Market Commentary

We frequently mention that, as long-term investors, we avoid the prevailing near-term sentiment. The activity around interest rates and the economic outlook over the past year validates this perspective. Equities have been particularly volatile with a sharp sell-off in the fourth quarter followed by an impressive rally over the first half of 2019. When the economy seems to be late in the cycle, capital markets can often experience random panic attacks over short-term headwinds. Weak economic data, which leads the Fed to consider interest rate cuts, tends to heighten these anxieties. With a wide variety of data points, conflicting news accounts and partisan political campaigns, it can be difficult to get a true sense of the status of our economy.

To filter through the noise, we track a handful of select data points that are a mix of concurrent and leading indicators. These generate a proprietary score that we have back-tested over several decades. In the past, this score has proven to be a reliable recession indicator with the absence of any false positives. We believe the model has been especially helpful as an unbiased measure late in the business cycle when the economy begins to slow and the Fed begins to cut rates, much like the environment we find ourselves in now. Our proprietary score also helps insulate us from being unduly influenced by the perma-bulls or perma-bears that seem to dominate much of the financial media.

It has been noted many times that the “state of the economy” is not synonymous with “the state of the market,” and vice-versa. Therefore, just as no two recessions are identical, the market and the economy do not necessarily move in sync, although they definitely march to a similar beat. We believe that keeping a close eye on our score enhances our decision making process when forecasting revenue and earnings growth rates for our holdings and, at the overall portfolio management level, as we consider allocations toward economically-sensitive sectors. The recent brief yield curve inversion and the likelihood of rate cuts this year have already generated initial recession calls. As we see it, we still need to experience a fair amount of deterioration in our key metrics before we declare that a downturn is imminent.

 Strategy Review

The Pacific Ridge Capital Partners’ Small Cap Value strategy rose 2.3%* during the second quarter of 2019, outperforming the 1.4% return of the Russell 2000® Value Index (“Index”). Over the trailing one-, three- and five-year periods, the strategy returned -13.8%*, 9.2%* and 3.9%* (annualized), respectively, compared to the Index returns of -6.2%, 9.8% and 5.4%. Since inception on August 1, 2010, the strategy returned 10.6%* annually versus 10.3% for the Index.

Top Contributors

Meta Financial (“CASH”) is an Iowa-based community bank and financial services firm. Its stock price has been very volatile over the past six months, but has rebounded strongly off its lows. A new CEO changed the bank’s strategy to focus more on growing the Commercial  Finance book rather than Specialty Consumer lending.

Ultra Clean Holdings (“UCTT”) is a developer and manufacturer of critical subsystems in the semiconductor capital equipment industry. The stock continued its recovery off the bottom during the quarter as the industry is in the midst of a trough in capital spending.

Hallmark Financial (“HALL”) is a property and casualty insurer based in Texas. The company has been in a multi-year turnaround led by a new CEO. He has revamped much of the company’s underwriting and claims administration, in addition to launching new programs. HALL’s earnings last quarter continued to demonstrate the success of those initiatives as the stock trades near all-time highs.

NV5 Global (“NVEE”) is a professional and technical consulting firm. The stock bounced back in the quarter on an earnings beat following a big miss in the fourth quarter. The company has been an aggressive acquirer and has been able to fund the transactions from their free cash flow. Analysts have been revising earnings estimates higher on expectations of positive synergies from this acquisition spree.  

Metropolitan Bank Holding (“MCB”) is a community bank based in New York City. The stock saw a nice recovery in the quarter following a sharp sell-off in the second half of 2018. Strong loan growth and an improved credit picture drove a big earnings beat for the first quarter. Additionally, MCB remains an attractive acquisition target thanks to their attractive deposit base and the uniqueness of being a small bank in the Manhattan market.

Top Detractors

Zovio (“ZVO”) is a for-profit education company that operates Ashford University. Management is looking to spin out the university as a non-profit and operate as an online program manager, providing services to Ashford and other online schools. The stock sold off in the quarter as the regulatory approval for the spin-out was delayed and enrollment trends were below expectations.

Poly (“PLT”), formerly known as Plantronics, is a supplier of headset, phone, and audio and video conferencing solutions. The stock sold off during the quarter following disappointing 2020 EBITDA guidance that some analysts feel is conservative. The company is in the process of integrating the Polycom acquisition and also has a new CFO. Poly continues to be very profitable with an attractive valuation.

Intevac (“IVAC”) is a manufacturer of capital equipment in the data storage industry. IVAC is slowly returning to profitability following a disappointing 2018. Demand in the industry tends to be very lumpy but management believes they can return to 15-20% growth later this year. Other small business segments provide additional upside for IVAC and its strong balance sheet should limit further downside.

Citi Trends (“CTRN”), a retailer of urban fashion, reported disappointing earnings for the quarter. Comp sales were down to mid-single digits as the company cycled tough comparisons from the prior year. CTRN has been aggressive in returning capital to shareholders through dividends and buybacks that helped buoy earnings. The company has an ambitious plan to grow their store base and feels expanding into the Hispanic market will help drive foot traffic. 

Caleres (“CAL”), a footwear retailer and wholesaler, continues to struggle with weak comp sales, declining margins, and difficulty integrating past acquisitions. Their Branded Portfolio business continues to perform well and offset some of the weakness on the retail side. The stock now trades near all-time lows. Like many retailers, the company should see significant upside if they manage to stabilize their margin decline.

**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.

Economic Sector Analysis

The strategy’s performance in Financials contributed approximately 110 basis points of excess return compared to the Index. However, performance in Information Technology detracted approximately 70 basis points versus the Index. The strategy’s lack of exposure to the Consumer Staples sector provided nearly 30 basis points of excess returns during the quarter, while the lack of exposure to the Utilities sector provided a headwind of approximately 20 basis points.

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 choppy activity in the near term. Sentiment amongst purchasing managers remains positive with the June US manufacturing PMI reading of 51.7, the 34th consecutive month of expansion. While new orders dropped to a three-year low, inventories contracted which can signal restocking in the second half of the year. Production and employment remain strong. First quarter 2019 GDP of 3.1% rebounded from the prior quarter and reflected an upturn in government spending and accelerations in inventory investment and exports. However, the cautious business spending climate is expected to cool growth to 2.5% for full year 2019. Corporate profitability and balance sheets remain strong.

Our concerns, given our portfolio positioning, are the potential for an unforeseen near-term economic contraction. We believe uncertainty related to the effects of a global trade war is the greatest risk to growth.

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 Operatingr/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 December 31, 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 December 31, 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.