The Bear Market in Small Caps
The first quarter of this year started off with a thud. While there are a myriad of reasons why (and analysis has been published in extremis), perhaps the simplest explanation is the best: Companies are reporting earnings declines after several years of growth. In fact, this is the third straight quarter of earnings decline for the S&P 500.
GDP expectations for the full year have been brought in a bit, likely causing the Fed to put a hold on raising interest rates. Of greater concern is the corporate credit market, where high yield defaults are increasing amidst signs of deteriorating fundamentals. Additionally, the recent Senior Loan Officer survey points to tightening loan standards for the first time in several years. This is important because it signals that banking clients are reporting thinning coverages on their credit agreements. In other words, the economy is finally slowing down. When we see this kind of deceleration in overall economic measures, we would expect small company stocks to sell off. And they have.
Small company stock prices are off nearly 25% since the June 2015 peak. Typically, sell-offs like this result in good future returns from stock price improvements or increases in buyout activity (more on this below). The screens we employ to look for good companies at low prices are producing more results than they have in the last several years, which is why our turnover is starting to increase.
Our research activity is yielding more companies with prospects for excellent returns than at any time in the last three years. Those returns might be found in two areas. The first is growing profits. Small companies are not yet as profitable as their larger company counterparts. The Companies in the Russell 2000 have annual operating profit margins of 6.1%, a full 10 percentage points below those in the S&P 500. (This removes all of the money-losing Bio-tech companies in the Russell 2000.) As these small companies grow, their profits will also grow nicely, setting up the potential for good returns.
The second area is mergers and acquisitions activity. In this sell-off environment, smaller companies are often the target of corporate buyouts or merger activity. While the very biggest deals grab all of the headlines, the vast majority of actual transactions happen with companies below $500 million in market capitalization. In fact, the average buyout deal in the US during 2015 was $233 million—and deal premiums are up. This could also lead to the good returns that we seek.
It is exactly this kind of market that gives us the opportunity that we have been waiting for during the last two years: to buy very good small companies at great prices.
On a different note, we are happy to welcome Tammy Wood as our new Director of Marketing and Business Development. We're glad she's here and you will be hearing more from her in the coming months.
Pacific Ridge Capital Partners
About Pacific Ridge Capital Partners
Pacific Ridge Capital Partners is an employee-owned firm. We generate our own investment ideas using fundamental analysis and bottom-up stock picking. The investment team applies a consistent, patient and disciplined process that results in low turnover and stability. Our proven philosophy has performed well over many investment cycles and it is the consistent application of this strategy that makes Pacific Ridge unique.
The principals of Pacific Ridge Capital Partners are invested along with our clients in each of our strategies.
PRCP Small Cap Value – Our Small Cap Value strategy generally purchases stocks in the bottom three-quarters of the Russell 2000® Index. This smaller capitalization segment has a large number of underfollowed companies, providing us the greatest opportunity to exploit market inefficiencies. The typical range of holdings is between 100 and 150.
PRCP Micro Cap Value – Our Micro Cap Value strategy generally purchases stocks in the Russell Microcap® Index. This segment is widely underfollowed, providing us the greatest opportunity to exploit market inefficiencies. The typical range of holdings is between 50 and 80.
We believe these market cap segments offer great potential returns and additional diversification for our clients. For further information about Pacific Ridge Capital Partners and our investment strat- egies, we invite you to contact Tammy Wood via email at Tammy.Wood@PacificRidgeCapital or by phone at (503) 878-8502.
Pacific Ridge Capital Partners, LLC (“Pacific Ridge”, “PRCP”, or “the Firm”) is an employee-owned investment advisor registered with the Securities and Exchange Commission under the Investment Advisor Act of 1940. The Firm was established in June 2010, and has one office located in Lake Oswego, Oregon. Pacific Ridge claims compliance with the Global Investment Performance Standards (GIPS®).
Sources: Pacific Ridge; FactSet Research Systems (“FactSet”); and Russell Investment Group (“Russell”) who is the source and owner of the Russell Index data.
The current annual investment advisory fees for the portfolios managed in the Firm’s Small and Micro Cap Value strategies are 1.00% and 1.50% of assets, respectively. Returns for the composites are presented gross and net of management fees and other expenses and includes realized and unrealized gains and losses, cash and cash equivalents and related interest income, and accrued based dividends. The Firm calculates time weighted rates of return by geometrically linking portfolio simple rates of return at least monthly, with adjustments made for significant external cash flows. The composite returns are calculated by asset weighting the individual portfolio returns using beginning of the period values. All returns are calculated after the deduction of the actual trading expenses incurred during the period.
The information provided should not be considered a recommendation to purchase or sell any particular security. There is no assurance that any securities discussed herein will remain in our strategy at the time you receive this report or that securities sold have not been repurchased. It should not be assumed that any of the holdings discussed herein were or will be profitable or that the investment recommendations or decisions we make in the future will be profitable or will equal the investment performance of the securities discussed herein. Past performance is no guarantee of future results.
Although the statements of fact and data in this report have been obtained from, and are based upon, sources that the Firm believes to be reliable, we do not guarantee their accuracy, and any such information may be incomplete or condensed. All opinions included in this report constitute the Firm’s judgment as of the date of this report and are subject to change without notice. This report is for informational purposes only and is not intended as an offer or solicitation with respect to the purchase or sale of any security.
The Russell 2000® Value Index measures the performance of the Russell 2000 companies with lower price-to-book ratios and lower forecasted growth values. For comparison purposes, the index is fully invested, which includes the reinvestment of income. The return for the index does not include any transaction costs, management fees or other costs.
The Russell Microcap® Value Index measures the performance of the microcap segment of the U.S. equity market. For comparison purposes, the index is fully invested, which includes the reinvestment of income. The return for the index does not include any transaction costs, management fees or other costs.
Returns and asset values are stated in US dollars.