Q1’19 Micro Cap Value Strategy
The Pacific Ridge Capital Partners’ Micro Cap Value strategy rose 11.7%* during the first quarter of 2019, outperforming the 10.4% return of the Russell Microcap® Value Index (“Index”). Over the trailing one-, three- and five-year periods, the strategy returned -6.1%*, 16.0%* and 10.7%* (annualized), respectively, compared to the Index returns of -3.2%, 13.3% and 6.0%. Since inception on April 1, 2007, the strategy has returned 10.4%* annually versus 4.9% for the Index.
As long-term contrarian investors, we don’t concern ourselves with prevailing sentiment in the market, particularly when it is exhibiting erratic behavior or focused on short-term issues. Toward the end of 2018, investors’ appetite for risk fell dramatically and equity markets experienced a sharp sell-off related to concerns over the government shutdown and a trade dispute with China. We noted in our year-end 2018 Strategy Letter that these factors were likely short-term in nature and sentiment was likely to improve. Unsurprisingly, we saw the market stage an impressive rebound, even before the government shutdown was resolved.
Far more important to investors with a longer-term focus is the recent inversion of a portion of the yield curve, a phenomenon that we have spent time assessing. An inverted yield curve has long been a reliable predictor of an ensuing recession (though the actual timing and market impacts can be less certain). So far, only the 3-Month and 1-Year Treasuries have risen above the 10-Year Treasuries, as illustrated in Exhibit 1. While the 1-Year to 10-Year spread does have a better track record of predicting an economic downturn, the 2-Year to 10-Year spread is still 15 basis points from inverting.
It is also worth noting that the credibility of this indicator is enhanced by its duration and magnitude. A brief inversion of a few basis points has less predictive value than a sustained inversion of 10-20 basis points over several weeks. We are already seeing signs that this inversion may be a temporary blip. At the time of this writing, implied odds at the Chicago Mercantile Exchange (CME) suggest a 70% chance that the Fed cuts overnight rates at least once by the end of the year. Such an action would likely require a significant rally in long bonds to see the yield curve remain inverted. Although the current market expansion is approaching a decade in length and we recognize the inevitability of a maturing business cycle, a recession call still seems premature.
First Quarter 2019
The Micro Cap Value strategy outperformed the Russell Microcap Value Index by approximately 130 basis points for the quarter. From a sector standpoint, the strategy’s performance in Industrials and Information Technology contributed approximately 300 basis points of excess return compared to the Index. However, performance in Health Care, Real Estate and Materials detracted approximately 170 basis points versus the Index.
There was a modest size-bias tailwind during the quarter, as smaller companies in the Index outperformed larger ones. Companies with a market cap over $400 million in the Index gained 9.0%, versus 12.2% for companies with a market cap below $400 million. The strategy had 78.5% of its holdings in companies with a market cap below $400 million, compared to 46.0% for the Index.
Solid performance of unprofitable companies provided a modest headwind during the quarter, as those firms in the Index returned 18.2%, compared to a gain of 10.3% for profitable companies. The strategy had just 1.8% of its holdings in unprofitable companies versus 11.2% for the Index.
The Financials sector had the highest weight in the strategy at 39.4%, compared to the Index at 37.7%. The strategy’s holdings in the sector returned 6.3% for the period, compared to a gain of 6.9% in the Index. The greatest contributor to performance was Summit Financial Group, Inc. (“SMMF”), with its shares returning 38.0% during the quarter. SMMF, a community bank operating in West Virginia and northern Virginia, reported better than expected earnings for the quarter, driven by an expanding net interest margin. In addition, SMMF closed a small acquisition that will strengthen its deposit franchise by providing low cost deposits, a much-needed source of capital to continue expanding the company’s loan portfolio. The stock continues to trade at a discount to our estimate of fair value. As it continues to successfully execute its roll-up strategy of banks in its market, we would expect the valuation discount to narrow.
Atlas Financial (“AFH”), a commercial auto insurer, was the greatest detractor to returns in the Financials sector, with its shares down 70.6% for the quarter. AFH reported several quarters of strong results throughout 2018 before announcing a massive reserve charge for the fourth quarter. Past reserving issues were largely confined to the Michigan market however, in recent years, adverse development spread to other geographies. A more aggressive claims management strategy, designed to resolve claims faster, proved incapable of addressing reserve deficiencies. Following the sharp reduction in book value and an uncertain business model going forward, we exited our position during the quarter.
Industrials was the second highest weighted sector in the strategy at 28.1%. It also has the greatest overweight compared to the Index at 11.8%. The strategy’s holdings in the sector returned 17.6% during the period, compared to a gain of 12.3% in the Index. The greatest contributor to performance was DMC Global (“BOOM”), with its shares returning 41.4% during the quarter. BOOM, a manufacturer of oil field service equipment, capped a terrific 2018 with another beat in the fourth quarter and provided a better-than-expected outlook for 2019. Capacity expansions are coming online that will allow the company to fulfill growing demand, particularly for its advanced well perforation systems. Insourcing of certain components and successful patent litigation should also provide significant margin tailwinds this year.
Freightcar America (“RAIL”) was the greatest detractor to returns in the Industrials sector, with its shares down 7.9% for the quarter. RAIL, a manufacturer of various types of railcars, reported a disappointing fourth quarter and 2019 shipments are expected to be down from last year. The company is in the midst of a major restructuring to restore profitability, but the turnaround is likely several quarters away. The balance sheet offers a long runway with approximately 80% of its equity value in cash.
Information Technology was the third highest-weighted sector at 15.5%, compared to 8.1% in the Index. The strategy’s holdings in this sector returned 24.7% during the period, compared to a gain of 16.4% in the Index. PCM Inc. (“PCMI”) was the greatest contributor to returns in the sector, with its shares returning 108.0% for the quarter. PCMI, a vendor of technology solutions, saw its stock rally in the first quarter after reporting strong earnings and solid guidance for 2019. The company has been transitioning their business to higher-margin sales and using cash flow to pay down debt. With margins expanding beyond the historical range, the market is assigning a higher valuation to PCMI.
Quantum Corporation (“QMCO”) was the greatest detractor to returns in the sector, with its shares down 16.0% for the quarter. QMCO, a computer storage and data protection solutions provider, continued to suffer the negative impacts of its aggressive revenue recognition accounting practices. Furthering these concerns was its relatively high level of corporate debt. As a result, Quantum is restating its financials back to 2015. These headaches, in addition to the impeding delisting from the NYSE (which took place on Jan. 16, 2019), caused us to exit our position of Quantum in early January.
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 gross of fees and 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, 2018. 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, 2018. 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.