Mairs & Power Growth Fund commentary for the first quarter ended March 31, 2016.
Mairs & Power Growth Fund – First Quarter Market Overview – March 31, 2016
At the end of last year we described the market as engaged in a tug-of-war between a steady consumer sector and a struggling industrial sector, asking if the pressures on the latter would overwhelm the economy and push us into a slowdown. The first quarter of 2016 delivered a preliminary answer which is positive for investors.
The Industrial and Materials sectors, after more than a year of weak performance, showed early signs of improvement as they led the market for the quarter by substantial margins. Positive reports from the Federal Reserve Banks of New York, Richmond and Philadelphia all cited improving conditions in the manufacturing sector and the Philadelphia Fed’s sixmonth forecast calls for growth in 46 of the 50 states. The only projected declines are in the energy-dominated economies of Alaska, Louisiana, Montana and North Dakota. At the end of the quarter the Institute for Supply Management released its national survey of manufacturers which showed the first signs of growth in six months. While it’s still early, these hopeful signs reinforce our continued positive, if cautious, outlook for the year.
While valuations for the Industrial and Materials stocks have increased, cash flow and earnings multiples remain slightly below their historic averages and dividend yields slightly above the 15-year average. While many investors still remain skeptical on industrials, thinking it’s too early to turn positive, in our experience these stocks to move before there are solid signs of a recovery. We expect the U.S. to continue to outperform other major economies and we remain positive on stocks. While we don’t necessarily expect a major rebound in the Industrial sector of the economy, minimum things are no longer getting worse and we see signs of stabilization. If at the beginning of an industrial recovery, and better-than-expected earnings start surprise the market, there will be plenty of upside from here.
Concerns that global economic and financial conditions could negatively impact U.S. economy continue to weigh on investors’ minds. Federal Reserve (Fed) Chair Yellen, as well as other Fed members, have cautioned that these concerns will continue to influence any Fed action on further raising interest rates this year. The slowing in China, negative interest rates in many major economies, continued strength of dollar and low oil prices all have been visible to the market for more than a year believe they are built into current expectations. Absent any dramatic shift in economic financial conditions, we remain cautiously optimistic on the outlook for the U.S. economy and stocks.
Mairs & Power Growth Fund Performance Review
The Mairs & Power Growth Fund got off to a solid start to the year, gaining 6.99% in the first quarter compared with the benchmark S&P 500 Total Return (TR) which gained 1.35% and the Dow Jones Industrial Average (DJIA) TR which gained 2.20%.
Stock selection drove performance, particularly in the Industrial, Materials, Information Technology and Health Care sectors. Overweight positions in Industrials and Materials sectors also contributed positively as these two sectors were among the strongest performers in the quarter. The snap-back among industrial stocks illustrates the benefit of Mairs & Power’s long-term investment approach. This sector had suffered from several quarters of earnings disappointments, driven by the effects of rapidly falling oil prices, slowing growth in China and weakness in commodity-dependent economies, compounded by the impact of a strong dollar on export– oriented manufacturers. Some of the headwinds that had been holding the industrial sector back are beginning to abate as both oil prices and the dollar have stabilized compared to their sharp moves last year and valuations in the sector, on a relative price earnings ratio, had fallen to levels not seen in over a decade. In the first quarter, the market finally found these stocks too cheap to ignore and they snapped back, rewarding patient investors.
As an example, Fastenal (FAST) reported better than expected sales for the month of January and the stock responded very positively, moving up 20% in the quarter. As we have said in the past, this diverse supplier of industrial products, tools and equipment is like a “canary in the coal mine” as its business turns up when its customers ramp up production. In another positive sign, 3M Company (MMM) delivered an upbeat outlook at its analyst day toward the end of the quarter. This highly diversified global company is looking at a more stable dollar going forward which it expects will benefit international results. Its stock was up double digits in the quarter, putting it among the top ten performers in Q1. Cray (CRAY) was also among the top ten performers in the quarter. It has benefited from disruption in the super computing space as the market leader, IBM, shifted strategies and sold its Intel-based high performance computing business to Lenovo. We remain enthusiastic about the long-term growth prospects for Cray in both high performance computing and the emerging big data market.
The complement to patient investing is watchful monitoring of the markets for opportunity. While some sectors performed well, others have struggled in the quarter, presenting us with the chance to add to positions in names we like. Uncertainty in the interest rate outlook has caused financial stocks to perform poorly. As a result, we are finding value in this beaten down sector and are selectively adding position in American Express (AXP), U.S. Bancorp (USB) and Wells Fargo (WFC) while establishing a new position in Great Western Bancorp (GWB). In a similar vein, negative news and concerns about potential pricing pressures have caused a sell-off among pharmaceuticals and medical device companies. We are selectively adding to our positions in St. Jude Medical (STJ) and Roche Holdings (RHHBY).
Following the announcement that it will be bought by the Sherwin-Williams Company (SHW), the top contributor to performance in the quarter was Minneapolis-based Valspar (VAL). The announced purchase price of $113 per share that Sherwin-Williams will pay Valspar shareholders in cash is a 35% premium to Valspar’s closing price on the day prior to the announcement. Sherwin-Williams recognized what we have long observed. Valspar has done a magnificent job of creating a branded product lineup in a crowded and highly competitive field. The management has maneuvered skillfully to build an excellent company with a durable competitive advantage. The acquisition should add to the combined company’s branded portfolio and global presence. We think this sale makes sense for the business and for shareholders. Valspar has been a core holding and a stellar performer of the Fund for a long time; one we are going to miss. Over the past five years, VAL has gained 176% and over the past ten years the stock is up 142%, far exceeding the S&P 500 TR Index over the same periods. While the transaction is not expected to close until the first quarter of next year, we are trimming our Valspar position this year since we believe there is not much upside left in the stock. Because of the Fund’s long-term positions in Valspar, the sale should cause elevated capital gains in 2016 and 2017.
Mark L. Henneman
Andrew R. Adams