Q4’19 Small Cap Value Strategy
Market Commentary
Fads come and fads go. What is popular for a period of time inevitably fades away once a new trend comes into vogue. Fads are especially common with children’s toys and fashion. Take unicorns, for example. Suddenly, they’re popular. Some of our staff member’s children dressed up as unicorns for Halloween and requested unicorn-themed gifts for their birthday and for the holidays. Yet, this trend will almost certainly die out when the next fad grabs their attention, just as we experienced with Pet Rocks, Beanie Babies and Tickle-me Elmo.
The world of investing has also been prone to fads—unicorns included. Not the magical rainbow-themed kind, but a private company with venture capital backing that has achieved a valuation in excess of $1 billion. To a growth-oriented investment manager, these companies can feel like a fairy tale, complete with enchanted returns for early investors.
Since unicorns aren’t publicly traded and investment managers have latitude in how these companies are valued on their books, their valuations are less reliable. This can result in artificial gains when revenues are growing rapidly. Investors become enthralled with the company’s swift upward mobility and lose their focus on profitability and cash flow. Subsequent capital raises at higher valuations can mask the reality that much of the investment is dependent on the greater fool theory and an eventual initial public offering. Investors mystically deceive themselves into thinking that increased scale will automatically lead to operating leverage and a path to profitability. When this is delayed or revenue growth begins to taper off, changes to investor confidence and in company valuation can be swift and dramatic. The magic dissipates and the fairy tale becomes a nightmare.
One recent example of this is WeWork, which was valued as high as $50 billion less than a year ago. Since then, a failed IPO and management shake-up has seen the estimated value sink below $10 billion, with numerous clouds still lurking over the company. Then there’s Uber, Lyft and Blue Apron. These prominent unicorns managed to go public even though they weren’t profitable, only to see a sharp reversal in sentiment and value. The number of unprofitable companies completing IPOs is reaching historic levels not seen since the tech bubble of the 1990s. In fact, over 70% of US-listed IPOs last year had negative earnings*. Just as sentiment shifted rapidly twenty years ago, we are beginning to see a similar dynamic play out again as access to capital becomes more challenging.
As value investors, we welcome this return to reasoned thinking. The unicorn mania of the past several years has led to a prolonged headwind for value stocks. Now, we see early indications that the long-awaited reversion may finally be underway. Just as with other investment fads in the past, be they Dutch tulips, the nifty fifty, dot coms, real estate flipping or unicorns, we calmly watch the current craze from a distance and ask ourselves a simple question: “When do we think the mania will end?” The decline of unprofitable technology stocks in 2000 led to a prolonged period of significant value outperformance. We anticipate a similar dynamic playing out again in this cycle.
Strategy Review
The Pacific Ridge Capital Partners’ Small Cap Value strategy rose 12.2%* during the fourth quarter of 2019, outperforming the 8.5% return of the Russell 2000® Value Index (“Index”). Over the trailing one-, three- and five-year periods, the strategy returned 30.0%*, 4.5%* and 6.5%* (annualized), respectively, compared to the Index returns of 22.4%, 4.8% and 7.0%. Since inception on August 1, 2010, the strategy returned 11.6%* annually versus 10.6% for the Index.
*Preliminary Results
For additional performance information, see the related GIPS® compliant presentation on the last page.
Top Contributors and Detractors to Return*
Top Contributors
COHU (“COHU”) is a manufacturer of semiconductor test and inspection handling equipment. The stock moved higher during the second half of the year on the heels of an improved outlook in the semiconductor space. The company is expecting a notable tailwind in the coming years, thanks to increased demand for radio frequency testers required by the ongoing expansion of 5G networks.
Ultra Clean Holdings (“UCTT”) is a developer and manufacturer of critical subsystems in the semiconductor capital equipment industry. The stock steadily recovered through the year following a consistent sell-off throughout 2018. Renewed optimism stems from a recovery in original equipment manufacturer sales, as well as solid growth in UCTT’s service business. Positive management commentary led to 2020 earnings estimates that reflect sharp growth over 2019.
Photronics (“PLAB”) is a maker of masks used in the production of semiconductors and flat panel displays. The stock bounced off of lows during the third quarter, then spiked higher during the fourth quarter thanks to higher earnings and a shift toward Asian-based semiconductor manufacturing. As trade tensions ease, PLAB should see a further boost to their 2020 top line.
Insight Enterprises (“NSIT”), a technology solutions provider, rallied during the second half of the year and reported earnings that met expectations. Analyst estimates are steadily moving higher as a recent acquisition appears to be performing well and is expected to be substantially accretive next year. While NSIT has over $800 million in outstanding debt, they recently refinanced into a lower-cost facility and are paying down the balance through free cash flow.
Bed Bath & Beyond (“BBBY”), a retailer of domestic merchandise and home furnishings, rallied over the quarter as a new CEO was hired to turn around the business. The subsequent departure of numerous C-level executives in December suggests that significant changes will occur, and the market is showing increased confidence that the new CEO will get business on the right track.
