Q4’20 Micro Cap Value Strategy
Market Commentary
With the coming change in the administration, there is a renewed focus on potential policy changes and the impacts they may have on both the economy and the financial markets. As with any presidency, policy is not just the product of the occupant of the White House, but also key Cabinet nominees and the size of the congressional majority. With this latest election, that majority (and hence control of each congressional body) is very narrow. In the Senate, a 50/50 split gives Democrats control only by virtue of Vice President-elect Harris casting the deciding vote. In the House, Democrats outnumber Republicans by a scant 222-213 majority.
Though their advantage is slim, Democrats have secured control of Congress and the White House. However, passing transformative legislation will prove difficult given the competing factions within the Democratic Party. More progressive members, particularly in the House, will push Congressional leadership to pass universal health care, the Green New Deal, reduced police funding and adding seats to the Supreme Court. Moderate Democrats will resist this progressive agenda and attempt to water down any legislation they view as too radical. Trying to arrive at a compromise within their own party that placates all sides may prove difficult, especially when House Democrats can only afford five defections if Republicans are united in opposition.
Democrats in the Senate may have a similar issue. Moderate members like Senators Manchin, Tester, and Sinema may not support a strongly liberal agenda. In fact, Senator Manchin of West Virginia, whose term expires in two years, represents the second largest coal producing state. He may be the most resistant Democrat to overtly progressive legislation, especially on issues such as energy and the environment.
We’re seeing early signs of this playing out in President-elect Biden’s Cabinet picks. He appears to be choosing moderate figures for key posts, particularly those that are relevant to the economy and capital markets. This has caused some unhappiness among a minority of progressive Democrats, who have been vocal in their displeasure. For the Treasury Department, he has selected Janet Yellen, the former Chair of the Federal Reserve. A committed Keynesian economist, she is hardly a radical and should easily be confirmed. While she may support sustained budget deficits and tolerate a moderate increase to inflation, it is unlikely that she would lobby for the more aggressive stimulus packages that have been proposed. Two additional key Cabinet posts that we have been watching closely are Labor and Commerce. Marty Walsh and Gina Raimondo, respectively, were nominated to head those departments. Walsh has long-standing ties with organized labor and Raimondo has experience in venture capital and the tech industry. Overall, these nominations suggest a business-friendly posture from the incoming administration.
Due to the narrow divisions along party lines in the House and Senate, we should not expect any transformative legislation. In a Congress so evenly divided, significant bills can only be passed on a bipartisan basis, such as during President George W. Bush’s first term with Tax Reform (EGTRRA), USA PATRIOT Act, Medicare Prescription Drug Act, and No Child Left Behind. President Obama’s legislative accomplishments were limited to his first two years in office when his party controlled the House and had a super-majority in the Senate.
Instead, we predict that policy impacts are more likely to arise via regulation from Cabinet departments. Looking at years 3-8 of the Obama administration, policy impacts were limited to Cabinet level regulation and executive actions. With the exception of potential stimulus measures that could move forward in the coming year, we expect policy in the Biden administration to play out similarly.
Strategy Review
The Pacific Ridge Capital Partners’ Micro Cap Value strategy returned 31.0%* during the fourth quarter of 2020, underperforming the 32.8% return of the Russell Microcap® Value Index (“Index”). Over the trailing one-, three- and five-year periods, the strategy returned -5.5%*, 0.3%* and 11.3%* (annualized), respectively, compared to the Index returns of 6.3%, 4.3% and 10.5%. Since inception on April 1, 2007, the strategy has returned 9.8%* annually versus 5.5% for the Index.
*Preliminary results. For additional performance information, see the related GIPS® Report on the last page
Top Contributors and Detractors to Return for Fourth Quarter 2020**
Top Contributors
COHU (“COHU”) is a manufacturer of semiconductor test and inspection handling equipment. The stock moved higher during the second half of the year on the heels of an improved outlook in the semiconductor space. The company is expecting a notable tailwind in the coming years, thanks to increased demand for radio frequency testers required by the ongoing expansion of 5G networks. We saw evidence of this with their most recently reported earnings, as the outlook for the fourth quarter greatly exceeded analyst expectations and the stock moved substantially higher.
Shyft Group (“SHYF”), a manufacturer of commercial vehicles, has seen its stock nearly triple from the lows earlier this year. With the shift to online shopping accelerating over the past year, demand for delivery vehicles has significantly increased. Estimates have steadily moved higher as analysts raise their expectations for both sales and EBITDA margins heading into 2021 and 2022. The company also reduced its debt following the sale of a non-core business, resulting in a very strong balance sheet with high levels of cash flow projected in the coming years.
