Market Commentary

At Pacific Ridge Capital, we have a strong conviction that the best risk-adjusted returns over a long-term time horizon can be found in undervalued small capitalization stocks. There is an abundance of data across numerous market cycles and various international markets that supports this philosophy. Occasionally, however, there are periods of time when growth stocks outperform, which has certainly been the case over the past decade. 

 We believe there are three key reasons for this disparity. First, growth stocks tend to outperform in low interest rate environments because they are more reliant on outside capital, which is more accessible when capital markets are performing well. Secondly, low interest rates or a flat yield curve tend to punish stocks in the Financials sector, which typically constitutes one-third of value benchmarks (and a much lower percentage in growth benchmarks). Finally, technological advances have transformed numerous industries and business models over the past decade. Some industries that have been populated with value stocks in the past have struggled to execute earnings turnarounds or stay in business. This has especially been the case in the Consumer Discretionary sector, where Amazon has driven many long-established retailers into bankruptcy.

 We are often asked, “When will value stocks outperform growth again?” Considering the factors identified above, we believe that value outperformance may be imminent. As it relates to the first factor, while interest rates are likely to remain low, access to low-cost equity capital will become more difficult for growth companies as the economy begins to slow. Similarly, established companies in the value benchmark are more likely to possess stable and profitable businesses that are capable of weathering a downturn. As allocators become more risk-averse in the face of an economic slowdown, we expect a capital shift from growth stocks into value stocks. As to the impact of technology on legacy business models, this will likely be a factor in the economy for years to come, though it would seem the most significant impacts have already occurred.

 This transition of investor capital could be accelerated by the apparent valuation disconnect between growth and value. We have recently seen several articles in mainstream publications (Wall Street Journal, Institutional Investor, MarketWatch) arguing that we are well overdue for a correction. Relative to growth stocks, value stocks are trading at one of the steepest discounts ever. The performance differential has been especially apparent over the past two-and-a-half years, as the Russell 2000® Growth Index outperformed the Russell 2000® Value Index by nearly 27% through June 30, 2019. Similar disconnects in the past have led to a sharp reversion, most notably following the tech boom in the early 2000s. After years of being told that value investing was dead, we saw capital and performance flood back into the space. While it is impossible to know exactly when this capital transfer will occur, we are confident that a similar dynamic will play out in this cycle. 

 Strategy Review

The Pacific Ridge Capital Partners’ Small Cap Value strategy rose 2.4%* during the third quarter of 2019, outperforming the –0.6% return of the Russell 2000® Value Index (“Index”). Over the trailing one-, three- and five-year periods, the strategy returned –9.9%*, 6.0%* and 5.9%* (annualized), respectively, compared to the Index returns of –8.2%, 6.5% and 7.2%. Since inception on August 1, 2010, the strategy returned 10.5%* annually versus 10.0% for the Index. 

Top Contributors

Hallmark Financial Services (“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 revamped much of the company’s underwriting and claims administration and has launched new business lines. HALL reported another solid quarter of earnings that easily exceeded analyst expectations. As a result of the company’s strong operating performance, the stock has made a significant run year-to-date, currently trading at all-time highs.

Photronics (“PLAB”), is a maker of masks used in the production of semiconductor and flat panel displays. Its stock price recovered during the quarter after a sell-off during the first half of the year. PLAB’s quarterly earnings met official estimates which, given the tough industry environment, was viewed as a positive surprise. The stock rallied in conjunction with an announcement of a significant share buyback. 

Meta Financial Group (“CASH”), an Iowa-based community bank and financial services firm, continued to perform well in the third quarter. The company completed the transformative acquisition of Crestmark Bancorp the prior summer, and investors are beginning to appreciate the impacts from the gradual transition of its loan portfolio. Despite a significant move year-to-date, the stock still trades at an attractive multiple on earnings and has favorable return metrics.

