Q1’20 Micro Cap Value Strategy
Market Commentary
At Pacific Ridge Capital Partners, we are always on the lookout for the next best opportunity to add to our portfolios. We do this on a “bottom-up” basis, sifting through the entire universe of small and micro cap companies in our hunt for great values and through the lens of being long-term owners and investors in quality businesses.
We know from experience that companies trade at a discount to fair value for one of four reasons:
1) They are neglected by Wall Street
2) They are oversold, often because of a market overreaction
3) They are in an earnings turnaround situation
4) There is an overarching theme or condition that is impacting a group of stocks
The COVID-19 pandemic has depressed markets, crashed stock prices and brought strong companies with stable operations to a complete standstill. These events have created a plethora of “oversold” companies, placing them directly into our sphere of contrarian investing. We relish the opportunity to add great companies to our strategies at discounted valuations. While we are spending our time during this crisis evaluating potential new holdings, we are also finding that the pool of companies we already own continue to be excellent long-term investments.
Incremental changes to revenue and margin remain central to our investment management model. Given the impact brought by the COVID-19 pandemic, we have widened that model to include new factors such as the extent of cash burn for impacted companies, the degree of credit impairments for banks and REITs, the impact of disruptions to the global supply chain and clarity around near-term earnings. Based on this expanded model, we have made a few minor modifications to our portfolios to ensure the continued resiliency of our strategies.
In times like these, we know the best thing to do is to stay true to our investment philosophy and our process. As investors in value stocks within the small and micro cap space, we will continue to focus on investing in companies with strong balance sheets and free cash flow.
Strategy Review
The Pacific Ridge Capital Partners’ Micro Cap Value strategy returned -40.9%* during the first quarter of 2020, trailing the -36.1% return of the Russell Microcap® Value Index (“Index”). Over the trailing one-, three- and five-year periods, the strategy returned -31.4%*, -9.9%* and 0.1%* (annualized), respectively, compared to the Index returns of -29.8%, -8.5% and -1.8%. Since inception on April 1, 2007, the strategy has returned 6.4%* annually versus 1.7% for the Index.
Top Contributors and Detractors to Return*
Top Contributors
Eagle Bancorp Montana (“EBMT”) is a Montana-based community bank. EBMT was recently added to the strategy as a defensive bank operating in a steady market that should be less impacted by COVID-19. The bank has completed several small acquisitions over the past several years. This roll-up strategy has led to a steadily increasing capital base, diversified loan book and improved deposit mix.
SMTC Corporation (“SMTX “) is a contract manufacturer in the electronic manufacturing services arena. SMTX was recently added to the strategy as a turnaround play. A new management team with previous success at other industry firms was recently brought in. The business is fairly well diversified across customers and industries, and the benefit from recent acquisition and integration initiatives should begin to flow through their income statement this fiscal year.
Quantum Corporation (“QMCO”), a manufacturer of computer storage devices, was recently added back to the strategy. We exited our position last year when QMCO was delisted due to late filings. New management has resolved these issues and has aggressively reduced the cost structure of the company. These improvements, along with the introduction of new products, should materially improve profitability after many years of break-even operation.
Hurco Companies (“HURC”) is a designer and manufacturer of computerized machine tools. Global demand has been weak over the past few years due to trade-related uncertainty and a manufacturing slowdown in Europe. HURC has focused on decreasing their inventory levels and the company has a strong balance sheet that can withstand a prolonged slowdown. Additionally, capex requirements are modest, which should minimize cash burn.
Zovio (“ZVO”) is a for-profit education company that also operates Ashford University. ZVO’s stock price has been volatile over the past few years as it attempts to spin off Ashford University and operate as an online-only program. Unfavorable enrollment trends have also impacted performance, an issue that management has struggled to resolve. Should ZVO successfully address these challenges, the stock has the potential to move substantially higher.
Top Detractors
Comtech Telecommunications (“CMTL”), a provider of advanced communications solutions, sold off sharply during the quarter following an earnings report that revealed an impact from COVID-19 much sooner than anticipated. While management initially provided guidance when they reported earnings in early March, they subsequently withdrew it, suggesting a more prolonged impact. Although CMTL is not losing business, the company’s recent contract wins will likely be delayed until business activity returns to a more normalized level.
CRH Medical (“CRHM”) is a provider of anesthesia services to outpatient gastroenterology clinics. The stock initially sold off during the quarter following an earnings report that reflected a lower than expected revenue-per-case level. This was caused by a shift of out-of-network providers to in-network facilities that billed at lower rates. The sell-off was also aggravated by the broad cancellation of elective medical procedures, a trend that will pressure volumes for the foreseeable future. However, with large profit margins, CRHM should be able to generate positive cash flow at a reduced level of activity once clinics partially reopen.
ZAGG Inc (“ZAGG”), a provider of mobile phone battery packs and accessories, sold off sharply in the quarter following a disappointing earnings report, reduced guidance and a suspension of its strategic review. Recent challenges to their business impacted ZAGG’s ability to secure a takeover offer, and the emergence of the coronavirus late in the quarter impacted their ability to secure inventory. The pending upgrade cycle following the rollout of the new 5G networks should hopefully provide a revenue tailwind.
COHU (“COHU”) is a manufacturer of semiconductor test and inspection handling equipment. COHU announced that their business operations had been impacted following the implementation of community quarantines in Malaysia and the Philippines. Focus has shifted towards their liquidity, though it is worth noting that there is minimal amortization through the maturity of a loan due in 2025. With few covenants and a healthy cash balance, the company appears to be in position to meet their near-term liquidity needs.
BG Staffing (“BGSF”) is a temporary staffing company focused on the clerical, light industrial, IT, finance and multifamily industries. While the company reported fourth quarter earnings that were in line with estimates, revenue and earnings expectations have been reduced due to the economic slowdown and uncertainty regarding the resumption of regular business activity.
*Past performance does not guarantee future results. The holdings identified do not represent all the securities purchased, sold or recommended to clients. The 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 no meaningful size bias effect during the quarter, as both the largest and smallest companies in the Index slightly outperformed those companies with a market capitalization in between. Those with a market cap over $400 million in the Index returned -35.6%, versus a loss of 36.9% for firms with a market cap below $400 million. The strategy had 64.3% of its holdings in companies with a market cap below $400 million, compared to 37.9% for the Index.
Style Analysis
There was a slight value-bias headwind for profitable companies during the quarter, as stocks with higher PEs out- performed those with lower PEs. Additionally, strong performance of unprofitable companies in the Index created a modest headwind, as those stocks returned -33.9%, versus -37.7% for firms that were profitable. The strategy had 2.2% of its holdings in unprofitable companies, compared to 15.7% for the Index.
Economic Sector Analysis
The strategy’s performance in Consumer Discretionary, Energy and Real Estate contributed approximately 240 basis points of excess return relative to the Index. However, performance in Health Care, Industrials, Information Technology and Materials detracted approximately 720 basis points versus the Index. The strategy’s lack of exposure to the Communication Services, Utilities and Consumer Staples detracted approximately 70 basis points of excess returns during the quarter.
Market Outlook
COVID-19 has reshaped daily life around the world. At some point, normalcy will return, but when that will happen is highly uncertain. In the near-term, much of the US economy is paralyzed and second quarter 2020 GDP will likely show significant contraction that could linger into the third quarter and the balance of the year. As we gain control of the virus and stability in returns, we believe the economy will climb out of this recession and begin a healthy multi-year recovery.
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 Officer/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 Micro 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 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.
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.
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 September30, 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 Micro Cap Value composite has been examined for the periods June 10, 2010 through September 30, 2019. 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.