Market Commentary

At Pacific Ridge Capital Partners, we are always on the lookout for the next best opportunity to add to our portfolios. We do this on a “bottom-up” basis, sifting through the entire universe of small and micro cap companies in our hunt for great values and through the lens of being long-term owners and investors in quality businesses.

We know from experience that companies trade at a discount to fair value for one of four reasons:

1) They are neglected by Wall Street

2) They are oversold, often because of a market overreaction

3) They are in an earnings turnaround situation

4) There is an overarching theme or condition that is impacting a group of stocks

The COVID-19 pandemic has depressed markets, crashed stock prices and brought strong companies with stable operations to a complete standstill. These events have created a plethora of “oversold” companies, placing them directly into our sphere of contrarian investing.  We relish the opportunity to add great companies to our strategies at discounted valuations. While we are spending our time during this crisis evaluating potential new holdings, we are also finding that the pool of companies we already own continue to be excellent long-term investments.

Incremental changes to revenue and margin remain central to our investment management model. Given the impact brought by the COVID-19 pandemic, we have widened that model to include new factors such as the extent of cash burn for impacted companies, the degree of credit impairments for banks and REITs, the impact of disruptions to the global supply chain and clarity around near-term earnings. Based on this expanded model, we have made a few minor modifications to our portfolios to ensure the continued resiliency of our strategies.

In times like these, we know the best thing to do is to stay true to our investment philosophy and our process. As investors in value stocks within the small and micro cap space, we will continue to focus on investing in companies with strong balance sheets and free cash flow.

Strategy Review

The Pacific Ridge Capital Partners’ Small Cap Value strategy returned -42.0%* during the first quarter of 2020, trailing the -35.7% return of the Russell 2000® Value Index (“Index”). Over the trailing one-, three- and five-year periods, the strategy returned -31.9%*, -13.8%* and -4.9%* (annualized), respectively, compared to the Index returns of -29.6%, -9.5% and -2.4%. Since inception on August 1, 2010, the strategy returned 5.2%* annually versus 5.4% for the Index.

Top Contributors

NETGEAR (“NTGR”) is a designer and manufacturer of computer networking equipment. It is holding up well in the current environment, given that demand for their products is likely to accelerate with the recent work-at-home transition. Though its stock price experienced a steady decline from the upper-20s to the mid-teens post-fourth quarter earnings, it has since recovered to the low-20s. Also, despite an earnings decline over the past few years, the recent surge in demand should provide an earnings tailwind through the remainder of the year. 

Ribbon Communications (“RBBN”) is a manufacturer of networking and security solutions for voice service providers and large enterprises. RBBN managed to tread water amid the recent selloff in the market. Their stock price was cut in half during the fourth quarter following the departure of their CEO and a large acquisition that many shareholders view negatively. We believe this acquisition will provide RBBN with a higher growth business segment that should help drive earnings.

PC Connection (“CNXN”), a provider of IT products and services, has seen their stock price avoid the broad market decline, which is notable given the security’s sell-off following an earnings miss early in the quarter. As a retailer of software and computer hardware, demand for CNXN products should also benefit from the work-at-home transition.

CareTrust REIT (“CTRE”) is an operator of independent living, memory care, assisted living and skilled nursing facilities. The stock fell to multi-year lows for a short period of time during the quarter due to concerns that the operations and demand for nursing facilities would be negatively impacted by the spread of COVID-19. It has since strongly rebounded as this tends to be a fairly stable business with a predictable level of cash flow.

Zovio (“ZVO”) is a for-profit education company that also operates Ashford University. ZVO’s stock price has been volatile over the past few years as it attempts to spin off Ashford University to operate as an online-only program. Unfavorable enrollment trends have also impacted performance, an issue that management has struggled to resolve. Should ZVO successfully address these challenges, the stock has the potential to move substantially higher.

Top Detractors

CRH Medical (“CRHM”) is a provider of anesthesia services to outpatient gastroenterology clinics. The stock initially sold off during the  quarter following an earnings report that reflected a lower than expected revenue-per-case level. This was caused by a shift of out-of-network providers to in-network facilities that billed at lower rates. The sell-off was also aggravated by the broad cancellation of elective medical procedures, a trend that will pressure volumes for the foreseeable future. However, with large profit margins, CRHM should be able to generate positive cash flow at a reduced level of activity once clinics partially reopen.

Hallmark Financial (“HALL”), a property and casualty insurer based in Texas, sold off late in the quarter after reporting an adverse development charge related to their commercial auto book. This came as a surprise after new management had spent several years turning around the business and cleaning up the underwriting portfolio—efforts that helped drive the stock price to all-time highs in 2019. HALL also delayed releasing their fourth quarter earnings due to a change in their auditing firm.

