Risk Framework - Part 3 of 3
In the past two commentaries, we’ve focused on Operational Risk and Price Risk. These are major components of our investment selection process and they form the basis of our “Value Zone.” We look for good companies with bad prices. It’s a simple enough maxim, but it requires a tremendous amount of discipline to practice.
Our initial review of any investment candidate is done in isolation from our existing portfolios. If the company looks attractive to us, we then determine how it fits into the collection of firms that we already own. First, we ask two questions: Do we have enough cash to buy the security and is the stock more attractive than the least attractive idea we already own? If the answer to either question is yes, then we deliberate as to whether its addition would make the portfolios overly exposed to a certain set of conditions, or risks, that we should be concerned about. This vetting process is commonly called Portfolio Management—and it’s the topic of this quarter’s commentary.
Part 3 - Portfolio Management
Beta and Correlation
One measure that is generally used to assess portfolio risk is historic Beta. This is the measure of past volatility of price movements relative to the market. In our case, we look at the slope of the security against the Russell 3000 on a 5-year monthly and 3-year weekly basis. And then, we usually yawn.
The reason that we do this is because historic Beta, while informative in some cases, is not as useful as one might think. This is because the Beta of individual securities changes over time, and can offer investors a false sense of security, or a false sense of intelligence. We believe that in the realm of small companies, where the market still demonstrates inefficiencies, Beta is even less reliable than it is with larger companies. While we do consider it in our analysis, it is not as critical to us as other factors.
Correlation is another statistic we consider. Correlation measures the relationship of one security to another. In a perfectly hedged portfolio, when one stock is doing poorly, another will be doing well. Some investors seek to disaggregate risk by using derivative products in an attempt to remove all market-related influence from the price of a particular stock. Doing this leaves only the company-related risk in the price. It sounds too good to be true! Of course, like Beta, Correlations can change over time.
Integrating Beta and Correlation into our investment decisions is as much art as it is science. As we review our holdings, we weigh more than 30 different risk factors (Pacific Ridge Risk Pack) that can influence the performance of the portfolios, depending on where we are in the economic cycle. However, we don’t overly rely on scenario analysis because it is based on historical patterns of returns that we believe are less reliable with small companies. If investors have learned anything in the last fifteen years, it’s that things change.
Beyond stock selection, there are three bedrock biases in our strategies that impact the investment decisions we make in our portfolios.
- Sector Risk. As you look at our Portfolio Characteristics each quarter, you will notice that we have some significant deviations from the benchmark weightings. Our portfolios are not designed to be sector neutral. They are a residual of the stock selection process described in our previous letters. As such, a significant market move in any given sector will impact our results. This is particularly evident with respect to the Financial Services sector of the small and micro cap indexes.
- Size Risk. Because our strategies focus on the smaller stocks within the benchmarks, any market move that favors larger cap stocks will likely have a negative impact on our portfolios. This size risk is most pronounced when the market is reacting to a financial crisis as opposed to a general slowdown in economic growth, as it was in 1998 and 2008. During these periods, we have observed that smaller companies, in aggregate and within the indexes, have suffered from a perceived “flight to safety” within the public equity markets that seem to outright favor larger companies.
- Style Risk. Our strategies have a deliberate “value” bias. We buy companies that have low multiples (or low expectations built into them). While not as strong as the size impact mentioned above, we have observed periods of extended market horizons where companies with low multiples underperform for no apparent reason. In general, this tends to happen near the end of economic expansions.
In the past three letters, we’ve described the various factors we use in our investment strategies. We review these factors on a formal and an ad hoc basis. We pay particular attention to changes in the underlying economy and how those changes are likely to impact the individual holdings that we have. While we may do some tactical trimming of our holdings, our investment methodologies rarely result in wholesale changes to the characteristics of our portfolios. To evidence this, our typical turnover is only 25–35% in any given year. Our experience managing the complexities of investing in good companies with bad prices helps us navigate the public equities market.
In the end, our competitive advantage is our exercise of independent judgment. We do not follow the herd and we are not concerned with the short-term fluctuations of the market. We focus on the long-term operating prospects of the companies that we buy. That will not change.
Pacific Ridge Capital Partners
About Pacific Ridge Capital Partners
Pacific Ridge Capital Partners is an employee-owned firm. We generate our own investment ideas using fundamental analysis and bottom-up stock picking. The investment team applies a consistent, patient and disciplined process that results in low turnover and stability. Our proven philosophy has performed well over many investment cycles and it is the consistent application of this strategy that makes Pacific Ridge unique.
The principals of Pacific Ridge Capital Partners are invested along with our clients in each of our strategies.
PRCP Small Cap Value – Our Small Cap Value strategy generally purchases stocks in the bottom three-quarters of the Russell 2000® Index. This smaller capitalization segment has a large number of underfollowed companies, providing us the greatest opportunity to exploit market inefficiencies. The typical range of holdings is between 100 and 150.
PRCP Micro Cap Value – Our Micro Cap Value strategy generally purchases stocks in the Russell Microcap® Index. This segment is widely underfollowed, providing us the greatest opportunity to exploit market inefficiencies. The typical range of holdings is between 50 and 80.
We believe these market cap segments offer great potential returns and additional diversification for our clients. For further information about Pacific Ridge Capital Partners and our investment strat- egies, we invite you to contact Tammy Wood via email at Tammy.Wood@PacificRidgeCapital or by phone at (503) 878-8502.
Pacific Ridge Capital Partners, LLC (“Pacific Ridge”, “PRCP”, or “the Firm”) is an employee-owned investment advisor registered with the Securities and Exchange Commission under the Investment Advisor 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®).
Sources: Pacific Ridge; FactSet Research Systems (“FactSet”); and Russell Investment Group (“Russell”) who is the source and owner of the Russell Index data.
The current annual investment advisory fees for the portfolios managed in the Firm’s Small and Micro Cap Value strategies are 1.00% and 1.50% of assets, respectively. Returns for the composites 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. The Firm calculates time weighted rates of return by geometrically linking portfolio simple rates of return at least monthly, with adjustments made for significant external cash flows. The composite returns are calculated by asset weighting the individual portfolio returns using beginning of the period values. All returns are calculated after the deduction of the actual trading expenses incurred during the period.
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.
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.
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.
Returns and asset values are stated in US dollars.