Q3’18 Micro Cap Value Strategy
The Pacific Ridge Capital Partners’ Micro Cap Value strategy fell 2.0%*during the third quarter of 2018, lagging the -1.3% return of the Russell Microcap®Value Index (“Index”). Over the trailing one-, three- and five-year periods, the strategy returned 10.4%*, 24.4%*and 16.9%*(annualized), respectively, compared to the Index returns of 12.0%, 17.8% and 11.1%. Since inception on April 1, 2007, the strategy has returned 12.3%*annually versus 6.2% for the Index.
Our clients often ask us, “Why has Growth outperformed Value for the past decade?” After all, the opposite has been the norm for many years: Value-style investing outperforms Growth. Countless studies, backed by long-term market data, have borne this out.
While there are many reasons behind this unusual phenomenon (human psychology being one of them), there is no denying that the pendulum has swung in favor of Growth. Just look at the number of unprofitable companies joining our benchmarks over the past five years. This is especially evident in the Russell Microcap Value Index.
Year-to-date, almost 17% of the Russell Microcap Value Index was composed of unprofitable companies, compared to only 8% in 2013. The majority of the increase stems from the Biotech space, an industry we hesitate to label as “Value.” Over the past two years, this shift has provided a notable headwind.
This puts the market at odds with our strategy. (This is not the first time our strategy has been considered out of favor, nor will it be the last). Despite where things are at the present moment, we believe that the market will eventually return to its normative pattern. Consider the mantra that was on the street twenty years ago: “Value Investing is Dead.” When the late 90’s bubble burst and stock prices of unprofitable companies crashed, the tide shifted and vast sums of capital flowed back into Value strategies.
We suspect that in the next market downturn, three things will happen. First, stock prices of these unprofitable companies will likely underperform. Second, the weight of these companies in “Value” benchmarks will revert back down to their historic norms. Finally, the combination of the first two factors will provide our strategies with a notable tailwind and the pendulum of style bias will again swing back towards Value.
Third Quarter 2018
The Micro Cap Value strategy lagged the Russell Microcap Value Index by approximately 70 basis points for the quarter. From a sector standpoint, the strategy’s strong performance in Health Care and Energy contributed approximately 90 basis points of excess return versus the Index. However, poor performance in Financials and Materials detracted approximately 160 basis points versus the Index. The strategy’s lack of exposure to Consumer Staples and Communication Services detracted 50 basis points versus the Index.
There was a modest size bias tailwind during the quarter, as smaller companies in the Index outperformed larger ones. Companies with a market cap over $400 million lost 1.9% versus a loss of 0.1% for companies with a market cap below $400 million. The strategy had 61.5% of its holdings in companies with a market cap below $400 million, compared to 35.5% for the Index.
The Financials sector had the highest weight in the strategy at 33.9%, compared to the Index at 36.6%. The strategy’s holdings in the sector fell 5.2% for the period, compared to a loss of 2.4% in the Index. The greatest contributor to performance was First Bancshares (“FBMS”), with its shares returning 8.8% during the quarter. FBMS, a community bank headquartered in Mississippi, reported strong earnings in July and continues to integrate small acquisitions along their Gulf Coast footprint. We trimmed our position as the stock neared our price target, but a more recent pullback late in the quarter has us standing pat. FBMS continues to be a well-managed bank with strong operating metrics, and we believe it will once again reach our target.
Metropolitan Bank Holding (“MCB”), a New York City-based community bank, was the greatest detractor to returns in the Financials sector, with its shares down 21.6% for the quarter. MCB reported second quarter earnings that were shy of expectations. More significantly, earnings estimates were gradually reduced in the following weeks due to downward pressure on the company’s fee income business. The bank has a prepaid card business that allows users to convert cash into cryptocurrency, with each of these transactions generating a fee. However, the level of activity around cryptocurrencies has declined from earlier this year, as have the number of transactions. We originally added our position when the bank went public late last year and the stock proceeded to go on a significant run in the first few quarters before the recent pullback. Despite the reduced level of fee income, we continue to find the stock attractive at current levels.
Industrials was the second highest weighted sector in the strategy at 29.3% and has the greatest overweight compared to the Index at 12.4%. The strategy’s holdings in the sector fell 1.4% during the period, compared to a loss of 2.1% in the Index. The greatest contributor to performance was P.A.M. Transportation Services (“PTSI”), with its shares returning 38.6% during the quarter. PTSI, a dry van truckload carrier, rallied as strong economic growth led to increased demand for trucking services. This created substantial pricing power and rate increases that offset a shortage of qualified drivers. Favorable market conditions and PTSI’s solid execution led to record high operating income in the last quarter.
Barrett Business Services (“BBSI”) was the greatest detractor to returns in the Industrials sector, with its shares down 30.6% for the quarter. BBSI, a leading human resource management and staff leasing provider, reported disappointing earnings and reduced guidance for revenue growth going forward. Their quarterly results included a small settlement with the SEC that resolved past accounting issues. Management stated that they will no longer chase lower rate workers’ compensation business, reflecting the company’s discipline and long-term focus. Following a substantial sell-off, we view the risk-reward as highly favorable.
Information Technology was the third highest-weighted sector at 20.7%, compared to 7.8% in the Index. The strategy’s holdings in this sector fell 0.1% during the period, compared to a 1.2% gain in the Index. PCM Inc. (“PCMI”) was the greatest contributor to returns in the sector, with the shares returning 29.0% for the quarter. PCMI, a vendor of technology solutions, reported another strong quarter of earnings following a difficult 2017. Their latest beat on expected earnings gave investors additional confidence that PCMI will meet their full year guidance. Record gross margins and strong results in their service business are boosting the company’s market value.
Ultra Clean Holdings (“UCTT”) was the greatest detractor to returns in the sector, with its shares down 24.4% for the quarter. UCTT is a developer and manufacturer of critical subsystems in the semiconductor capital equipment industry. This is a highly cyclical industry and the stock price has suffered in the past year as investors believe UCTT’s key customers are reaching a trough in the cycle. A recently-completed acquisition that diversifies UCTT’s revenue streams should lead to higher margins.
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 June 30, 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 Micro Cap Value composite has been examined for the periods June 10, 2010 through June 30, 2018. 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.