Don’t Fight the Fed

“Reality is that which, when you stop believing in it, doesn’t go away.“
— Phillip K. Dick

PERFORMANCE

DON’T FIGHT THE FED

That’s how the old saying goes. In the Flash Report from Q4 we pondered the notion of Fed Chairman Ben Bernanke and his “Tilting at windmills” or attacking imaginary enemies. It seems the Chairman may be tilting at windmills as he and the Fed have embarked on a program to buy as many mortgage-backed bonds as is necessary until the labor market improved dramatically. It would be interesting to know what windmills our Fed Chairman sees on the horizon.

It seems whenever the Fed attempts to engineer such outcomes it is the unsuspecting individual investor who pays the price. With the Fed engineering negative interest rates and with Operation Twist flattening the entire yield curve, the environment for preferred issuance has never been better. Credit spreads on the long end of the yield curve have tightened to record levels and this includes preferred spreads.

From the perspective of a preferred issuer this environment is almost a too good to be true. During 2012 about 90 preferred issues with a total market value of $14.4 billion came to market with about half of the issuers being unrated. This volume buried the prior record year of 2004 when $10.7 of preferred deals came to market.
About one-third of these deals were simply the refinancing of existing higher coupon preferred at lower rates. This certainly has a positive impact on the earnings and cost of capital for the issuer. These vehicles have quickly become a type of perpetual long-term debt on the balance sheet. They can currently be issued at below the long term cost of capital rates for most corporations. This is very good for users with capital intensive balance sheets like REITs – particularly lower quality REITs that have an inherently higher total cost of capital over a real estate cycle. We are actively evaluating micro cap REIT opportunities that fit this benefit description. Thank You Ben!

This is inherently a high-risk (read bad) trade for the investor/owner of the paper because these preferred stocks never mature. In a rising rate environment the duration profile of an average preferred issue behaves like a 50 year bond. A 100bps rise in the 30 year bond could easily lead to a 20% drop in the value of a typical preferred. If credit spreads were to widen, that would cause more hurt for the owner. And, the less liquid nature of these shares typically creates a relatively large bid/ask spread which makes trading expensive.

For the issuer it is a different story. If rates were to rise, the preferred becomes the low cost piece of the capital stack as loans mature and re-price and equity premia rise with interest rates. With 3-5 year call protection the norm when issued, the only downside to the issuer is a sharp drop in interest rates shortly after a deal is issued. That seems like a very small risk in the current rate environment. So this abundance of preferred capital has been very good for issuers and it looks like it will continue in 2013.

With the asymmetric risk profile of the standard preferred trade, it seems like the best place to be is on the side of the issuer rather than the side of the buyer. As such, we have benefited within the portfolio by owning the shares of several REITs and other financial companies that have been able to take advantage of lowering their capital cost and improving their balance sheet through the issuance of preferred stock. This mechanism has clearly helped the earnings growth of the issuers. It has also left a limited number of opportunities within the preferred space for investors.

COMMENTS ON THE QUARTER

In a generally volatile environment, micro caps stocks moved ahead in large increments as the “risk trade” was on in the broader market. Since quarter end two of our micro cap portfolio positions have become takeover targets as larger companies, flush with cash and with low cost debt available, have begun to focus on M&A opportunities in a slow growth economic environment. We suspect this trend will accelerate in the back half of 2013 as capital remains abundant in a low return environment.

On April 22, 2013 CECO Environmental Corp. agreed to acquire Met-Pro Corporation (NYSE: MPR) a Uniplan micro cap portfolio company. Met-Pro is a leading global provider of product recovery, pollution control, and fluid handling and filtration solutions across multiple diversified end-markets. CECO will acquire all of the outstanding shares of Met-Pro common stock in a cash and stock transaction valued at a total of approximately $210 million, or $13.75 per share, which represents a 43% premium to Met-Pro’s share price as of the close on April 19, 2013. The consideration includes $7.25 per share in cash and $6.50 per share in CECO common stock. Under the terms of the agreement, Met-Pro’s shareholders may elect to exchange each share of Met-Pro common stock for either $13.75 in cash and/or shares of CECO common stock.

A week later, on April 29, 2013 our micro cap portfolio holding Telular Corp (NASDAQ:WRLS) announced it has agreed to be purchased by Avista Capital Partners for $253 million and the assumption of $18.5 million of debt. The company, which makes wireless home security systems, will be taken private in an all cash transaction for $12.61 per share or than 31% higher than its prior closing price on Friday. The Board of Directors approved the acquisition by Avista however the agreement between the two companies allows Telular to review better offers from third parties through May 29, 2013.

SECTOR COMMENTS

The broad based rally acted like the tide lifting all boats. Within the Micro Cap Portfolio, the only sector which failed to make a positive contribution to portfolio performance during the quarter was the telecomm sector; all others were additive to performance:

CONCLUSION

We continue to find and take positions in new opportunities that appear to have good long term value. As the current Q1 earnings season unfolds, we will have better insights regarding the impact of the current economic environment and its possible effects on our portfolio holdings and potential investments on our watch list. Given our analysis of the data so far, we have a mild bias toward the idea that a summer rally could occur in the micro-cap sector since we expect earnings of those stocks to outpace those of the broader market. Therefore, we remain focused on making further investments in emerging opportunities of quality micro-cap companies before then.

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 March 31, 2013 is 15.50% for the composite and 18.53% 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.