Q2’20 Micro Cap Value Strategy
Market Commentary
Each year, at the end of second quarter, the Russell Indexes’ reconstitution takes place. While this activity seems trivial compared to other current events, there were some meaningful changes this year that will impact how investors measure performance of their managers and frame expectations for the coming twelve months. Take the Russell Microcap® Value Index (“Index”), for example.
The first notable change pertains to market capitalization. Due to the market decline over the past year, the weighted average market capitalization of the Index decreased from $578 million on June 30, 2019 to $486 million at this year’s reconstitution. The smallest company added to the Index was approximately $25 million.
Second, sector weightings shifted significantly after the reconstitution. Look at the scope of these sector changes.
Health Care dropped from 16.1% to 11%. Most of that weighting difference can be attributed to the 78 companies that exited the Index due to size or valuation implications. (Incidentally, all but two of those companies were unprofitable biotech or pharmaceutical firms).
Information Technology declined 4.1%. Its weighting went down to 5.7%.
Since February, the Industrials sector has been hit hard with valuation declines. As a result, its weight shifted from 10.1% to nearly 13%, with most of the increase reflected in the Capital Goods industry.
Financials grew from 31.3% to 34.1%. Banking and Diversified Financials (including REITS and specialized lending firms) drove this weighting shift.
Consumer Discretionary weighting increased from 10.7% to 12.9% due to underperforming companies in the sector.
Additionally, the number of unprofitable companies in the Index declined from 24.3% prior to reconstitution to 20.2%.
Here is the critical point. The Index structure may have changed, but how we invest did not. We focus on companies that are profitable, that generate cash flow and that trade at discounted valuation multiples. That is the core of our investment discipline. Additionally, our sector weightings are an indirect outcome of our bottom-up stock selection process. While we closely monitor our sector and industry weightings on a relative basis, ultimately, we are sector indifferent.
We know from experience that benchmark changes like we saw in this recent reconstitution can have an impact on go-forward relative performance. With the steep decline in unprofitable biotech company weights in the Index, a relative performance headwind will be removed if they continue to outperform as a group, or a tailwind will be missed if they underperform and revert to the mean.
Strategy Review
The Pacific Ridge Capital Partners’ Micro Cap Value strategy returned 20.9%* during the second quarter of 2020, trailing the 22.9% return of the Russell Microcap® Value Index (“Index”). Over the trailing one-, three- and five-year periods, the strategy returned -21.4%*, -5.3%* and 4.3%* (annualized), respectively, compared to the Index returns of -14.9%, -2.9% and 2.2%. Since inception on April 1, 2007, the strategy has returned 7.9%* annually versus 3.3% for the Index.
Top Contributors and Detractors to Return*
Top Contributors
Ultra Clean Holdings (“UCTT”) is a developer and manufacturer of critical subsystems in the semiconductor capital equipment industry. The stock recovered much of its March losses during the quarter, given that both current and future outlook for demand remains strong and the pandemic caused minimal supply chain and manufacturing disruption. UCTT was quick to respond to these trends and picked up business from its less-prepared competitors.
AXT, Inc. (“AXTI”) is a key supplier of silicon-alternative semiconductor substrates, such as gallium arsenide (GaAs) and indium phosphide (InP). After a tough 2019 tied to the move of a Chinese manufacturing facility, AXTI reported stronger results for the first quarter. We are optimistic that demand for InP and GaAs will rise because both substrates are used in 5G infrastructure buildout, 3D sensing in mobile handsets and a new display technology called Micro LED.
Northeast Bank (“NBN”) is a community bank headquartered in southwest Maine. The stock recovered during the quarter following a sharp decline in March due to credit concerns. The company reported earnings in April that missed estimates, but put investors at ease by providing detailed disclosure around their underwriting and current portfolio. A key segment of NBN’s business is counter-cyclical, which should provide a tailwind to future earnings.
COHU (“COHU”) is a manufacturer of semiconductor test and inspection handling equipment. The stock was hit particularly hard in the first quarter due to its auto industry exposure and perceived risk from debt on the balance sheet. COHU shares recovered a fair amount in the second quarter, driven by overblown debt concerns and the potential for a strong recovery in mobile handsets, based largely on 5G-related demand.
Shyft Group (“SHYF”), a manufacturer of commercial vehicles, performed well over the past few years thanks to strong demand in the delivery vehicle segment. While on-line shopping continues to capture market share from traditional brick and mortar retailers, there has been robust growth in deliveries for commercial vehicles. Weakness in other segments somewhat offset this trend however, most notably in luxury motor coach chassis units.
