The third quarter of 2013 continued the year's upward march of positive returns. The three months ending September 30 added 5.24% to the S&P 500's year-to-date return of 19.79%. Gains occurred not only in the S&P, but also across the small-cap, mid-cap and international sectors. Despite interest rate concerns, bonds fared well also.
These short-term results were generated by a Federal Reserve (Fed) that announced it will continue to be accommodative. Some volatility occurred early in the quarter when investors incorrectly predicted the Fed would ease off its Quantitative Easing program. Then late in the quarter, the Fed announced that it would continue purchasing long-term bonds. The markets reacted positively to this continued monetary stimulus. The Fed's intent is to keep long-term interest rates at their historically low levels, thus encouraging economic growth.
Other factors adding to the market's performance were an improvement in the Eurozone economy and resurgent growth in emerging markets. As these economies grow, we expect their demand for U.S. goods and services will rise. Domestic tensions in Egypt and a possible U.S. intervention in the Syrian civil war did worry the markets, but as those episodes passed and the fear of conﬂ ict spreading to other oil-producing countries diminished, market returns bounced back. U.S. growth continued to plod along compared to the rate of past economic recoveries. Unemployment remains high, which we view as one of the main reasons the Fed has not slowed its quantitative easing. However, Americans still seem willing to spend money. Residential housing and retail sales, while not robust, saw gains. Strong auto sales proved that consumers have a willingness to spend on big-ticket items.
Our outlook for future performance has changed with the rising market. We still believe that most valuations are appropriate; however, they are approaching the high end of that appropriate range. We expect stock market returns will slow from the dramatic pace set so far this year. As valuations are reasonable, we believe stock prices will move more in line with midsingle- digit year-over-year corporate earnings growth in the near term.
Nevertheless, we are heartened by three factors that support our positive outlook for the years ahead. We think that rising domestic oil and gas production will have a material positive impact on the U.S. economy. Estimates of reserves are increasing to the point where, when they are married with energy conservation, the U.S. will soon be energy independent. Domestically sourced energy and more effi cient energy processing should provide a signifi cant cost savings in the U.S. These expected lower energy prices are not a good sign for energy producers — in which Mairs & Power is underweighted — but they are a boon for all other companies, from manufacturers to data processing centers, that need energy.
On the U.S. housing front, we have seen a pause as home buyers respond to higher mortgage rates. We feel home construction will continue to grow, stimulating everything from the buying of housewares to construction companies and building materials manufacturers.
Finally, what some see as a problem, we see as a competitive advantage. U.S. economic growth has been described as anemic — however, it is still positive. We prefer to describe it as "slow and steady." The benefi t of slow and steady is that it is an easier environment for managements to run their companies. It is more diffi cult, for example, to have growth rates swing from 3% in one quarter to 10% the next, followed by another 3% quarter, which is more typical of recoveries. With a slow and steady environment, company managers are able to plan and function better, given a more predictable and stable economy. They can better anticipate staffi ng and materials needs and focus on making gains through productivity improvements. We believe our Funds are positioned to benefi t in the coming months. With continued effi ciency gains in industrial manufacturing, the U.S. is now on a more even playing fi eld, and many companies are looking to expand in the U.S. We are optimistic that prospects for growth and economic expansion are solid and stable, boding well for our long-term approach to investing.
Balanced Fund Performance
The Mairs & Power Balanced Fund continues to outpace the market in 2013 through strong security selection. The Fund returned 12.10% through the third quarter compared to a 10.54% return for the benchmark composite index (60% S&P 500 Stock Index and 40% Barclays Capital Government/ Credit Bond Index). For the quarter, the Fund was up 3.98% compared to 3.30% for the benchmark composite index.
While the equity portion of the Fund shined, the fi xed income holdings faced two mild headwinds — rising interest rates and widening bond yield spreads.
Interest rates began to rise on fears that the Federal Reserve would begin tapering its purchase of bonds. The fear is that, relatively speaking, as interest rates rise, the value of bonds falls. Our exposure to interest rates is higher than that of our benchmark, the Barclays Capital Government/Credit Bond Index. However, the quality of our holdings is higher. We believe the yield derived from these holdings and the unlikelihood of a large hike in interest rates in the face of low economic growth rates justifies this position.
We experienced a widening of the corporate bond spreads as fi xed income investors began to evaluate the quality of their holdings in the face of that potential Fed tapering. Again, the higher quality of our holdings somewhat muted our exposure to this market action.
On the equity side of the portfolio, the Fund's large allocation to health care, 13.56%, was a slight drag on returns. We feel this to be simply an off quarter for the sector. We don't think it's a refl ection of long-term prospects for the sector, nor do we believe it was caused by the debates surrounding the Affordable Care Act. In the long term, we believe national demographics will drive returns for companies in this sector — an aging population and more people in the health care system mean more customers. Finally, with a 2.6% yield, this sector contributes to the income portion of the portfolio. The yield for the Balanced Fund is also increased by our 12.04% allocation to the energy sector. Energy stock prices offered nice value and good dividend payments. For example, ConocoPhillips has a dividend yield of approximately 4%, Xcel Energy 3.68%, B.P. 5.1% and Exxon Mobil Corp. 2.9%. We fi nd these to be desirable numbers when compared to one-year U.S. Treasury Bonds paying around one-tenth of 1% and investment-grade bond yields equalling dividend yields.
On a year-to-date basis, Lincoln National Corp., Principal Financial Group, Graco Inc., Bristol-Myers Squibb Co. and Sturm, Ruger and Co., Inc., lead our returns. However, looking at just the third quarter, these leaders were replaced as top performers, which now include Schlumberger Ltd., Deluxe Corp. and Toro Co. As they have for the year, Baxter International, Inc., and Exxon Mobil Corp. failed to perform this quarter. Other underperforming companies included ALLETE Inc. and Abbott Laboratories. Target Corp. was our biggest disappointment in the quarter; however, we believe the challenges the retailer is encountering with its expansion into Canada will be overcome and its share price will soon refl ect that.
Ronald L. Kaliebe
William B. Frels