Mairs & Power Small Cap 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 longterm investors.
Mairs & Power Small Cap Fund Performance
While the Mairs & Power Small Cap Fund was up 2.61% on an absolute basis in the first quarter of 2015, it lagged its benchmark, the S&P 600 Small Cap Total Return Index, which was up 3.96%. The Fund also underperformed its peer group in the first quarter as measured by the Lipper Small Cap Core Index which was up 3.75%.
While our focus remains fixed on longer term performance, Q1 marked a slow relative start to the year for the Fund. Stock selection, primarily in the technology sector, drove short term results relative to the index and peers.
Two of the largest detractors from performance in the first quarter were Cray Inc., and Vasco Data Security. Over the long term both stocks have been phenomenal performers for the Fund, but in the first quarter they both “gave a little back.” We’ve discussed Cray in the past as having a very attractive opportunity in high performance computing as the company bolsters its offering just as its largest competitor, IBM, changes course. As the sales cycle is typically quite long for these high end systems, we expect orders to pick up in the second half of this year and into 2016 as IBM turns its Intel-based super computer business over to Lenovo. We are also watching Cray’s foray into big data with a couple of new products focused on that rapidly growing space. While the company’s fourth quarter financial release and conference call indicated only modest near term traction with both of these opportunities, longer term we believe these growth avenues for Cray remain intact. Vasco Data Security has also been a strong performer for the Fund over the longer term, but in the first quarter was down. We believe the pullback was primarily due to profit taking following the stock’s phenomenal 2014 performance.
While the U.S. financial industry has been slow to adopt anything other than rudimentary two-factor authentication when consumers log in to their bank and brokerage accounts (e.g. “What is your mother’s maiden name?”), multi-level authentication is widely utilized in other parts of the world where Vasco holds a leading share. Vasco’s security offering includes number code generators deployed with or without a card reader or PIN key pad. In addition, the company is now offering a system that uses a built-in camera and Quick Response (QR) codes generated on a consumer’s computer, tablet, or phone screen to increase security and simplify manual keypad entry. Longer term we remain very excited about the company’s position in online ID and transaction verification.
The largest contributor to performance in the first quarter was Gentherm which reported solid year-end results and provided a positive outlook for its core market; heating and cooling technology for automobile seats. Gentherm has been a consistent performer over the past few years as its products have become more of a standard offering as opposed to an upgrade and are now found on many mid-priced models as well as the high end segment. We continue to like Gentherm as the company broadens not only its heated/cooled products for the auto industry, but its pipeline for new products focused on other industries continues to advance and looks promising as well.
In the first quarter the Fund added two new stocks to the portfolio, Actuant and Stratasys. Actuant is a Milwaukee-based manufacturer of high end tools with a strong competitive position in tools such as hydraulic lifts and presses. Its end markets include the energy and agricultural sectors, so the company’s revenues have been under pressure driven by lower oil and commodity food prices in these cyclical businesses. As the stock price has pulled back significantly, it has created a very compelling investment opportunity due to the company’s strong cash flow generation.
Stratasys also became a new holding for the Mairs & Power Small Cap Fund in the first quarter, although Mairs & Power has actually held the stock in the past in the Growth Fund. Stratasys is a market leader in the rapidly growing 3D printing/additive manufacturing space. While the stock once traded as high as 15 times its trailing twelve months revenue when 3D printing headlined seemingly every publication, the stock has now dropped back below 4 times its trailing revenue, a more reasonable multiple. We remain excited about the long term potential for additive manufacturing and we believe Stratasys, with its strong position in two of the leading additive manufacturing technologies, offers a compelling investment in the space.
Our expectation for small cap stocks is for somewhat muted returns until the global economy gains more momentum. While smaller companies are more domestically focused, many do have significant exposure to the rest of the world, either directly or through their customers who often are larger export oriented mulitnationals. So a slow global economy, and more importantly a very strong dollar, will hurt their international results. Valuations are at a 10-year high on an absolute basis. However, the lofty valuations seem somewhat justified by the historically low interest rate environment the world is currently in. Earnings are likely to grow in the mid-single-digits this year, a slight deceleration from last year. Small stocks will likely perform in-line with that growth.
Andrew R. Adams
Allen D. Steinkopf
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