Market Commentary

The economic trajectory over the past year has been unlike anything we have ever seen. A record decline in economic activity followed by a debt-fueled stimulus reduced the amount of time it will take to resume pre-pandemic trend growth. Since society has not fully returned to normal, we are still waiting to see how this transition process plays itself out. 

As normal economic activity steadily resumes, we should see significant changes on the employment front as jobless claims decline and supplemental unemployment insurance tapers off. Several government programs meant to support those most adversely impacted by the pandemic will also phase out. These include student loan deferrals, eviction and foreclosure moratoriums and assistance through the Paycheck Protection Program (PPP). With so many moving parts, forecasting economic growth for the next twelve to eighteen months remains challenging. 

Amid this backdrop, the financial media is giving a lot of attention to the prospect of inflation. Figures for the Consumer Price Index (CPI) and Personal Consumption Expenditures (PCE) are grabbing headlines, showing a year-over-year increase north of 3%, well above the Federal Reserve target of 2%. Month-over-month changes have been a little noisier, with CPI spiking as high as 11%. However, alternative measures such as the Trimmed Mean PCE are significantly more muted, with year-over-year inflation in line with the mean of the past twenty years. 

Sustained inflation increases the likelihood that the Fed will be forced to increase interest rates sooner than anticipated, thereby slowing down the economic recovery. Though some commentators and market participants ring alarm bells about this possibility, others suggest that higher inflation levels are temporary. Several key indicators that provide insight into market expectations around future inflation validate this latter view, suggesting fears of runaway inflation are overblown. For example, the implied inflation in Treasury Inflation Protected Securities (TIPS) declined to 2.33% after peaking at 2.54% in mid-May. Similarly, yields on ten-year Treasury Securities declined by the same amount, reflecting a fall in implied inflation expectations, rather than a decrease in real rates.  

As the saying goes, to understand the future, you need to understand the past. Across the economy, unprecedented stimulus created a tremendous amount of liquidity. The resultant increased demand for goods, combined with pandemic supply chain disruptions, led to shortages in several industries, most notably semiconductors, lumber and low-wage labor. This resulted in several knock-on effects where a lack of supply became distributed across a broad range of products and services such as new cars, appliances, gaming consoles, housing and retail staffing. In microeconomics, we learned that when supply is low, prices rise and equilibrium is only pushed back down when supply improves, demand decreases or consumers choose lower-cost substitutes. 

Another unappreciated factor that drove inflationary pressure for durable goods last quarter was the inability for consumers to spend money on services and entertainment because of government-mandated lockdowns. As these lockdowns ease, we anticipate a shift in spending back to services. This should reduce demand for durable goods and ease inflationary pressure.

At some point, supply chains will recover from prior shutdowns and production will accelerate to take advantage of above-average profit margins. Combined with a decline in government stimulus and excess liquidity, we believe that concern over inflation will moderate.  

Investors are understandably relieved about the speed of the economic recovery. A premature end to accommodative monetary policy would serve as an unwelcome headwind to financial markets. At this time, we are more concerned about the economic and societal adjustments that will occur as various stimulus and assistance programs are phased out. Navigating our way out of a slowly fading pandemic may prove more challenging to policymakers than most currently expect.

*Preliminary results.  For additional performance information, see the related GIPS® Report at the bottom of the page.

Strategy Review

The Pacific Ridge Capital Partners’ Small Cap Value strategy rose 4.0%* during the second quarter of 2021, underperforming the 4.6% return of the Russell 2000® Value Index (“Index”). Over the trailing one-, three- and five-year periods, the strategy returned 80.2%*, 7.7%* and 13.5%* (annualized), respectively, compared to the Index returns of 73.3%, 10.3% and 13.6%. Since inception on August 1, 2010, the strategy returned 12.3%* annually versus 12.0% for the Index.

*Preliminary results.  For additional performance information, see the related GIPS® Report on the last page.

Top Contributors

Medifast (“MED”) is a direct marketer of weight loss and healthy living products. The stock performed very well over the past year as it recovered from several operational missteps that impacted revenue growth and internal execution. Management appears to have moved past their recent growth pains and resumed the company’s trajectory of 30%+ revenue growth. This opens up a long potential runway of expansion as the company looks to increase its international footprint.  

Customer’s Bancorp (“CUBI”), a Pennsylvania-based community bank, performed well during the second quarter as the stock continued its steady rise from the bottom last summer. The bank earned significant fees by originating PPP loans, a temporary revenue source that could cumulatively add as much as $10 per share in earnings.  With the wind-up of PPP and the spin-out of their ownership stake in BM Technologies (“BMTX”), a mobile banking platform that caters to students and those underserved by the banking industry, CUBI will soon return to its core banking business.

Signet Jewelers (“SIG”), an operator of jewelry stores, rallied strongly last quarter, thanks to a leaner pandemic cost structure that improved gross margins. The company’s loss to shareholders came in far lower than expected, enabling SIG to aggressively pay down debt and finish the year with an improved balance sheet. We continue to evaluate the company’s true earnings power going forward under normalized economic and societal conditions.

