Q2'23 Micro Cap Value Strategy

Performance Review

The Pacific Ridge Capital Partners Micro Cap Value strategy (the “Strategy”) returned 3.7%* (3.3%* net of fees) during the second quarter ended June 30, 2023, underperforming the Russell Microcap® Value Index (the “Index”) return of 4.5%.

The Strategy’s portfolio characteristics can be significantly different from the Index because we generally invest in smaller-sized and lower-valued stocks, as well as being sector indifferent. This difference is depicted in the charts below.

Size Analysis

During the quarter, the Strategy faced a slight size bias headwind, where larger companies in the Index performed better than smaller ones. Stocks with a market capitalization below the $220 million Index median saw a return of 3.9%, versus a 4.7% return for stocks with a market capitalization above the breakpoint level. The Index had 85.2% of its weight above the median market capitalization level, while the Strategy had a comparatively lower 58.3% weight.

Style Analysis

The Strategy faced a modest overall value style bias headwind during the quarter. This was due to the outperformance of unprofitable companies in the Index. These unprofitable companies posted the highest return in the Index at 12.1%. The headwind was slightly offset by the performance of profitable companies with relatively low valuations, where the Strategy has its highest weight. Those firms with a PE ratio greater than 15x had a small return of 0.2%, versus a 1.3% return for those companies with a PE below 15x.

*P/E ratios are based on analyst estimates for the current fiscal year, including both completed and estimated quarterly results. Companies that have no earnings estimates have been excluded, and thus the bars may not add up to 100%.

Top Contributors

Top Detractors

Top Contributors

Sterling Infrastructure (“STRL”), a provider of highway construction and site development services, continues to report strong financial results and has beaten analyst estimates in eight of the last nine quarters. Demand remains healthy in most end markets, particularly in excavation for new data centers, warehouses, and next generation manufacturing facilities. The diversification into alternative markets such as aviation and rail has been a tailwind to profitability in the legacy construction business. Following several sizable acquisitions, free cash flow has been very robust, leading to a stronger balance sheet.

Whole Earth Brands (“FREE”) is a distributor of sweetener alternatives in the consumer packaged goods industry. The stock rebounded late in the quarter after a large shareholder announced a non-binding offer to acquire the company. The business has struggled the past few years as FREE worked to integrate several acquisitions, work through challenging supply chain issues, and adjust to a higher cost of debt. Given the amount of leverage, there is room for the Board of Directors to negotiate a higher sale price without materially impacting the company’s valuation.   

Photronics (“PLAB”) is the leading merchant manufacturer of photomasks used in the production of semiconductors and flat panel displays. PLAB reported another good quarter of strong earnings results, and management’s outlook continues to be positive. Despite concerns about US/China semiconductor trade tensions, PLAB is well positioned throughout Asia to supply product to mature (non-cutting edge) manufacturing nodes that are expected to see very strong demand. Despite a recent move up in the shares, the valuation remains attractive and the balance sheet has ample cash reserves.

Northeast Bank (“NBN”) operates a Maine-based community bank and is also a nationwide commercial lender. The stock recovered during the quarter after selling off sharply following the banking panic in March. The company acquired a very large loan book at a 13% discount during the fourth quarter that led to positive earnings revisions. Management has a long track record of earning strong risk-adjusted returns by purchasing loans at a sizable discount to par value.

inTest (“INTT”) is a supplier of highly engineered process and test solutions used by a broad range of manufacturers. A relatively new management team turned in impressive results, with 32% organic revenue growth in the first quarter, compared to 17% for the full year 2022. While a nice long-term upside remains, we have decided to gradually reduce our position due to the substantial increase in the share price that has more than tripled in the past three quarters.

Top Detractors

Comtech Telecommunications (“CMTL”) is a niche provider of satellite and terrestrial wireless communications solutions. The company has struggled over the past few years, dealing with a failed acquisition, shareholder activism, and management changes, and the impact of US military actions in Afghanistan and Ukraine. Margins have suffered and debt service has become more expensive, adding pressure on the shares. We continue to like CMTL as a key provider to many important long-term programs. Furthermore, the company offers a diverse range of technologies that possess significant potential for future opportunities and value creation.

