Q3'17 Micro Cap Value Strategy
The Pacific Ridge Capital Partners (“PRCP”) Micro Cap Value strategy rose 7.7%* in the third quarter of 2017, ahead of the 6.4% return for the Russell Microcap® Value Index (“Index”). Over the trailing one-, three-, and five-year periods, the strategy returned 38.3%*, 21.0%* and 22.6%* (annualized), respectively, compared to the Index returns of 26.2%, 13.3%, and 14.5%. Since inception on April 1, 2007, the strategy has returned 12.5%* annually versus 5.7% for the Index.
With the economic recovery now in its eighth year, the Federal Reserve has taken a cautious approach to raising rates and unwinding its sizable balance sheet. After a period of sluggish growth in the first quarter, the economy seems to have rebounded back to a more normalized rate of expansion. Despite this, recent comments from Janet Yellen noted that inflation has not been trending as high as initially thought, suggesting a slower pace to additional rate hikes.
The impact to the financial system from the Fed allowing assets to roll off their balance sheet is even more uncertain. Over the eight-year period of quantitative easing, approximately $2 trillion in deposits were added to the banking system. Competition for deposits in the banking industry could become more intense with the gradual reversal of quantitative easing. This additional pressure on funding costs could lead to higher borrowing rates and downward pressure on the economy as banks look to maintain an adequate margin. Given this dynamic, investors may want to keep a watchful eye on the banking industry to again provide the first early clues to the next downturn in the economy.
Third Quarter 2017
For the quarter, the Micro Cap Value strategy delivered approximately 130 basis points of excess return versus the Russell Microcap Value Index. Although the strategy outperformed its benchmark, there was little discernible effect due to size bias. In the Russell Microcap Value, stocks with a market cap below $200 million and above $800 million returned 8.2%, while those with a market cap between $200 million and $800 million returned 5.9%. On a P/E basis, stocks in the benchmark with a P/E less than zero returned 11.7%, versus 5.3% for those with a P/E greater than zero. This provided a 70-basis point headwind to the strategy, as we had 5.4% of our holdings in unprofitable companies versus 19.3% for the benchmark.
From a sector standpoint, the strategy’s strong performance in Industrials and Materials contributed approximately 480 basis points of excess return versus the Index. However, poor performance in Health Care and Information Technology detracted about 390 basis points versus the Index. The strategy’s lack of exposure to Real Estate, Telecommunications, and Utilities created a minor tailwind and contributed 20 basis points versus the Index.
Industrials remained the highest weighted sector in the strategy at 32.3% and is the greatest overweight compared to the Index at 12.3%. The strategy’s holdings in the sector returned 15.8% in the period, compared to a return of 5.7% in the Index. The greatest contributor to performance was Columbus McKinnon (“CMCO”), with its shares returning 49.2% in the quarter. CMCO, a maker of hoists, cranes and other material handling equipment, reported earnings in July that beat estimates with better than expected organic growth. The company’s end markets tend to closely follow capacity utilization, and a recovery from the recent trough in the energy industry has begun to materialize. The recent acquisitions of STAHL and Magnetek have also had a positive impact on results.
BG Staffing (“BGSF”), a provider of temporary staffing services, was the greatest detractor to returns in the Industrials sector, with its shares down 3.4% in the quarter. BGSF reported earnings that included a decline in organic revenue due to weakness in their commercial segment. Recent acquisitions provided some growth and slightly improved gross margins. A return to sustained growth is expected in the near-term, along with a significant increase in forecasted earnings in 2018.
Financials was the second highest weighted sector in the strategy at 27.0% and had the greatest underweight compared to the Index at 37.1%. The strategy’s holdings in this sector increased 6.2% during the period, compared to a return of 5.6% in the Index. Northeast Bancorp (“NBN”), a community bank operating in Southwest Maine, was the greatest contributor to returns in the sector, with its shares up 28.6%. NBN’s unique business model utilizes funding from their community bank franchise to purchase commercial real estate loans at a discount to par. The stock was added to the strategy earlier this year and has performed well thanks to earnings that have exceeded estimates by a wide margin.
Meta Financial (“CASH”) was the greatest detractor, with its shares down 11.7% during the period. CASH, an Iowa-based community bank and financial services firm, saw their stock fall after it was announced that a key relationship in their tax refund segment was lost to a competitor. CASH has already made up for some of this lost business by signing expanded agreements with other firms involved in tax preparation. In a rising rate environment, CASH’s low-cost deposit base makes them an attractive acquisition target.
Information Technology was the third highest weighted sector at 26.2%, compared to 8.7% in the Index. The strategy’s holdings in this sector returned 1.7% during the period, compared to 5.9% gain in the Index. Ultra Clean Holdings (“UCTT”) was the greatest contributor to returns in the sector, with the shares returning 63.3% in the quarter. UCTT, a developer and manufacturer of critical subsystems in the semiconductor capital equipment industry, beat estimates and raised guidance for the remainder of the year. The company continues to ride a wave of success from its top two customers in its legacy gas panel business, as well as growing their Organic Light-Emitting Diode (OLED) components segment.
RadiSys Corporation (“RSYS”) was the greatest detractor to returns in the Information Technology sector, with shares down 63.6% in the quarter. RSYS, a maker of hardware and software solutions for the wireless telecom industry, sold off following an earnings miss and issued lower guidance for the remainder of the year. A pause in purchasing from a key customer was the primary culprit, and promising new developments in one of their smaller business lines are still in the early stages. Increased clarity into the run-rate of the business in the first quarter of 2018 should provide a tailwind to the stock.
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 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 June 30, 2017. 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 June 30, 2017. 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.