Micro Cap Flash 2018 Q4

“Out of adversity comes opportunity”

Benjamin Franklin

Summary for 2018 Q4 – Small Business Conditions Remain Strong

For the year-to-date period ended December 31, 2018, the preliminary estimated investment results for the Uniplan micro cap portfolio are as follows:

 

MTD

QTD

YTD

Uniplan Micro Gross

-10.82%

-21.61%

-14.08%

Uniplan Micro Net

-11.02%

-22.11%

-15.88%

Russell Micro

-12.05%

-22.14%

-13.09%

Wilshire Micro

-12.25%

-22.13%

-14.96%

 

Micro cap stocks peaked in June having gained about 10% YTD only to turn down in August and have continued a downward trend that accelerated into year end. The impact of tax selling and the shadow of overall market volatility put many market participants into a “risk-off” mode. As of this writing (1/11/19) micro caps had gained about 5% YTD; hopefully, ending the downward slide.

The selloff itself is perplexing because the micro cap universe has far less exposure to China and other non U.S. markets and we are in a period of the highest small business confidence since the early 1950’s when these measures began.  More on these topics later in this report but first let’s examine the potential risk and reward in micro cap stocks and the Uniplan Micro Cap portfolio.

A Quarter of Adversity = Opportunity

 For the patient long-term investor micro cap stocks offer better return opportunities than any domestic equity class. In looking back at the history of micro cap securities they are often punctuated with periods of extreme volatility. It’s easy to argue that we are in one of those periods of volatility. Given the market conditions, we thought it might be helpful to review some of the historical performance for the Uniplan Micro Cap Portfolio and the Micro Cap market segment in general.

The table below analyzes the rolling returns of the Uniplan Micro Cap Strategy from its inception on August 1, 1999, through December 31, 2018; a period of about 19.5 years. As can be seen, the best 12-month period (March 2003 through February 2004), returned +66.4%. The worst 12-month period (March 2008 through February 2009), showed a loss of -46.3%.  Looking at more discrete time periods, the best quarter (Q2 2009) was up +30.6%, the best month (April 2009) up +16.6%. The worst quarter (Q4 2008) was down -24.8%, the worst month (October 2008) down -18.5%.  As one might assume, the worst and best performance months were contained in the worst and best performance quarters.


We then went on to ask the question: During the worst period of volatility how bad would the losses have been? The worst drawdown from peak to trough was the period of June 2007 through February 2009 which would have been 15 months. During that period if an investor had invested at the top, the decline would have been 55% until the bottom. The recovery, the time until an investor recovered from the low in February 2009, would have been April 2011 a 26-month period. So, the round-trip from top to bottom would have lasted just under three and one-half (3.5) years. Certainly, the duration of the worst drop to complete recovery is within a reasonable time horizon for most normal investors.


Source: Uniplan Investment Counsel


It can be useful to look at the continuous rolling 12 month returns of the Micro Cap Portfolio to get a better sense of the second differential, or the rate of change in the acceleration or slowing of return performance.  This is shown in the graph below:


 Source: Uniplan Investment Counsel

As what would be mathematically expected given mean reversion, each period of either return acceleration or deceleration is followed by the opposite with the average rolling 12 month expected return being 15.7%. As can be seen in the graph, micro caps are currently experiencing a relatively deep and lengthy deceleration of returns. Although there could be more downside, one would expect mean-reversion to begin to emerge at some point in the near future and appears to be reversing given the January rebound as of this writing.

The three best and worst discrete periods (those that are not contained within the same period) are as follows: The average drawdown has lasted slightly over 10 months with an average loss of 31% while the best three period gains lasted about 7 months and returned about +31%.


For long term investors micro cap stocks offer a good probability of beating their larger cap brethren. In looking at data from the University of Chicago Booth Center For Research in Securities Pricing (CRSP) which covers the period of 1926 through 2015, micro cap stocks (the bottom 10% of market capitalization) have outperformed large cap stocks (the top 10% of market capitalization) 98% of the time if held for 20 years; Micro caps outperform 79% of the time if held for 10 years and half the time (50%) if held for only 5 years. For most investors, a 5-year time horizon is not unreasonable and beyond 5 years the odds of outperforming tilt to over 50% in favor of the investor.

Micro Cap Stocks as an Asset Class

One of the most widely discussed and researched topics in finance academia is the “small-firm effect.” Dozens of research studies have been published looking at all aspects of the theory that investing in smaller companies will generate superior returns when compared to investing in larger stocks, given the same level of risk.  Market capitalization is the key indicator in many of these studies and is often cited as a return differentiator.

One of the first important studies related to the small-cap effect was “The Relationship Between Return and Market Value of Common Stocks” by Rolf Banz in 1981. Banz suggested that company size was a contributing factor to its stock’s return. His findings show that the size of a firm and the return on its common stock are inversely related. In other words, the smaller a public company, the better its potential return.

Risk & Return

One of the often-cited counter-argument to investing in smaller companies is that they are riskier, and this added risk is the reason for their higher returns. Small-company stocks do possess more risk than do large-firm stocks on an absolute level. The smallest stocks which comprise the bottom 20% of market capitalization, had an average annual standard deviation of 42.1% from 1926 to 2015, compared to 19.1% for the largest 20% of stocks.

