Q4'17 Micro Cap Value Strategy
The Pacific Ridge Capital Partners (“PRCP”) Micro Cap Value strategy rose 3.6%* in the fourth quarter of 2017, ahead of the 2.4% return for the Russell Microcap® Value Index (“Index”). Over the trailing one-, three-, and five-year periods, the strategy returned 22.0%*, 19.2%* and 22.5%* (annualized), respectively, compared to the Index returns of 11.1%, 10.7%, and 14.6%. Since inception on April 1, 2007, the strategy has returned 12.6%* annually versus 5.8% for the Index.
The equity markets completed another strong year, with most indices hitting all-time highs. Key macro indicators continue to suggest a broad-based strength in the overall economy. The recently-passed tax reform legislation will likely provide a modest tailwind to stock prices early in the year. The market may also see valuations reset as earnings estimates adjust to lower corporate tax rates.
This barrage of positive news has led to a lot of enthusiasm in the capital markets, and a speculative mania in a new industry has us recalling similar events from approximately twenty years ago. The decade of the 1990’s saw the world fundamentally change as internet connectivity became widespread. New businesses and industries were created almost overnight. This naturally led to excessive speculation and skyrocketing stock prices for those with exposure to this exciting new industry. A company need only announce they were adding “.com” to their name or publicize that they had plans to sell their products online and their stock price would instantly soar. It became apparent that some stock price movements were based more on the “Greater Fool Theory” than the potential for future economic profits. With cryptocurrencies, we see a similar dynamic at play.
Over the past few months, we have observed digital currencies skyrocketing in value. In fact, some of these cryptocurrencies are worth more in total value than Citigroup, a highly profitable global bank. Companies looking for a short-term boost to their stock price need only announce a modest affiliation or investment in cryptocurrency to see their stock price soar. The most recent example of this is Eastman Kodak, whose stock price tripled after announcing their own digital currency for photographers. Similarly, Long Island Iced Tea, a publicly traded company, saw its stock price triple after changing its name to Long Blockchain.
At some point, common sense will return and this mania will end. Regardless of when this inevitably occurs, we will continue to adhere to our time-tested strategy of investing in attractively valued companies that generate cash-flow and are overlooked by the rest of the market. This strategy served us well through the dot-com bubble and we are confident that it will continue to do so in this current environment, and in any future manias.
Fourth Quarter 2017
The Micro Cap Value strategy delivered approximately 120 basis points of excess return versus the Russell Microcap Value Index for the quarter. The strategy experienced a modest benefit due to size bias as smaller market cap segments outperformed larger ones. In the Russell Microcap Value Index, stocks with a market cap below $600 million returned 3.1%, while those with a market cap above $600 million returned 1.3%. Stocks with a market cap below $600 million accounted for 83% of the weight in the strategy, versus 62% in the Index.
From a sector standpoint, the strategy’s strong performance in Industrials and Financials contributed approximately 370 basis points of excess return versus the Index. However, poor performance in Information Technology detracted about 220 basis points versus the Index. The strategy’s lack of exposure to Consumer Staples, Telecommunications, and Utilities created a minor tailwind and contributed 20 basis points relative to the Index.
Industrials remained the highest weighted sector in the strategy at 33.0% and is the greatest overweight compared to the Index at 12.2%. The strategy’s holdings in the sector returned 9.6% in the period, compared to a return of 2.6% in the Index. The greatest contributor to performance was DMC Global (“BOOM”), with its shares returning 48.3% in the quarter. BOOM, a manufacturer of oilfield service equipment, reported a “dynamite” quarter in earnings, which was well ahead of analyst estimates. Strong revenue growth is being driven by a recovery in their end markets as key customers increase their investments in energy exploration. The company has paid down their debt to modest levels, while increasing their investment in working capital and has plans to double capacity with the addition of two new manufacturing facilities.
ARC Document Solutions (“ARC”), a provider of document solutions to the design, construction and engineering industries, was the greatest detractor to returns in the Industrials sector, with its shares down 37.7% in the quarter. ARC reported poor quarterly results with declining revenues and margin contraction. Companies in this industry continue to transition from offering legacy printing services to providing all-digital reprographics services. We believe the investments the ARC has made in the digital space will pay off over time, though the market is currently pricing in a slow decline.
Financials was the second highest weighted sector in the strategy at 31.0%, compared to the Index at 36.7%. The strategy increased 4.8% in this sector during the period, compared to a return of 0.5% in the Index. Heritage Insurance Holdings (“HRTG”) was the greatest contributor to returns in the sector, with the shares returning 36.9% in the quarter. HRTG, a property and casualty insurer based in Florida, rallied following a mild storm season in their core markets. Investors are beginning to appreciate the cost synergies from the pending acquisition of Narragansett Bay Insurance. This deal reduces HRTG’s dependence on the Florida homeowners’ insurance business, as well as their single-event catastrophe exposure. The combination of these two underwriters will also lead to significant reinsurance savings and earnings growth.
