Q3'17 Small Cap Value Strategy
The Pacific Ridge Capital Partners (“PRCP”) Small Cap Value strategy rose 2.9%* in the third quarter of 2017, behind the 5.1% return for the Russell 2000® Value Index (“Index”). Over the trailing one-, three-, and five-year periods, the strategy returned 25.0%*, 11.8%* and 15.7%* (annualized), respectively, compared to the Index returns of 20.6%, 12.1%, and 13.3%. Since inception on August 1, 2010, the strategy has returned 14.5%* annually versus 12.9% 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 Small Cap Value strategy lagged the Russell 2000 Value Index by approximately 220 basis points. In the Index, those stocks with a market cap less than $1 billion returned 5.8% during the quarter, while those with a market cap greater than $1 billion returned 4.9%. This small size bias provided a slight tailwind to the strategy, given that companies with market caps under $1 billion comprised 67.8% of its weight, compared to 27.9% for the Index. However, poor stock selection caused the strategy to underperform, with its sub-$500 million holdings falling 4.8% during the period. Strong stock selection from holdings with market caps between $500 million and $1 billion helped offset some, but not all, of the smaller stock underperformance. Those stocks with market caps between $500 million and $1 billion returned 8.5% in the strategy.
From a sector standpoint, the strategy’s performance in Industrials and Energy contributed nearly 110 basis points of excess return versus the Index. However, poor performance in Health Care, Financials, and Consumer Discretionary detracted over 310 basis points versus the Index. Our large overweight position in the Industrials sector contributed approximately 60 basis points of excess return versus the Index.
Industrials remained the highest weighted sector in the strategy at 31.0% and had the greatest overweight compared to the Index at 12.4%. The strategy’s holdings in the sector returned 8.3% in the period, compared to an 8.0% gain 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.
Sykes Enterprises (“SYKE”) was the greatest detractor to returns in the Industrials sector, with its shares down 13.0% in the quarter. SYKE, a provider of outsourced customer-support services, saw its stock price slide early in the quarter when they lowered guidance in the second half due to reduced revenue expectations from a key telecom client. Management is currently reducing their capacity to preserve profitability. That said, the company has a strong balance sheet and will look to replace lost business through acquisition or a sizable new client.
Information Technology was the second highest weighted sector in the strategy at 23.3%, compared to 8.4% in the Index. The strategy’s holdings in this sector returned 3.2% during the period, compared to a gain of 2.4% 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.
Financials was the third highest weighted sector in the strategy at 22.6%, and had the second greatest underweight compared to the Index at 30.5%. The strategy’s performance in this sector returned 1.6% during the period, compared to a gain of 5.2% in the Index. BofI Holding (“BOFI”) was the greatest contributor to returns in the sector, with the shares returning 20.0% in the quarter. BOFI, an internet bank based in San Diego, CA, has been a volatile and controversial holding over the past two years as they have battled attacks from short-sellers and a lawsuit from a former employee. The stock has performed well and the company continues to grow their loan book at a steady pace with minimal credit issues.
PRA Group (“PRAA”) was the greatest detractor to returns in the sector, with the shares down 24.4% in the quarter. PRAA, an acquirer and collector of charged-off consumer debt, sold off following disappointing quarterly results. This suggests the recovery in pricing and collection of receivable debt is not proceeding as quickly as PRAA had hoped. Several one-time items, including a higher tax rate, legal expense and debt issuance costs, further clouded the results during the quarter. While the company is stepping up its pace of purchasing receivables, they will need to spend several quarters staffing up their operations before they can once again maximize their revenue potential.
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 Small Cap Value composite has been examined for the periods August 1, 2010 through June 30, 2017. 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.