Micro Cap Flash 2016 Q4

“Genius is eternal patience.“
— Michelangelo

“Genius is nothing but a great aptitude for patience.“
— Michelangelo

SUMMARY FOR 2016 / OUTLOOK 2017

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 core investment thesis is focused on companies with little or no balance sheet leverage trading at a low multiple of cash flow or EBITDA, and having meaningful smart money activity in the form of insider buying, or 13G/13D activity.

Historically the patient micro-cap investor has been rewarded with strong relative returns for long term exposure to the asset class. Looking back in time, 2015 proved to be very volatile leaving the benchmark down -5.4% while the portfolio gained +3.9%; our value bias added return over the year as biotech and other more speculative micro-cap sectors gave back early year gains. As we began 2016, our portfolio returns were essentially flat with the two year trailing performance at about 1% versus -1% for the benchmark. But by year end, 2016 proved to be a far stronger environment for our value tilt as portfolio returns came in at about 27% versus 20% for the benchmark with almost all of the returns loaded into the back half of the year. This moved the performance needle with the two year return coming in at about 15% and the three year number moving up to over 9% as of yearend 2016. The key idea here is that micro-cap returns can be lumpy, but patient investors in the asset class are rewarded over time.

Every month we undertake a complete portfolio review with a rigorous reassessment of each of our holdings. This is designed to be somewhat like pruning a perennial garden with some plants needing to be culled in order to make room for more robust growers. During 2016, we moved into a more risk-on position based on our forecast of improving US domestic earnings and a better economic outlook during the year. In addition, we harvested some gains and losses in an attempt to be as tax efficient as possible while redeploying capital. For 2016, the changes took root as the portfolio provided a strong positive contribution relative to the benchmark while doing so with far less volatility.

For the year end December 31, 2016, the preliminary estimated investment results for the micro-cap portfolio are as follows:

CURRENT PORTFOLIO POSITIONING

So what might distinguish our current micro-cap holdings from other micro-cap managers as well as the broader market? In reviewing our attribution data, there are several thematic items that stand out. First, the Uniplan micro-cap holdings have limited direct exposure to the energy sector which until recently was struggling under the deadly combination of low commodity pricing and burdensome regulation. In positioning the portfolio, we chose to mitigate this strategy by holding some industrial names that have some indirect sales exposure to the energy sector as a hedge to a rebound in demand or pricing.

Our underweight to the financial sector, which represents about 26% of the Russell micro-cap index vs. our 4% exposure also helped performance. Financials were largely negative on the year until Q4 when they rebounded to about even but continued to trail the broader benchmark by a large margin. We believe small financial company stocks have under-performed due to broad based concerns over volatility in interest rates and general credit concerns. Our portfolio is historically underweight financial stocks due to the relatively high level of debt leverage that is often used on the balance sheets of those companies. This removes many of them from consideration early in our screening process which seeks to avoid too much debt on company balance sheets.

Stock selection has also been a large contributor to portfolio performance, with selection contributing about half of our excess performance to overall portfolio returns for the year-to-date.

The areas where stock selection have made the largest contribution have been in the health care and consumer discretionary sectors contributing about +394 bps and +222 bps respectively with these sectors representing about 23% of the overall portfolio. The areas where stock selection was the weakest were utilities and real estate, detracting by about -44 bps and -47 bps respectively; however these sectors have less benchmark and portfolio weighting than the contributing sectors and represent about 8% of the total portfolio.

THE STATE OF M&A

We continue to see MEGA deals play out in the M&A space but have yet to see a meaningful resurgence of activity in the micro-cap space.  The question is whether the market conditions that have fueled mega merger activity will push down into micro-cap M&A in 2017?

The drivers behind M&A activity have been the abundance of corporate cash available to be deployed and the reemergence of reasonably priced bank financing for the deal community. Additionally, while less applicable to the micro-cap market, slow corporate earnings growth downstream of the recession has forced big corporations to seek growth externally rather than focus on organic increases in revenue.

