Market Commentary

Each year, at the end of second quarter, the Russell Indexes’ reconstitution takes place. While this activity seems trivial compared to other current events, there were some meaningful changes this year that will impact how investors measure performance of their managers and frame expectations for the coming twelve months. Take the Russell 2000® Value Index (“Index”), for example.

The first notable change pertains to market capitalization. Due to the market decline over the past year, the weighted average market capitalization of the Index decreased from $2.2 billion on June 30, 2019, to $1.9 billion at this year’s reconstitution. The smallest company added to the Index also fell from approximately $150 million last year to nearly $100 million this year.

Second, sector weightings shifted significantly after the reconstitution. Look at the scope of these sector changes.

Technology stocks decreased from approximately 10% to just over 6%. Of all the weight changes made as a result of this year’s reconstitution, this was the largest. It was primarily driven by the Semiconductor Equipment industry’s weight cut from 4.4% to 1.3%--more than half. That decrease was largely dispersed to the Industrial and Financial sectors.
Since February, the Industrials sector has been hit hard with valuation declines. As a result, its weight shifted from 12.5% to nearly 15.3%, with most of the increase reflected in the Capital Goods industry.
Financials grew from 27.3% to 28.5%. The Specialty Finance industry, which contains the Mortgage REITS category, drove this weighting shift.

Additionally, the number of unprofitable companies decreased because many of these firms have appreciated to the point that their price-to-book value ratios pushed them to the Growth indices.

Here is the critical point. The Index structure may have changed, but how we invest did not. We focus on companies that are profitable, that generate cash flow and that trade at discounted valuation multiples. That is the core of our valuation discipline. Additionally, our sector weightings are an indirect outcome of our bottom-up stock selection process. While we closely monitor our sector and industry weightings on a relative basis, ultimately, we are sector indifferent.

We know from experience that benchmark changes like we saw in this recent reconstitution can have an impact on go-forward relative performance. With the steep decline in unprofitable biotech company weights in the Index, a relative performance headwind will be removed if they continue to outperform as a group, or a tailwind will be missed if they underperform and revert to the mean.

Strategy Review

The Pacific Ridge Capital Partners’ Small Cap Value strategy returned 20.9%* during the second quarter of 2020, ahead of the 18.9% return of the Russell 2000® Value Index (“Index”). Over the trailing one-, three- and five-year periods, the strategy returned -19.5%*, -8.3%* and -1.6%* (annualized), respectively, compared to the Index returns of -17.5%, -4.4% and 1.3%. Since inception on August 1, 2010, the strategy returned 7.1%* annually versus 7.1% for the Index.

*Top Contributors and Detractors to Return**

Top Contributors

Patrick Industries (“PATK”), a manufacturer of parts and components for the recreational vehicle industry, staged a massive rebound during the second quarter, following a sharp fall in its stock price during March. Due to recently imposed travel restrictions, interest in RV travel has increased as Americans look for alternative ways to vacation for the summer. A lean inventory position heading into the year provided an additional tailwind to the industry.

Ultra Clean Holdings (“UCTT”) is a developer and manufacturer of critical subsystems in the semiconductor capital equipment industry. The stock recovered much of its March losses during the quarter, given that both current and future outlook for demand remains strong and the pandemic caused minimal supply chain and manufacturing disruption. UCTT was quick to respond to these trends and picked up business from its less-prepared competitors.

Bed Bath & Beyond (“BBBY”), a retailer of domestic merchandise and home furnishings, has been volatile over the past year while new management attempts to execute a turnaround. The company announced a new financing facility during the quarter and rumors stirred about their intention to sell two of their retail concepts: Christmas Tree Shop and Cost Plus World Markets. Strong cash-flow generation has alleviated some prior concerns over the debt on BBBY’s balance sheet.

COHU (“COHU”) is a manufacturer of semiconductor test and inspection handling equipment. The stock was hit particularly hard in the first quarter due to its auto industry exposure and perceived risk from debt on the balance sheet. COHU shares recovered a fair amount in the second quarter, driven by overblown debt concerns and the potential for a strong recovery in mobile handsets, based largely on 5G-related demand.

CRH Medical (“CRHM”) is a provider of anesthesia services to outpatient gastroenterology clinics. The stock fell dramatically during the first quarter as earnings coincided with widespread lockdowns and cancellation of elective procedures. It recovered some of those losses during the second quarter as the quarantine eased and volumes slowly picked up. Because CHRM is a high margin variable cost business, it should be in a good position to weather depressed volumes for the balance of the year.