Textainer Group Holdings (“TGH”) is a lessor of cargo shipping containers. Thanks to strong demand for containers, maintenance, storage, handling and repositioning costs have lowered, benefitting stock performance. With secondary market prices elevated, the company should continue to see significant gains from selling end-of-life containers. 

Metropolitan Bank Holding (“MCB”), a Manhattan-based community bank, continued to rally during the quarter as credit concerns related to New York City and their health care portfolio dissipated. Sell-side estimates have been steadily revised higher as the company continues to play up their fintech capabilities. MCB is also catering to other online-only banks, helping these customers with their backend infrastructure. This new business generates a nice stream of fee income and should reward MCB with a better earnings multiple over time.

Top Detractors

Rimini Street (“RMNI”) is a provider of support and services for enterprise software. The company reported first quarter revenues that were slightly below expectations and adjusted EBITDA notably downward compared to the fourth quarter. Reigniting growth on the domestic front is a key metric that analysts are watching going forward. Using cash on hand and free cash flow, the company will look to retire $140 million of costly preferred debt that is now callable. 

Heritage Insurance (“HRTG”) is a provider of property and casualty insurance. The stock has struggled over the past year due to a high frequency of weather events in their core markets. Though the impact of these events on HRTG’s financials is under control, management has blamed their issues on “death by a thousand cuts.” The company is culling the least profitable policies from their book of business and implementing double-digit premium increases. 

COHU (“COHU”) is a manufacturer of semiconductor test and inspection handling equipment. The stock gave back some gains after a big move during the prior two quarters. While earnings results came in ahead of expectations, company guidance suggested lower gross margins, an announcement that caught some investors off guard. However, the recent divestiture of a lower-margin segment to pay down a term loan should help alleviate some of those investor concerns.  

Wabash National Corporation (“WNC”) is a manufacturer of semi-trailers, truck bodies, and specialized commercial vehicles. The stock traded down modestly during the quarter following a strong bounce off the bottom one year ago. Earnings results met consensus, though mild expectations around margins in the near-term may have pressured the stock. With significant end-market demand for trailers, there should be a strong revenue tailwind through 2022.  

Matrix Service Company (“MTRX”) is an engineering and service provider to the energy and mining industries. The stock trended down during the quarter following a soft earnings report. Multiple headwinds pressured results, including the Covid pandemic, political concerns and severe weather. Current trends are expected to reverse as we move into 2022 and multiple initiatives currently underway by management gain traction.

**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® Report on the last page.

Market Capitalization Analysis

There was a slight 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 5.1%, versus a return of 4.5% for companies with a market cap above $1 billion. The strategy had 53.5% of its holdings in companies with a market cap below $1 billion, compared to 16.3% for the Index.

Style Analysis

There was a modest value-bias tailwind during the quarter as stocks with lower PEs outperformed those with higher PEs. Those with a PE ratio greater than 15x returned 2.1% versus 5.1% for those companies with a PE below 15x. The strategy had 44.9% of its holdings in companies with a PE greater than 15x compared to 49.1% for the Index. However, strong performance of unprofitable companies in the Index created a modest headwind, as those stocks returned 13.2%, versus a gain of 3.3% for firms that were profitable. The strategy had 8.2% of its holdings in unprofitable companies, compared to 14.1% for the Index.

Economic Sector Analysis

The strategy’s performance in Financials and Consumer Staples contributed approximately 190 basis points of excess return relative to the Index. However, performance in Information Technology and Communication Services detracted approximately 290 basis points versus the Index. The strategy’s lack of exposure to AMC Entertainment (“AMC”) detracted approximately 120 basis points of excess return during the quarter.

Market Outlook

We continue to have a modest growth outlook for the US economy as society slowly returns to normal. The recovery carried through 1Q21 with GDP growth of 6.4% as business re-openings and additional fiscal stimulus helped drive increases in corporate profits and personal consumption. Sentiment amongst purchasing managers remains positive with the June 2021 US manufacturing PMI reading of 60.6, the thirteenth consecutive month of expansion. New Orders and Production components remain strong while inventories appear to be building slightly. However, a challenged labor market and supply chain disruptions could limit economic growth in the near-term.

Portfolio Characteristics and Top Ten Holdings (as of 6/30/21)

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 Veronica Orazio Operations Assistant
Justin McKillip, CFA® Senior Analyst
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® Report 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. Pacific Ridge has been independently verified for the periods June 10, 2010 through March 31, 2021. 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 Small Cap Value Composite has had a performance examination for the periods June 10, 2010 through March 31, 2021. The verification and performance examination reports are available upon request.

The Small Cap Value composite was created and incepted 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 gross returns of the portfolios included for the entire year. 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. Performance-based fees are available upon request. All returns are calculated after the deduction of the actual trading expenses incurred during the period. The management fee schedule and total expense ratio for the Small Cap Value Fund, which is included in the composite, are 1.00% on all assets and 1.23%, respectively, as of the most recent audit. Total fees for the fund may not exceed 1.25% annually.

The fee schedule for separately managed accounts 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 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 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.