This fund spots big opportunities in small-cap stocks

  • By Teresa Rivas,
  • Barron's
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When you think of profitable ventures dreamt up in dorm rooms, tech start-ups like Facebook (META) or Dell (DELL) come to mind. But fund managers Brian Smoluch and David Swank began dreaming of investments as college roommates nearly three decades ago. Now, they’re navigating the tumultuous world of small-cap stocks, looking for companies that are rapidly growing but overlooked by other investors.

The former students at the University of Virginia are co-principals and portfolio managers of the Hood River Small-Cap Growth fund (HRSRX). They graduated from college in 1994, and while their professional paths initially took them in different directions, they “always wanted to do something together,” says Smoluch.

The opportunity arrived when Smoluch’s partner at Roxbury Capital Management retired in 2008, and Swank stepped into the role. “Our investment styles kind of grew up together,” says Swank. Both men are now 50.

The pair co-founded the Roxbury spinoff Hood River Capital Management in 2013, but the Growth fund’s institutional shares (HRSMX) predate that. Since its 2003 inception, with Smoluch at the helm, it has beaten both its small-cap growth category and index, as defined by Morningstar, for the past three-, five-, 10-, and 15-year periods. Morningstar gives it a five-star rating.

Smoluch and Swank have been able to outperform by exploiting inefficiencies in this undercovered corner of the market. That means independent research, meetings with management teams, largely confining themselves to profitable, undervalued companies, and not flinching when it’s time to sell.

They say these strategies show there’s still attractive opportunities, even as small-cap shares have fallen harder than the broader market this year. The Russell 2000 index (.RUT) is down about 25% this year, compared to a 21% drop for the broader S&P 500 index (.SPX). But small-caps are likely to outperform when the market rebounds.

The fund is off about 31% in 2022, hurt in part by a decline in consumer-discretionary stocks, as SeaWorld Entertainment (SEAS) and Caesars Entertainment (CZR) were recently among its top 10 holdings. Over the past year, it’s still outperforming its Morningstar Small Growth benchmark index.

An edited version of our conversation follows.

Barron’s: What did you talk about in college? Did you ever think you’d end up here?

Brian Smoluch: We were always interested in researching companies, and extremely competitive. Our fourth year at UVA, we roomed together and talked a lot about stocks and starting an investment firm together, so we’re excited to be able to do this for a job.

What drew you to small-caps?

Smoluch: We like small-caps because it’s inefficient. A big company like Apple (AAPL) might have 50 to 55 analysts covering it; one of our companies might only have five or 10.

How do you narrow down the field and choose what to buy?

Smoluch: We talk to approximately 400 companies every quarter. It allows you to get the pulse of what’s happening in business in real time across a bunch of different industries. With small-caps, you have good access to the management teams. Usually we can get the CEO or (chief financial officer) on the phone in 24 to 48 hours.

We tend to be a top-10 or top-20 shareholder, so they’re open to having discussions with us. We’re talking to that company, some competitors, and we’re able to put together a mosaic of how it’s doing in real time.

What do you look for before you invest?

Smoluch: We want to buy companies with great management teams that are stealing share, in a space that’s growing well. And we’re buying at good valuations. The vast majority of our companies are profitable and they’re growing.

We’re looking at it on a price-to-earnings or price-to-cash-flow basis, et cetera, and we want those valuations to be median or better over time. When estimates are too high for our companies, and we think the stock is going to go down, we’ll trim those positions. There’s a strict sell discipline to control risk.

If our bottom-up work points to an impending fundamental rough patch, negative future sell-side earnings revisions, or overvaluation, we will sell it and revisit it later.

Do you find it hard to sell a stock that has made you a lot of money?

Smoluch: It can be very difficult to sell winners, but you have to be disciplined and sell overvalued stocks or those stocks will haunt you later. Part of the reason we did really well in 2021 was we sold our overvalued stay-at-home winners in 2020.

