The growing popularity of smart beta, indexing and other strictly-by-the-numbers investment strategies suggests that many have given up on trying to beat the market with funds whose managers make judgment calls, speak with CEOs and customers or uncover earnings surprises. But the investment returns of the Hood River Small Cap Growth Fund, whose three co-managers do all those things, might change investors’ minds.

Over the 10 years ending December 2016, the fund’s institutional class shares had an 8.31% annualized total return, while its bogey, the Russell 2000 Growth Index, saw 7.76%. Its three-year annualized return of 7.49% and five-year return of 17.08% trounced the index’s 5.05% and 13.74% returns over the same periods.

The secret to the fund’s success is that it looks for small company stocks Wall Street has ignored or underestimated, even though these companies might actually be able to deliver positive earnings surprises.

“With large caps there aren’t that many opportunities to find mispricing because everything is pretty efficient and there’s a lot of information out there,” says co-manager Brian Smoluch. “That’s not the case with small companies.” It’s easier to figure out which of those will exceed their earnings estimates, he says.

Smoluch, along with co-managers David Swank and Robert Marvin, scour a 2,000-stock universe for companies that can beat estimates. These companies must not be bigger than $3 billion in market value, and they must be able to grow earnings at least 15%. About 80 or so companies make the final cut in the portfolio, and these must also have strong cash flow, superior products and rising market share.

A key part of the process is that the managers talk with these companies’ CEOs and senior executives, competitors, customers, distributors and anyone else who can shed light on a business. That allows the fund to unearth those companies with unrecognized strength.

“Talking to multiple sources about a company is like putting together a puzzle,” says Swank, who has known Smoluch since the two were roommates at the University of Virginia. “We turn over a lot of rocks because you never know where you’ll find something interesting.

“Conversations with managers help us pick up on whether they are more or less confident than usual. Customers and distributors provide valuable information on the product and how it stacks up against the competition.”

Collectively, the three managers log well over 1,000 calls a year to dig up relevant information.

Although Hood River Capital Management is just a little over three years old, the three managers have each been practicing their boots-on-the-ground research for over two decades. Smoluch and Marvin met as part of the small/mid-cap team at Portland, Ore.-based Columbia Management Company in the 1990s. The three worked at Roxbury Capital Management before spinning off the firm to create Hood River Capital Management in 2013. Their fund, which had been around since 2003 as a Roxbury product, came along with them.

Both the firm and the fund are named for Hood River, a town about an hour away from its headquarters in Portland. “We like the outdoorsy feel of the area, and our name provides a link to that,” says Smoluch, who enjoys fly-fishing and cross-country skiing in his spare time.
Despite the emergence of numerous information sources on the Internet since their careers began, Smoluch observes that opportunities for digging up earnings surprises have expanded in recent years. When he graduated from Harvard Business School back in 1998, investment bank compensation arrangements at the time provided a financial incentive for analysts to cover smaller companies and shed a favorable light on them. Such arrangements were called into question and fell out of favor after the stock market crashed a couple of years later.

Now that there is less financial incentive to support research and trading activity in this space, small stocks are under-covered by analysts, which sometimes means the earnings estimates are faulty. Stocks with the largest gap between Wall Street and Hood River estimates usually get more space in the portfolio, since they are potentially more rewarding than those with estimates closer to the consensus.

The firm subdues risk by limiting individual stock positions to a 5% maximum weight in the portfolio, and sector concentrations cannot be more than 15 percentage points different from the weightings of the Russell 2000 Growth index benchmark. Usually, however, both stock and sector positions fall well within those guidelines. The firm also has a strict discipline to sell a stock whenever the original thesis about it changes, whenever the stock hits its price targets or whenever the firm sees a better opportunity elsewhere.

Morningstar pegs turnover at 170%, but Smoluch says that’s a bit misleading because the fund often trades around positions by trimming when a stock’s price is high and buying again when it’s lower. He says a typical holding period is around nine months and also says the fund is tax-efficient because it harvests losses to offset gains. Morningstar figures, which show only a small gap between pretax and after-tax returns, confirm that contention.

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