"Suppose a man leaps from an airplane without a parachute…he faces no risk. Risk requires both exposure and uncertainty."—Glyn Holtoz 

Many investors regard the word risk in the negative: "How much can I lose?" Value at Risk (VaR) is a commonly used risk metric that is defined as the worst expected loss over a given horizon at a given confidence level under normal market conditions. This is relevant because recovering from losses is extremely difficult. Here's a little experiment to prove that it's true. Assume you begin with one dollar in an investment. Go ahead and put alternating returns of +10% and -10% for ten periods. Your investment will never recover the losses generated by the erosion of capital, even though your average return will be zero percent! In that vein, investors will employ certain strategies to control and mitigate as much downside risk as possible. 

Ultimately, risk represents the chance that our expectations are not met. We would like to share with you how we view risk in the context of our Value Zone™. Our Value Zone framework is driven by three primary considerations in building our portfolios. First, there is the Operational Risk associated with the companies that we own over a three- to five-year horizon. Second, there is the Price Risk associated with the stocks of those companies. We believe that in the short term, those two items may be completely uncorrelated, but that over time, good companies will garner good prices. Finally, the practice of Risk Management should provide a portfolio that outperforms the benchmark over a three- to five-year period. In this commentary, we are going to focus on our approach to Company Risk. 

Part 1: Operational Risk 

The operational risk of any potential investment is often difficult to describe. Warren Buffet has addressed this concern with a subjective description for companies that have a "moat" around their business (some competitive advantage that can protect it) 2. A fellow named Edward Altman came up with the Z-score in 1968 in an attempt to objectively measure financial risk—or risk of bankruptcy by using a quantitative model. S&P, Moody's, and Fitch also have models that help score the financial risk of various companies and instruments. All of these models are based on historical trends, designed to assign some probability that an entity will go kaput! 

At Pacific Ridge, we use a combination of subjective and objective measures to assess the operational and financial risk of the companies we invest in. As equity investors, our measures focus on the three drivers of Return on Equity: Sales, Profit Margin, and Leverage. We do this to answer a simple question: over a three- to five-year period, what earnings can we reasonably expect a company to generate? To do this, we overlay some basic assumptions about overall economic growth rates, raw material and wage inflation, interest rates, and the overall liquidity of the capital markets. We want to find profitable companies earning a posi-tive return on their capital. 

It is our nation's happy experience that the vast majority of publicly traded companies are earning a profit (80% of the companies in the Russell Indexes reported operating profit in the latest twelve month period). Approximately 75% of companies are earning a profit after their interest payments. And this year, nearly 70% of all reporting companies are generating cash after making capital expenditures and allocations to working capital. In terms of actual bankruptcy, it's fairly remote. In fact, only about three percent of publicly traded companies filed for bank-ruptcy in each of the last two years (86 each year) according to Bankruptcydata.com. That's a good start to putting the odds in your favor—certainly better than a coin flip, and we like the odds stacked in our favor. 

Next, we have to determine who gets to divvy up the profits that a company generates. For unlevered firms, equity holders have the first claim on residual cash flows from a business. For levered firms, however, debt holders have a call option on the value of the firm that must be satisfied before equity holders get anything. It is important because if the Total Enterprise Value is not enough to cover the claims of creditors, equity holders will be left with nothing. We term this default risk. 

Our experience tells us that the market often overprices a company's risk of default, creating good buying opportunities. Using a combination of quantitative performance measures like a Z-score does give us insight into the probability of default and bankruptcy. At times, however, other measures such as the tightness of credit markets are helpful. For an explanation of that, see our letters dated October 2010 and August 2011. 

We then employ a combination of stress test scenarios to determine a range of operating outcomes that a company may produce. That analysis is independent of the market's view of the firm's value. The company either generates a return on its capital or it does not. After determining that a company is a good one, the merits of its attraction become a matter of price. 

We will pick up the last two legs of our Risk Framework in our May and August Commentaries. 

We would also like to add a short note on last quarter's commentary. Birth rates in the United States have continued to fall, and according to the most recent release from CDC, the preliminary birthrate data for 2011 suggest the lowest recorded birthrate in US history. Jonathan Last of the Weekly Standard has provided some very insightful facts and interpretations of the current trend. An essay adapted from his new book was published in the Wall Street Journal on February 2, 2013. 

Sincerely, 

Pacific Ridge Capital Partners

About Pacific Ridge Capital Partners

Pacific Ridge Capital Partners is an employee-owned firm. We generate our own investment ideas using fundamental analysis and bottom-up stock picking. The investment team applies a consistent, patient and disciplined process that results in low turnover and stability. Our proven philosophy has performed well over many investment cycles and it is the consistent application of this strategy that makes Pacific Ridge unique. 

The principals of Pacific Ridge Capital Partners are invested along with our clients in each of our strategies. 

PRCP Small Cap Value – Our Small Cap Value strategy generally purchases stocks in the bottom three-quarters of the Russell 2000® Index. This smaller capitalization segment has a large number of underfollowed companies, providing us the greatest opportunity to exploit market inefficiencies. The typical range of holdings is between 100 and 150. 

PRCP Micro Cap Value – Our Micro Cap Value strategy generally purchases stocks in the Russell Microcap® Index. This segment is widely underfollowed, providing us the greatest opportunity to exploit market inefficiencies. The typical range of holdings is between 50 and 80. 

We believe these market cap segments offer great potential returns and additional diversification for our clients. For further information about Pacific Ridge Capital Partners and our investment strat- egies, we invite you to contact Tammy Wood via email at Tammy.Wood@PacificRidgeCapital or by phone at (503) 878-8502. 

Disclosures 

Pacific Ridge Capital Partners, LLC (“Pacific Ridge”, “PRCP”, or “the Firm”) is an employee-owned investment advisor registered with the Securities and Exchange Commission under the Investment Advisor 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®). 

Sources: Pacific Ridge; FactSet Research Systems (“FactSet”); and Russell Investment Group (“Russell”) who is the source and owner of the Russell Index data. 

The current annual investment advisory fees for the portfolios managed in the Firm’s Small and Micro Cap Value strategies are 1.00% and 1.50% of assets, respectively. Returns for the composites 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. The Firm calculates time weighted rates of return by geometrically linking portfolio simple rates of return at least monthly, with adjustments made for significant external cash flows. The composite returns are calculated by asset weighting the individual portfolio returns using beginning of the period values. All returns are calculated after the deduction of the actual trading expenses incurred during the period. 

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. 

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. 

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. 

Returns and asset values are stated in US dollars.