Is there an investment you passed on that you now regret?

Smoluch: We spoke to MongoDB (MDB)—which is a great company—multiple times several years ago and passed due to valuation. Even after the pull-back this year, the stock has tripled from where we were looking at it.

A rare year when you underperformed the index and the competition was 2019. What happened?

Smoluch: In 2019, we trailed our benchmark index by about four percentage points, with the majority of that coming from healthcare in the second half of the year. Going into that period, we were underweight biotech, as we perceived valuations weren’t very appealing. Then biotech kicked off a speculative run, leading to some underperformance.

But today, small-cap biotech stocks have fallen back below where they were in mid-2019. In retrospect, from a longer-term perspective, our assessment of those valuations is looking a lot smarter, and sticking to our valuation discipline ultimately helped our long-term performance.

Tell me about the worst investment you ever made and what you learned from it.

Smoluch: The worst investment we ever made was in 2002, in HPL Technologies, which made yield-optimization software for semiconductor companies. Unfortunately, the CEO created invoices which overstated revenue, and when it became public, the stock was justifiably hammered. The experience emphasized the importance of involving yourself with credible management teams.

What are you telling clients, when small-caps have been so down?

Smoluch: We have a lot of sophisticated investors, and they’re typically allocating a small percentage of their portfolio to the asset class. But they know small-caps are more inefficient, and they have 20 years of data through all sorts of markets to show our ability to have good risk control. We’re also well diversified.

David Swank: That’s why investors are in small-cap, to find the undiscovered names where the market isn’t adequately appreciating the business. The returns over the past two decades, nearly the entirety of it, is from bottom-up stock selection, not making sector calls.

Speaking of doing well, Lantheus Holdings (LNTH) is up more than 100% this year. Do you still like it?

Swank: Lantheus sells diagnostic agents for cardiology, oncology, and radiopharmaceuticals. The real story is that it has upside in the near and longer term from its imaging agent Pylarify. Pylarify has a longer half-life, yields crisper images, and has more scalable manufacturing compared to the competition.

At the end of last year, analysts were looking for Pylarify to sell under $100 million (of product) in 2022; now it’s looking more like over $400 million. Even though the stock is up, it’s growing revenue and still only trades at 19 times consensus earnings for next year. I think there’s still substantial upside to sales and earnings estimates for next year.

Option Care Health (OPCH) is another healthcare name you own.

Swank: It’s the largest independent provider of home infusion services; about 70% of its revenue is from chronic conditions. It’s benefiting from the shift away from institutions and into the home, being pushed by both cost and patient preference.

It should be able to grow earnings in the mid-teens. Right now it’s trading at about 21 times my 2023 earnings estimate; I think there will be upside to that from better revenue. It could also do some tuck-in acquisitions that could be immediately accretive.

You’ve been adding to your position in energy-drink maker Celsius Holdings (CELH). Why?

Smoluch: Right now it’s growing revenue at over 200%, which is phenomenal, and has approximately 4% market share; Monster Beverage (MNST), to give some perspective, has about 37% share. We think there’s a lot of room for Celsius to grow. It wouldn’t shock me if it got to 20% share.

SeaWorld is one of your top holdings. How does it keep thriving?

Smoluch: SeaWorld used Covid to its benefit by optimizing how it runs the park from a labor perspective. Its net revenue per capita—how much each person is generating in the park—has gone up significantly. Pre-Covid, it was about $62. It’s up to around $79 in the latest quarter. You couple that with the fact that admission is slightly above 2019 levels, it can deliver significantly greater profits.

What about Caesars Entertainment do you find it attractive?

Swank: There are a lot of good fundamental things going on, and it’s inexpensive relative to its prospects. Business is ripping in Las Vegas, and other regions probably aren’t far behind. Caesars is deleveraging by selling some noncore assets, which makes the stock more appealing to a broader swath of investors.

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