BuildABear Workshop (“BBW”) is a specialty retailer offering an interactive “make your own stuffed animals” experience, with a strong brand and consumer affinity. While first quarter revenue growth (2%) was a bit weaker than expected, profit margins and cash flow are still impressive. However, BBW shares were down 8% in the quarter, likely tied to consumer spending concerns. Management forecasts high-single-digit top-line growth for the year, and low-teens growth in profits. With a PE ratio of 6x and a substantial cash-rich balance sheet (even after the distribution of a special dividend payment of $1.50 per share), this investment remains a significant and favorable holding.

Asure Software (“ASUR”) is a provider of Human Capital Management (HCM) software and services, specifically in payroll processing and related functions. The stock slid 16% this quarter, after nearly tripling in the previous two quarters, when we trimmed our position. As expected, the company posted another strong quarter of 36% year-over-year revenue growth, following 22% the previous quarter. New marketplace options such as credit monitoring for employees of payroll customers, as well as a relatively new human resources compliance offering, are proving to be fruitful add-ons for a maturing sales force to market into the existing customer base.

STRATTEC SECURITY CORPORATION (“STRT”) is a manufacturer of automotive mechanical and electronically enhanced locks and keys, latches, power lift gates and door handles. Though the company’s shares underperformed in the previous quarter, we are encouraged by STRT’s long-term prospects. As global auto production gradually rebounds from its recent lows, and with the company managing the effects of cost inflation, we anticipate a resurgence in operating margins, leading to shares approaching their implied value.

Destination XL Group (“DXLG”) is a men’s clothing retailer focusing on the “big and tall” consumer. The company has gone through a multi-year turnaround that has seen it successfully grow sales and sustain double-digit margins. The stock likely sold off over concerns that the increased revenue and profitability levels will not be sustained as we move through the current economic cycle.

Market Outlook

During the second quarter of 2023, the performance disparity between domestic large cap growth stocks and small cap value stocks was quite notable. This discrepancy can be attributed to two primary factors: the surge in artificial intelligence chipmaker stocks and the lingering effects of the regional bank crisis.

In April and May, the performance of the broad US equity market was negative to flat. However, June witnessed a strong reversal, reminiscent of last year’s robust October performance that was driven by investors anticipating a shift in the Federal Reserve’s (Fed) stance on raising interest rates. This time, investor sentiment was bolstered by the Fed’s decision to pause interest rate hikes, despite signaling the possibility of further increases, potentially as early as July.

Although we maintain a modest growth outlook for the US economy, conflicting economic data from various leading indicators suggest potential stock market volatility in the near term. The core PCE Index, the preferred inflation gauge, saw a 0.1% decrease in May compared to the previous month, but still an elevated yearly reading of 4.6%. The yield curve remains severely inverted, historically a strong indicator of an impending recession. Lending availability and underwriting standards have noticeably tightened. In terms of employment, the U.S. economy added more than 1.4 million jobs this year, including 209,000 in June. However, this represents the smallest gain since December 2020, resulting in an unemployment rate of 3.6% versus May’s reading of 3.7%.

During the first quarter of 2023, GDP increased 2.0%, driven by increased consumer and government spending and nonresidential fixed investment. Though the second quarter 2023 GDP growth is also expected to remain positive, a majority of economists project negative growth from late 2023 to early 2024. Sentiment amongst purchasing managers continues to weaken, evidenced by the June 2023 US manufacturing reading of 46.0. This marks the eighth consecutive monthly reading below 50 and the lowest level since the initial Covid lockdowns. All five subindexes directly contributing to the Manufacturing PMI were in contraction territory.

As we look ahead to the remaining half of the year, we anticipate continued market volatility based on current economic data and the Fed’s potential decision to raise interest rates again in July. While we did observe the stock market performance extending to small caps in June, we are exercising caution until we see evidence of a decline in inflation and interest rates.

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 June 30, 2023. 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 June 30, 2023. 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. Performance from 2007 to 2010 is from portfolios managed at another entity. 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. Smaller capitalization equities have historically had greater volatility than large capitalization equities. 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. 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. It is not possible to invest directly in the Index.

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 time-weighted and 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 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 of contributors and detractors to portfolio return as well as a complete list and description of composites and pooled funds, policies for valuing portfolios, calculating performance, and preparing GIPS Reports, all of which are available upon request by contacting Peter Trumbo, Chief Operating Officer/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 and Bottom Performing Securities represent those security holdings that had the largest positive and negative total contribution to the portfolio return for the quarter. Top and Bottom Economic Sectors represent those sectors that had the largest positive and negative total contribution to the portfolio return. The holdings identified do not represent all the securities purchased, sold or recommended to clients.

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.