Pitchbook suggests that Private Equity has approximately $950 billion of “dry powder” available for deal-making through recent equity raises. In addition a large number of small companies that were taken private pre-2007, are beginning to reenter the market through IPOs resulting in additional liquidity.  The availability of debt continues to improve and be more accessible.  These factors are helping to support valuations. E&Y’s recently published US Capital Confidence Barometer suggests that the robust M&A market will continue for the near term.  A near all-time high of 78% of E&Y’s respondents believed that the M&A market would improve in 2017. The vast majority of deal-makers asked are evaluating more than one deal and almost half were considering more than five potential transactions.

In addition, E&Y reports that the middle market will benefit from this bullish outlook; this should have a positive impact on the micro-cap space as more money is deployed in the middle market which is the sweet spot for micro-cap transactions.  The bid-ask spread of price expectation has significantly shifted toward middle market deals over the past 12–18 months.  Until recently M&A markets have been led by large cap transactions, followed by a period of focus on the middle market as acquirers fully digest their large acquisitions and reshape their future plans.

RECENT PORTFOLIO M&A

With that in mind, there were two M&A transactions in the micro-cap portfolio during 2016. The first was RR Media (RRM), a media services company which provides fixed and mobile satellite broadcasting services to other media companies, which agreed to be acquired by European satellite services firm SES for $13.291 in cash; a 53% premium to the prior day’s closing price. The deal  closed during Q3, 2016.

The second deal was the acquisition of Alliance Fiber Optics (AFOP) by Corning (GLW).  The all-cash deal was announced April 7^th at a 20% premium to the prior closing price and closed in June, an incredibly fast two months later.

This illustrates to us the embedded strategic and financial value of many of the companies in the micro-cap portfolio and the opportunity set available in the nearly 4,000 micro-cap companies that comprise our investable universe.

The investment banking community has not missed the fact that the collective cash on the balance sheet of the American industrial complex has reached an all-time high. As measured by net debt to equity, balance sheet leverage for non-financial companies is currently running at below 15%, a level unseen since the late 1950’s. And, according to Thomson Reuters’ data, companies around the world held almost $13 trillion of cash and equivalents on their balance sheets at the end of 2016; that is more than twice the level of 10 years ago. Additionally capital expenditure relative to sales is at a 22 year low while the average age of corporate fixed assets and equipment has been stretched to 14 years from pre-crisis norms of about 9 years.

In the large-cap world, some of this money has been returned to shareholders in the form of share buybacks and dividends often with the encouragement of dissident shareholders and corporate activists. In micro-cap land, there have been very few share repurchases, but dividends and special dividends have become far more widespread. As of December 31, the average dividend yield in the micro-cap portfolio stood at around 1.69% which is an encouraging positive indicator of valuation given the low interest rate environment.

OUTLOOK

AND NOW FOR SOMETHING COMPLETELY DIFFERENT…

THE ELECTION AND MICRO CAPS

In electoral terms, the status quo has been repudiated. There’s a new Sheriff in town and it seems pretty clear that things are going to change. The unanswered question is: How are things going to change? In an attempt to answer this question it’s reasonable to begin by asking two other questions: What do we know? And, what don’t we know? The answers will be concise and the observations are those of a “fair observer” attempting to leave political passions and preferences aside.

WHAT DO WE KNOW?

The center of gravity has shifted in Washington DC. The vested interests of both the right and the left are clearly being rejected by a populist center that, for practical purposes, represents the moderate electorate of both parties. In a primary battle, where the far left and far right of each party respectively maneuvered to control the primary process, the disenfranchised main stream voter showed up at the polls to reject the incumbent power structure. This resulted in two deeply flawed candidates emerging. One who represented the certain continuation of “business as usual” and the other who represented the rejection of the status quo. In what can only be described as a stunning defeat for both parties, the verdict was delivered and the populist candidate was elected.

WHAT DON”T WE KNOW?