Great Ajax (“AJX”), a mortgage REIT, saw its stock decline sharply late in the quarter over credit and liquidity concerns related to the COVID-19 crisis. This trend was consistent with the rest of the REIT industry. Subsequent to quarter end, AJX raised additional capital from private investors to enhance their liquidity and facilitate opportunities to purchase discounted mortgages. 

Customers Bancorp (“CUBI”), a Pennsylvania-based community bank, fell during the quarter because of credit concerns. With a smaller capital cushion compared to other banks, management’s ability to navigate the pandemic crisis will be very important to avoid dilution of book value—a concern that the market may already be pricing in.

Bed Bath & Beyond (“BBBY”), a retailer of domestic merchandise and home furnishings, has been volatile over the past year as new management attempts to execute a turnaround. In addition to replacing several senior executives, BBBY has reduced the number of in-store items, cut inventory and sold ancillary businesses. Their ability to minimize costs in the near-term will be critical to maximizing their long-term value.   

*Past performance does not guarantee future results. The holdings identified do not represent all the securities purchased, sold or recommended to clients. Top contributors and detractors to return represent those securities that had the largest positive and negative total contribution to the overall portfolio return for the quarter.  A complete list of contributors to portfolio return can be obtained by contacting Peter Trumbo, Chief Compliance Officer, at 503-886-8972 or by email at Peter.Trumbo@PacificRidgeCapital.com. For additional information, see the related GIPS® compliant presentation on the last page.

Market Capitalization Analysis

There was a significant size bias headwind during the quarter as larger companies in the Index outperformed smaller companies. Those with a market cap under $1 billion in the Index returned -39.4%, versus a return of -34.5% for companies with a market cap above $1 billion. The strategy had 71.6% of its holdings in companies with a market cap below $1 billion, compared to 23.1% for the Index.

Style Analysis

There was a significant value-bias headwind during the quarter, as stocks with higher P/Es outperformed those with lower P/Es. Companies with a P/E ratio greater than 15x returned –28.8% during the quarter, versus -42.8% for those companies with a P/E ratio between 0 and 15x. The strategy had 61.8% of its holdings in companies with a P/E ratio between 0 and 15x, compared to 42.0% for the Index.

Economic Sector Analysis

The strategy’s performance in Energy and Materials contributed approximately 80 basis points of excess return compared to the Index. However, performance in Financials, Industrials and Health Care detracted approximately 510 basis points versus the Index. The strategy’s lack of exposure to the Utilities sector detracted an additional 140 basis points versus the Index.

Market Outlook

COVID-19 has reshaped daily life around the world. At some point, normalcy will return, but when that will happen is highly uncertain. In the near-term, much of the US economy is paralyzed and second quarter 2020 GDP will likely show significant contraction that could linger into the third quarter and the balance of the year. As we gain control of the virus and stability in returns, we believe the economy will climb out of this recession and begin a healthy multi-year recovery.

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.

 Sincerely,

Pacific Ridge Capital Partners

Investment Team Additional Professionals
Mark Cooper, CFA® Co-Senior Portfolio Manager Peter Trumbo Chief Operating/Compliance Officer
Dominic Marshall, CFA® Co-Senior Portfolio Manager Mike McDougall Senior Trader
Ryan Curdy, CFA® Portfolio Manager Tammy Wood Director, Marketing & Business Development
Justin McKillip, CFA® Senior Analyst Veronica Orazio Operations Assistant
Adam Boyce, CFA® Senior Analyst

Regulatory Disclosures

The contributors and detractors to return, market capitalization weightings and total effect, economic sector weightings and total effect, portfolio characteristics, and top ten holdings for the Small Cap Value Composite are based on a representative account within the strategy. The representative account statistics are shown as supplemental information and complement the composite's GIPS® disclosure presentation as provided on the last page. 

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. 

In order to maintain consistency when comparing the Small 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.

Disclosures                                                                                             

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 September 30, 2019. 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 Small Cap Value composite has been examined for the periods August 1, 2010 through September 30, 2019. The verification and performance examination reports are available upon request.

The Small Cap Value composite was created on August 1, 2010. The Small Cap Value composite comprises fully discretionary portfolios managed by the Firm invested primarily in an equity portfolio of small companies with market capitalizations similar to those found in the bottom three-quarters of the Russell 2000® 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 2000® Value Index which is used as our benchmark. Eligible portfolios must be managed for a full calendar month prior to inclusion in the Small Cap Value composite. 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 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.

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 Small 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 1.00% 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 1.00%.

The portfolio characteristics, sector weightings and attribution analysis for the Small 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.