Q2'23 Small Cap Value Strategy

Performance Review

The Pacific Ridge Capital Partners Small Cap Value strategy (the “Strategy”) returned 4.0* (3.8%* net of fees) during the second quarter ended June 30, 2023, outperforming the Russell 2000® Value Index (the “Index”) return of 3.2%.

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 $719 million Index median saw a return of 2.7%, versus a 3.3% return for stocks with a market capitalization above the breakpoint level. The Index had a significant 86.5% of its weight above the median market capitalization level, while the Strategy had a comparatively lower weight of 51.9%.

Style Analysis

The Strategy faced a modest overall value style bias headwind during the quarter from the outperformance of unprofitable companies in the Index. These unprofitable companies posted the highest return in the Index at 9.4%. 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 returned 1.9%, versus a 2.4% return for those companies with a PE below 15x.

Sector Analysis

The top two contributing sectors to the Strategy’s performance were Financials and Consumer Staples, with a weighting of 27.2% on a combined basis. Underweighting Financials compared to the Index, plus positive stock selection scores, created a slight tailwind for the Strategy. At the same time, overweighting Consumer Staples created a slight headwind that was more than offset by positive stock selection scores. The top two sector detractors in the Strategy were Consumer Discretionary and Health Care. Although the Strategy benefited from a modest tailwind by overweighting Consumer Discretionary, poor stock selection scores caused a slight headwind. The lack of exposure to the Health Care sector was also a negative factor.

Portfolio Characteristics (as of 6/30/23)

Top Contributors

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.

Customers Bancorp (“CUBI”) a Pennsylvania-based community bank, experienced a rebound in the second quarter as market uncertainty surrounding bank runs subsided. Throughout the turbulence created by SVB Financial Group’s failure, CUBI demonstrated resilience with a relatively stable deposit base. Given that the bank currently trades at 5x earnings, we remain comfortable maintaining our sizeable position.

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.

SP Plus (“SP”), a provider of parking management, ground transportation, and baggage handling services, reported solid results in its latest quarter and raised its long-term target growth rate by several points. The company has invested heavily in technology, particularly since the start of the pandemic. This is driving new contract awards and market share gains, as well as transforming the parking industry. Free cash flow remains strong and should continue to support further investment, organic growth, and additional acquisitions.

Top Detractors

Intevac (“IVAC”) is a maker of thin-film deposition equipment used primarily for hard disk drive (HDD) manufacturing. After a nice two-quarter increase in the share’s value fueled by large HDD purchase contracts, the stock experienced a significant decline, losing nearly half of its value during the quarter. In May, management noted unexpected slowness in delivering on contracts, then announced significant contract cancellations in June. IVAC also hired an investment bank to do a review of strategic alternatives. With shares now trading at a small premium to cash value, and given the potential of non-HDD applications for IVAC products, we are maintaining our position for now.

PRA Group (“PRAA”) is a debt collector that purchases portfolios of nonperforming loans. The stock sold off sharply during the quarter after reporting disappointing earnings. The company faced a weaker tax refund season and a downward adjustment to expectations of future collections. While a slowing economy creates a headwind in the near term, PRAA should benefit from more supply and earnings power over the intermediate to long-term, highlighting the counter-cyclical nature of their business.

1-800-FLOWERS.COM (“FLWS”) is an online retailer of flowers and gifts. The business has struggled over the past few years due to high inflation and shipping costs. There is also concern about the discretionary nature of FLWS’s business should an economic downturn come to fruition. Management has completed several acquisitions to diversify its revenue stream and is now known as a primary destination for all gifting occasions.

NETGEAR (“NTGR”) is a provider of networking solutions to consumers and small-to-medium businesses. Initially, the company benefited from the pandemic when workers were sent home and demand for routers increased. Over time, that created a glut of competitors, especially in the lower and mid-range markets. Though NTGR responded by focusing on the high-end home router market, which features better margins and high subscription attach rates, revenue has still dampened. Shares fell over 20% after reporting disappointing first quarter results, but we are attracted to the company’s valuation that is well below tangible book value.

Avantax (“AVTA”) has transformed into a pure-play tax-focused financial planning and wealth management company, including broker-dealer and RIA. The company sold its TaxAct tax preparation business late last year and as promised, returned roughly half of the divestiture proceeds to shareholders via a combination of a Dutch tender offer and stock buybacks. However, shares have since pulled back recently, due in part to depressed earnings from short-term expenses related to TaxAct service contract support. As those close out late this year, margins should expand, improving AVTA’s valuation.

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.

PRCP GIPS Report

*Information is not statistically meaningful due to an insufficient number of portfolios in the composite for the entire year.

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 Small 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 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. 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 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. 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 Small 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 1.00% 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 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 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 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.