Top Detractors
Ribbon Communications (“RBBN”) is a manufacturer of networking and security solutions for voice service providers and large enterprises. The stock sold off in two phases during the quarter. First, RBBN reported earnings well short of estimates, caused in part by a shift in their business model toward higher-margin software. Second, the company announced an acquisition in December that was viewed unfavorably by investors, who saw the purchase as lacking in synergy and outside of RBBN’s core competency.
Plantronics (“PLT”) is a manufacturer of headsets, voice, video, and content-sharing solutions. After rebounding from lows seen during the third quarter, the stock sold off sharply in November on weak earnings results that fell far short of estimates. With older technology in their core product line, they are racing to catch up as customers transition to UCC-compliant solutions. Management hopes to rebound next fiscal year when they launch their new headset and handset endpoints that are compatible with new standards.
NV5 Global (“NVEE”) is a professional and technical consulting firm. The stock fell sharply during the quarter when they simultaneously announced earnings that fell short of estimates and a large debt-financed acquisition. The company is expected to resume organic growth this year, while their recent transaction should help drive higher margins.
NETGEAR (“NTGR”), a designer and manufacturer of computer networking equipment, reported disappointing earnings in October that caused the stock to give up gains that came from an earnings beat the prior quarter. A lowered outlook for the fourth quarter also contributed to the sell-off. NTGR is navigating a transition from legacy Wi-Fi technology to the new Wi-Fi 6 format and is experiencing some lumpiness ahead of their new product rollout. This should be addressed in early 2020.
Lifetime Brands (“LCUT”) is a manufacturer of kitchenware and tableware products. The stock has been on a steady downtrend the past few years as LCUT continues to experience margin pressure from the changing retail landscape. More recently, management cited the strengthening dollar, macro headwinds and tariffs as factors that led to poor performance in some of their product lines.
*Past performance does not guarantee future results. The holdings identified do not represent all the securities purchased, sold or recommended to clients. Top contributors and detractors to return represent those securities that had the largest positive and negative total contribution to the overall portfolio return for the quarter. A complete list of contributors to portfolio return can be obtained by contacting Peter Trumbo, Chief Compliance Officer, at 503-886-8972 or by email at Peter.Trumbo@PacificRidgeCapital.com. For additional information, see the related GIPS® compliant presentation on the last page.
Market Capitalization Analysis
There was a moderate size bias tailwind during the quarter as smaller companies in the Index outperformed larger companies. Those with a market cap under $1 billion in the Index gained 10.5%, versus a return of 7.7% for companies with a market cap above $1 billion. The strategy had 75.6% of its holdings in companies with a market cap below $1 billion, compared to 26.7% for the Index.
Style Analysis
There was a significant value-bias tailwind for profitable companies during the quarter, as stocks with lower P/Es outperformed those with higher P/Es. However, strong performance of unprofitable companies in the Index was a modest headwind, as those stocks returned 15.8%, versus a gain of 7.9% for firms that were profitable. The strategy had 2.9% of its holdings in unprofitable companies, compared to 9.2% for the Index.
Economic Sector Analysis
The strategy’s outperformance in 8 of the 11 economic sectors contributed approximately 420 basis points of excess return versus the Index. However, Consumer Staples and Health Care detracted approximately 20 basis points relative to the Index.
Portfolio Characteristics Top Ten Holdings As of 12/31/2019
Market Outlook
We continue to have a modest growth outlook for the US economy, though pockets of softening data and trade-related uncertainty could lead to uneven activity in the near-term. Sentiment amongst purchasing managers continued to indicate a slowdown in the manufacturing sector. The December US manufacturing PMI slipped further to 47.8, the lowest since June 2009. Third quarter 2019 GDP of 2.1% was essentially flat from the prior quarter and reflected positive contributions from personal consumption, government spending, and residential investment offset by slower corporate inventory investment and non-residential spending. Consumer spending remains healthy and employment is high, but jobs data will be closely monitored given the cautious business climate. GDP growth is expected to remain moderate around the 2.0% level going into the 2020 election year. Corporate profitability and balance sheets remain strong.
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
Investment Team Additional Professionals
Mark Cooper, CFA® Co-Senior Portfolio Manager Peter Trumbo Chief Operating/Compliance Officer
Dominic Marshall, CFA® Co-Senior Portfolio Manager Mike McDougall Senior Trader
Ryan Curdy, CFA® Portfolio Manager Tammy Wood Director, Marketing & Business Development
Justin McKillip, CFA® Senior Analyst Veronica Orazio Operations Assistant
Adam Boyce, CFA® Senior Analyst
Regulatory Disclosures
The contributors and detractors to return, market capitalization weightings and total effect, economic sector weightings and total effect, portfolio characteristics, and top ten holdings for the Small Cap Value Composite are based on a representative account within the strategy. The representative account statistics are shown as supplemental information and complement the composite's GIPS® disclosure presentation as provided on the last page.
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.
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.
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 September 30, 2019. 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, 2019. 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.