We know little about the new President or his core values and political priorities beyond a relatively vague outline of initiatives. A close look at the early political appointees and advisors is seemingly inconsistent with a number of stated policy goals and at the moment, the real policy priorities of his team are unclear. Policies will certainly emerge, but we don’t know how long it will take or how clearly the objectives will be stated. Nor do we know how effective or responsive the entrenched political establishment will be in working with the new administration to implement change. If history is any indicator, it’s safe to assume that things will grind slowly in Washington although this is an uncertainty as well, because so much of the current legislative outcomes were mandated by the former Executive and as such can be substantially altered or repealed by new Executive orders. So, policy visibility in the near term is limited at best.

LOW VISIBILITY = MORE VOLATILITY

One thing is abundantly clear: markets roil at the notion of uncertainty. The larger the degree of uncertainty, the larger the “uncertainty discount” becomes. That uncertainty typically translates into volatility. Interestingly, since the election, this volatility has played out to the upside with the broader market advancing about 6% between the election and the inauguration. If the market is in fact a leading indicator, this performance suggests that market participants consider the new Executive to be on balance a positive agent.

The rally has been in the period leading up to the actual inauguration of the new President. Now in office, it will be instructive to observe market action. The political process on its best days grinds slowly and by Washington standards moving quickly can be measured in years rather than months. So it’s entirely possible that the markets have discounted more results than the new administration will be able to immediately deliver and as such increased volatility is likely to continue. It is likely that there will be investment opportunities created by the volatility of uncertainty. Our current strategy will be to focus on any apparent dislocations resulting from volatility and focus on what, if any, opportunities result.

There are some stated policy initiatives form the new Executive that coupled with a willing Congress could result in an improved operating environment for business in general and small business in particular. A few of the key initiatives are as follows:

LESS REGULATION – The prospects of a less restrictive regulatory environment has clearly increased business optimism and certainly a less burdensome environment is supportive of more efficient business outcomes. Studies show that the average micro-cap company spends approximately $2 million annually on compliance and regulatory reporting. Any reduction in this expense should be positive for micro-cap earnings.

TAX REFORM – Real bipartisan momentum appears to be building for meaningful corporate tax reform. This includes a reduction in the top corporate tax rate from 39.1% to some lower marginal rate. Micro cap companies pay among the highest marginal tax rates of any corporate payers and any reduction in marginal rates would be a positive cash flow generator for small companies.

INFRASTRUCTURE SPENDING – It appears that there is reasonable bipartisan support building for targeted infrastructure spending. The details on this are far less certain, but generally speaking, well targeted infrastructure spending often supports local business capital spending and that is generally good for small companies.

REPATRIATION OF CASH – Along with tax reform there is a move afoot to allow a one-time repatriation of corporate cash stranded in off-shore operations. This return of cash could have two positive impacts – lowering corporate debt as many companies borrow against these cash holdings and simulative deal spending in the M&A area. Both outcomes are generally positive for small businesses.

HIGHER CONFIDENCE LEVEL – Finally, these outcomes should generally bolster business confidence levels. This, while not a legislative or political outcome, should nonetheless be a broad positive that should stimulate higher levels of business activity.

CONCLUSION

With corporate cash at an all-time high, a sea change in the political environment and a combination of improved earnings and economic outlook will all combine to raise small business confidence and profitability. This in turn should give buyers the confidence to more vigorously return to the M&A Market. We anticipate there will be continued volatility during the balance of 2017, as factors such as the global economic outlook and the strong US Dollar continue to cause uncertainties around earnings and economic growth. But, valuations remain attractive for many micro-cap companies and as a contrary indicator, the lack of investor interest in the micro-cap space seems to be nearly universal. We continue to position in new opportunities within the portfolio that appear to have good long term value. Thus, we continue our deployment of portfolio funds with a focus on our thematic framework and increasing the quality of names within the portfolio with dividend yields as an added bonus.

Richard Imperiale
Portfolio Manager

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. 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 30, 2016 is 17.52% for the composite and 25.52% 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 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. Uniplan 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.