Q4'17 Small Cap Value Strategy
The Pacific Ridge Capital Partners (“PRCP”) Small Cap Value strategy rose 2.5%* in the fourth quarter of 2017, ahead of the 2.0% return for the Russell 2000® Value Index (“Index”). Over the trailing one-, three-, and five-year periods, the strategy returned 9.4%*, 9.6%* and 15.4%* (annualized), respectively, compared to the Index returns of 7.8%, 9.6%, 13.0%. Since inception on August 1, 2010, the strategy has returned 14.3%* annually versus 12.7% 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
For the quarter, the Small Cap Value strategy beat the Russell 2000 Value Index by approximately 50 basis points. There was little discernible size bias in the Index, as those stocks with a market cap less than $1 billion returned 2.2% during the quarter, while those with a market cap greater than $1 billion returned 2.0%. This small size bias provided a slight tailwind to the strategy, given that companies with market caps over $1 billion comprised 74.0% of the Index, compared to 34.7% for the strategy. Strong stock selection in the strategy from holdings with market caps below $500 million helped offset underperformance in stocks with a market cap above $500 million. Those stocks with market caps below $500 million returned 7.3% in the strategy versus a 0.3% return for stocks with market caps above $500 million.
From a sector standpoint, the strategy’s performance in Industrials and Consumer Discretionary contributed nearly 210 basis points of excess return versus the Index. However, poor performance in Information Technology detracted over 190 basis points versus the Index. Higher beta stocks performed better in both the Index and the strategy, though the impact on returns was negligible given similar weights by beta quintile.
Industrials remained the highest weighted sector in the strategy at 31.6% and had the greatest overweight compared to the Index at 12.6%. The strategy’s holdings in the sector returned 7.2% in the period, compared to a 2.9% gain in the Index. The greatest contributor to performance was Textainer Group Holdings (“TGH”), with its shares returning 25.4% in the quarter. TGH, the world’s second largest shipping container lessor, continued to rally in the fourth quarter following a strong earnings release. Much of the noise of the past few years (e.g., the bankruptcy of one of their competitors, Hanjin, write-downs of seasoned containers) appears to be behind them. TGH experienced their first revenue increase in nine quarters. The company should see future ROEs in the mid-teens and erase the discount at which it trades relative to its peers.
Essendant (“ESND”) was the greatest detractor to returns in the Industrials sector, with its shares down 28.5% in the quarter. ESND, a wholesale distributor of business products, reported earnings in the quarter that fell short of estimates because of weaker revenue and margin pressures. The company is looking to address the challenging end markets with a cost reduction initiative and improved sourcing. Free cash flow generation is being used to reduce the level of debt and support organic growth.
Financials was the second highest weighted sector in the strategy at 25.2%, compared to the Index at 30.9%. The strategy’s holdings in this sector returned 1.3% during the period, compared to a gain of 0.7% 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.
Customers Bancorp (“CUBI”) was the greatest detractor to returns in the Financials sector, with shares down 20.3% in the quarter. CUBI, a Pennsylvania-based community bank, reported weak earnings due to a series of charges related to their mobile banking platform, as well as their investment in a banking affiliate in India. CUBI’s decision to exit its investment in the banking affiliate during the quarter resulted in a charge that brought the remaining fair value of the affiliate close to zero. The company is in the process of selling the mobile banking subsidiary which should help remove an overhang from the stock.
Information Technology was the third highest weighted sector in the strategy at 20.4% and had the second greatest overweight compared to the Index at 8.2%. The strategy’s holdings in this sector fell 7.7% during the period, compared to a gain of 0.2% in the Index. NETGEAR (“NTGR”) was the greatest contributor to returns in the sector, with the shares returning 23.4% in the quarter. NTGR, a designer and manufacturer of computer networking equipment, rebounded in the latter half of the year due to strong sales of their network-based security cameras. Reports of sold-out conditions at online and physical retailers have the market expecting strong fourth quarter earnings.
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 its earnings guidance. Due to concerns that these revenue headwinds may be permanent, we exited our position.
2017 Full Year
The Small Cap Value strategy outperformed the Russell 2000® Value Index for the year by approximately 160 basis points. The strategy benefited from a slight size bias during the year, with the smaller market cap segments outperforming the larger ones. In the Russell 2000® Value, stocks with a market cap below $500 million returned 9.1%, while those with a market cap greater than $1 billion returned 7.7%.
In terms of sectors, the strategy’s performance in Industrials and Energy contributed approximately 800 basis points of excess return versus the Index. However, poor performance in Consumer Discretionary and Financials detracted approximately 590 basis points versus the Index. The lack of Utilities exposure within the strategy was a slight headwind, resulting in approximately 30 basis points of underperformance during the year.
Industrials remained the highest weighted sector in the strategy at 29.8% and had the greatest overweight compared to the Index at 12.7%. The strategy’s holdings in the sector returned 40.0% in the period, compared to an 18.3% gain in the Index. The greatest contributor to performance was Textainer Group Holdings (“TGH”), with its shares returning 188.6% for the year. TGH, the world’s second largest shipping container lessor, has benefited from the latest upturn in the business cycle and has slowly moved past the noise from the bankruptcy of Hanjin and write-downs of seasoned containers. Pricing in the industry began to stabilize following a long downward trend and excess capacity. Additionally, a rebound in general commodity prices and a slight uptick in trade activity contributed to strong performance.
Acacia Research (“ACTG”) was the greatest detractor to returns in the Industrials sector, with its shares down 37.7% for the year. ACTG, a licensor and enforcer of technology patents, has struggled in recent years in an environment that has been increasingly difficult to monetize patents. A new management team has adjusted the strategy and shifted away from the “whale hunting” of years past into smaller, lower risk transactions. The company has a very strong balance sheet and portfolio that provides some downside protection from current levels.
Financials was the second highest weighted sector in the strategy at 22.8% and had the greatest underweight compared to the Index at 31.5%. The strategy’s holdings in this sector fell 5.3% during the period, compared to a gain of 4.6% in the Index. Third Point Reinsurance (“TPRE”) was the greatest contributor to returns in the sector, with the shares returning 26.8% for the year. TPRE, a property and casualty reinsurer, rebounded in 2017 after a strong year of investment returns. Earnings are primarily driven by performance at the parent hedge fund. The prospect of higher reinsurance pricing should provide a modest tailwind as we move through 2018.
Maiden Holdings (“MHLD”) was the greatest detractor to returns in the Financials sector, with shares down 59.6% during the year. MHLD, a Bermuda-based reinsurer, reported several weak quarters of earnings as the result of adverse reserve development. The company had to revise loss estimates from several prior years in the commercial auto and reinsurance lines. The current valuation implies that the market has concerns of more reserve development in future quarters.
Information Technology was the third highest weighted sector in the strategy at 22.5% and had the second greatest overweight compared to the Index at 9.2%. The strategy’s holdings in this sector returned 7.7% during the period, compared to a gain of 10.3% 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 Small Cap Value composite has been examined for the periods August 1, 2010 through September 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.