Q4’18 Micro Cap Value Strategy
The Pacific Ridge Capital Partners’ Micro Cap Value strategy fell 22.8%* during the fourth quarter of 2018, lagging the loss of 19.5% in the Russell Microcap® Value Index (“Index”). Over the trailing one-, three- and five-year periods, the strategy returned -17.7%*, 11.7%* and 9.0%* (annualized), respectively, compared to the Index returns of -12.0%, 8.5% and 4.3%. Since inception on April 1, 2007, the strategy has returned 9.6%* annually versus 4.2% for the Index.
Financial markets are experiencing uncertainty as we enter into 2019, as multiple moving parts produced a spike in volatility during the fourth quarter. After nine years of generally tepid economic expansion, the business cycle already seemed poised to enter a slowdown. Then a trio of headwinds converged to result in an ugly quarter for capital markets. First, the administration’s trade dispute with China, which had been brewing for some time, picked up steam during the quarter. Second, a rate hike with more combative commentary than expected accelerated market anxiety. Finally, the government entered into a partial shutdown in late December, completing the triple-crown of market headwinds.
As forward-looking investors, we don’t act on front page headlines. Rather, our attention goes to the intermediate- to long-term impact of today’s economic news. While the market is turbulent and sentiment is currently depressed, it is not too difficult to envision these obstacles resolving themselves within the next several quarters. An agreement to end the shutdown will almost certainly be reached, and the incentives to resolve the trade dispute seem significant enough that it will be resolved or the proverbial “kick the can down the road” will occur. Also, market expectations for further rate hikes have diminished in light of the turbulence in capital markets and weakening economic indicators. Should these events play out over the coming quarters, market sentiment will most likely improve. Whether this translates to sustained economic growth for the next several years is less certain.
Fourth Quarter 2018
The Micro Cap Value strategy lagged the Russell Microcap Value Index by approximately 330 basis points for the quarter. From a sector standpoint, the strategy’s performance in Energy, Health Care, Communication Services and Materials contributed approximately 180 basis points of excess return compared to the Index. However, performance in Information Technology, Consumer Discretionary and Industrials detracted approximately 560 basis points versus the Index.
There was a modest size-bias headwind during the quarter, as larger companies in the Index outperformed smaller ones. Companies with a market cap over $400 million in the Index lost 19.0%, versus a loss of 20.2% for companies with a market cap below $400 million. The strategy had 70.6% of its holdings in companies with a market cap below $400 million, compared to 35.3% for the Index.
Poor performance of unprofitable companies provided a modest tailwind during the quarter, as those firms in the Index fell 29.9%, compared to a loss of 17.8% for profitable companies. The strategy had 4.1% of its holdings in unprofitable companies versus 14.4% for the Index. Offsetting this tailwind was a modest headwind as stocks with a P/E over 15x in the Index fell 17.0%, versus a decline of 18.9% for those stocks with a P/E below 15x. The strategy had 41.4% of its holdings in companies with a P/E below 15x, compared to 30.8% for the Index.
The Financials sector had the highest weight in the strategy at 38.1%, compared to the Index at 37.0%. The strategy’s holdings in the sector fell 15.2% for the period, compared to a loss of 14.7% in the Index. The greatest contributor to performance was Alcentra Capital (“ABDC”), with its shares returning 11.2% during the quarter. ABDC, a specialty finance lender to middle market companies, reported a clean quarter of earnings without any large write-downs. The company has had a slight shift in strategy as they look to focus more on private equity, middle market, senior secured positions. If ABDC can avoid additional write-downs, the stock should have decent downside protection as it trades for 60% of tangible book, with an 11% dividend yield.
Northeast Bancorp (“NBN”), a community bank operating in southwest Maine, was the greatest detractor to returns in the Financials sector, with its shares down 22.9% for the quarter. NBN’s unique business model utilizes funding from their community bank franchise to purchase commercial real estate loans at a discount to par. They also have an origination platform for non-standard loans and for borrowers seeking alternative financing. Given the nature of their business model, the company tends to report lumpy earnings—and this quarter was no exception. Despite a growing balance sheet and strong earnings power, NBN trades at a significant discount to its peers and a slight premium to tangible book.
Industrials was the second highest weighted sector in the strategy at 27.8%. It also has the greatest overweight compared to the Index at 12.0%. The strategy’s holdings in the sector fell 26.9% during the period, compared to a loss of 23.2% in the Index. The greatest contributor to performance was Northwest Pipe (“NWPX”), with its shares returning 17.9% during the quarter. NWPX, a manufacturer of engineered steel pipe systems, reported strong earnings during the quarter, as well as a strong demand outlook over the short- and long-term. Management has made several positive moves by exiting unprofitable businesses, cleaning up the balance sheet, and focusing on profitably running their water transmission business.
P.A.M. Transportation Services (“PTSI”) was the greatest detractor to returns in the Industrials sector, with its shares down 39.5% for the quarter. PTSI, a dry van truckload carrier, rallied strongly in the first half of the year when economic growth led to increased demand for trucking services. This created substantial pricing power and rate increases, despite a shortage of qualified drivers. However, the stock sold off sharply over the last two months as economic uncertainty and concerns over a trade war cast a shadow over near-term demand for trucking capacity.
