Q3'24 Small Cap Value Strategy

Performance Review

The Pacific Ridge Capital Partners Small Cap Value strategy (the “Strategy”) returned 8.6* (8.4%* net of fees) during the third quarter ended September 30, 2024, underperforming the Russell 2000® Value Index (the “Index”) return of 10.2%.

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

Size was a neutral factor this quarter, with stocks below the Index median market capitalization of $713 million returning 10.1%, nearly matching the 10.2% return for those above the median. While the Index allocated 14.4% to stocks below the median, the Strategy held a much higher allocation at 46.0%.

Style Analysis

The Strategy faced a modest style bias headwind from unprofitable companies (PE ratio below 0x) during the quarter, as these stocks led the Index with a return of 15.8%. The Index had a 13.9% weighting, compared to the Strategy’s much lower weighting of 4.7%. Profitable companies with lower valuations (PE ratio below 15x) posted the second-best return of 9.2%, where the Strategy had a significant overweight at 67.3% compared to the Index’s 51.6%.

Sector Analysis

The top two contributing sectors to the Strategy’s performance were Financials and Energy. A slight overweight in Financials, combined with moderate positive stock selection scores, benefited the Strategy. Additionally, the Strategy’s underweight in Energy (the only sector in the Index with negative performance) also added to the positive effect. Conversely, the two sectors that most negatively impacted the Strategy’s performance were Communication Services and Technology. In Communication Services, subpar stock selection hurt performance, despite the sector delivering the highest return in the Index at 35.1%. Furthermore, the Strategy’s significant overweight in Technology, which posted the second worst return behind Energy, detracted from the overall performance.

Portfolio Characteristics (as of 9/30/24)

Top Contributors

CompoSecure (“CMPO”) is primarily known for its dominant position in the manufacturing of metal credit cards, notably for Chase and American Express. We initiated a position in March, with the idea that this former SPAC was under-the-radar and misunderstood. The notion that physical credit cards are going away anytime soon is overblown, and metal cards have low penetration and significant marketing appeal. The stock moved up sharply this quarter on news that the new Executive Chairman of the Board was taking out the legacy venture investors who controlled CMPO and eliminated the company’s dual class share structure.

Metropolitan Bank Holding (“MCB”) is a community bank based in New York. The stock has had a bumpy ride over the last several years, following several bank runs in the spring of 2023, and the collapse in the share price of a geographic competitor in the first quarter of this year. However, MCB saw a strong rally early in the quarter after reporting earnings that surpassed expectations. MCB also gained traction on several initiatives that are expected to drive earnings growth in 2025 and 2026.

Northeast Bank (“NBN”) is a community bank and specialty finance lender with significant expertise in investing in distressed commercial real estate assets. Management has done an excellent job of controlling their portfolio of loans and avoiding credit challenges which have started to impact others in the space. NBN received an additional boost late in the quarter when they announced the purchase of a sizable loan portfolio that should drive additional earnings power in the coming years.

Hanesbrands (“HBI”) is a worldwide marketer of undergarments. We purchased shares several years ago, assuming that excess leverage could be cured by inventory liquidation, or by a sale of their outerwear division, the latter of which has taken place. This should reduce debt by nearly 30% toward the end of this year. Also, inventories in the undergarment business will continue to provide cash in the coming years for further debt paydown. This latest transaction should leave HBI a much nimbler competitor in its remaining markets.

ConnectOne Bancorp (“CNOB”) is a community bank based in New Jersey. The firm has been a consistent high performer, despite being liability sensitive. The stock has performed well in recent months, driven by increased expectations for Federal Reserve rate cuts, and the announcement of an acquisition. CNOB is acquiring First of Long Island (“FLIC”), which is expected to be very accretive to earnings. Combined with a low current multiple, we are optimistic that the strong performance will continue into 2025.

Top Detractors

Cohu, Inc. (“COHU”) makes a broad range of semiconductor equipment including test, inspection, handling, and contactor products. While the company has improved its positioning with a broader product portfolio and strong balance sheet resulting from free cash flow, it is still relatively dependent on auto, industrial, and mobile handsets. That has hit COHU’s earnings harder than some of its peers. Shares were down 22% in the quarter, compared to 14% for the broader semiconductor group in the Index. We believe that COHU will demonstrate more earnings power in the next industry upcycle.

