Mairs & Power Growth Fund commentary for the first quarter ended March 31, 2015.
While we’ve only finished one quarter, 2015 is shaping up to be the year of the dollar, which has risen more rapidly against major foreign currencies than any time in the last 40 years. The dollar’s rapid rise and enduring strength have created significant changes in the outlook for earnings and the economy. This dynamic particularly hurts U.S. companies that do most or all of their manufacturing domestically and have a strong component of overseas sales. These companies, reporting their earnings in dollars, cannot fully offset weaker local currencies with pricing moves. As a result, many companies have reduced their outlook for earnings in 2015. Market expectations have adjusted accordingly, with earnings growth expected at just over 1% for 2015 with year-over-year declines in the first two quarters. Slow growth, along with valuations near a ten-year high, increase the likelihood of a stock market correction.
The drop in energy and commodity prices worldwide continues to present a headwind for many companies, particularly in sectors such as industrial manufacturing, mining and agriculture. In addition, weather related factors and a labor shutdown of ports along the west coast combined to hold the first quarter back somewhat, giving a slow start to the year. We saw an illustration of this when industrial supplier Fastenal (held in the Mairs & Power Growth Fund) reported slowing sales beginning in January. Because of its broad exposure across multiple sectors, Fastenal is viewed as a “canary in the coal mine” in terms of the pace of the industrial economy.
And what a difference a word can make. When Federal Reserve (The Fed) Bank Chairwoman Janet Yellen decided to drop the word “patient” in describing the Open Market Committee’s attitude toward maintaining record low interest rates, her change in vocabulary captured the market’s attention. Because the Fed has held short-term rates near zero since 2008, the market’s focus has centered on the timing of interest rate hikes. Although recent unemployment numbers may have pushed the timing of any move out a bit, making the timing and pace of increases uncertain, the market is telling us rates will rise later this year and we agree.
We are more cautious on the direction of the market near-term due to the disruptive effects of the stronger dollar and the likelihood of higher interest rates. Longer term, however, we remain quite positive. The balance sheets of companies across the S&P 500 are very clean with low debt to total assets, giving them significant capacity to invest in their businesses, grow dividends and buy back stock. Following the success of the U.S. economic recovery, slow and uneven as it has been, many foreign governments are following the U.S. example by adopting more accommodative monetary policies and pumping money into the system to stimulate their economies. We believe this will ultimately improve the outlook for growth internationally, particularly in Europe and Japan. As international economies strengthen, the currency imbalance will self-correct, benefiting the same companies that currently are hurt by the stronger dollar.
As always, our approach is to stick with the names we like long-term, buy stocks that we believe have been excessively beaten down and trim positions that we see as fully valued. While it may take some time before the full benefits of our investment approach are seen, we believe it is the way to build wealth for long-term investors.
Mairs & Power Growth Fund Performance
The Mairs & Power Growth Fund returned 0.82% in the first quarter, slightly below the benchmark S&P 500 Total Return (TR) Index, while outpacing the Dow Jones Industrial Average TR Index, up 0.95% and 0.33% respectively. The Fund’s relative overweight position in the industrial sector and underweight position in consumer discretionary were major factors weighing down performance in the quarter.
Two of our portfolio companies, Graco (GGG) and Target (TGT) illustrate our investment approach in the current environment. With 53% of its sales overseas and all of its costs in dollars, at year end Graco told investors the stronger dollar will present a headwind in its ability to grow earnings in 2015. We like the company. It holds a leading market position as an industrial supplier of pumps and coating equipment. It has an experienced and focused management team with a clear, positive and executable strategy. We view the stock as cheap so we are using the current weakness to add to our position. On the other hand, last year the market thought the retail giant Target could do nothing right while this year it can do nothing wrong (we disagree with both views). With all of its sales in the U.S., the company sources much of its merchandise overseas so the strong dollar boosts its buying power and margins. In addition, the company’s customers have benefited from lower gasoline prices. As a result, Target’s stock is hitting all-time highs. We view the stock as generously valued currently and have been using it as a source of funds to add to our positions elsewhere.
We are always on the lookout for good companies at compelling values. Sometimes that means we return to names we have held in the past. Stratasys is one such stock which was newly added to the Growth Fund in the quarter. The company is a market leader in the rapidly growing 3D printing/additive manufacturing space, generating over 30% organic top-line growth annually and holding a dominant position at the high end of the market. We believe the company is just scratching the surface on a very large opportunity going forward.
The stock once traded as high as 15 times its trailing twelve months revenue as investor euphoria followed a spate of positive news reports, allowing us to take profits in a good company but an overvalued stock. It has now dropped back below 4 times its trailing revenue, a more reasonable multiple. The retrenchment was due to two main factors. Hewlett Packard has said it intends to move into the 3D printing space, but we believe competitive concerns are overblown given Stratasys’s strong market positon and momentum. In addition, the market reacted negatively to the company’s increased spending plans to add technical sales people which strengthens its vertical market presence and builds barriers to competition. While near term profits will be impacted, we see the company’s durable competitive advantage continuing to improve, offering a compelling investment in the space.
Mark L. Henneman
Andrew R. Adams