So It Begins – 2014; Can It Get Better?

“Genius is eternal patience.“
— Michelangelo

Patience has been rewarded. In a digital world where communication is instantaneous and markets are constant, the notion of waiting for return seems obsolete. In fact, according to the NYSE, the average holding period for common stocks has declined from 6.3 years in 1970, to about 11 months in 2012. In micro-cap land, copious amounts of patience and long holding periods are often required for business plans to materialize and markets to recognize progress. During 2013, the patient micro cap investor was rewarded for staying in the game.

For the year-to-date period ended December 31, 2013 the investment results for the micro cap portfolio are as follows:

What changed? Why did micro cap stocks finally launch? There were a number of relevant factors which likely helped micro cap performance beginning with what appears to be a modest but broad based recovery in the U.S. economic outlook. This was confirmed by the Fed’s announced reduction of quantitative easing. Add to that a flurry of private equity deals in the public company arena, driven by cash-rich growth-starved larger companies, and the environment ripened for micro cap performance. The final catalyst may well have been the vast amount of private equity capital that was raised in 2008-2009 that remains un-invested and will need to be returned to partners in 2014-2015 if it is not put to work. These factors taken together could very well create continued support for micro cap performance. The relative gross performance of the Uniplan Micro Cap Portfolio during the year 2013 was about 246bps over the Wilshire Microcap benchmark, a notable data-point because our portfolio with its value bias tends to under perform the benchmark in strong bull markets.

But, there is more to this story. 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 $7 trillion of cash and equivalents on their balance sheets at the end of 2013; that is more than twice the level of 10 years ago. And, 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 an average of 14 years from pre-crisis norms of about 9 years.

(Source: BofA Merrill Lynch; Uniplan Consulting, LLC.)

In the large-cap world, some of this money has been returned to shareholders in the form of share buybacks and dividends. In micro cap land, there have been very few share repurchases, but dividends and special dividends have become far more widespread. As of year-end, the average dividend yield in the micro cap portfolio stood at around 2% which is an encouraging positive indicator of valuation given the low interest rate environment.

During the past year or so, there has been a modest acceleration in mergers and acquisitions, particularly late last year. But, even with the number of mega deals during 2013, M&A as a share of market capitalization remains lower than it was in 2002, according to industry data.

It was a quiet year for deal activity in our portfolio – There were three deals in the portfolio during 2013; up from one deal in 2012 and two during 2011 but still below the average of five deals annually which was the norm through 2010

Micro Cap Portfolio Deal Activity 2013

(Source: Uniplan Investment Counsel Inc.; Baseline)

THE YEAR IN REVIEW – 2013 SNAPSHOT

Each year we recap the statistical data for the micro cap universe of stocks from which we screen and select our investment opportunities. The premise of which is that there is a world of small companies that have little or no analyst coverage, are too small for traditional institutional investors and through diligent research, an investor can gain an information advantage about these micro cap investment opportunities. Based on the historical return profile and company size, this strategy is similar to private equity investing but with reasonable liquidity and more flexibility in portfolio construction.

The recent market volatility has been a two edged sword for micro cap investors. The bad side of the equation is that low quality, high beta names often lead the volatility on both the up and downside. As a result, our more conservative, value oriented approach often struggles during up periods and often leads during down periods. The benefit is that the volatility in prices can create a quickly shifting array of attractive possible investment opportunities. In addition, big short-term price declines can lead to a large number of favorable stock valuations

SOME DATA TO PONDER

The micro-cap world is a strange and interesting place and 2013 has been among the most interesting years in micro cap memory. To illustrate that point, each year we like to review some of the interesting data points that emerged from the micro cap universe. So here are some facts:

~ We started 2013 with 3,810 reporting companies with a market cap of $500 mil or less.

~ We ended 2013 with 3,112 reporting companies with a market cap of $500 mil or less. A Y/Y decrease of 18% in the number of micro-cap opportunities.

During 2013, 442 of the original companies disappeared from the universe vs. 476 in 2012.

~ 352 companies graduated to above $500 mil in market value
~ 49 companies had merged or gone private vs. 58 in 2012
~ 41 companies were delisted or failed to report vs. 89 in 2012

During 2013 1150 new names joined the universe vs. 560 during 2012.

~ 178 companies went public, were spun-off or regained listing status vs. 156 in 2012

~ 430 companies over $500 mil in market cap declined enough in price to join the universe vs. 448 during 2012

(Source: BofA Merrill Lynch; Uniplan Consulting, LLC.)

As can be seen in the chart above, the micro cap universe has remained fairly constant at about 4,000 companies over the last decade.

UNIVERSE PERFORMANCE – 2013

Historically, for the purpose of this data, we use companies with a share price of $5.00 or greater as large percentage price moves in stock prices below $5.00 per share can skew the data.

