Q1'18 Micro Cap Value Strategy
The Pacific Ridge Capital Partners (“PRCP”) Micro Cap Value strategy fell 2.1%†in the first quarter of 2018, lagging the 0.5% return for the Russell Microcap® Value Index (“Index”). Over the trailing one-, three-, and five-year periods, the strategy returned 13.5%†, 15.9%†and 19.0%†(annualized), respectively, compared to the Index returns of 12.7%, 10.4%, and 12.3%. Since inception on April 1, 2007, the strategy has returned 12.6%† annually versus 5.7% for the Index.
Much of the recent market turbulence originates from concerns over the possibility of a trade war with China. The proposed policy changes are generally disappointing, with little historical evidence that tariffs provide a net economic benefit over the long-term. The administration has legitimate reasons to be frustrated with China’s trade policy. They often make it difficult for US companies to compete there. Additionally, China is notorious for having little regard for intellectual property rights of foreign companies. On the other hand, the United States has benefited tremendously from trade with China over the past several decades, both as a source of low cost labor, and as a rapidly growing market for our goods and services. Addressing the challenges of trading with China, while trying to create a level playing field, is an issue that multiple administrations have struggled with in the past.
In the near term, there is likely to be little impact to our investment decision making from these trade discussions. We think steel and aluminum producers are in the best position to benefit initially, although we do not currently have a position in either of these industries. Less competition at the margin in these industries will likely lead to increased producer profits, while the costs will be borne broadly across all sectors of the economy as higher inflation gets passed down to the end consumer. Initial commentary from management teams in the Industrials sector suggests that this is a minor issue given strong economic demand, and that increased costs will be passed along, though with a one-to-two quarter lag. That said, a sustained trade war with additional tariffs would likely lead to higher inflation, an increased pace of rate increases from the Fed and slower economic growth.
Initial retaliation from China seems limited to food products and finished steel, areas where we have little exposure. Given that our strategies focus on smaller market capitalization companies that have less exposure to international trade, we would expect our holdings to be less impacted by the implementation of additional tariffs or trade restrictions when compared to mid- and large-cap companies. As the Administration’s policies are still in the early stages of being implemented, it is difficult to forecast how this will ultimately play out in the intermediate- to long-term. As mentioned earlier, our concern lies in a continued escalation of trade tensions that could have a materially negative impact on economic growth.
First Quarter 2018
The Micro Cap Value strategy trailed the Russell Microcap Value Index by approximately 260 basis points for the quarter. From a sector standpoint, the strategy’s strong performance in Energy and Consumer Discretionary contributed approximately 130 basis points of excess return versus the Index. However, poor performance in Financials and Health Care detracted approximately 260 basis points versus the Index. The underperformance in Health Care was driven primarily by the strategy’s significant underweight at 1.8% versus 13.1% for the Index. Health Care was by far the top performing sector in the Index, with the Biotech/Pharmaceutical industry leading the way. This is an area where we have not historically invested due to lack of attractive cash flow characteristics and valuations. Bio/Pharma stocks had a weight of 10.3% in the Index and returned 15.3%, while the strategy had no holdings in this space. The strategy’s lack of exposure to Consumer Staples, Telecommunications, and Utilities had a negligible impact to returns, relative to the Index.
There was no discernible size bias during the quarter, though there was a style-related impact in the Index. Most notably, a significant headwind arose from the strong performance of unprofitable companies in the Index, as they returned 3.6% versus a decline of 0.3% for companies with a P/E greater than zero. The strategy had 0.8% of its holdings in stocks with a P/E less than zero, versus 18.9% for the Index.
The Financials sector had the highest weight in the strategy at 31.8%, compared to the Index at 36.0%. The strategy’s holdings in the sector fell 1.6% in the period, compared to a return of 2.1% in the Index. The greatest contributor to performance was Esquire Financial (“ESQ”), with its shares returning 23.6% in the quarter. ESQ, a single branch business bank catering to the legal industry, launched their initial public offering last summer. They have since reported several quarters of solid operating results, with strong revenue growth and pristine credit. Given the significant operating leverage inherent in their business model, analysts have steadily revised their earnings estimates higher.
Atlas Financial (“AFH”), a commercial auto insurer, was the greatest detractor to returns in the Financials sector, with its shares down 49.6% in the quarter. AFH reported several quarters of strong results throughout 2017 before announcing a massive reserve charge for the fourth quarter. While past reserving issues were largely confined to the Michigan market, this development was more broad based. In an attempt to soothe investors, the company made great efforts to explain that part of the reserve was due to a more aggressive claims management strategy designed to resolve claims faster, before they spiral out of control. While management has guided towards solid earnings for 2018, the market will likely keep them in the penalty box for some time.
Industrials was the second highest weighted sector in the strategy at 31.7% and is the greatest overweight compared to the Index at 12.4%. The strategy fell 1.5% in this sector during the period, compared to a loss of 0.9% in the Index. The greatest contributor to performance was Barrett Business Services (“BBSI”), with its shares returning 28.9% in the quarter. BBSI, a leading human resource management and staff leasing provider, rallied after reporting strong fourth quarter earnings and having further resolved previous reserving and filing issues. The company has grown revenues at a solid pace the past several years, and that is expected to continue in 2018 as they steadily win new clients.
