Q3'16 Small Cap Value Strategy
The Pacific Ridge Capital Partners (“PRCP”) Small Cap Value strategy rose 11.8% for the third quarter of 2016, ahead of the 8.9% return for the Russell 2000© Value Index (“Index”). Over the trailing one-, three-, and five-year periods, the strategy returned 11.9%*, 6.7%*, and 17.9%* (annualized), respectively, compared to the Index returns of 18.8%, 6.8%, and 15.5%. Since inception on August 1, 2010, the strategy has returned 12.8%* annually versus 11.7% for the Index.
The third quarter began with equity markets continuing their recovery from the sell-off that followed the Brexit vote in late June. The quarter concluded with two of the world’s largest banks facing intense scrutiny, though for different reasons. In Germany, Deutsche Bank (“DB”) has seen its stock price falter amid questions about their capital adequacy and the potential need for a bailout. This concern was amplified upon news reports that some hedge fund clients had begun reducing their cash exposure as the bank worked to secure a multi-billion dollar settlement with the US government relating to improper packaging of mortgage backed securities. Closer to home, Wells Fargo (“WFC”) has been under heavy scrutiny following revelations that pressure from management to meet internal sales targets led to millions of accounts being opened for customers without their authorization. While both banks will likely weather the current storm, they have much work to do on the public relations front. However, just as Brexit faded from the headlines, assuming DB reaches a settlement and WFC makes a few internal changes, we anticipate these news stories will fade as well. With an election looming next month and the Federal Reserve potentially making news in December, investors will quickly shift their focus.
The third quarter experienced the return of a clear size bias, with smaller market cap segments outperforming the larger ones in a linear fashion. In the Russell 2000 Value, stocks with a market cap below $250 million returned 13.9%, while those with a market cap greater than $1 billion returned 8.0%. Not surprisingly, the Russell Microcap© Value outperformed the Russell 2000 Value with returns of 10.8% and 8.9%, respectively. From a sector standpoint, the strategy’s stock selection in Financials and Real Estate contributed over 260 basis points of return versus the Index. However, poor stock selection in Health Care and Technology detracted almost 150 basis points versus the Index. The lack of Utilities exposure in the Small Cap Value strategy produced a performance tailwind, contributing approximately 110 basis points of excess return to the strategy for the quarter. Within the Russell 2000 Value Index, Utilities was the worst performing sector (-4.7%) with a weight of 7.3%.
Industrials remained the highest weighted sector in the strategy at 25.5%, and was the greatest overweight compared to the index at 12.9%. The strategy’s holdings in the sector returned 11.9% in the period, compared to an 11.8% gain in the Index. The greatest contributor to performance in the sector was Acacia Research (“ACTG”), with the shares returning 48.2% in the quarter. ACTG, a licensor and enforcer of technology patents, reported quarterly earnings which were well ahead of estimates as the Company continues its turnaround and looks to expand its intellectual property portfolio. New management has done a good job of cutting expenses, shifting their focus to smaller deals, and maintaining a large cash position.
Textainer Group (“TGH”), a container lessor and logistics company, was the greatest detractor to returns in the Industrials sector, with its shares down 32.6% in the quarter. The container industry has been under significant pressure the past few years, and TGH is no exception. In August, they reported disappointing earnings and also cut their dividend, sending the stock down 20%. While the core operations seem to have flattened, the stock still trades at a sharp discount to tangible book value. We expect that when the industry rebounds to normalized return levels, the stock will increase in value.
Information Technology was the second highest weighted sector in the strategy at 21.8%, and is the second greatest overweight compared to the Index at 10.1%. The strategy’s holdings in this sector increased 12.7% during the period, compared to an 18.1% gain in the Index. Daktronics (“DAKT”), a designer and manufacturer of information display systems, was the greatest contributor to returns in the sector, with shares up 53.7%. Most of that performance occurred in late August when the Company reported earnings that beat expectations, with strong revenues and the highest gross margins in nearly two years. These solid results boosted confidence that management finally has its arms around warranty issues that had plagued profits for several quarters. The easing cost pressure combined with stable demand should lead to an earnings recovery next year.
Super Micro Computer (“SMCI”) was the greatest detractor to returns in the Information Technology sector, with its shares down 6.0% during the period. SMCI, a maker of specialty computer servers for enterprise, data center, and cloud computing applications, preannounced weak earnings that were much lower than the market expected. The stock initially sold off 28%, which was much more than we felt was warranted. As we expected, it subsequently recovered much of that loss over the remainder of the quarter. We are hopeful that fundamentals will improve in the near-term, as management is looking to strike the right balance between revenue growth and margins. SMCI remains one of the largest holdings in the strategy.
Financials was the third highest weighted sector at 21.0%, compared to 27.5% in the Index. The strategy’s holdings in this sector returned 15.0% during the period, compared to a 10.9% gain in the Index. It is important to note that Real Estate is no longer included within the Financials sector. This is the first quarter it has been broken out as a separate sector and its weights and returns are no longer calculated within Financials. BofI Holding (“BOFI”) was the greatest contributor to returns in the sector, with the shares returning 26.5% in the quarter. BOFI is a controversial online “direct bank” with very strong fundamentals and a high level of profitability. We established a position in late 2015 after the stock sold off following a lawsuit filed by a former internal auditor alleging a variety of misdeeds. After reviewing the allegations of the terminated employee, we felt it was unlikely that his claims had merit, as his allegations had previously been investigated and rejected by several regulatory agencies and an outside law firm hired by the company. The stock has rebounded from recent lows after reporting another solid quarter of results and publishing their annual 10-K, indicating no material concerns by their outside auditors. BOFI has also seen numerous legal claims against it dismissed, while they continue with their lawsuit against the disgruntled employee on several grounds. Given the attractive valuation and continued strong fundamental performance, we will continue holding BOFI as it approaches our estimate of fair value.
Hallmark Financial (“HALL”) was the greatest detractor to returns in the Financials sector, with the shares down 11.2% in the quarter. HALL, a specialty property and casualty insurer, has struggled in recent years as alternative capital has flooded into the industry, leading to declines in both pricing and returns. New management has identified several areas of potential improvement in their underwriting which should begin working their way into results in the coming year. With HALL trading at less than book value with a high quality investment portfolio, the downside risk should be limited.
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 perio
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 June 30, 2016. 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 June 30, 2016. 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.