Mairs & Power Growth Fund commentary for the second quarter ended June 30, 2016.

H/T Dataroma

The market turned a page at the start of the year and we are seeing a very different story play out compared to a year ago. In 2015, the consumer sectors were the only parts of the economy that seemed to work for investors as the market struggled with the impacts of a rapid fall in oil prices and rapid rise of the dollar against most foreign currencies, hurting the energy sector and export-oriented industrial companies in particular.

With those rapid and dramatic price adjustments now behind us, both factors are neutral to slight tailwinds on a year-over-year basis. In addition, the first half of 2016 saw broad participation across most sectors accompanied by encouraging signs of accelerating economic growth. In the second quarter of this year, forecasted Gross Domestic Product (GDP) growth was revised upward from 0.8% to an annual rate approaching 3%. The services sector remained fairly strong in the second quarter and continues to be the primary driver of economic growth. Industrial and materials sector stocks, having risen sharply in the first quarter as the market anticipated manufacturers would begin to feel less headwind from the strong dollar, continued to benefit from positive economic news. Toward the end of the second quarter, a survey of manufacturers reported new orders grew for the fifth consecutive month, the best streak for this survey since last summer. In addition, the composite Purchasing Managers’ Index (PMI), which measures several manufacturing indicators, including employment, inventories, orders, and production, was also up. It looks like the worst of the manufacturing slowdown is behind us.

The consumer side of the economy delivered mixed signals, however. Weaker than expected job growth in May and continued moderate wage growth put a damper on consumer spending expectations as stocks in the consumer discretionary sector remained weak. On the other hand, housing remained surprisingly strong, mortgage applications were well ahead of expectations, auto sales remain at all-time highs and retail sales were robust.

The decision by British voters on June 23rd to leave the European Union within two years caused a sharp two day decline in the U.S. market with the S&P 500 down more than 5%. It was followed by a quick recovery that brought the market nearly back to the level where the decline started and up 2% for the quarter. The Federal Reserve once again took a pass on raising interest rates as the negative interest rates in Europe and Japan on over $9 trillion in government issued debt are beginning to spill into our fixed income markets. As the market searches for yield, the overall corporate bond market has been strong, with longer maturity instruments outperforming equities in the quarter.

Mairs & Power Growth Fund – Future Outlook

A look at valuations indicates a market that, while not overpriced, is near its longterm average based on dividend yield and is slightly above its long-term average forward price per earnings (P/E) ratio. The market has been strong the first six months, and while we remain positive on equities for the long run, we may be entering a of lower returns in the near-term. In this environment, stock selection is increasingly important and we continue to find plenty of stock positions worth adding to.

The historic Brexit vote has added a degree of uncertainty and volatility to the market but the ultimate outcome and impacts are unknown. While the British pound weakened after the vote, the Euro has come back near its pre-Brexit vote level. The biggest potential currency risk we see would result from Japan attempting to generate growth devaluing the yen relative to the dollar which would potentially impact companies compete against Japanese exporters. We will continue to stay on top of developments, but won’t make investment decisions based on day-to-day news. In this environment, may see short-term market displacements which present opportunities. Our focus continue to be on identifying strong companies with a durable competitive advantage that are well positioned to outperform their peers over the long-term.

Growth Fund Performance Review

Stock selection drove relative performance as the Growth Fund gained 3.78% in the second quarter and 11.03% for the first six months of the year, outpacing its benchmark index and peer group for both periods. The S&P 500 Total Return (TR) benchmark was up 2.46% and 3.84% and the Lipper Multi-Cap Core Funds Index of peers gained 2.18% and 3.21% for the quarter and the first six months, respectively. On a sector basis, health care, industrials and materials were the leading contributors to performance while consumer discretionary was weak on a relative basis in both periods.

The Fund’s strong performance year-to-date demonstrates the benefits of our long-term investment approach and reinforces the effectiveness of our disciplined investment process. As the market struggled last year with the rapid decline in oil prices and strengthening dollar against other major currencies, we used the weakness to increase positions selectively where we found attractive valuations, focusing, as always, on companies with a durable competitive advantage. In 2016, the market again began to recognize the attractiveness of these great companies, benefiting Fund performance.

Despite market valuations near their long-term averages, we continue to find plenty of opportunity to put money to work and have been buying names such as U.S. Bancorp (USB), Hormel (HRL) and
Disney (DIS) as well as establishing new positions in United Health Group (UNH) and Great Western Bank (GWB).

Mairs & Power, Mairs & Power Growth Fund

We are not the only investors finding compelling values in some of these stocks. During the first half of the year, we saw announcements that two of our long time portfolio companies were being acquired for substantial premiums over their recent trading ranges, further contributing to the Fund’s performance. In the first quarter report, we mentioned that the paint and coatings company Valspar (VAL) is being bought by Sherwin Williams (SHW), with the transaction expected to close in the first quarter of next year. As we discussed last quarter, Valspar complements Sherwin Williams’ U.S. presence with a solid international footprint. In the second quarter, Minneapolis-based medical device maker St. Jude Medical (STJ) announced it is being bought by Abbott Laboratories (ABT), with the sale expected to close by the end of this year, creating a clear global leader in cardiac devices. Both of these strategic buyers recognized some of the same competitive strengths that had originally attracted our investment interest and over time continued to reinforce our conviction. In fact, St. Jude was one of the companies we were opportunistically buying on weakness prior to the acquisition announcement. Both transactions will result in large capital gains for the Fund. We have taken advantage of strength in Valspar to pare back our positions, allowing us to redeploy the funds elsewhere.

Mark L. Henneman
Lead Manager

Andrew R. Adams
Co-Manager

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