Top Detractors
Twin Disc (“TWIN”) is a manufacturer of power transmission equipment. Their stock sold off this year given the high cyclicality of several of the company’s business lines. They also experienced supply chain issues due to COVID-19. In the most recent quarter, downward pressure on energy prices and an increased debt load from a recent acquisition have weighed on shares. TWIN plans to prune their working capital in the near term to help generate cash flow.
Capital Bancorp (“CBNK”), a community bank headquartered near Washington D.C., trended down slightly during the quarter. The stock sold off sharply in March, along with many other banking firms, then saw a substantial bounce in its stock price prior to the end of the first quarter. Since then, it has been trading down. The bank appears to have limited exposure to the most at-risk areas of hotels and restaurants.
Midland States Bancorp (“MSBI”), an Illinois-based community bank, also sold off in March. Credit concerns for MSBI were especially pronounced because they came into this crisis with elevated credit concerns. Despite several fee-based businesses to help offset credit losses, we remained concerned that MSBI would face an elevated level of provisions that would negatively impact tangible book value. As a result, we exited our position.
Big 5 Sporting Goods (“BGFV”), a California-based sporting goods retailer, has traded down this year following the emergence of COVID-19. With many of their stores closed, the company faces inventory risks because of the cancellation of many youth sports activities. The company has curtailed some discretionary spending and fiscal support from the government has partially blunted the impact to decreased retail spending. However, due to BGFV’s debt load and thin margins, we decided to exit our position during the quarter.
Bank of Commerce Holdings (“BOCH”), a Sacramento-based community bank, faces the same concerns as other industry companies: scrutiny over potential credit losses. BOCH has experienced a conservative growth trajectory over the past few years that should mitigate the need for elevated provisions. The stock trades at very attractive levels relative to tangible book value and is still rumored to be a takeout candidate.
*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 a moderate size bias effect during the quarter, as the smallest companies in the Index slightly outperformed larger ones. Those with a market cap below $400 million in the Index returned 24.8%, versus a return of 20.6% for firms with a market cap above $400 million. The strategy had 84.4% of its holdings in companies with a market cap below $400 million, compared to 58.8% for the Index.
Style Analysis
There was no value-bias effect for profitable companies during the quarter. However, strong performance of unprofitable firms in the Index created a sizable headwind, as those stocks returned 52.3%, versus 17.8% for firms that were profitable. The strategy had 6.5% of its holdings in unprofitable companies, compared to 21.0% for the Index.
Economic Sector Analysis
The strategy’s performance in Financials and Information Technology contributed approximately 250 basis points of excess return relative to the Index. However, performance in Consumer Discretionary and Health Care detracted approximately 560 basis points versus the Index. The strategy’s lack of exposure to the Communication Services, Utilities and Consumer Staples contributed approximately 90 basis points of excess returns during the quarter.
Market Outlook
Despite expectations of a very poor second quarter earnings period that captured most shutdowns across the globe, the equity market rallied off the lows set in late March. We remain cautious in the near-term given uncertainties regarding the impact from COVID-19. The US economy is expected to show contraction of 20-30% in 2Q20, and while activity is slowly coming back the shape of the recovery is unclear.
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. Pacific Ridge has been independently verified for the periods June 10, 2010 through December 31, 2019. A firm that claims compliance with the GIPS standards must establish policies and procedures for complying with all the applicable requirements of the GIPS standards. Verification provides assurance on whether the firm’s policies and procedures related to composite and pooled fund maintenance, as well as the calculation, presentation, and distribution of performance, have been designed in compliance with the GIPS standards and have been implemented on a firm-wide basis. The Micro Cap Value Composite has had a performance examination for the periods June 10, 2010 through December 31, 2019. The verification and performance examination reports are available upon request.
The Micro Cap Value composite was created on June 10, 2010 and incepted on April 1, 2007. 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 gross returns of the portfolios included for the entire year. 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. Performance-based fees are available upon request. All returns are calculated after the deduction of the actual transaction costs incurred during the period. The management fee schedule and total expense ratio for the Micro Cap Value Fund, which is included in the composite, are 1.50% on all assets and 1.55%, respectively, as of the most recent audit. Total fees for the fund may not exceed 1.75% annually.
The fee schedule for separately managed accounts 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 and pooled funds, policies for valuing portfolios, calculating performance, and preparing GIPS Reports which are available upon request by contacting Peter Trumbo, Chief Compliance Officer at (503) 886-8972 or Peter.Trumbo@PacificRidgeCapital.com.
GIPS® is a registered trademark of CFA Institute. CFA Institute does not endorse or promote this organization, nor does it warrant the accuracy or quality of the content contained herein.
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 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.