Q3'23 Small Cap Value Strategy

Performance Review

The Pacific Ridge Capital Partners Small Cap Value strategy (the “Strategy”) returned -3.4%* (-3.6%* net of fees) during the third quarter ended September 30, 2023, underperforming the Russell 2000® Value Index (the “Index”) return of -3.0%.

The Strategy’s portfolio characteristics can be significantly different from the Index because we primarily invest in smaller, undervalued stocks and adopt a sector-agnostic approach. You can see these distinctions in the charts below.

Size Analysis

During the quarter, the Strategy faced a significant size bias headwind, where larger companies in the Index performed better than smaller ones. Stocks with a market capitalization below the $799 million Index median saw a return of –6.6%, versus a -2.3% return for stocks with a market capitalization above the breakpoint level. The Index had 84.1% of its weight above the median market capitalization level, which was significant, while the Strategy had a comparatively lower weight of 44.2%.

Style Analysis

The Strategy benefited from a modest tailwind due to its pronounced value style bias, largely influenced by the sharp underperformance of unprofitable companies (PE ratio less than 0x) during the quarter, resulting in a -13.0% return in the Index. Additionally, the Strategy benefited by overweighting stocks with a PE ratio below 15x, which was the best-performing category for the quarter with a return of 2.3%.

Sector Analysis

The Strategy’s top two positive sector contributors were Consumer Discretionary and Health Care. Notably, the modest overallocation to Consumer Discretionary was a slight headwind that was significantly offset by positive stock selection scores. The lack of exposure to Health Care generated a moderate overall tailwind. The two sectors with the most negative contribution to the Strategy were Communication Services and Energy. Subpar stock selection scores in Communication Services and underweighting the Energy sector, the best performing sector during the third quarter, detracted from the Strategy’s overall performance.

Portfolio Characteristics (as of 9/30/23)

Top Contributors

Perdoceo Education (“PRDO”) is an online for-profit education company that exhibited strong performance in the recent quarter. The company reported robust earnings, prompting an upward adjustment in their full-year guidance. Given its position in a countercyclical industry, PRDO should do well as job growth decelerates and higher education enrollment gains momentum. The stock remains attractively valued and generates significant free cash flow.

Sterling Infrastructure (“STRL”), a provider of highway construction and site development services, reported another strong quarter that handily beat expectations and highlighted the company’s impressive transformation beyond its legacy highway construction business. Several large site preparation projects for new manufacturing facilities and data centers have ramped up, with additional secured phases adding to a record level of backlog. Management raised guidance for the rest of the year and the near-term outlook remains favorable.

Matrix Service Company (“MTRX”), a provider of engineering, construction, and maintenance services to support critical energy infrastructure, appears to be turning the corner following a prolonged period of headwinds. The spending recovery in the company’s end markets is beginning to materialize in a meaningful way, as evidenced by the doubling of project awards in the quarter that include new LNG peak shaving facilities and specialty vessels at industrial and gas processing plants. Fortunately, MTRX has maintained a cash-rich balance sheet that will support its elevated backlog.

Customers Bancorp (“CUBI”), a Pennsylvania-based community bank, continued its rebound during the third quarter, calming market fears of a potential bank run. CUBI has exhibited a consistent deposit base since Silicon Valley Bank’s failure. With the bank currently trading at a significant discount compared to our calculated value, we remain comfortable with our sizeable position in the stock.

Designer Brands (“DBI”) is a shoe retailer under the DSW brand and wholesaler with several popular names in its brand portfolio. Though shoe retail sales continue to decline year-over-year, the company has been able to generate results slightly better than expected. This has resulted in shares outperforming in the past quarter. Despite this, the stock continues to trade at a sizable discount to price multiples of peers and to our target valuation.

Top Detractors

System1 (“SST”) utilizes online ad placement software to target high-intent customers for advertisers. However, in the most recent quarter, the stock experienced a significant decline due to a notable pullback in the digital ad market. Given the company’s strong reliance on demand in digital ad spending, the results for the last quarter fell short of expectations. Despite this, we have maintained our position in the company, anticipating a rebound in digital ad spending.