FormFactor (“FORM”), a designer of test and measurement solutions, rebounded during the third quarter following a sell-off in May. Earnings came in ahead of estimates. FORM continues to gain market share following critical product releases from Intel, and the company is progressing toward their targeted 40% market share. Although growth in the semiconductor industry is sluggish and expected to decline slightly in the near-term, FORM maintains a strong balance sheet that should provide needed stability in a highly cyclical industry.

Spartan Motors (“SPAR”), a manufacturer of commercial vehicles, reported another solid quarter of earnings in September. They continue to regain investor confidence after a major miss in their prior year’s third quarter results due to supply chain issues. Recent strength has been driven by large orders from USPS and Amazon, combined with management’s decision to focus on plant consolidations to boost profitability.

 Top Detractors

Zovio (“ZVO”) is a for-profit education company that operates Ashford University. Management is in the final stages of spinning out the university as a non-profit entity. It will then operate as an online program manager, providing services to Ashford and other online schools. The stock sold off in the quarter as ZVO struggles to resume enrollment growth. Management has blamed the latest challenges on increased difficulty of the initial coursework rolled out earlier this year. They are adjusting the on-boarding process in hopes of restoring retention rates to historical levels.

Twin Disc (“TWIN”), a manufacturer of power transmission equipment, reported poor earnings results during the quarter. The company said that they do not anticipate a material improvement in their financial metrics until 2020. Weakness in the oil and gas industry continues to be a headwind, with analysts expecting revenue to be down next year before a possible recovery in 2021. The best time to buy TWIN tends to be when the valuation bottoms out around tangible book value and expectations are low.

BuildABear (“BBW”) is a retailer of customized plush toys. The stock has been weak for several years as management struggles to transition their business in the face of decreasing shopping mall traffic.  BBW continues to diversify away from their legacy mall locations, with added non-traditional locations such as cruise ships, theme parks and specialty sites. We believe this should improve underlying profitability.

Patrick Industries (“PATK”), a manufacturer of parts and components for the recreational vehicle industry, continues to struggle as RV sales wane following their peak in 2018. Management has been careful to secure financing through 2027 to help weather an industry recession. Also, to avoid the excess capacity that plagued the industry during the last downturn, PATK expects to aggressively scale back production.

NV5 Global (“NVEE”) is a professional and technical consulting firm. The stock fell during the quarter on an earnings miss, following a nice beat during the second quarter. NVEE has been an aggressive acquirer and is in the process of integration. Although management raised revenue guidance for the year, costs related to internal control modifications resulted in a GAAP earnings-per-share guidance that remained unchanged. Needless to say, this disappointed investors.

**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® compliant presentation on the last page.

 Market Capitalization Analysis

There was a moderate size bias headwind during the quarter, as larger companies in the Index outperformed smaller companies. Those with a market cap over $1 billion in the Index lost 0.1%, versus a decline of 1.9% for companies with a market cap below $1 billion. The strategy had 77.2% of its holdings in companies with a market cap below $1 billion, compared to 26.6% for the Index.

Style Analysis

There was a significant value-bias tailwind during the quarter, as profitable companies in the Index outperformed unprofitable ones. Profitable companies in the Index were down just 0.1%, versus a decline of 6.7% for firms that were unprofitable. The strategy had 0.6% of its holdings in unprofitable companies, compared to 8.4% for the Index.

Economic Sector Analysis

The strategy’s out performance in 7 of the 11 economic sectors contributed approximately 480 basis points of excess return compared to the Index. However, Industrials and Real Estate detracted 120 basis points relative to  the Index. The strategy’s lack of exposure to the Consumer Staples and Utilities detracted approximately 40 basis points of excess return.  

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 turned negative last quarter, and the September US manufacturing PMI reading of 47.8 was the lowest since June 2009. Second quarter 2019 GDP of 2.0% cooled from the prior quarter and reflected downturns in corporate inventory investment, non-residential spending and exports. Consumer spending remains healthy and employment is high, but jobs data will be closely monitored, given the cautious business climate. GDP growth is expected to remain at the current pace in the second half, resulting in moderate full year growth. Corporate profitability and balance sheets remain strong.

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 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 June 30, 2019. 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 June 30, 2019. 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.