Information Technology was the third highest-weighted sector at 17.3%, compared to 7.9% in the Index. The strategy’s holdings in this sector fell 28.8% during the period, compared to a loss of 15.8% in the Index. magicJack VocalTec (“CALL”) was the greatest contributor to returns in the sector, with its shares returning 3.9% for 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. After the stock performed poorly over concern that a previously-announced buyout was taking too long and might not occur, it snapped back on news that the deal was eventually finalized in November.
Asure Software (“ASUR”) was the greatest detractor to returns in the sector, with its shares down 59.1% for the quarter. ASUR is a cloud-based human capital management and workplace management software provider. Its stock sold off sharply during the quarter when it reported revenues and forward guidance below expectations. Management blames the shortfall on a period of transition for large buyers who are amortizing relevant hardware over the length of their ASUR contracts. This should lead to more predictable revenue, but it will remain a headwind until ASUR is able to cycle through the transition.
Full Year 2018
For the year, the Micro Cap Value strategy lagged the Russell Microcap Value Index by approximately 570 basis points. The strategy’s performance in Energy and Real Estate contributed approximately 160 basis points of excess return versus the Index. However, performance in Information Technology, Consumer Discretionary, and Financials detracted approximately 660 basis points versus the Index. The strategy’s lack of exposure to Consumer Staples, Communication Services, and Utilities detracted a further 50 basis points versus the Index.
There was a notable size bias headwind over the course of the year, as larger companies in the Index outperformed smaller ones. Companies with a market cap over $400 million lost 10.6% in the Index, versus a loss of 15.0% for companies with a market cap below $400 million. The strategy had 66.4% of its holdings in companies with a market cap below $400 million, compared to 36.6% for the Index.
Poor performance of unprofitable companies provided a modest tailwind during the year, as those companies in the Index fell 16.3%, versus a loss of 12.7% for profitable companies. The strategy had 0.9% of its holdings in unprofitable companies, compared to 15.4% for the Index.
A notable headwind came in the form of poor performance of higher beta stocks, as securities in the top two quintiles of the Index fell 19.8% during the year, while stocks in the bottom two quintiles only fell 6.4%. The strategy had 41.4% of its holding in the top two quintiles (versus 37.1% for the Index), and 24.3% in the bottom two quintiles (versus 37.3% for the Index).
The Financials sector had the highest weight in the strategy at 34.2%, compared to the Index at 36.2%. The strategy’s holdings in the sector fell 14.1% for the year, compared to a loss of 9.1% in the Index. The greatest contributor to performance was People’s Utah Bancorp (“PUB”), with its shares returning 19.6% during the year. PUB, a community bank based in Utah, has been performing quite well on a fundamental basis, with very high return measures and strong loan growth. The valuation reached a point where we felt that it was trading at a fair price given the outlook, and we exited our position during the third quarter of the year.
Atlas Financial (“AFH”), a commercial auto insurer, was the greatest detractor to returns in the Financials sector, with its shares down 60.6% for the year. Despite several quarters of strong results throughout 2017, AFH’s fourth quarter earnings, reported in early 2018, came with an announcement of a massive reserve charge. While past reserving issues were largely confined to the Michigan market, this development was more broad-based. In an attempt to soothe investors, the company went to great efforts to explain that part of the reserve involved a more aggressive claims management strategy designed to resolve claims faster and more efficiently. Even with solid earnings reports throughout the rest of 2018, the market remains unhappy with AFH and its reserve charge and will likely keep them in the penalty box for some time.
Industrials was the second highest weighted sector in the strategy at 29.5%, and has the greatest overweight compared to the Index at 12.3%. The strategy’s holdings in the sector fell 19.0% during the year, compared to a loss of 19.0% in the Index. The greatest contributor to performance was DMC Global (“BOOM”), with its shares returning 40.5% during the year. BOOM, a manufacturer of oil field service equipment, continues to benefit from rapid growth in their end markets and overall market share gains. As energy prices recover, key customers continue to increase their investments in energy exploration. Because BOOM’s products increase the efficiency of their oil field investments, the company is also benefiting from increased pricing power.
NN, Inc. (“NNBR”) was the greatest detractor to returns in the Industrials sector, with its shares down 75.2% for the year. 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 are not as prone to cyclical volatility. The stock was pressured during the year as results were impacted by acquisition costs and up-front investments for new programs. If management can successfully execute their plan and decrease leverage, NNBR’s stock price should experience significant upside.
Information Technology was the third highest-weighted sector at 20.2%, compared to 7.8% in the Index. The strategy’s holdings in this sector fell 26.1% during the year, compared to a loss of 3.0% in the Index. PCM Inc. (“PCMI”) was the greatest contributor to returns in the sector, with the shares returning 77.9% for 2018. PCMI, a vendor of technology solutions, reported strong earnings throughout the year following a difficult 2017. Their latest beat on expected earnings led to increased estimates for the coming year. Record gross margins and strong results in their service business are boosting PCMI’s market value.
Ultra Clean Holdings (“UCTT”) was the greatest detractor to returns in the sector, with its shares down 63.3% for the year. UCTT is a developer and manufacturer of critical subsystems in the semiconductor capital equipment industry. The company’s stock price has suffered in the past year because investors believe that UCTT’s key customers are reaching a trough in this highly-cyclical sector. That said, 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.