However, Banz and others found, when adjusted for risk, the returns for small-company stocks still outperformed those of larger stocks. In a later study, Banz created five portfolio segments containing the largest to smallest stocks listed on the New York Stock Exchange (NYSE). Over the 50-year period 1926 through 1976 he studied, Banz found that the four portfolios containing the largest NYSE firms generated an average risk-adjusted excess annual return of -0.72%. On the other hand, the portfolio containing the smallest NYSE companies provided a risk-adjusted excess rate of return of about +6% a year.

In another study professors Thomas Cook and Michael Rozeff from the University of Iowa examined the small-firm effect using stocks listed on the NYSE, Amex and those traded over-the-counter (OTC) over the period 1968 to 1978. They divided 3,130 stocks into 10 portfolios, each containing an equal number of stocks, on the basis of market cap. The four portfolios with the lowest market caps provided risk-adjusted average annual excess returns of 1.69% to 5.54%, while the remaining six portfolios with the larger company stocks all generated negative annual excess returns ranging from -0.12% to -4.12%.

The most famous study regarding micro cap stocks is from University of Chicago professors Eugene Fama and Kenneth French. Their 1992 research, “The Cross-Section of Expected Stock Returns” found that company size, as measured by market cap, helped explain market returns. Fama and French examined the companies that traded on the New York Stock Exchange (NYSE) and divided them into deciles based on their market capitalization. What they found was that the smallest companies—those in the 10th decile based on
market cap—outperformed the stocks with larger market caps.

In summary, there is a long foundation of academic research that suggests smaller stocks add return to a portfolio and that the smallest of those stocks add the most return. While small and micro cap stocks may experience significant volatility over short-term periods, investors who hold these same stocks over longer periods of time have experienced better risk-adjusted returns than what they would have received if investing in larger-company stocks during similar periods.  A little bit of return over a long period of time makes a big difference in total portfolio growth.

The table below from the Center for Securities Price Research at the University of Chicago supports this thesis.  Based on performance data between 1926 and the end of 2014. The smallest companies in the 10th decile have, on average, generated an annual return of 13.5% over that period. By comparison, the companies in the S&P 500—the 500 largest companies traded on U.S. exchanges based on market cap—generated an average annual return of 10.1% over the same period. So, if you invested $1,000 in these 10th-decile stocks at the beginning of 1926, you would have had $79,455,996 at the end of 2014, versus $5,235,865 if you had invested the same $1,000 in the S&P 500. 

 

1926 to 2015

#

% of

 

Annual

of

Total

Decile

Return %

Co’s

Mkt Cap

1 – Largest

10.1

 

185

64.3

2

10.7

 

199

14.1

3

11.1

 

194

6.9

4

11.0

 

221

4.5

5

11.7

 

215

3.0

6

11.5

 

265

2.5

7

11.6

 

317

2.0

8

11.7

 

417

1.5

9

11.6

 

395

0.8

10 – Smallest

13.5

 

948

0.6

T-Bills

3.5

     

Inflation

2.9

     

 Source: Center for Securities Price Research at the University of Chicago

“China Resistant”

Last quarter we discussed the notion of a China resistant portfolio.  The problematic question of a continued foreign trade dispute lingers over the market with the possibility of a trade war looming ever-present on market sentiment.  These continue to remain unresolved issues for the global financial markets and as such hurt the valuation of global companies.

And beyond the rhetoric, some blunt actions on trade are being signaled as the US charged ten Chinese spies with hacking into American aviation firms to steal trade secrets while former Attorney General Jeff Sessions ordered the FBI and the Justice Department to step up enforcement actions against Chinese companies.  And just to amp things up a bit, the U.S. somehow convinced Canada to detain for extradition the CFO of Huawei who coincidentally happens to be the daughter of the founder and a well-known supporter of President Xi and the Party in China.  This is clearly the U.S. playing hardball with China.

Given the notion that the China trade situation is likely to remain an irritant to the market and may continue to cause uncertainty around the outlook for US global companies, we see little of this situation having a material business impact on small companies like those that we own in our micro cap portfolio. In fact, 86% of the aggregate sales of the Uniplan micro cap portfolio holdings are within the United States. With regard to sourcing from China, there are four companies in the portfolio that source some content from China but in speaking with management, none use China to sole source any parts or materials and all have alternative sourcing which is used as a normal supply channel. The key takeaway here is that the Uniplan micro cap portfolio holdings should not be materially impacted by any trade disruptions with China.

We would characterize the portfolio as “China resistant” from a business perspective but continue to believe that the China trade situation could potentially cast a longer lasting shadow over the earnings outlook for large multi-national companies and in turn the broader market as a whole. As such, market risks remain but smaller companies look more favorably positioned to turn in operating performance that is better than large multinational names.