Premier Financial Bancorp (“PFBI”) was the greatest detractor, with its shares down 7.2% during the period. PFBI, a West Virginia-based community bank, has been a long-term turnaround story that we have owned for several years. When we first entered the position, management had a written agreement with their regulators to build capital and clean up their credit quality. Over the years, they have accomplished these goals and restored steady profitability. Now that the management team is aging, the bank seems a likely acquisition target or is set to begin a succession process.
Information Technology was the third highest weighted sector at 22.1%, compared to 8.7% in the Index. The strategy’s holdings in this sector fell 6.7% during the period, compared to a 2.8% gain in the Index. magicJack VocalTec (“CALL”) was the greatest contributor to returns in the sector, with the shares returning 18.2% in the quarter. CALL, a VoIP (Voice over Internet Protocol)-based telecommunications company, offers a product that replaces traditional wireline telephone service at a fraction of the cost. Previous management had mixed success with their strategy of using the cash flow from their core legacy business to jumpstart growth through internal development and acquisition. After the stock performed poorly following weak second quarter earnings, it popped on the news that CALL will be acquired at a healthy premium.
Meet Group (“MEET”) was the greatest detractor to returns in the sector, with the shares down 32.7% in the quarter. MEET, a social networking company, generates the majority of its revenue from online ads. Despite successfully executing several acquisitions and new feature rollouts, the company has been buffeted by substantial declines in online ad rates. Given the operating leverage inherent in their business model, MEET saw steady declines in earnings guidance. Due to concerns that these revenue headwinds may be permanent, we exited our position.
Full Year 2017
For the year, the Micro Cap Value strategy delivered approximately 1,090 basis points of excess return versus the Russell Microcap Value Index. From a size perspective, the best performing stocks were in the upper and lower ends of the Index. Stocks in the Index with a market cap above $800 million or below $200 million had a return of 15.8% during the period, compared to a return of 9.8% for stocks with a market cap between $200 million and $800 million.
The strategy’s strongest outperforming sectors included Industrials, Financials and Materials. These three sectors added approximately 1,320 basis points of excess return versus the Index. Negative returns in Health Care and Consumer Discretionary detracted about 460 basis points relative to the Index. The strategy’s lack of exposure to Telecommunications and Utilities created a minor tailwind and contributed 30 basis points versus the Index.
Industrials remained the highest weighted sector in the strategy at 31.4% and is the greatest overweight compared to the Index at 12.1%. The strategy’s holdings in the sector returned 40.0% for the year, compared to a return of 14.8% in the Index. The greatest contributor to performance was CAI International (“CAI”), with its shares returning 226.6% for the year. CAI, an intermodal freight container leasing and management company, initially rallied early in the year on strong earnings and signs that industry trends were improving faster than anticipated. The stock continued to do well over the summer as the company pre-announced results that suggested this improved environment would continue into the back half of the year.
ARC Document Solutions (“ARC”), a provider of document solutions to the design, construction, and engineering industries, was the greatest detractor to returns in the Industrials sector, with its shares down 49.8% for the year. ARC reported poor results with declining revenues and margin contraction. Companies in this industry continue to transition from offering legacy printing services to providing all-digital reprographics services. We believe the investments ARC has made in the digital space will pay off over time, though the market is currently pricing in a slow decline.
Financials was the second highest weighted sector in the strategy at 27.8% and the greatest underweight compared to the Index at 38.6%. The strategy’s holdings in this sector increased 14.1% during the period, compared to a return of 6.0% 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 71.7%. 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 early in the year and has performed well thanks to earnings that have exceeded estimates by a wide margin.
Bancorp, Inc. (“TBBK”) was the greatest detractor, with its shares down 23.8% during the period. TBBK, a community bank headquartered in Delaware, had been in the process of a slow earnings turnaround, but continue to battle credit issues with their legacy commercial loan book. We purchased the stock believing that new management had a handle on their problem credits. However, with credit deterioration worsening in recent months, we quickly exited our position.
Information Technology was the third highest weighted sector at 25.1%, compared to 9.9% in the Index. The strategy’s holdings in this sector increased 17.0% during the period, compared to a 26.5% gain in the Index. Ultra Clean Holdings (“UCTT”) was the greatest contributor to returns in the sector, with the shares returning 138.0% for the year. UCTT, a developer and manufacturer of critical subsystems in the semiconductor capital equipment industry, reported several strong quarters of earnings during the year and raised guidance prior to a modest pullback late in 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 continued growth in their Organic Light-Emitting Diode (OLED) components segment.
RadiSys Corporation (“RSYS”) was the greatest detractor to returns in the sector, with the shares down 80.7% for the year. RSYS, a maker of hardware and software solutions for the wireless telecom industry, sold off following several weak quarters and lower guidance issued for the remainder of the year. A slowdown in orders from a key customer was the primary culprit. This introduced enough risk into the company’s outlook that we recently sold our position in this holding.
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 September 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 September 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.