Rimini Street (“RMNI”) is a provider of support and services for enterprise software. RMNI has faced long-term ongoing legal challenges from Oracle, while peacefully coexisting with many of its peers. This quarter saw a big setback on the legal front, causing RMNI to throw in the towel on its PeopleSoft/Oracle practice. We are hopeful that this outcome will reduce legal expenses and allow the firm to restructure and grow profitably, albeit from a smaller base.

Wabash National (“WNC”) is the leading maker of semi-truck dry van trailers, as well as related solutions for tanks, flatbeds, and last-mile products. Despite a positive transformation of the business over the past decade, coupled with a much stronger balance sheet, WNC’s business is still cyclical and the stock is getting punished in the current truck/trailer downcycle. However, the company remains solidly profitable and well-positioned to achieve higher earnings than the previous cycle. The stock is trading for less than a 5x PE ratio on demonstrated 2023 results and should perform well at the first sign of an upturn.

Ultra Clean Holdings (“UCTT”) is a developer and manufacturer of critical subsystems in the semiconductor capital equipment industry. The shares were down 19% in the quarter, as the downturn has lasted longer than most industry observers expected, including us. However, the company reported better than expected second quarter results, and management noted that they see evidence from customers of an upturn before year-end and at least double-digit growth in 2025. We are encouraged that UCTT has remained profitable and generated cash throughout an elongated trough in the industry.

Ichor Holdings (“ICHR”) is a maker of fluid delivery subsystems and components for major semiconductor capital equipment manufacturers. For reasons similar to UCTT, the company’s shares were down 17%, following a small second quarter industry rally in its share prices. The digestion of post-pandemic spending and lingering supply chain issues are still playing out in industry slowness for all but a select few with outsized exposure to AI spending. Though ICHR posted better than expected results recently, the market is waiting for evidence of an uptick in broad-based spending. We expect that to occur going into 2025.

Market Outlook

In early September, after two years of inversion, the yield curve finally dis-inverted. Two weeks later, the Federal Reserve lowered rates by 50 basis points, bringing the federal funds rate to 4.75%-5.00%. This larger-than-expected cut followed Fed Chair Jerome Powell’s remarks about a cooling labor market, indicating the Fed’s response to softening economic conditions. Although a dis-inversion often suggests potential for economic growth, recession risks persist. The full effects of previous rate hikes, as well as the recent cut, will likely become clearer over the next year as key economic indicators are revised and continue to evolve.

Despite mixed economic data, the stock market reached new highs in September, a month historically marked by weaker market performance. Small-cap value stocks significantly outperformed large-cap growth stocks during the third quarter, with the Russell 2000 Value Index returning 10.2%, compared to the Russell 1000 Growth Index’s return of 3.2%. This performance reflected a broader market rotation as investors sought opportunities in smaller, undervalued companies while moving away from large-cap growth stocks, which were seen as overvalued.

In August, the core PCE Index, which excludes food and energy, rose to 2.7%, slightly above July’s 2.6% and higher than the Fed’s year-end target of 2.0%. Consumer confidence dropped sharply in September, with the index falling to 98.7 from 105.6 in August, the largest monthly decline since August 2021. Concern over jobs and inflation dominated consumer sentiment. However, the September jobs report was stronger than expected, with nonfarm payrolls adding 254,000 jobs, well above the estimate of 142,500, and the unemployment rate fell to 4.1%. Employment gains were concentrated in food services, healthcare, government, social assistance, and construction.

Final Q2 2024 GDP grew by 3.0%, and the Atlanta Fed projects Q3 2024 GDP growth of 2.5%. The ISM Manufacturing Index remained unchanged at 47.2%, signaling contraction, while the ISM Services PMI rose to 54.9%, its highest level since February 2023.

The next Federal Reserve meeting on November 6-7 could bring further rate cuts if economic conditions align with expectations. As we mentioned in our first quarter 2024 Strategy Reports, there is a significant discount in the valuation of small-cap value stocks. The Russell 1000 Growth is presently trading at a price-to-earnings ratio (PE) of 31.2x for the next fiscal year, whereas the Russell 2000 Value is trading at 13.0x PE for the same period. Therefore, we believe a rotation into small-cap value stocks has further room to run.

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, 2024. 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, 2024. 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 the 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.