Twin Disc (“TWIN”) was the greatest detractor, with its shares down 18.2% during the period. TWIN, a manufacturer of power transmission equipment, traded down during the quarter despite reporting solid earnings in early February. TWIN’s poor performance is likely due to market concerns about potential overheating in the company’s end markets. The Energy sector is a key end market for TWIN, and it was one of the worst performing sectors during the quarter. Despite a choppy recovery, we believe TWIN’s trimmed operating structure affords it greater earnings power during this upswing.
Information Technology was the third highest weighted sector at 21.3%, compared to 8.0% in the Index. The strategy’s holdings in this sector fell 4.9% during the period, compared to a 0.8% gain in the Index. Comtech Telecommunications (“CMTL”) was the greatest contributor to returns in the sector, with the shares returning 35.8% in the quarter. CMTL, a provider of advanced communications solutions, was originally added to the portfolio last year after the company stumbled while integrating a large acquisition and the stock sold off. Since then, many improvements have been made, including several management changes, a restructuring of bank debt with more favorable terms, and the company has announced a steady increase in new multi-year contracts from its clients.
Quantum Corporation (“QTM”) was the greatest detractor to returns in the sector, with the shares down 35.3% in the quarter. QTM, a manufacturer of computer storage devices, sold off in early February when the company cancelled their earnings call and announced that they had received a subpoena from the SEC seeking information on revenue recognition issues dating back to 2016. While we do not have a lot of details at this time, there are a few encouraging signs. QTM’s bank has agreed to relax some of their covenants until the company catches up on its filings, and a new CEO, fully aware of the legal challenges facing the company, joined the firm only a few days after the official start of the inquiry. The CFO also appears to be secure in his position, suggesting that any discrepancies or mistakes in reporting may be minor.
As always, we continue to search for companies that demonstrate an ability to earn a fair return on capital. We welcome any questions or comments you may have and thank you for your continued support.
Pacific Ridge Capital Partners
†Returns are preliminary
Note: Sector weights for the strategy and Index are the average for the period
Pacific Ridge Capital Partners, LLC (“Pacific Ridge”, “PRCP”, or “the Firm”) is a 100% employee owned investment advisor registered with the Securities and Exchange Commission under the Investment Advisors 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®) and has prepared and presented this report in compliance with the GIPS standards. PRCP has been independently verified for the periods June 10, 2010 through December 31, 2017. 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 Micro Cap Value composite has been examined for the periods June 10, 2010 through December 31, 2017. The verification and performance examination reports are available upon request.
The Micro Cap Value composite was created on June 10, 2010. The Micro Cap Value composite comprises fully discretionary portfolios managed by the Firm invested primarily in a concentrated equity portfolio of smaller companies with market capitalizations similar to those found in the Russell Microcap® Index. The strategy ascribes to a disciplined bottom-up fundamental selection process with an emphasis given to the cash flow generating capabilities of a company. The strategy’s objective is to outperform the Russell Microcap®Value Index which is used as our benchmark. Eligible portfolios must be managed for a full calendar month prior to inclusion in the Micro Cap Value composite. Prior to June 10, 2010 the performance represents the track record established by the Portfolio Management Team while affiliated with prior firms. The portability of the prior track record has been reviewed by Ashland Partners & Company LLP. Composite dispersion is measured using an asset weighted standard deviation of returns of the portfolios. Returns and asset values are stated in US dollars.
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.
Sources: Pacific Ridge; FactSet Research Systems (“FactSet”); and Russell Investment Group (“Russell”) who is the source and owner of the Russell Index data.
Returns for the Micro Cap Value composite 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. Net returns are calculated by deducting the highest annual management fee of 1.50% from the quarterly gross composite return. All returns are calculated after the deduction of the actual trading expenses incurred during the period.
The management fee is a flat rate of 1.50%.
The portfolio characteristics, sector weightings and attribution analysis for the Micro Cap Value composite are based on a representative account within the strategy. The representative account statistics are shown as supplemental information. The Firm maintains a complete list and description of composites, policies for valuing portfolios, calculating performance, and preparing compliant presentations which are available upon request by contacting Peter Trumbo, Chief Compliance Officer at (503) 886-8972 or Peter.Trumbo@PacificRidgeCapital.com.
Top 5 and Bottom 5 Performing Securities represent those security holdings that had the largest positive and negative total contribution to the portfolio return. Top 3 and Bottom 3 Economic Sectors represent those sectors that had the largest positive and negative total contribution to the portfolio return.
In order to maintain consistency when comparing the Micro Cap Value strategy to the Russell benchmark, the Firm utilizes FactSet’s outlier methodology calculations which provide a comparable portfolio characteristic calculation methodology as Russell applies to its indices.
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.