Small Business Conditions Remain Strong

Small business confidence continues to remain strong although off its recent peak by a touch. The 2018 tax cuts along with the current Administration’s economic policies, particularly in the area of regulation, are proving to be an exceptional boost to business confidence. The new Tax Law is providing higher cash flow for businesses to pay down debt, buy back shares, increase dividends, reinvest in their business, expand critical personnel, and buy other companies. In addition, the capital markets in the form of both debt and equity are currently open for micro cap companies. We would argue that all these factors are positive for business in general and micro caps in particular.

Conclusion

History has shown that small companies have provided superior risk-adjusted returns compared to large companies. Other research has shown that this return premium is the result of the limited liquidity in smaller companies and the lack of research or analyst coverage on many of these companies. While micro-cap stocks do tend to have greater volatility and higher trading costs (wider bid-ask spreads), they offer long-term investors an opportunity to capitalize on market inefficiencies that are not possible for large professional investors to exploit. In addition, these stocks offer diversification benefits when added to a portfolio of larger-company stocks, since the two groups tend to not move in perfect unison. For these reasons, micro-cap stocks have a meaningful place in the portfolios of individual investors.

###

Richard Imperiale

Chief Investment Officer

The Uniplan Micro Cap Portfolio is a low-turnover high-conviction micro cap strategy designed to offer investors a quality alternative to private equity having a similar unlevered return while providing daily liquidity.  The Uniplan core investment thesis is focused on companies trading at a low multiple of cash flow or EBITDA, those with little or no debt and meaningful insider holdings.  We search for smart money activity which we define as insider buying which is found in 13G/13D filings.  A cash dividend and an identifiable macro or company-specific catalyst are preferred. 

 

Important Information: 1. Uniplan Investment Counsel is a boutique investment firm, with roots dating back to 1984, that manages a variety of portfolios primarily for US clients. Uniplan maintains a complete list and description of composites that is available upon request. 2. The composite was created August 1, 1999. Performance is calculated in US dollars utilizing a time-weighted total rate of return. Total return for the composite is represented by the asset-weighted returns of the portfolios within the composite. Trade-date valuation is used. 3. Performance is net of all transaction costs and net performance is net of transaction costs and (maximum allowable total) investment management fee, but before any custodial fees (that may be incurred separately by the client). 4. The benchmark for the composite is the Wilshire US Micro Cap Index that represents a float-adjusted, market capitalization-weighted portfolio of all stocks below the 2,500th rank by market capitalization in the Wilshire 5000 at March 31 and December 31 of each year. The index is used to measure small stocks and is adjusted to reflect the reinvestment of dividends, when applicable. It is not possible to invest directly in an index. The index figures do not reflect any deduction for fees, expenses or taxes. 5. The dispersion of annual returns is measured by the standard deviation of asset-weighted portfolio returns represented within the composite for the full year. The standard deviation of the annual returns for the period August 1, 1999 to December 31, 2018 is 17.86% for the composite and 24.89% for the Wilshire Micro Cap Index. 6. The composite does not have a minimum size criterion for composite membership. All fee-paying discretionary accounts with similar investment objectives are included. Leverage is not used in this composite as a means to generate higher returns. There may be non-fee paying portfolios in the composite.  Individual account holdings may vary depending on numerous factors including the size of an account, cash flows, and account restrictions.  7. There have been no changes in the personnel responsible for the management of this composite. 8. The composite contains both traditional and wrap fee portfolios. Uniplan has a flexible and negotiable fee schedule reflecting the differences in size, composition and servicing needs of clients’ accounts. A complete description of investment advisory fees is contained in Uniplan’s Form ADV and is available upon request. 9. Uniplan Investment Counsel does not claim GIPS Compliance. Individual account performance may vary from the results shown because of differences in inception date, restrictions and other factors. 10. Investors should understand that micro cap stocks are subject to a higher degree of risk than other equity investments due to the small size of the companies and the limited trading volume inherent in micro cap stocks. Past performance is no guarantee of future results. Investment involves a risk of loss.

All investments carry a certain degree of risk, including possible loss of principal. REITs are subject to illiquidity, credit and interest rate risks, as well as risks associated with small- and mid-cap investments. It is important to review your investment objectives; risk tolerance and liquidity needs before choosing an investment style. Value style investing presents the risk that the holdings or securities may never reach their full market value because the market fails to recognize what the portfolio management team considers the true business value or because the portfolio management team has misjudged those values. In addition, value style investing may fall out of favor and underperform growth or other style investing during given periods.

Uniplan Investment Counsel is a registered investment advisor. The views expressed contain certain forward-looking statements. Uniplan Investment Counsel believes these forward-looking statements to be reasonable, although they are forecasts and actual results may be meaningfully different. This material represents an assessment of the market at a particular time and is not a guarantee of future results. This information should not be relied upon by the reader as research or investment advice regarding any particular security. Past performance does not guarantee future results. Prices, quotes and other statistics have been obtained from sources we believe to be reliable, but Uniplan Investment Counsel cannot guarantee their accuracy or completeness. All expressions of opinion are subject to change without notice. It should not be assumed that recommendations made in the future will be profitable or will equal the performance of this security. A list of securities purchased and sold in the portfolio during the past year, including the purchase or sale price and the current market price, is available upon request by calling 262-534-3000.

 


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