Mairs & Power Growth Fund commentary for the third quarter ended September 30, 2016.
H/T Dataroma
Also see
- Q3 2016 hedge fund letters
- Q2 2016 hedge fund letters
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The market continued its nervous advance with the only consensus opinion being “uncertainty.” For the quarter and the first nine months, the S&P 500 Total Return (TR) was 3.85% and 7.84% respectively and the Dow Jones Industrial Average TR was 2.78% and 7.21%. Our other key benchmark, the Barclays Government/Credit Bond Index Return was 0.40% and 6.66% for the third quarter and year-to-date.
Economic indicators continued to deliver mixed signals in the third quarter. Industrial production and manufacturing output both softened in the quarter and capacity utilization in the industrial sector dipped 0.4 percentage points in August to 75.5 percent, 4.5 percentage points below its long run (1972 – 2015) average. Reflecting strength on the consumer side of the economy, interest rates moved up a bit in the quarter. Financial stocks performed well on the expectation that the Federal Reserve (Fed) would raise rates in Q3. But like Lucy pulling the football away from Charlie Brown one more time, the central bank deferred action and Fed chair Janet Yellen’s most recent comments have led us to conclude that they will take no action on rates until December at the earliest. As a result, the market remains focused on two key questions: “What is the Fed going to do?” and “When is it going to do it?”
While no one knows with certainty the direction of earnings or the timing of interest rate hikes, the large political uncertainty hanging over the markets will be taken away with the presidential election occurring in early November.
Future Outlook
As the third quarter’s earnings reports are coming in, the outlook is not sunny, with earnings expectations for the S&P 500 down year-over-year for the sixth straight quarter. But we see some brightening on the horizon as we expect that earnings growth for the S&P 500 will turn positive in the fourth quarter and revenues will post positive growth for the first time in several quarters. While the industrial side of the economy remains soft, consumers continue to do well. The economy appears to be approaching full employment and wage gains are tracking higher. Consumer confidence is high and spending has been growing at a healthy pace. Overall economic growth continues at a moderate pace. And, while oil prices have begun to recover from their precipitous drop sustained weakness in the energy sector continues to pull down aggregate corporate earnings for the broader market. Persistently sluggish economic growth along with low interest rates have fueled merger and acquisition (M&A) activity as companies “buy” growth through acquisitions and we expect increased M&A activity to continue as long as these conditions persist. We remain optimistic about the U.S. economy long-term and the outlook for stocks of good companies for which we are always on the lookout. Near term, the S&P 500 appears slightly expensive based on the next twelve months earnings outlook, so we remain watchful and cautious.
Mairs & Power Growth Fund Performance Review
The Mairs & Power Growth Fund performed about as expected in the quarter. Financials and industrials were the largest contributors to the Fund’s performance on a sector basis, but the information technology (IT) sector continued to lead the market over all other sectors in terms of stock performance, driven in part by improved PC demand and rising expectations for the recently introduced Apple iPhone 7. Because of the Fund’s relative underweight position in the IT sector, we did not fully participate in the gains in Q3, similar to the dynamic we saw in previous periods when the IT sector led performance. For the first nine months, industrials, health care and materials sector stocks were the largest contributors to the Fund’s performance.
As noted in our outlook section, we have seen increased M&A activity driven by low interest rates and sluggish organic growth, which has affected several portfolio companies in the Fund. In addition to previously announced acquisitions of St. Jude Medical (STJ) by Abbott Labs (ABT) and Valspar (VAL) by Sherwin Williams (SHW) this year, in the third quarter we saw the announcement that Cintas Corporation (CTAS) will acquire G&K Services (GK). Each of these transactions has had a positive impact on near-term Fund performance. They will also have an impact on the Fund’s capital gains. We will announce estimated capital gains distribution in mid- to late November. For more information regarding capital gains please visit www.mairsandpower.com.
The St. Jude acquisition, expected to close in the fourth quarter, will result in current shareholders receiving a combination of cash and Abbott shares. We like the long-term outlook for Abbott Labs and expect to retain this position. Valspar and G&K are all cash transactions with G&K expected to close before year-end and Valspar expected to close next year. We have been trimming some of these acquisition targets, and using the proceeds to acquire new names. One such stock is Alphabet (GOOG) the holding company parent of Google, the leader in on-line search engines. While the company is headquartered outside of the Upper Midwest where many of our investments are located, it is an example of a stock that fits our investment approach in most other ways. The company enjoys above average growth, maintains a durable competitive advantage globally and is attractively valued.
Not every M&A transaction is necessarily positive for investors and we evaluate each based on its individual merits. That is why, earlier this year, when MTS Systems (MTSC) announced the acquisition of sensor maker PCB Group for $580 million, we decided it was time to exit the stock. In addition to our concerns about execution of the current business, we did not believe the strategy behind the acquisition was solid. It added to the company’s existing sensor business, where the company does not enjoy a strong competitive advantage, and it diluted MTS’s durable competitive advantage in its core test business while adding substantial leverage to the balance sheet.
Another name in the Fund that has been in the news recently is Wells Fargo (WFC). Following reports of widespread deceptive sales practices and resulting government fines, which have hurt both the stock price and the company’s reputation, we have received questions from many of our investors expressing concerns about our Wells Fargo position. While we share investors’ concerns about the extent of the unauthorized accounts problem at Wells Fargo, we have decided to hold existing positions for the present. We know many of the senior executives at Wells Fargo and believe they are people of good character. We do not think the current situation indicates a systemic problem with the values of the organization or its people and we are convinced that changes are underway that will remove the incentives that caused the problem. We are also expecting a slower growth rate for Wells Fargo going forward. Despite our expectation for slower growth, the market has (in our opinion) overly punished the stock and this is a very inopportune time to sell Wells Fargo. We will closely monitor the situation and the impact on the company’s competitive position and may make changes to our holdings of Wells Fargo if deemed appropriate.
Mark L. Henneman
Lead Manager
Andrew R. Adams
Co-Manager
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