Counting election year performance. June 2012

“Everything that can be counted does not necessarily count; everything that counts cannot necessarily be counted.“
— Albert Einstein

The preliminary estimated investment results for the Micro Cap portfolio are as follows:

COUNTING ELECTION YEAR PERFORMANCE

“Sell in May and go away” is the mantra of the Stock Trader’s Almanac. The strategy is based on the seasonal pattern that shows since 1928, the return for the six months from May through October has been well below that of November through April. According to Strategas Research Partners, the total return on November through April since 1928 would have been 4.9% vs. 1.8% for the May through November period. And May was a dismal month for stocks but it was followed by a relatively solid June. It was not enough to rescue the quarter with equity benchmarks in general posting a loss for the period.

The market pundits are now turning their attention to the Presidential election. Much is being said about how markets behave in an election year. This prompted us to take a look at the data. Interestingly, the “Sell in May” strategy might not be as reliable in an election year. In fact, it might not give a great deal of insight into market performance.

ELECTION YEARS AND THE STOCK MARKET

The stock market is almost always positive in an election year. At least that is generally what you hear from market authorities in interviews and financial columns.

Throughout modern presidential history, the four-year presidential cycle has had an unusually consistent pattern. The market seems to experience most of its serious corrections in the first two years of a presidential term and then makes a substantial recovery in the last two years. The pattern did not hold true during the financial crisis of 2007 and 2008, the last two years of the Bush Administration, as investors experienced a serious bear market.

Intuitively it makes sense that election years would be positive as each presidential administration and the incumbents’ political party pulls out all the stops to make sure the economy and stock market are positive when re-election time arrives. However, the data just doesn’t seem to support that conclusion. The table below shows how the Dow Jones Industrials fared in each presidential election year. The chart indicates that, whether a Republican or a Democrat was in the White House seemed to make little difference to market outcomes.

Dow Performance For Presidential Election Years

Source: Dow Jones, Uniplan, Inc.

SUMMARY OF RESULTS

• About two-thirds (66.7%) of the 23 election years were positive
• If a Democrat was in the White House the market was up 63% of the time
• If a Republican was in the White House the market was up 68% of the time

Interestingly, looking at all the years between 1920 and 2012, the market was up during 62 years or 68% of the time. So, market results during election years did not show a statistical bias toward outperforming more often than non-election years. The statistics also show there is an upward bias regardless of which party is in the Whitehouse at election time.

There can be interesting patterns embedded in the data if it is deconstructed at a more granular level. One that emerges and runs directly contrary to the “Sell in May” thesis is the monthly return profile during election years. The following table shows the monthly return pattern for the S&P during election years since 1926.

As can be seen, June, July and August are far and away the best 3 consecutive months to own stocks during an election year. This is contrary to the “Sell in May” strategy.

Source: Bianco Research, Uniplan, Inc.

Sam Stovall, the market historian for S&P, also noticed an interesting pattern in election year data. This one, he notes, reliably predicts who will win the upcoming presidential election in the election year. His thesis is as follows: The S&P 500’s price performance during the three calendar months leading up to the presidential election has been a good predictor of whether the president or his party would be re-elected or replaced. An S&P 500 price rise from July 31 through October 31 traditionally has predicted the reelection of the incumbent person or party, while a price decline during this period has pointed to a replacement. Since 1948, this election-prognostication technique did an excellent job recording an 88% accuracy rate in predicting the re-election of the party in power (it failed in 1968). What’s more, it recorded an 86% accuracy rate of identifying when the party in power would be replaced (it failed in 1956). Therefore, pay attention to the market’s performance in the three months leading up to the presidential election, as it will probably do a better job than the plethora of political pundits prognosticating on the presidency.

So, useful and interesting patterns may exist in the return data, but the problem is that the data set is extremely limited. In order to be statistically significant, it would require 1,000 election year data points in order to achieve a 0.10 significance level. Similar levels of observations would be needed for the other data points. So with limited data it is probably worth giving only limited weight to the outcomes but it provides interesting fodder for election year discussions.

COMMENTS ON THE QUARTER

In a generally volatile environment, micro caps stocks moved in large increments as the “risk trade” was on or off in the broader market. Indicative of the volatility was the spread between our top performing portfolio holding during the quarter (RRST +36.9%) vs. our worst performing holding during the quarter (MRGE -51.2%) leaving a spread of 88.1% between the top and bottom performing stocks. The normal average quarterly spread between the top and bottom performer has been 37.2%.

