Q3’20 Micro Cap Value Strategy
Market Commentary
There is a reason we use the term “business cycle.” Over time, we see periods of expanding economic growth and intermittent recessions. Fortunately, we have automatic stabilizers in our economic system that can smooth out these business cycle fluctuations, including unemployment benefits and progressive income tax rates. While these tools can’t completely blunt the deleterious impacts of job losses and reduced income, they are vital to those without adequate alternative financial resources.
The Federal Reserve also provides a manual form of economic stimulus through its monetary policy; specifically, the overnight rates that the Fed lends to banks. This impacts the accessibility of credit within the financial system. The lower the interest rate on loans, the more credit becomes available and the more businesses are willing to borrow and invest.
In the late 1980s, we became accustomed to a more aggressive form of monetary stimulus. Led by then Chairman Alan Greenspan, the Fed began increased its bond purchases, including lower quality instruments than they typically had bought. They took this aggressive action when equity markets experienced a decline of greater than 20%, with the intention of reducing the volatility of both the business cycle and the capital markets. This bond-buying spree limited the downside in equities and lower quality bonds and became known as the “Greenspan put.” During the great financial crisis, it also became associated with his successor, Ben Bernanke.
Our current economic crisis is unlike anything our country has ever experienced. The aggressive actions towards limiting the spread of COVID-19 resulted in a previously unthinkable 31.4% decline in GDP. In addition to the recent trend of quantitative easing and newer policy tools such as the Main Street Lending Facility, Congress and the Administration passed an unprecedented economic stimulus package designed to mitigate the effects of an economic shutdown. While equity markets experienced a sharp selloff late in the first quarter, they came roaring back as consumers benefited from deferred loan payments, bans on evictions and direct cash payments from the Treasury. Based on how this program successfully boosted consumer spending, pressure remains for additional stimulus.
No one will argue that fiscal stimulus is a necessary prescription for any sharp decline in economic activity. These policies stimulate near-term economic activity, prevent job losses and provide support for capital markets. However, there’s a downside to monetary policy like the Greenspan or Bernanke put. These measures can create the expectation that the Fed will always come to the rescue with similar put-type solutions—and grow them in size and scope. While the Fed can allow the bonds they purchase to simply mature, fiscal stimulus adds to the national debt and must be repaid at some point in the future. There are competing arguments as to how consequential this is; specifically, are increasing debt levels inflationary or deflationary. Most concerning, Fed policy like the Greenspan put risks the creation of investor complacency. If economic activity declines, Congress will face substantial pressure to act aggressively to solve the problem.
The next two quarters will be a crucial period for the capital markets. The results of the US Presidential election and progress towards a Covid vaccine will provide a backdrop for the Fed and Congress to decide if more fiscal stimulus is needed, which will invariably move the equity markets. In any event, the valuation disparity between small companies and large companies should continue to shrink in the face of a recovering economy.
Strategy Review
The Pacific Ridge Capital Partners’ Micro Cap Value strategy returned 1.1%* during the second quarter of 2020, trailing the 2.0% return of the Russell Microcap® Value Index (“Index”). Over the one-, three- and five-year periods, the strategy returned -19.3%*, -7.3%* and 6.8%* (annualized), respectively, compared to the Index returns of -11.5%, -4.3% and 5.0%. Since inception on April 1, 2007, the strategy has returned 7.8%* annually versus 3.4% for the Index.
Top Contributors and Detractors to Return*
Top Contributors
CAI International (“CAI”), an intermodal freight container leasing and management company, continued its rally during the quarter following a sharp drop earlier in the year. The company recently announced that utilization is once again approaching 100%, and they have leased nearly all of their container inventory. Furthermore, CAI is expecting an increase in their book value by year end, based on the commencement of favorable contracts.
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 another strong quarter of results. 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 MicroLED.
Inner Workings (“INWK”) is a provider of print procurement through a large network of printing production providers. The stock more than doubled early in the quarter when they announced their intention to be acquired by HH Global. The stock had been under pressure given their high exposure to the retail industry.
Lifetime Brands (“LCUT”) is a manufacturer of kitchenware and tableware products. The stock continued its rebound from multi-year lows during the quarter following a boost to profitability, attributable to strong margins and sales that exceeded expectations. Momentum from the e-commerce channel helped offset weakness from the institutional channel as the restaurant industry continues to struggle.
Global Medical REIT (“GMRE”) is a real estate investment trust specializing in health care properties. The stock rebounded from the lows earlier this year because the properties in their portfolio experienced little impact from reduced economic activity. Management of the REIT was recently internalized, opening up the stock to a new pool of investors. GMRE continues to execute on their strategy of buying strong credit properties in less competitive markets.
Top Detractors
BG Staffing (“BGSF”) is a temporary staffing company focused on clerical, light industrial, IT, finance and multifamily industries. Because the global pandemic has affected hiring and staffing, the stock has struggled this year, impacting results. However, BGSF expects to remain profitable and generate cash flow to pay down debt. A gradually declining unemployment rate should serve as a tailwind to earnings.
Heritage Insurance (“HRTG”), a property and casualty insurer, sold off late in the quarter despite reporting solid earnings results in August. While in the midst of hurricane season, one major storm that struck the mainland was in Louisiana and Mississippi where they have no policy coverage. HRTG provided a very positive update in their quarterly earnings call and in subsequent road-shows as they continue to expand their relationships with larger insurers in an effort to drive premium growth.
Riverview Bancorp (“RVSB”), a community bank headquartered in southwest Washington, continued to trade down during the quarter following a sharp sell-off in the previous period. The stock has been under pressure due to elevated exposure to hospitality loans. While the bank has above average reserves, capital and low loan-to-value ratios, uncertainty in the hospitality industry will burden the stock until the economy has fully reopened and hotel occupancy rates have recovered.
Rimini Street (“RMNI”), a company that specializes in providing third-party software support services, was added to the strategy during the quarter. RMNI provides similar support services as large software providers but at a fraction of the cost. The stock traded lower during the quarter following a secondary offering and pre-trial rulings related to ongoing litigation with Oracle. While the legal dispute is likely to continue for a number of years, there is substantial upside given the opportunity for revenue growth and operating margin expansion.
Universal Electronics (“UEIC”) is a provider of remote controls and other home entertainment technologies. The company reported revenues that were below expectations, although improved margins helped earnings and EBITDA beat consensus. Forward guidance was disappointing as Covid-19 has impacted the willingness of consumers to have a technician in their home to set up a new system. We feel that the revenue hit from these installation delays is temporary.
*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 slight tailwind due to size bias 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 2.8%, versus a return of 1.0% for firms with a market cap above $400 million. The strategy had 77% of its holdings in companies with a market cap below $400 million, compared to 55.5% 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 9.0%, versus -0.3% for firms that were profitable. The strategy had 13.3% of its holdings in unprofitable companies, compared to 29.2% for the Index.
Economic Sector Analysis
The strategy’s performance in Industrials and Energy contributed approximately 170 basis points of excess return relative to the Index. However, performance in Consumer Discretionary and Financials detracted approximately 310 basis points versus the Index. The strategy’s lack of exposure to the Communication Services, Utilities and Consumer Staples contributed approximately 60 basis points of excess returns during the quarter.
Market Outlook
The economy snapped back in the third quarter of 2020 following COVID-19 related shutdowns that drove a 31.4% decline in GDP during the second quarter. While third quarter GDP is expected to show significant growth, the sustainability of the recovery is clouded by uncertainties related to the virus, fiscal policy, and the upcoming election. We remain cautious in the near-term particularly given concerns about the length of the pandemic.
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 June 30, 2020. 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, 2020. 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.