The Pacific Ridge Capital Partners’ Small Cap Value strategy fell 2.0%* for the third quarter of 2018, lagging the 1.6% gain in the Russell 2000®Value Index (“Index”). Over the trailing one-, three- and five-year periods, the strategy returned 5.7%*, 13.9%*and 9.9%*(annualized), respectively, compared to the Index returns of 9.3%, 16.1% and 9.9%. Since inception on August 1, 2010, the strategy has returned 13.3%*annually versus 12.4% 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, which overlaps significantly with our Small Cap Value strategy. (Remember: Our focus is on the bottom 75% of the Russell 2000 universe ranked by market capitalization). 

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 Small Cap Value strategy trailed the Russell 2000 Value Index by approximately 360 basis pointsfor the quarter. There was a significant size bias in the Index, with larger companies outperforming smaller ones. Companies with a market cap greater than $1 billion rose 2.5% during the quarter, while those with a market cap less than $1 billion fell 1.4%. This size bias provided a 170 basis point headwind to the strategy, given its significant overweight with smaller companies relative to the Index. Companies with market caps over $1 billion comprised 78.1% of the Index, compared to just 28.5% for the strategy. 

From a sector standpoint, the strategy’s performance in Energy, Real Estate and Health Care contributed approximately 130 basis points of excess return versus the Index. However, poor performance in Financials and Industrials detracted almost 420 basis points versus the Index. Similar to previous quarters, higher beta stocks performed better in the Index, though the impact on returns was negligible given similar weights for both the strategy and the Index by beta quintile.  

Industrials remained the highest weighted sector in the strategy at 29.2% and had the greatest overweight compared to the Index at 12.7%. The strategy’s holdings in the sector fell 3.5% for the period, compared to a return of 6.1% in the Index. The greatest contributor to performance was Comfort Systems (“FIX”), with its shares returning 23.3% for the quarter. FIX, a provider of HVAC installation, maintenance and repair services, reported a solid quarter of sales and growth in their backlog, driven by a strong economy. FIX is a well-run company and has benefited from steadily rising margins, thanks to increased demand from both commercial and residential customers. The company continues to have a solid balance sheet and strong free cash flow generation. 

composite.jpg
 

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. 

Financials was the second highest weighted sector in the strategy at 26.2%, compared to the Index at 28.5%. The strategy’s holdings in the sector fell 7.6% during the period, compared to a gain of 0.7% in the Index. Hallmark Financial Services (“HALL”) was the greatest contributor, with its shares returning 10.2% for the quarter. HALL, a property and casualty insurer, reported earnings ahead of expectations and a combined ratio that is trending in the right direction. Actions by management suggest that the recent history of unfavorable development may be abating, potentially leading to a sustained period of higher profitability. The stock remains attractively valued at only 70% of book value. 

Maiden Holdings (“MHLD”) was the greatest detractor to returns in the Financials sector, with shares down 49.0% for the quarter. MHLD, a Bermuda based reinsurer, announced additional reserve adjustments during the quarter, along with the retirement of the CEO and CFO. The company’s problems stem from issues that arose at its quota-share partner AmTrust (“AFSI”)—problems that have persisted much longer than anticipated. The impact to book value has increased concerns about a potential capital deficiency. In light of these concerns and lack of clarity around future reserve development, we exited our position during the quarter. 

Information Technology was the third highest weighted sector in the strategy at 21.1% and had the second greatest overweight compared to the Index at 10.2%. The strategy’s holdings in this sector rose 0.4% during the period, compared to a gain of 0.3% in the Index. Photronics (“PLAB”) was the greatest contributor to returns in the sector, with the shares returning 23.5% for the quarter. PLAB, a maker of photomasks used in the production of semiconductors and flat panel displays, recently reported strong quarterly results and forward guidance. Strong unit demand for semiconductors and the adoption of organic light-emitting diode (OLED) displays in smartphones have driven strong performance. Additionally, investors are beginning to see the potential returns in 2019 and beyond from big capital investments the company has made in China over the past couple years.

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.

Sincerely,

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

NN, Inc. (“NNBR”) was the greatest detractor to returns in the Industrials sector, with its shares down 21.0% for the quarter. NNBR, a maker of high precision industrial, medical, and auto components, is undergoing a multi-year business transformation. They have made several acquisitions into higher-growth end markets that have less cyclicality. The stock has been pressured this year as results have been impacted by acquisition costs and up-front investments for new programs. If management can successfully execute their plan and decrease leverage, there should be significant upside to the stock price. 

Financials was the second highest weighted sector in the strategy at 26.7%, compared to the Index at 30.7%. It returned 2.0% during the period, compared to a gain of 4.4% in the Index. Maiden Holdings (“MHLD”) was the greatest contributor, with the shares returning 21.5% for the quarter. MHLD, a Bermuda based reinsurer, rebounded from its lows that were set last quarter following their report of additional reserve development. Despite the solid return for the quarter, the market remains skeptical about MHLD’s reserve adequacy. More than likely, the stock will continue to trade at a discount until they can report several periods free from any new adverse developments. 

ConnectOne Bancorp (“CNOB”) was the greatest detractor to returns in the Financials sector, with shares down 13.3% for the quarter. CNOB, a NJ-based community bank, reported first quarter earnings that were slightly short of estimates. The company continues to recognize write-downs on their taxi medallion portfolio, and intense competition in their markets has led to a lower-than-anticipated net interest margin. However, the bank remains highly efficient and profitable, with strong double-digit loan growth. Despite the recent headwinds, we believe CNOB is one of the more attractive banks in our strategy.  

Information Technology was the third highest weighted sector in the strategy at 20.9% and had the second greatest overweight compared to the Index at 8.2%. The strategy’s holdings in this sector rose 16.1% during the period, compared to a gain of 7.0% in the Index. Super Micro Computer (“SMCI”) was the greatest contributor to returns in the sector, with the shares returning 39.1% for the quarter. SMCI, a maker of specialized application-specific server solutions, bounced back with strong earnings after a disappointing report earlier this the year. The company announced a new debt facility that helped assuage investor concerns while they catch up on their delinquent regulatory filings. Strong revenue growth on the back of difficult comps also bolstered confidence that the worst may soon be behind SMCI. 

Intevac (“IVAC”) was the greatest detractor to returns in the sector, with the shares down 29.7% for the quarter. IVAC, a manufacturer of thin film deposition used in the manufacture of hard disk drives, reported earnings that met estimates, but lowered guidance for the remainder of the year. While sales were originally expected to grow by ten percent, current guidance now calls for an 11% decline. Much of the weakness in guidance appears to be the result of delayed orders, rather than lost market opportunities or softening demand. 

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

 *Returns are gross of fees and are preliminary

Note:  Sector weights for the strategy and Index are the average for the period

quad.jpg
gips.jpg
 

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. 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 Small Cap Value composite has been examined for the periods August 1, 2010 through June 30, 2018. 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.