Bill Frel's Mairs & Power First Quarter Letter
The stock rally that began in the fourth quarter of 2011 continued. While the economy did not grow rapidly, it did continue to grow. This is in stark contrast to expectations of another recession that caused markets to tumble in the middle of 2011. In September of 2011, stocks were quite inexpensive. The rally was than triggered by strong corporate earnings reports and renewed confidence that problems in Europe are manageable.
The Fund benefited in the first quarter by having substantial exposure to economically sensitive stocks. H.B. Fuller was up 42% because of better than expected earnings. Pentair was up 43%, largely because of enthusiasm over its announced combination with Tyco Flow. JPMorgan was up 38% in the quarter. Defensive stocks were out of favor in the quarter with SuperValu (-30%), Xcel Energy (-4%), Bristol-Myers Squibb (-4%), Eli Lilly (-3%), and General Mills (-2%) detracting from the Fund's performance
The improving United States economic outlook put a little pressure on United States Treasury obligations. The United States 10 year Treasury note ended 2011 at 1.87% yield, then increased to 2.20% by the end of the first quarter of 2012. The longer maturities, as measured by 30 year United States Treasury bonds, had a sharp increase in yield in the quarter from 2.9% to 3.3%. Many of the Fund's corporate bonds tightened their spread relationship to United States Treasuries during the quarter as investors looked for absolute yield.
The preliminary first quarter GDP report showed continuing steady growth. The 2.2% overall growth rate was supported by a surprisingly large increase in household purchases, which were up 2.9%. There was encouraging strength in homebuilding which grew at its fastest pace in nearly two years.
Valspar (NYSE:VAL) – a long term holding
One of the keys to our success at Mairs and Power is our long-term approach to investing, and one of the keys to successful long-term investing is the ability to find companies with a sustainable growth rate. Generally, these are going to be companies that have a strong franchise or, as Harvard Business School Professor and well-known author Michael Porter phrased it, "a competitive advantage". It is easy to look at some of the holdings at Mairs and Power and see that they clearly have some sort of advantage over their competition, whether it be a superior franchise, product or cost position. Companies that come to mind include Ecolab, General Mills, and Medtronic, among others. But one of the larger holdings in the Mairs and Power Balanced Fund, and one of our most successful, is Minneapolis-based paint company Valspar Corporation. So how does a company selling a product as mundane as paint fall into the select category of having a durable competitive advantage? There is no question that Valspar has been a long-term success story. The company was founded over 200 years ago in Boston and grew steadily due to the success of innovative products such as "Valspar", the first varnish ever produced that remained clear when exposed to water. The nature and rate of growth changed dramatically in 1970 when it merged with privately-held Minnesota Paints and moved its headquarters to Minneapolis. At the time of the merger, the combined company was largely a domestic consumer paint manufacturer with sales of just over $50 million. Valspar then began a series of mergers over the next forty years that grew sales to over $4 billion, turned it into a dominant player in the industrial coatings business and greatly expanded its global presence.
Which brings us back to our original question: why has Valspar been so successful over such a long period selling a largely commodity-type product? Is this enviable track record the result of a superior product, a well-defined and exceptionally executed acquisition strategy, some other factor or a unique combination of several factors? We would argue it is the latter that accounts for much of the difference. While Valspar may not have any one overwhelming advantage over its competitors, it does compete very effectively in a number of areas. In the Paint segment, which is extremely competitive, Valspar has an advantage through its relationship with Lowes, which positions the company well for the fast-growing do-it-yourself market. In the Coatings segment Valspar is a market leader in several categories due to its technology leadership. In addition, the business is well-entrenched with its customer base because switching costs are high relative to the cost of the product. Finally, and perhaps most importantly, Valspar management has done an outstanding job of acquiring businesses that position the company in attractive markets, both in terms of new product lines as well as promising international markets. So while the "competitive advantage" of the company may not be quite as clear as that of other leading firms, we would argue it is just as significant a factor in Valspar's long history of success.
We expect economic growth for the full year to be similar to what we saw in the first quarter. Growth should be strong enough to support continued corporate earnings growth, but not so strong as to be inflationary. We find valuations to be reasonable and are comfortable holding stocks for the long-term, but believe near term performance may be subdued. Because of the powerful rally, stocks already reflect all the earnings growth we expect to see in 2012. The uncertainty surrounding the presidential election and ongoing issues in Europe may increase short-term volatility.
William B. Frels
President and Lead Manager
Ronald L. Kaliebe
Vice President and Co-Manager
Performance data quoted represents past performance and does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost. Current performance of the Fund may be lower or higher than the performance quoted. As of the prospectus dated April 30, 2012, the Mairs and Power Balanced Fund had an annual expense ratio of 0.80%. For most recent month-end performance figures, visit the Fund's website at www.mairsandpower.com, or call Shareholder Services at (800) 304-7404.
(1) Performance information shown includes the reinvestment of dividend and capital gain distributions, but does not reflect the deduction of taxes that a shareholder would pay on Fund distributions or the redemption of Fund shares.
(2) The S&P 500 Index is an unmanaged index of 500 common stocks that is generally considered representative of the U.S. stock market. It is not possible to invest directly in an index.
(3) The Composite Index reflects an unmanaged portfolio of 60% of the S&P 500 and 40% of the Barclays Capital Government/Credit Bond Index.
(4) The Dow Jones Industrial Average is an indicator of stock market prices based on the share values of 30 bluechip stocks listed on the New York Stock Exchange.
(5) The Lipper Balanced Funds Index is a non-weighted index of the 30 largest funds within the Lipper Balanced Fund investment category. This Index does not include the effect of expenses, is not representative of any specific fund or product and cannot be invested in directly.
The stocks mentioned herein represent the following percentages of the total net assets of the Mairs and Power Balanced Fund as of March 31, 2012: H.B. Fuller 2.4%, Pentair 2.3%, JPMorgan 1.7%, SuperValu 0.1%, Xcel Energy 0.5%, Bristol-Myers Squibb 0.8%, Eli Lilly 1.1%, General Mills 1.3% and Valspar 2.6%. All holdings in the portfolio are subject to change without notice and may or may not represent current or future portfolio composition. The mention of specific securities is not intended as a recommendation or offer for a particular security, nor is it intended to be a solicitation for the purchase or sale of any security.
The Fund's investment objectives, risks, charges and expenses must be considered carefully before investing. The summary prospectus or full prospectus contains this and other important information about the Fund, and they may be obtained by calling Shareholder Services at (800) 304-7404, or visiting www.mairsandpower.com. Read the summary prospectus or full prospectus carefully before investing.