The average micro cap stock price in our universe on an equal weighted basis for 2013 was up 34.2%. When compared to our gross investment return of about 51.5% for the year, it would suggest that we managed to add about 1730 bps of portfolio value by selecting from the universe. Interestingly the screening process creates a universe of stocks that has the potential to outperform the micro-cap value benchmark and it normally does. But, in the first half of 2013, our investable universe underperformed the value universe by about 420 bps. This seemed to be due in part to the low number of financial stocks that make it into our universe due to the debt restrictions we place on companies as part of our screening process. In general, here is how the universe performed:

• 45% of the universe was up on a total return basis and 55% was down
• There were 209 stocks were up over 100% during the year vs. 69 in 2012; this was an all time record since 1980 and well ahead of 2003, the second best year with 148
• The best performer in the universe was CSIQ up 777% (see chart below)
• There were 18 stocks that went down over 90% or went bankrupt and were delisted during the year—an all time low since we have tracked the micro cap universe back to 1980

RESEARCH COVERAGE

• As of 12/31/2013 2,248 companies or 59% of the companies had sell-side analyst coverage up from 55% in 2012
• Only 1,067 or 28% had two or more analysts covering the company vs. 29% during 2012
• 1362 (41%) of companies had no sell-side analyst coverage

This level of coverage reflects a relatively stable level in the amount of micro cap coverage. Prior to 2009, there was a continuing and relentless contraction of research coverage on the part of Wall Street, particularly in the small and micro cap areas. But, since the financial crisis and the distress on large financial companies, there has been a modest rebound of small and micro cap boutiques that have started to expand research coverage on names in the micro cap world. We view this in general as a good trend, as added research helps us cover a larger slice of our investable names. But, with only about half of our companies having any analyst coverage, there is still a large amount to discover through focused research. In addition, there has been a steady growth in the amount of sponsored or paid research in the micro-cap space. Although we can find no good industry data to determine what percentage of micro caps pay to have research done, it is safe to assume that several of the 1067 names are covered by paid analysts.

PORTFOLIO STRATEGY

During 2013, we had seven of 39 companies in the portfolio that were up over 100%; an all time record for “doublers” in a year. Our best performing name was NXST, which was up 431% for the year.

The strong appreciation led us to sell a number of names that exceeded the practical capitalization limit of our micro cap strategy. This has left us with a relatively large cash position. We have seen a strong positive correlation among portfolio companies which paid a dividend – either regular or special – and the overall performance of the company stock. As such, we have redoubled our efforts to focus on dividend paying stocks that meet our micro cap screening criteria. We continue to judiciously work on repositioning the portfolio with an eye toward longer arc strategies for 2014

With the high level of economic and market uncertainty, there seems to be no clear broad thematic long arc paradigms outside of our increasing M&A thesis within which we can construct a portfolio framework. However, we have created a list of our “Top Ten Thematic Ideas” which we use as a macro framework for idea generation among companies that meet our screening criteria. The top ten themes are as follows:

1. Genomic medicine will revolutionize the way we look at and treat illness.
2. Shale gas, will likely within the next decade, change the dynamics of world energy and make the US a net exporter of energy.
3. Military spending will shift to fast deployment and human intelligence vs. large weapons systems and multi-billion dollar platforms.
4. Labor costs will continue to rise around the globe. The world is flat and substitution of capital for labor will accelerate. Robotics, smart machine tools, high skilled model making and JIT manufacturing, mid-tech precision systems will benefit from this trend.
5. Food inflation will become a growing issue as billions around the globe move from grain to protein consumption due to rising standards of living. Farmland, ag-business, fertilizer, GMO plants, non-point pollution control, genetics of plants and cells are among the opportunities.
6. Water will continue to be the next looming threat for developing and emerging economies. It’s scarce and expensive to treat or transport and that’s not going to change—water technologies will be increasingly important.
7. Retail and the internet – those who successfully integrate a web and bricks and mortar strategy will win the race—but the way consumers shop will continue to stress the retail paradigm.
8. Education of a lost generation will become front-and-center as college becomes unaffordable and student performance continues to slump. Systems to deliver effective low cost curriculum and training will become more of a focus as the current education system slowly decays.
9. New models of eldercare will become a growth business as the world population ages and need for care of the aging increases in a world short on skilled labor in the healthcare field.
10. SAAS (Software as a Service) will continue to emerge as the new paradigm and drive demand for data-related storage and bandwidth particularly when coupled with the growth in mobile computing.

Currently we are building our portfolio on more of a traditional analysis and less based on a macro or sector theme. However, if opportunities fit into one of the thematic areas, additional weight is given to that factor. We have a number of promising candidates on our watch list; we continue to carefully monitor the operating performance and valuation levels of those candidates while we await threshold events to signal a potential entry opportunity.

CONCLUSION

With the large turnover in the micro cap universe, we expect 2014 to provide an excellent new group of possible micro cap investment opportunities for investors who do their homework. 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. We anticipate there could be a pullback in early 2014, after such a strong 2013 but valuations remain attractive and as a contrary indicator, investor interest in the risk trade seems to be lacking. Thus we continue our deployment of cash into quality micro-cap opportunities with a preference (or we can say ‘bias’) for those that pay dividends and those that fit one or more of our macro themes.

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 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 December, 2013 is 18.4% for the composite and 27.3 % 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.

Uniplan Investment Counsel, Inc. (Formerly known as Forward Uniplan Advisors) 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