Our worst performing name Merge Technology, (MRGE – NASDAQ), develops software solutions that facilitate the sharing of images to create a more effective and efficient electronic healthcare experience for patients and physicians. The solutions are designed to help solve some of the most difficult challenges in health information exchange today. Examples are the incorporation of medical images and diagnostic information into broader healthcare IT applications, the interoperability of proprietary software solutions, and the ability to improve the efficiency and cost effectiveness of medical delivery businesses. During the quarter, the company unexpectedly announced that it was going to make a major change to its pricing model that would lower near term revenue but enhance revenue over the long term. This guidance sent the stock down -51.2% during Q2 as it put all earnings models in question.

Our best performing position was RRsat Global Communications Network Ltd. (NASDAQ: RRST). They provide global, end-to-end, content management and distribution services to the rapidly expanding television and radio broadcasting industries, covering more than 150 countries. Through its RRsat Global Network, composed of satellite and terrestrial fiber optic capacity and the public Internet, RRsat provides high-quality and flexible global distribution services 24/7 to more than 630 channels reaching multiplatform operators, Internet TV and direct-to-home viewers worldwide. They also offer occasional use services for sports, news and events with a fleet of fly-away mobile trucks and over 10 transportable satellite news gathering services (SNG) units. More than 130 television and radio channels use RRsat’s advanced production and play-out centers comprising comprehensive media asset management services. A new CEO along with a dividend increase sent the stock up 36.9% for the quarter.

In looking at our attribution for the quarter, our stock picking added value unlike last quarter when our stock picking lagged. Our sector weighting was about neutral in terms of portfolio contribution for Q2, which was about the same in Q1.

ATTRIBUTION OF RETURNS

—— insert sector bets jpg- uploaded separately——
Source: Baseline, Inc.

When it comes to micro caps, patience is truly a virtue. If history is any guide, the longer term, higher quality portfolio tends to win the race. During Q1, micro caps were led by a low quality rally. That moderated somewhat during Q2, with medium and higher quality stocks holding up better in a more difficult market environment.

Health care and utilities led the race during the second quarter as the more defensive nature of those sectors came into play. When digging deeper into the attribution analysis, the performance of dividend paying stocks were generally mixed relative to the market during Q2. The Uniplan Micro Cap portfolio has 23 stocks out of 38 stocks (60%) which pay a current dividend—and the portfolio yield is nearly 2%. These names generally moved in-line with their sectors during the quarter. We suspect the high cash positions on many corporate balance sheets could trigger a large number of special dividend payouts in Q4 2012 if the election results suggest an end to the Bush era tax structure resulting in a higher tax rate on dividend income.

PORTFOLIO STRATEGY

Our portfolio is well diversified by sector and industry. We continue to be slightly overweight non consumer themes and underweight financials.

Micro Cap Portfolio Sector Weighting vs. Russell 2000

Source: Baseline, Uniplan Inc.

With the high level of uncertainty, there seem to be few clear broad thematic long arc paradigms outside of our M&A thesis within which we can construct a portfolio framework. A lower beta within the overall portfolio along with higher quality dividend paying stocks give us better comfort going into what will likely be a volatile election season. So, for the time being, we are largely building our portfolio on more of a company level analysis and less of a macro or sector framework. With corporate cash at an all-time high, we believe any combination of improved earnings and economic outlook will give buyers the confidence to step back into the M&A Market.

Source: Uniplan Inc.

CONCLUSION

In spite of the market’s increased volatility, ahead of a contentious presidential election, despite market concerns over the European and domestic economies, we will continue to adhere to our long-term investment strategy: managing a portfolio of well-run companies with strong balance sheets, above-average insider ownership and little Street coverage. The upcoming Q2 earnings season will give us a unique gauge of the economy, the market and the conditions of our holdings. We will also be able to better assess the viability of the names on our watch list. Given the data from the presidential year cycle analysis, we have a mild bias toward a summer rally that could last well into September. We believe this will give us an opportunity to trim or sell fully valued positions in favor of quality micro-cap stocks that are, in our opinion, unrecognized by the market and will therefore provide better returns.

Richard Imperiale
Portfolio Manager

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. Gross performance is net of all transaction costs and net performance is net of transaction costs and maximum investment management fees, but before any custodial fees.
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 September 30 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 September 30, 2012 is XX.XX% for the composite and XX.XX% for the benchmark 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 is one non-fee paying portfolio in the composite.
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. Individual account performance may vary from the results shown because of differences in inception date, restrictions and other factors. Past performance is no guarantee of future results.
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.