Q4'22 Small Cap Value Strategy

Performance Review

The Pacific Ridge Capital Partners Small Cap Value strategy returned 13.2%* during the fourth quarter ended December 31, 2022, outperforming the Russell 2000® Value Index (“Index”) return of 8.4%. For the twelve-month period ended December 31, 2022, the strategy returned -15.9%* versus the Index return of -14.5%.

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

The strategy faced a significant size bias headwind during the fourth quarter, as smaller companies in the Index underperformed larger companies. Those with a market capitalization below the $791 million Index median posted a 4.9% return, versus a 9.1% return for stocks with a market capitalization above the median. The Index had 82.4% of its weight above its median market capitalization level compared to 43.9% in the strategy.

Style Analysis

The strategy benefitted from a significant style bias tailwind for profitable companies during the quarter, as stocks with lower PEs outperformed those with higher PEs. Those with a PE ratio greater than 15x had a 9.1% return, versus a 11.7% return for those companies with a PE below 15x. The performance of unprofitable companies in the Index also created a notable tailwind, as those stocks posted a -3.6% return, and the strategy has a lower weight in such stocks than the Index.

Sector Analysis

The top two contributing sectors to the strategy’s performance in the quarter were Technology and Industrials, with a combined benefit of over 350 basis points. Being overweight in Industrials was a tailwind, given that it was one of the top performing sectors in the Index, while being overweight in Technology was a small headwind. The top two sector detractors were Communication Services and Materials, combining for almost 90 basis points of headwind.

Portfolio Characteristics (as of 12/31/22)

Top Contributors

Sterling Infrastructure, Inc. (“STRL”), a provider of highway construction and site development services, reported solid results in its most recent quarter, and the highest operating margins in over a decade. Strong demand for new distribution centers, data centers, and warehouses has led to revenue and profit growth in the excavating segment. STRL’s legacy highway business has benefited from more disciplined bidding practices and the diversification to alternative markets such as airports and ports.

Super Micro Computer (“SMCI”), a maker of specialized computer server systems and components, was the largest holding in the strategy until recently. During the quarter, we exited this position after the stock eclipsed our upper market cap threshold. The company continued its string of impressive organic growth results thanks to market share gains, with revenue up 79% in the fiscal first quarter (ending September), after being up 46% for the full year fiscal 2022 period.

Wabash National Corp. (“WNC”) is the leading provider of semi-truck trailer dry vans, and increasingly participates in specialty trailers and final-mile delivery trucks. Third quarter and year-to-date growth have both been in excess of 35%, and operating margins eclipsed 8% in the third quarter. With new refrigerated trailers and last-mile truck products coming online, as well as increased capacity in their industry-leading Duraplate dry vans, we are comfortable with the outlook for continued growth and margin expansion.

Perdoceo Education Corp. (“PRDO”), a for-profit provider of higher education services, rebounded during the quarter as they reported earnings ahead of expectations and guided towards a better-than-expected fourth quarter. The industry has been battling steady enrollment headwinds for several years following excessive government stimulus and a tight labor market. With an uncertain economic outlook for 2023, the revenue expectations over the intermediate term are steadily improving, as PRDO’s business tends to be counter-cyclical.

Cohu, Inc. (“COHU”) is a maker of back-end semiconductor equipment, such as testing and handling equipment. The company’s shares reacted favorably to third quarter results, despite the fact that industry conditions have been weak (and will probably continue that way into the first half of 2023). COHU’s forecasted 2022 revenue will be down roughly 10%, with a similar decline expected in 2023. However, long-term demand trends in the industry remain strong, as does the company’s market position. Gross margins have been improving per expectations, and operating margins appear to be holding in the mid- to high-teens, despite the industry’s current down-cycle.

