Q3'22 Micro Cap Value Strategy

Performance Review

The Pacific Ridge Capital Partners Micro Cap Value strategy returned -5.7%* during the third quarter ended September 30, 2022, underperforming the Russell Microcap® Value Index (“Index”) return of -2.2%.

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

Size was a neutral factor during the quarter. Stocks in the Index with a market capitalization below the $241 million Index median posted a -2.12% return, versus a -2.14% return for stocks with a market capitalization above the breakpoint level. The Index had 83.2% of its weight above the median market capitalization level, compared to 59.8% for the strategy. Of note, the strategy had a 31.9% weight compared to 10.5% in the Index in the smallest two quintiles (market capitalization below $170 million comprising 40% of the number of stocks in the Index universe) which returned -6.1%. (This detail is not represented in the chart below).

Style Analysis

The strategy faced a value style bias headwind during the quarter as unprofitable companies in the Index significantly outperformed profitable ones. Within the unprofitable group, the companies that report little or no revenues were bid up by investors (producing high-single digit positive returns), while companies in this unprofitable group that operated at or near profitability over the past year were sold off (producing mid-to high-single digit negative returns). Combined, these two groups returned 4.9% in the Index, whereas the unprofitable companies in the strategy returned -6.8%. During the third quarter, investors clearly placed a greater value on speculative companies in which we do not invest.

Sector Analysis

The top two contributing sectors to the strategy’s performance in the quarter were Industrials and Financials, with a combined benefit of over 110 basis points. These poorly performing sectors within the Index were overweight in the strategy, resulting in a slight headwind that was more than offset by favorable stock selection. The top two sector detractors were Health Care and Energy, combining for over 430 basis points of headwind. These two were the only sectors in the Index to post positive returns.

Portfolio Characteristics (as of 9/30/22)

Top Contributors

Destination XL Group, Inc.  (“DXLG”) is an apparel retailer for big and tall men. The company is in the midst of a multi-year turnaround under new management. Despite the headwinds in the industry and difficulties with supply chains, DXLG continues to execute its business plan and post strong earnings results. Despite the 59.9% move up during the quarter, it continues to be attractively valued.

Twin Disc, Incorporated (“TWIN”), a manufacturer of power transmission equipment, reported strong results last quarter that were well above expectations. The supply chain loosened a bit last period which helped the company catch up on some of its growing backlog. Higher volume and favorable pricing drove margins back to pre-pandemic levels. End markets continue to gain momentum and TWIN should grow revenue and earnings in the coming year, despite the uncertain macro environment.

Esquire Financial Holdings (“ESQ”) is a New York based business bank that specializes in serving the legal industry. The bank continues to perform very well, rapidly growing its loan portfolio while maintaining a very low cost of deposits, despite rising interest rates. Management recently announced a new strategic partnership that should drive additional revenue and earnings without any material credit risk. The company continues to be a good candidate for acquisition by a larger institution.

Barrett Business Services, Inc. (“BBSI”) is a western US-focused provider of outsourced human resource services. Wage inflation benefitted the company because its revenue model is largely based on a percentage of the collective salaries of its customers’ employees. Management’s strong performance in overseeing workers’ compensation risk, combined with a favorable new insurance relationship, continues to have a positive impact on free cash flow, the balance sheet and the bottom line.

AXT, Inc. (“AXTI”) is a maker of non-silicon, high-performance semiconductor substrates. The company posted very strong second-quarter results, with earnings roughly doubling investor expectations. A big sequential improvement in gross margins tied to efficiency and scale yielded these favorable results. A new contract award by one of the largest smartphone makers also drove operational improvements. While AXTI remains well positioned to take advantage of several key technology trends, its revenue can be lumpy, and it recently preannounced a weaker third quarter.

Top Detractors

Lifetime Brands, Inc. (“LCUT”) is a leading provider of branded tableware and kitchen tool products. After posting very strong 2021 results, this year’s performance has been negatively impacted by inventory slashing at large retailers. LCUT gross margins are holding up, but sales will likely be down 10% this year and investors have reacted negatively to the stock. We like management’s discipline and expect strong free cash flow to help improve a balance sheet that could benefit from some deleveraging.

STRATTEC SECURITY CORP. (“STRT”) manufactures mechanical and electrical lock and key assemblies for the automotive industry. Most of its sales are direct to OEMs. The tight labor market and supply chain issues have been especially difficult on the automotive industry, lowering short-term market expectations for auto production. With STRT’s strong balance sheet and ability to generate free cash flow, we expect the company to weather the storm and benefit from a turnaround in auto production in the future.   

Whole Earth Brands (“FREE”) is a global food company selling low-calorie sweetener products, flavors and ingredients. The company reported earnings during the quarter that beat expectations and guided toward the top end of previous guidance. Despite solid results, the stock traded down through the end of the quarter. Management is competently guiding the company through the challenges posed by high inflation and labor shortages.

Sunlight Financial Holdings, Inc. Class A (“SUNL”) is a technology-enabled financing facilitator for the solar power industry. SUNL preannounced a significant loss just before the end of the quarter. The loss stems from an advance made to a solar contractor that is going out of business. SUNL is also dealing with the short-term impact on its profitability given the rapid rise in rates. The risk profile will remain elevated in the near term while it looks to diversify its capital providers and shore up its long-term financing. If SUNL can manage through this near-term stretch and return to its historic margins, the stock should move materially higher.

BuildABear Workshop, Inc. (“BBW”) is an experiential retailer of stuffed animals, with a very strong brand and consumer affinity. The company is increasingly seeing its sales trend toward specialty locations like theme parks and cruise ships, online orders and an older demographic (late teen and adult gifting). These emerging markets often result in higher profitability. The most recent quarter was negatively impacted by increased freight costs, leading to a stock sell off combined with consumer weakness fears. Management is still guiding to full-year results roughly in-line with last year’s record 12% operating margins. BBW shares are attractively valued, trading at a PE of 5x.

Market Outlook

“Extreme volatility” can describe market performance during the past three months ending September 30, 2022. The quarter began on a strong note in July, due in part to investor expectations that the Fed would “pivot” from rate hikes as concerns for inflation and slowdown in economic growth subsided. However, August reports showed inflation remaining at a stubbornly-high 8.3%. Other economic reports were also weak. As a result, August and September were significantly worse than July. Value stocks performed poorer than growth stocks during the third quarter, a reversal from the April-June period.

The Federal Reserve raised its benchmark federal funds rate twice by 75 basis points in their July and September meetings, to a range between 3.0% to 3.25%. This triggered a stock market sell off in August and September.

We continue to have a modest growth outlook for the US economy, though supply chain disruptions, inflationary pressures and rising interest rates have led to a slowdown in the near-term.

GDP decreased 0.6% in 2Q 22, marking the second consecutive quarter of decline. This was driven by decreased private inventory and residential investment. Construction and manufacturing were particularly weak, while consumer spending accelerated compared to the first quarter.

3Q 22 GDP growth is expected to turn slightly positive and near 2%. Sentiment amongst purchasing managers remains upbeat with the September 2022 US manufacturing reading of 50.9, the 28th consecutive month of expansion. However, this is the lowest level since the onset of the pandemic, and several sub-components continue to deteriorate.

New orders, production, and employment have weakened over the past several months as material and labor availability continue to be headwinds. There are also growing concerns of a global economic slowdown. Despite these challenging economic indicators, we continue to find good quality companies at attractive prices.

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, 2022. 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, 2022. 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. 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 1.56%, 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 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 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.