Q4’18 Small Cap Value Strategy
The Pacific Ridge Capital Partners’ Small Cap Value strategy fell 22.2%* during the fourth quarter of 2018, lagging the loss of 18.7% in the Russell 2000® Value Index (“Index”). Over the trailing one-, three- and five-year periods, the strategy returned -19.8%*, 4.5%* and 2.4%* (annualized), respectively, compared to the Index returns of -12.9%, 7.4% and 3.6%. Since inception on August 1, 2010, the strategy has returned 9.6%* annually versus 9.3% 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 Small Cap Value strategy lagged the Russell 2000 Value Index by approximately 350 basis points for the quarter. From a sector standpoint, the strategy’s positive excess returns in Energy, Health Care and Materials contributed approximately 240 basis points relative to the Index. However, performance in Financials, Consumer Discretionary, Industrials and Information Technology detracted approximately 430 basis points of excess return compared to the Index. The strategy’s lack of exposure to Consumer Staples and Utilities detracted approximately 100 additional basis points versus the Index.
There was a minor size-bias headwind during the quarter, as larger companies in the Index outperformed smaller ones. Companies with a market cap over $1 billion lost 18.3% versus a loss of 20.1% for companies with a market cap below $1 billion. The strategy had 31.4% of its holdings in companies with a market cap above $1 billion, compared to 78.9% for the Index.
Poor performance of unprofitable companies provided a modest tailwind during the quarter, as those firms in the Index fell 30.3%, compared to a loss of 17.6% for profitable companies. The strategy had 2.5% of its holdings in unprofitable companies, versus 8.1% for the Index. Offsetting this tailwind was a modest headwind as higher P/E stocks outperformed lower P/E stocks. Stocks with a P/E over 15x in the Index fell 15.3%, versus a decline of 21.0% for those stocks with a P/E below 15x. The strategy had 42.5% of its holdings in companies with a P/E below 15x, compared to 35.4% for the Index.
A notable headwind came in the form of poor performance of higher beta stocks, as securities in the top quintile fell 33.5% during the quarter, while stocks in the bottom quintile fell 8.4%. The strategy had 22.7% of its holdings in the top quintile (versus 16.7% for the Index), and 7.9% in the bottom quintile (versus 20.0% for the Index).
The Industrials sector had the highest weight in the strategy at 29.3%, and has the greatest overweight compared to the Index at 12.6%. The strategy’s holdings in the sector fell 22.3% for the period, compared to a loss of 20.1% in the Index. The greatest contributor to performance was Navigant Consulting (“NCI”), with its shares returning 4.5% during the quarter. NCI, a management consulting firm, reported solid earnings during the quarter and their initial guidance for 2019 looked positive following the completion of a sizeable divestiture. NCI should now have a stronger profit margin profile and have the balance sheet flexibility to return capital or invest for future growth.
Houston Wire & Cable (“HWCC”) was the greatest detractor to returns in the Industrials sector, with its shares down 34.3% for the quarter. Though HWCC, a manufacturer of electrical and mechanical wire and cable, lacks analyst coverage, they reported solid third quarter results that showed double digit top- and bottom-line growth. However, poor market sentiment overshadowed the company’s recovering business fundamentals and the stock collapsed. We believe the selling pressure was exacerbated by HWCC’s high debt load following a recent acquisition, and the company’s ties to offshore drilling. Nonetheless, we view the shares as attractive at just over 1x tangible book value and we are encouraged by the company’s cash flow generating ability.
Financials was the second highest weighted sector in the strategy at 27.6%, compared to the Index at 28.6%. The strategy’s holdings in the sector fell 21.1% during the period, compared to a loss of 15.7% in the Index. The greatest contributor to performance was Heritage Insurance (“HRTG”), with its shares down 0.3% during the quarter. HRTG, a property and casualty insurer based in Florida, recently completed the acquisition of Narragansett Bay Insurance, who provides insurance in states along the Eastern seaboard. This acquisition lessens HRTG’s overall exposure to the Florida homeowners’ insurance market, as well as to single-event catastrophes. The combination of these two underwriters will also lead to significant reinsurance savings and earnings growth.
Meta Financial (“CASH”), an Iowa-based community bank and financial services firm, was the greatest detractor to returns in the Financials sector, with its shares down 29.5% for the quarter. CASH rallied strongly during the first half of the year before selling off sharply in the second half. A number of factors contributed to this trend. CASH missed earnings estimates during a noisy summer quarter. They were wrapped up in their acquisition of Crestmark Bancorp. Although they met estimates during the latest quarter, management announced a surprise CEO change in November. Given the company’s tax advance and refund business, modeling earnings on a quarterly basis is challenging and tends to increase the volatility. We like the steps CASH has taken to utilize their balance sheet and increase earnings power in the near future. The stock trades at a significant discount to its peers, despite having a solid low-cost deposit base.