Top Detractors

System1, Inc. Class A (“SST”) is an online customer acquisition company that targets high-intent customers for advertisers with over 15 SST-owned websites. Fears of a near-term contraction in ad spending caused the stock to underperform during the quarter. SST continues to generate sizable free cash flow that enables it to acquire new web properties that exponentially increases its product offering to advertisers. We view this short-term sell-off as an opportunity, and see significant upside from the current share price.

Stagwell, Inc. Class A (“STGW”) operates several advertising, media and public relations agencies. The company has a larger focus on the digital ad space, which is expected to outpace the growth of traditional ad mediums. Though the long-term prospects are favorable, advertisers have been pulling back on digital ad spend since August. Continued uncertainty around digital ad spending led to a sell off of STGW shares. We continue to see underlying value thanks to recent company acquisitions and expect the stock to rebound once the upturn begins.

Rimini Street (“RMNI”) is a third-party provider of enterprise resource planning (ERP) software support and related software and services, primarily for large ERP software packages such as SAP and Oracle. Over the past couple of years, RMNI has struggled to find consistent leadership and growth of its sales force, with volatile quarterly results. In the most recent quarter, results fell below expectations and macroeconomic concerns, especially in Europe, persisted, putting pressure on the shares. However, RMNI’s valuation remains attractive, given their price advantage over big software vendors.

Heritage Insurance Holdings, Inc. (“HRTG”) is a property and casualty insurer based in Florida. The stock continued to underperform this year due to the difficult conditions in the Florida market, and the higher than normal storm activity over the past several years. Management has responded by implementing aggressive rate increases and diversifying their premium base outside of Florida. We exited our position during the quarter, given the decline in the market cap below our targeted range.

Lifecore Biomedical, Inc. (“LFCR”) recently changed its name from Landec (and ticker from “LNDC”) and is in the late stages of selling off its legacy food businesses. LFCR will soon be a pure play CDMO (pharmaceutical contract development and manufacturing organization), with an expertise in developing and packaging pharmaceuticals into vials and syringes. The stock sold off due to uncertainty with its balance sheet, which should be remedied once the remaining food business is sold and its corporate debt is paid down. LFCR raised $5 million in an equity sale to fund growth-related manufacturing expenditures from its largest shareholder.

Market Outlook

The performance of U.S. equities in the last three months of 2022 was primarily driven by investors’ expectations of the Federal Reserve’s (the Fed) interest rate policies. October returns were solid as investors expected the Fed to “pivot” from previous aggressive rate hikes. November results were positive but subdued as investors digested another 75-basis points rate hike. December returns were negative as investors feared further large interest rate hikes due to sticky inflation.

For the full calendar year 2022, domestic equities turned negative after three consecutive years of positive returns. The primary concerns were high inflation, interest rates, and worries about a potential recession. This resulted in a rotation out of growth stocks and into value stocks that had strong earnings, dividends, and cash flows. The gap between value and growth returns has been widest amongst large cap stocks with the Energy sector producing the best results in excess of 60% for the year.

The pace of the Fed’s 2022 interest rate hikes—350 points in total--was the fastest in 40 years. The target interest rate is expected to go over 5.0% by the end of 2023 with the intent of slowing down consumer spending and employment. Housing and oil prices have already come down significantly. Given the amount of public discussion in the press about a possible recession, companies and consumers are already acting with caution. As such, we believe that the probability of a soft landing is more likely.

We continue to have a modest growth outlook for the US economy, though supply chain disruptions, inflationary pressures, and rising interest rates have created uncertainty in the near-term. GDP rebounded and increased 3.2% in 3Q22, driven by growth in consumer spending (particularly in service-related industries), and higher government spending. While 4Q22 GDP growth is expected to tick even higher sequentially, consensus is for growth to slow in 2023.

PRCP GIPS Report

*Information is not statistically meaningful due to an insufficient number of portfolios in the composite for the entire year.
**Information is not statistically meaningful due to an insufficient period of time (36 months).

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, 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 Small Cap Value Composite has had a performance examination for the periods June 10, 2010 through September 30, 2022. 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. 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.

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 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.