AXT, Inc. (“AXTI”) is a key supplier of silicon-alternative semiconductor substrates, such as gallium arsenide (GaAs) and indium phosphide (InP). The stock moved higher during the quarter following a strong earnings report and the announcement of their intention to list their stock on the Shanghai exchange. This will supply AXTI with capital to fund future growth initiatives and allow it to benefit from the higher valuation levels typically seen in that market. On the business side, AXTI’s competitive posture remains strong as one of the few suppliers of two key substrates that are heavily utilized in several emerging technologies.
Ultra Clean Holdings (“UCTT”) is a developer and manufacturer of critical subsystems in the semiconductor capital equipment industry. The stock was volatile through the year and rallied strongly during the fourth quarter following an earnings beat and an improved outlook heading into 2021. A recently announced acquisition is intended to drive top-line growth over the longer-term.
Lifetime Brands (“LCUT”) is a manufacturer of kitchenware and tableware products. The stock performed very well during 2020 following several years of steady declines as the company sought to turn around its business. In late 2019, management laid out a multi-year plan for mid-single-digit organic sales growth, coupled with expansion into commercial food service. These initial efforts appear to be bearing fruit, with LCUT generating strong cash flow that reduced debt and strengthened its balance sheet.
Top Detractors
Asure Software (“ASUR”), is a cloud-based human capital management and workplace management software provider. The company reported earnings during the quarter that were slightly short of expectations. The stock then came under additional pressure late in the quarter as the company raised more capital through a secondary offering that investors were not expecting.
FreightCar America (“RAIL”), a manufacturer of rail cars, reported earnings that showed a continued degradation in the business. While the industry has shown signs of turning, the company is short of badly needed capital. Recent high-cost dilutive financing has helped provide a cash runway, but at the sake of future earnings. We decided to exit our position during the quarter.
Alpine Income Property Trust (“PINE”), a real estate investment trust, has been volatile over the past year because of the coronavirus pandemic. The portfolio includes retail, office and entertainment holdings. Management has been acquiring additional properties since coming public to diversify their holdings. The stock trades at a substantial discount that should hopefully revert as the economy normalizes in the coming years.
Photronics (“PLAB”) is a maker of masks used in the production of semiconductors and flat panel displays. The stock was added to the strategy during the quarter, after which the company reported disappointing earnings and a weak near-term outlook due to supply chain disruptions for a key customer. Intermediate-term guidance remains quite positive with high single-digit revenue growth and another year of record revenue.
Heritage Insurance (“HRTG”), a property and casualty insurer, traded down over the second half of the year as the 2020 Atlantic hurricane season was one of the most active ever. This led to higher claims costs that negatively impacted earnings and book value. While this could provide a tailwind to rates and earnings going forward, investors remain in “wait and see” mode. Management has done a good job of diversifying their book of business away from the deteriorating Florida market, and they should experience more predictable earnings going forward.
**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® Report on the last page.
Market Capitalization Analysis
There was minor size bias tailwind during the quarter, as smaller companies in the Index slightly outperformed larger companies. Those with a market cap over $400 million in the Index returned 29.9%, versus a gain of 35.6% for firms with a market cap below $400 million. The strategy had 76.7% of its holdings in companies with a market cap below $400 million, compared to 52.8% for the Index.
Style Analysis
There was a slight value-bias headwind for profitable companies during the quarter, as stocks with higher PEs outperformed those with lower PEs. Those with a PE ratio greater than 15x returned 33.3% versus 29.6% for those companies with a PE below 15x. The strategy had 45.4% of its holdings in companies with a PE below 15x compared to 36.0% for the Index. Strong performance of unprofitable companies in the Index created a more significant headwind, as those stocks returned 40.9%, versus a gain of 31.0% for firms that were profitable. The strategy had 13.4% of its holdings in unprofitable companies, compared to 29.0% for the Index.
Economic Sector Analysis
The strategy’s performance in Consumer Discretionary contributed approximately 205 basis points of excess return compared to the Index. However, performance in Industrials and Financials detracted approximately 280 basis points versus the Index. The strategy’s lack of exposure to the Utilities sector provided 15 basis points of excess returns during the quarter.
Market Outlook
Equities continued to rally in the fourth quarter of 2020 aided by the vaccine rollout and removal of election uncertainty. Despite COVID outbreaks around the holidays, the US economy edged higher with expectations of mid to high single digit GDP growth for 4Q20. The outlook for 2021 is for more normalized growth of 3-4% but could be more heavily weighted to the back half of the year. This outlook is dependent on the scale of ongoing COVID resurgence and rate of inoculation as the nation gradually returns to normal. We remain cautious in the near-term, given continued uncertainties related to 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 Veronica Orazio Operations Assistant
Justin McKillip, CFA® Senior Analyst
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® Report 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.
PRCP GIPS Report
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 September 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 September 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.