Information Technology was the third highest-weighted sector at 18.2%, compared to 10.0% in the Index. The strategy’s holdings in this sector fell 20.3% during the period, compared to a loss of 14.4% in the Index. Intevac (“IVAC”) was the greatest contributor to returns in the sector, with the shares returning 0.6% for the quarter. IVAC, a manufacturer of thin film deposition used in the manufacture of hard disk drives, announced two new multi-year contracts late in the quarter which propelled the stock from its quarterly lows. Though IVAC initially beat earnings when they were reported early in the quarter, weak guidance led to a muted reaction in the stock. The company’s new wins will have a material impact on revenue and earnings for the next two years and have already led to meaningful estimate revisions.
Cohu (“COHU”) was the greatest detractor to returns in the sector, with its shares down 35.8% for the quarter. COHU is a manufacturer of semiconductor test and inspection handling equipment. The company reported earnings below expectations during the quarter due to softening in the mobile handset market. As a result, COHU guided down expectations for the next few quarters. The shift towards the mobile phone market has led to increased volatility and the slower rate of cell phone growth in China has had a negative impact on results. That said, the acquisition of Xcerra (“XCRA”) was recently completed and should drive earnings accretion in the coming quarters, as merger-related synergies are tracking according to plan.
Full Year 2018
For the year, the Small Cap Value strategy lagged the Russell 2000 Value Index by approximately 690 basis points. The strategy’s performance in Health Care and Energy contributed approximately 250 basis points of excess return versus the Index. However, performance in Financials, Industrials and Consumer Discretionary detracted approximately 870 basis points compared to the Index. The strategy’s lack of exposure to Consumer Staples and Utilities detracted a further 60 basis points versus the Index. There was no meaningful size bias impact over the course of the year.
Poor performance of unprofitable companies provided a modest tailwind during the year, as those firms in the Index fell 21.0%, versus a loss of 12.4% for profitable companies. The strategy had 1.0% of its holdings in unprofitable companies, compared to 6.7% for the Index. Offsetting this tailwind was a modest headwind as higher P/E stocks outperformed lower P/E stocks. Stocks in the Index with a P/E over 15x fell 10.2%, versus a decline of 15.6% for those stocks with a P/E below 15x. The strategy had 46.1% of its holdings in companies with a P/E below 15x, versus 35.4% for the Index.
A notable headwind came in the form of poor performance of higher beta stocks, as securities in the top quintile of the Index fell 28.8% during the year, while stocks in the bottom quintile fell 0.6%. The strategy had 21.9% of its holdings in the top quintile (versus 17.2% for the Index), and 10.6% in the bottom quintile versus 18.8% for the Index.
The Industrials sector had the highest weight in the strategy at 29.3% and has the greatest overweight compared to the Index at 13.0%. The strategy’s holdings in the sector fell 23.8% for the period, compared to a loss of 12.2% in the Index. The greatest contributor to performance was Navigant Consulting (“NCI”), with its shares returning 24.4% during the year. Details regarding NCI are outlined above in the Fourth Quarter 2018 section.
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 last 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, NNBR’ stock price should experience significant upside.
Financials was the second highest weighted sector in the strategy at 26.8%, compared to the Index at 29.8%. The strategy’s holdings in the sector fell 23.5% during the period, compared to a loss of 10.8% in the Index. The greatest contributor to performance was BofI Holding (“BOFI”), with its shares returning 35.8% for the year. BOFI, an internet bank based in San Diego, CA, rallied early in the year as its earnings expectations were steadily revised higher. Over the past few years, however, the company has battled attacks from short-sellers, as well as lawsuits alleging various financial indiscretions. Those attacks appear to have fizzled out, most of the lawsuits against BOFI have been dismissed and the company continues to perform well. Because BOFI’s stock price more than doubled over the prior 18 months and surpassed our price target, we exited our position early in 2018. Incidentally, BOFI announced a company name change to Axos Financial (AX) during an overall company rebranding that took place mid-2018.
Meta Financial (“CASH”), an Iowa-based community bank and financial services firm, was the greatest detractor to returns in the Financials sector, with its shares down 36.8% for the year. Details regarding CASH are outlined above in the Fourth Quarter 2018 section.
Information Technology was the third highest-weighted sector at 20.0%, compared to 9.0% in the Index. The strategy’s holdings in this sector fell 11.1% during the period, compared to a loss of 10.9% in the Index. Xcerra (“XCRA”) was the greatest contributor to returns in the sector, with the shares returning 37.5% for the year. XCRA, a manufacturer of semiconductor and electronics manufacturing test equipment, agreed last year to be acquired by Cohu (“COHU”), following a failed acquisition by a Chinese partnership. Our position transitioned into our existing holding of COHU shares with the completion of the transaction.
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 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.