In our February 2013 letter, we mentioned that first and foremost, we are financial analysts at Pacific Ridge. We focus on doing the extra bit of work that might uncover something that other investors have either misjudged or ignored. This process of financial analysis is the first leg of our Risk Framework – Operational Risk. We assess operational risk to determine what a reasonable level of profitability is for any given company. This is the horizontal axis of the Value Zone. At the end of this analysis, we have a good idea of what we would be willing to pay for the company. Usually, our view of price and the market's view of price are fairly close. However, we occasionally come across a discrepancy, a company trading for below a fair price. 

The second leg of our analysis, once we find a company that we like, is to measure its current stock price and why it might change. This is the vertical axis in our Value Zone. There are multiple factors that we look at to determine why the market is paying a particular price today, and why it would be willing to pay a higher price in the future. 

One of three things must happen for us to be right about a particular stock that we buy: 

1. The multiple paid by the market must increase
2. The earnings generated by the company must increase
3. A combination of 1 and 2 – the double whammy! 

Part 2: Price Risk 

A simple way to see the expectations in the stock market is to look at the "multiple" paid for earnings in the market. For every asset, the market signals its expectation by the multiple it is willing to pay. Higher multiples suggest higher expectations. For example, at today's writing, the market is valuing the S&P 500 at just over 13x its projected earnings for 2013. Here is a graph of how those expectations have looked at the end of each of the last 12 calendar years:

As you can see, the market has a different "mood" or "expectation" about the future at different times. And it can be dead wrong. In late 2008, it appeared that the market was expecting very dour results from the S&P 500 for a considerable period in time. Of course, the following three years were the most profitable in S&P 500 earnings history. The exact opposite was true in late 2000, as the market priced in a continuing expansion, only to be presented with no real growth in earnings for nearly five years. 

When we purchase a company, we are specifically taking on the probability (the "risk") that the price will change. Of course the price will change, we presume to the upside. Over the years, we have found that different industries sometimes trade on different multiples. For example, we have found a strong indicator for bank expectations is "Price to Tangible Book Value." For grocery stores, a strong indicator is "Total Enterprise Value to Sales." We then compare the company we are interested in to its industry peers and to the overall market. We want to make sure that we are not paying an above-average multiple for a given stock. 

The best investment decisions begin with price. Said another way, don't overpay. We don't pay higher than the average multiple in the market on a prospective basis. The reason that we use prospective earnings is that the past is not necessarily indicative of the future. Just as we demonstrated with the S&P 500, chances are that periods of good returns will follow periods of low multiples, etc. We know that companies with high multiples have high expectations. The academic research also supports the notion that stocks with higher multiples (higher expectations) tend to have higher betas (volatility). This is also the basis for "style" indexes that separate growth stocks (high expectations) from value stocks (low expectations) based on their price to book ratios. We insulate ourselves as much as possible from overly optimistic expectations by focusing on lower multiples.

A Change in Earnings 

As equity investors, we are concerned with the earnings that accrue to equity owners, the Return on Equity. In that regard, there are only three things that will cause a change in the return:

1. A change in Sales
2. A change in Profitability
3. A change in Leverage

Sales is the headline item that seems to grab Wall Street attention. Sales growth can be a legitimate sign of the health and breadth of any company. A combination of increasing unit sales and price per unit is an attractive attribute of any business. Naturally, many companies that find themselves in the "low multiple" universe have disappointed investors with anemic or retreating sales. We spend our time trying to discern which of these companies are experiencing a short term problem and which have permanent impairments. 

Profitability is sometimes the most understated element of valuation. Back in the dot-com days it was almost forgotten. Figuring out which industries and which companies have a profitability advantage is likely the most difficult task we face. We know that high profits generally attract more market entrants, altering the landscape. As well, input costs may change, creating new economic models. We employ a range of potential profit outcomes in assessing the future prospect of an investment target. By considering history, in its proper context, we create our own expected profit model for the coming three to five years, based on a downside case, base case, and best case scenario. 

Balance Sheet leverage is easily measured by using basic credit statistics such as Total Debt/EBITDA, EBITDA/Interest Expense, and Debt/Capitalization, among others. Ultimately, when a company issues debt, it is equivalent to selling a call option on the value of the equity of the firm. Said another way, if you don't pay your debt, the creditor seizes ownership of the business and can leave you out in the cold. Debt holders are usually more exacting in their terms than equity holders, because they want their money back with a guaranteed return. As such, they include things like covenants and restrictions as a condition to their lending. However, even creditors can get sloppy, effectively creating low cost, penalty free capital for a business. We look for situations where companies have debt that is easily serviceable, either as a function of its size or of its lax restrictions. Sometimes, two companies with the same amount of debt can have very different financial risk characteristics. We look for those companies with lower financial risk. 

All of the Above - the Double Whammy! 

For a stock-picker, the best thing that can happen is the convergence of improving operating fundamentals and increased market expectation. It takes a tremendous amount of luck, buttressed by good fundamental due diligence, to achieve the returns afforded by increasing institutional awareness and earnings growth. Fortunately, many investors get swept up in the unrealistic expectations that improving earnings begets, and we are only too happy to sell them our shares at higher and higher prices. These new growth stock darlings are actually yesterday's fantastic value buys. Most likely during the next several years, something will happen to sour investors tastes and the expectations will come down and these companies will be put on sale once again. And the cycle begins anew. 

Now that we have explained how we look at the operational risk of the companies we buy, and how we look at the market perception of that value, we have to compare how all of these pieces fit together in a portfolio. Words like beta, correlation, and scenario analysis are the vocabulary of the portfolio construction process, whereby the individual pieces of the puzzle come together to present a picture. We will pick up the last leg of our Risk Framework in our August Commentary.

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.