Q2'18 Small Cap Value Strategy
The Pacific Ridge Capital Partners’ Small Cap Value strategy rose 7.2%* for the second quarter of 2018, lagging the 8.3% gain in the Russell 2000® Value Index (“Index”). Over the trailing one-, three- and five-year periods, the strategy returned 11.0%*, 10.0%* and 12.1%* (annualized), respectively, compared to the Index returns of 13.1%, 11.2% and 11.2%. Since inception on August 1, 2010, the strategy has returned 14.1%* annually versus 12.6% for the Index.
Following seven rate increases by the Federal Reserve, the spread between long- and short-term interest rates has tightened considerably. Some commentators are pointing to the flattening yield curve as an indicator that economic growth may stagnate. While an inverted yield curve has preceded the last nine recessions, the timing and relationship to equity market movement is less precise. For example, in 1988, 1998, and 2006, the market rallied another 33%, 40%, and 22%, respectively, after the yield curve had already inverted. While the curve flattening gives us some concern over the intermediate- to long-term, nearly all other key indicators suggest strong economic growth in the near-term.
One of the key measures we continue to monitor is wage inflation. While the unemployment rate is near cyclical lows, meaningful wage growth has not materialized. In conversations with management teams, we hear of increasing signs of labor shortages. One CEO in the lodging industry stated that new employees are so difficult to find that he can no longer drug test applicants. “If you can fog a mirror with your breath,” he observed somewhat sardonically, “you can get a job.” This should, in theory, lead to increased wage inflation and pressure for additional rate increases. If the long-end of the yield curve remains low, it seems an inversion is a very real possibility at some point in the next year. While such a development would be disappointing, it is important to remember that the lag effect in the economy and markets can be as much as two years. A lot can happen in that time.
Second Quarter 2018
The Small Cap Value strategy trailed the Russell 2000 Value Index by approximately 110 basis points for the quarter. There was a modest size bias in the Index, with smaller companies outperforming larger ones. Companies with a market cap less than $1 billion rose 10.8% during the quarter, while those with a market cap greater than $1 billion rose 7.5%. This small size bias provided a slight tailwind to the strategy, given that the strategy is significantly overweight with smaller companies relative to the Index. Companies with market caps over $1 billion comprised 74.7% of the Index, compared to just25.9% for the strategy. On another note, the performance of unprofitable companies in the benchmark acted as a headwind, as these companies returned 16.4% during the quarter and accounted for 8.8% of the weight in the benchmark, versus only 1.6% in the strategy.
From a sector standpoint, the strategy’s performance in Information Technology contributed approximately 160 basis points of excess return versus the Index. However, poor performance in Consumer Discretionary and Financials detracted almost 180 basis points versus the Index. Similar to the prior quarter, higher beta stocks performed better in the Index, though the impact on returns was negligible given similar weights for both the strategy and the Index by beta quintile.
Industrials remained the highest weighted sector in the strategy at 28.5% and had the greatest overweight compared to the Index at 13.2%. The strategy’s holdings in the sector returned 6.9% for the period, compared to a return of 5.6% in the Index. The greatest contributor to performance was Barrett Business Services (“BBSI”), with its shares returning 16.9% for the quarter. BBSI, a leading human resource management and staff leasing provider, continued its strong performance from the first quarter with an apparent full recovery from prior reserving and accounting issues. With solid revenue growth over the past several years, we expect the company to continue expanding in 2018 as it steadily wins new clients.
NN, Inc. (“NNBR”) was the greatest detractor to returns in the Industrials sector, with its shares down 21.0% for the quarter. NNBR, a maker of high precision industrial, medical, and auto components, is undergoing a multi-year business transformation. They have made several acquisitions into higher-growth end markets that have less cyclicality. The stock has been pressured this year as results have been impacted by acquisition costs and up-front investments for new programs. If management can successfully execute their plan and decrease leverage, there should be significant upside to the stock price.
Financials was the second highest weighted sector in the strategy at 26.7%, compared to the Index at 30.7%. It returned 2.0% during the period, compared to a gain of 4.4% in the Index. Maiden Holdings (“MHLD”) was the greatest contributor, with the shares returning 21.5% for the quarter. MHLD, a Bermuda based reinsurer, rebounded from its lows that were set last quarter following their report of additional reserve development. Despite the solid return for the quarter, the market remains skeptical about MHLD’s reserve adequacy. More than likely, the stock will continue to trade at a discount until they can report several periods free from any new adverse developments.
ConnectOne Bancorp (“CNOB”) was the greatest detractor to returns in the Financials sector, with shares down 13.3% for the quarter. CNOB, a NJ-based community bank, reported first quarter earnings that were slightly short of estimates. The company continues to recognize write-downs on their taxi medallion portfolio, and intense competition in their markets has led to a lower-than-anticipated net interest margin. However, the bank remains highly efficient and profitable, with strong double-digit loan growth. Despite the recent headwinds, we believe CNOB is one of the more attractive banks in our strategy.
Information Technology was the third highest weighted sector in the strategy at 20.9% and had the second greatest overweight compared to the Index at 8.2%. The strategy’s holdings in this sector rose 16.1% during the period, compared to a gain of 7.0% in the Index. Super Micro Computer (“SMCI”) was the greatest contributor to returns in the sector, with the shares returning 39.1% for the quarter. SMCI, a maker of specialized application-specific server solutions, bounced back with strong earnings after a disappointing report earlier this the year. The company announced a new debt facility that helped assuage investor concerns while they catch up on their delinquent regulatory filings. Strong revenue growth on the back of difficult comps also bolstered confidence that the worst may soon be behind SMCI.
Intevac (“IVAC”) was the greatest detractor to returns in the sector, with the shares down 29.7% for the quarter. IVAC, a manufacturer of thin film deposition used in the manufacture of hard disk drives, reported earnings that met estimates, but lowered guidance for the remainder of the year. While sales were originally expected to grow by ten percent, current guidance now calls for an 11% decline. Much of the weakness in guidance appears to be the result of delayed orders, rather than lost market opportunities or softening demand.
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 March 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 Small Cap Value composite has been examined for the periods August 1, 2010 through March 31, 2018. 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.
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 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.