Top Detractors

Meta Financial Group (“CASH”) is an Iowa-based community bank and financial services firm. The stock originally sold off during the first quarter, along with many other banking firms, because of concerns over recession credit losses. While the rest of the market rebounded following last quarter’s fiscal and monetary stimulus, the response for banks has been more muted. Reserve adequacy and strong underwriting will be critical for banks in the quarters ahead.

Hallmark Financial (“HALL”), a property and casualty insurer based in Texas, traded down slightly during the quarter while the company was behind with their regulatory filings. HALL not only announced a large reserve charge for fiscal 2019, they also changed auditors, leading to delayed reporting of their last two quarterly earnings. This created uncertainty around the potential impact to book value and raised concerns about their new business model.

Like the rest of the banking industry, Midwest One Financial Group (“MOFG”), an Iowa-based community bank, saw their stock fall during the first quarter due to credit concerns. Given our doubts regarding the quality of their underwriting and their credit, we exited our position.

Twin Disc (“TWIN”) is a manufacturer of power transmission equipment. Their stock sold off this year given the high cyclicality of several of the company’s business lines. They also experienced supply chain issues due to COVID-19. In the most recent quarter, downward pressure on energy prices and an increased debt load from a recent acquisition have weighed on shares. TWIN plans to prune their working capital in the near term to help generate cash flow.

Signet Jewelers (“SIG”), a jewelry retailer, was recently added to the strategy during the quarter. The company reported slightly disappointing earnings, while announcing their intention to permanently close many locations. SIG has a modest amount of debt on their balance sheet and generates substantial free cash flow. These factors do not appear to be reflected in their current share price.

*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 tailwind during the quarter as smaller companies in the Index outperformed larger ones. Those with a market cap under $1 billion in the Index returned 27.3%, versus a return of 14.3% for companies with a market cap above $1 billion. The strategy had 82.2% of its holdings in companies with a market cap below $1 billion, compared to 36.9% for the Index.

Style Analysis

There was a significant value-bias tailwind for profitable companies during the quarter, as stocks with lower P/Es outperformed those with higher P/Es. Companies with a P/E ratio between 0 and 15x returned 22.1% during the quarter, versus 11.9% for those with a P/E ratio greater than 15x. The strategy had 75.8% of its holdings in companies with a P/E ratio between 0 and 15x, compared to 50.6% for the Index. A moderate headwind from the strong performance of unprofitable companies slightly offset this value tailwind. Those companies returned 33.9% during the quarter, versus 17.9% for profitable companies. The strategy had 4.5% of its holdings in companies that were unprofitable, compared to 10.5% for the Index.

Economic Sector Analysis

The strategy’s performance in Financials and Real Estate contributed approximately 260 basis points of excess return compared to the Index. However, performance in Consumer Discretionary and Materials detracted approximately 260 basis points versus the Index. The strategy’s lack of exposure to the Utilities and Communication Services sector contributed an additional 190 basis points versus the Index.

Market Outlook

Despite expectations of a very poor second quarter earnings period that captured most shutdowns across the globe, the equity market rallied off the lows set in late March. We remain cautious in the near-term given uncertainties regarding the impact from COVID-19. The US economy is expected to show contraction of 20-30% in 2Q20, and while activity is slowly coming back the shape of the recovery is unclear.

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. Pacific Ridge has been independently verified for the periods June 10, 2010 through December 31, 2019. A firm that claims compliance with the GIPS standards must establish policies and procedures for complying with all the applicable requirements of the GIPS standards. Verification provides assurance on whether the firm’s policies and procedures related to composite and pooled fund maintenance, as well as the calculation, presentation, and distribution of performance, have been designed in compliance with the GIPS standards and have been implemented on a firm-wide basis. The Small Cap Value Composite has had a performance examination for the periods June 10, 2010 through December 31, 2019. The verification and performance examination reports are available upon request.

The Small Cap Value composite was created and incepted 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 gross returns of the portfolios included for the entire year. 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. Performance-based fees are available upon request. All returns are calculated after the deduction of the actual trading expenses incurred during the period. The management fee schedule and total expense ratio for the Small Cap Value Fund, which is included in the composite, are 1.00% on all assets and 1.08%, respectively, as of the most recent audit. Total fees for the fund may not exceed 1.25% annually.

The fee schedule for separately managed accounts 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 and pooled funds, policies for valuing portfolios, calculating performance, and preparing GIPS Reports which are available upon request by contacting Peter Trumbo, Chief Compliance Officer at (503) 886-8972 or Peter.Trumbo@PacificRidgeCapital.com.

GIPS® is a registered trademark of CFA Institute. CFA Institute does not endorse or promote this organization, nor does it warrant the accuracy or quality of the content contained herein.

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.

Q2'20 Small Cap Value Strategy

Q2’20 Small Cap Value Strategy