $10 billion, we have done a great job. But the odds are, by the time it gets to $10 billion that information gap has disappeared; people have figured out things are going well with the company, earnings estimates come up, and valuations expand.
Companies in the $4-billion to $5-billion market-cap range do not significantly sway the overall weighted average market cap of the portfolio, but ones closer to $20 billion can get things out of whack. Our hurdle rate would increase in that kind of situation, but those situations are quite rare.
Q: Is the return on capital important when you consider a company?
We are happier owning companies with attractive return on investment (ROI), but what is probably most important in the near and intermediate terms is how investors are going to be surprised by how ROI changes.
A company with an ROI that is mediocre or just okay is attractive if we think its ROI will improve. But for the most part, we are not interested in getting the last puff of a cigarette from the gutter; looking at junky companies with low ROI in the hope they will improve from 1% to 2% is like having the wind in your face. In the longer term it is tough to overcome that.
Q: How does having three portfolio managers affect processes and decision-making?
The portfolio managers have worked together for many years, and if working from the same facts, we typically arrive at a similar decision. Though we have sector biases, we are also generalists who push each other’s ideas, and cannot bowl over anyone with technical jargon. Once a consensus is reached on an idea, we put it into the portfolio.
However, we are not trying to do management by committee. Every stock in the portfolio is attached to one manager who is responsible for it. Individually, we can put on a position up to 70 basis points when the others are unavailable; presumably, within 24 hours, we will discuss and scale it up past 70 basis points. On the flip side, the manager responsible can sell a stock immediately should information contradict our thesis.
Q: Could you provide an example of how you selected a current holding?
VCA Inc., which runs veterinary hospitals and clinical labs in more than 40 U.S. states, has been in the portfolio for several years.
I had been talking to its management team at least every quarter for several years before I even bought the stock, so I had a finger on its pulse. The company was well positioned within the industry and had no exposure to government reimbursement—which is good in the healthcare space.
But what triggered the buy is what I heard from contacts in the veterinary distribution space, who informed me that nationally, volumes at veterinary hospitals were picking up. Combined with everything else I knew, this created an information gap suggesting VCA’s earnings would have more upside than the Street anticipated. The company was also trading at a reasonable valuation well below its typical price-to-earning multiple.
Today, VCA is one of our larger positions. Recently, we increased it because the business is poised to accelerate again in the near term. In 2017, we estimate it could earn $3.50, and if it trades at 20 times that, VCA will be a $70 stock—right now it is around $60 a share.
Q: How do you define and manage risk?
The portfolio has outperformed with less market risk than its benchmark. Some of the simpler, but more robust and important things we do to manage risk are limiting position size, segment exposure, and cash. We also stay diversified because small-cap companies tend to be pure plays on individual businesses, and it can get ugly when those businesses go wrong.
Over the short run, these measures help to keep us within a reasonable range of the index’s performance, while giving us enough leeway to put on sizeable positions when we get an important insight.
At the highest level of risk management, we think about market exposure. Historically, our beta has averaged about 0.93, which I attribute to having better quality, less volatile companies than the index. We are always at least 95% invested in small cap stocks and don’t try to time the market or make macro calls.
We use models to predict our go-forward beta, look at macro factors like exposure to foreign exchange and value-versus-growth, and stress test the portfolio to see how it performs in historical situations. Although we keep an eye on these more esoteric metrics, we do not typically manage the portfolio to them; the portfolio normally comes together organically based on our bottom-up ideas.
Liquidity is also important in small-cap portfolios. Because it is a capacity-constrained space—only so much money can be put to work—it is crucial not to get stuck in a position. Only about 1% of the portfolio is based on positions with more than three days’ volume.
We do not want to have so much tracking error that our bottom-up stock picking gets swamped by the impact of macro noise. Instead, we construct the portfolio so it behaves reasonably similarly to the index while letting the alpha we generate via our original bottom-up research shine through.
