There are some interesting changes about to take place in small cap stock trading that we want to highlight for you.

October 2016 marks the beginning of the 18-month “Tick Size Pilot Program,” an SEC-approved effort to determine if trading spreads in small company stocks influence liquidity and valuations.

So why exactly is this an issue? A bit of history is necessary to answer that question.

In the aftermath of the dot com bubble, several reforms were introduced to the public equities markets. Regulation FD (2000) reduced the need for small investors to rely on their brokers for research and company information. This was punctuated by the Global Analyst Research Settlement in 2003. In 2001, stocks began trading in $0.01 increments (decimalization), which reduced the trading spreads and therefore the profits of market makers. In 2002, the Sarbanes-Oxley Act created a new layer of audit and compliance costs for public companies that hit small firms the hardest.

Combined with the recession in the early 2000s, these reforms resulted in a significant consolidation of the smaller broker/research network in the United States. The evidence to us was stark. In 1998, we traded trough 100 firms. Today, that broker coverage list measures just over fifty. This has resulted in fewer small public companies having broad research coverage.

While all of this was going on, newly emergent “dark pools” began to grow; that is, private venues where large institutions trade their shares outside of the traditional exchanges such as NYSE and NASDAQ. More on this later.

The central idea behind the Tick Size Pilot Program is that if liquidity is increased, valuations will increase, market makers and analysts will be enticed to cover small companies again, small companies will have an easier time with capital formation, IPO issuance will increase, and a virtuous cycle will ensue.

After several years of politicking and study (and against the advice of one of its own subcommittees), the SEC mandated the Tick Size Pilot Program. Nearly 2,400 public company stocks will be monitored, 800 of which will be traded in increments of $0.05 (as opposed to $0.01).

The theory of trading at a nickel instead of a penny can be compared to a bus stop route. The bus generally stops every five blocks, not at every street corner. It aggregates riders and unloads passengers at fixed locations. Even though the bus may still carry the same number of people, fewer stops increases the size of the crowd waiting to board. Stock spreads work much the same way, so the theory goes. A perceived depth of market should encourage more trading and offer wider profits for market makers, which in turn should encourage more research coverage and increase trading volume and liquidity in smaller company stocks.

Some opponents of the Tick Size Pilot Program have suggested that the real beneficiaries of this test will be High Frequency Traders (“HFT”). They fear that HFTs will figure out a way to step in front of a trade and make $0.05 profit on a stock, rather than settle for a penny. Others suggest that the exact opposite will take place: The risk of a $0.05 mistake is too costly for an HFT to take. There are also detractors who argue that the Tick Size Pilot Program is merely a back door attempt by the NYSE to diminish the power of dark pools.

We believe that tick size should be a function of the market and there should be little if any regulation as to their size. Today’s technology allows for minimal trade spreads and the market should, with some time, find its own natural clearing prices. For the time being, we will be denied that privilege on nearly 800 of the potential stocks we trade in.

When we determine to own a company, we set a purchase price range and then search for stock available at that price. Because we are not a short term investor, we have enough patience to wait for our price or move on to our next best idea. With regard to this “tick test pilot,” our senior trader summed up our view this way: On some stocks we might do a little better and other stocks we might do a little worse.

At Pacific Ridge, we don’t mind inefficiencies because we don’t believe that they persist for very long. To us, it’s only a matter of time before the public markets recognize value in any given stock, or the private market investor will do the same.

We are also fans of greater transparency and we welcome good market data. In the next two years, the Tick Size Pilot Program will give us tangible evidence about the impact of bid and ask spreads in the marketplace, and who will benefit and who will lose. We welcome the results of this study when it is complete.

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 90 and 140.

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 strategies, we invite you to contact Tammy Wood via email at Tammy.Wood@PacificRidgeCapital.com 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.