Chefs’ Warehouse (“CHEF”) is a consolidator in the food distribution industry. During the past several months, concerns over a recession in restaurant spending have resulted in a significant decline in the value of CHEF shares, as well as those of other food distributors. While the company does have some debt, its leverage appears to be well covered and its current financial risk appears limited. However, any prolonged slowdown in restaurant spending by consumers will result in compressed margins and lethargic operating performance. These results are expected to be short-term, and the shares appear to be undervalued.

Stagwell (“STGW”) is a global advertising and marketing company. The stock moved lower during the quarter as results for the past three months came in lower than expected and management lowered its guidance for the remainder of the year. STGW has positioned its business toward the digital ad space, which has seen a cutback in spending over the past 16 months and a pronounced recent downturn. We maintain our holdings in STGW with the belief that the company will successfully navigate the ad market pullback and eventually regain a fair valuation. Seizing the recent sell-off as an opportunity, we have increased the position weighting.

Rimini Street (“RMNI”) is a third-party provider of enterprise resource planning (ERP) software support and related software and services. In late July, the company was handed a big loss in its longstanding and ongoing legal battles with Oracle, with 10% of RMNI’s business at risk from becoming economically unviable. Also of concern is the increased risk in the minds of existing and potential customers, in addition to the continued legal expenses from ongoing appeals. The company should continue to be profitable and generate cash flow, and trades at an attractive low valuation.

Photronics (“PLAB”) is the leading merchant manufacturer of photomasks used in the production of semiconductors and flat panel displays. After being the top contributing stock in the strategy the previous quarter and trimming our position, the shares fell 22% in the quarter. This drop was influenced by a slight earnings shortfall and persistent apprehension regarding US/China semiconductor trade tensions. With a leading market position, solid ongoing unit-driven demand expectations, strong balance sheet driven by strong ongoing cash flow, and attractive valuation, PLAB remains a large holding.

Market Outlook

During the third quarter, small cap value stocks performed in-line with large cap growth stocks, a sharp contrast from the first half of the year when large cap growth stocks significantly outperformed their small cap counterparts. In July, small cap value stocks rebounded, buoyed by a spike in regional bank shares. However, concerns over rising interest rates led to a market downturn in the last two months of the quarter. Energy was the best performing sector during the quarter, driven by a spike in oil prices.

We have concerns about the pace of economic growth in the coming year as the labor market continues to show signs of cooling. The final GDP reading for second quarter showed 2.1% growth, slightly trailing the first quarter growth of 2.2%. The consensus estimates for third quarter GDP is 2.3%. Even though the manufacturing sector continues to contract, there are reasons for optimism. The Institute for Supply Management’s PMI ticked up to 49.0 in September from 47.6 in August. This increase, albeit modest, signals a potential deceleration in manufacturing contraction.

The core PCE Index, the preferred inflation gauge, rose by 0.1% in August compared to the previous month, with an annualized reading of 3.9%, the slowest pace in two years. However, the impact of rising energy prices was felt in the headline PCE Index, which rose a sharp 0.4%, the biggest increase in seven months. The 10-year Treasury yield stood at 4.57%, well off the pandemic lows of under 1.0%. This raises the concern that higher borrowing costs might stifle economic growth.

On the jobs front, the U.S. economy added a solid 336,000 jobs in September versus expectations of 163,000. The unemployment rate held steady at 3.8% versus expectations of 3.7%. The JOLTS Job Openings Index for August came in strong at 9.6 million versus the prior month of 8.9 million. However, hourly wages rose only 0.2%, marking the smallest gain in 18 months.

We are concerned about economic growth over the balance of the year and into 2024 given elevated interest rates, the softening labor market as discussed above, and the tapering off of new bank loan demand. The Fed has made significant progress in bringing down inflation to more reasonable levels, though it remains to be seen if they will need to enact additional rate hikes. Current elevated interest rates and the higher cost of capital should drive more investors to focus on value stocks that are less dependent on seeking additional financing from the market.

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.