March 31, 2014
As measured by the Standard and Poor’s Total Return (TR) Index, the stock market advanced 1.81% for the quarter ending March 31, 2014. This positive outcome didn’t appear likely earlier in the period when a combination of lackluster employment numbers, Russia’s invasion of Crimea and the market’s anxiety over the Federal Reserve’s interest rate intentions pushed equity prices lower.
The market’s change of mood to the upside was credited in part to Federal Reserve Chair Janet Yellen’s assurance that any near-term rate increases would be gradual, incremental and no threat to economic growth. By March, investors began to realize that January’s weak data had more to do with shoppers staying home because of the unusually cold winter than with any actual shift in economic fundamentals to the negative side1. Meanwhile, in the bond market, similar doubts triggered a now-familiar “flight to quality” which drove U.S. Treasury yields lower and pushed the Barclays Government/Credit Bond Index up 1.98% for the period.
Our investment approach, however, has never depended on shifting, quarter-to- quarter market perceptions. Instead, we make decisions whether to buy, hold or sell portfolio securities based on evidence of consistent, above average growth and durable competitive advantages, focusing first on companies headquartered in the Upper Midwest – the region we understand and know best.
At the end of the first quarter, the price/earnings (P/E) multiple of the S&P 500 stood slightly above its long term average of around 15.5 —a signal to us that 2014 may prove to be a transition year as stock prices are influenced less by Federal Reserve-driven liquidity and affected more by growth of company earnings. Just as an improving economy is needed to drive earnings up, higher earnings are required to drive stock prices up.
Both earnings per share (EPS) and operating earnings are at multi-year record highs for most of the S&P 500 firms, indicating that many are close to fully valued. As “bottom up” investors, we focus our attention almost exclusively on companies and how they are managed. History shows us that profitable, well-managed firms have tended to do well even when industry-specific factors or economic conditions stood in the way.
Even though Mother Nature frosted up the first quarter, we have not wavered from our conviction that the underlying fundamentals of our selections still bode well for pursuing an attractive level of risk adjusted return through the remainder of 2014. However, while we do not see any signs that the economy will slow down significantly, we also do not see a significant near-term increase either. Still, we are fully conscious that the kind of volatility experienced by the equity and fixed income markets in the fi rst quarter could be repeated at any time. And, as the Federal Reserve continues to taper back on Quantitative Easing (QE), more short-term volatility is likely.
As long-term investors, we maintain enough distance from the influence of day-to-day news feeds to recognize encouraging growth signs and attractive valuations when they appear. A marked increase in commercial and industrial lending, for example, tells us that the slowly improving employment picture has a solid foundation. We also see positive growth prospects for companies that will benefit from rising abundance of domestic natural gas supplies, as well as for companies likely to profit from a sustainable recovery in the U.S. housing market.
As always, we apply our bottom-up approach on company-centric attributes over macro- economic measurements in our selection process. Just as an improving economy is needed to drive up earnings, higher corporate earnings are required to sustain and drive up stock prices. Accordingly, in the search for good stocks of well-run companies, we pay close attention to how a company’s earnings, relative to its stock price, compares to other companies. The yard- stick for this measurement, the P/E multiple, has signaled to us that 2014 may prove to be an important transition year for stock prices as they gradually become less influenced by the Fed’s relaxed liquidity standards and more affected by the underlying company’s ability to deliver on the promise of increased earnings.
Balanced Fund Performance
The Mairs & Power Balanced Fund gained 2.02% for the first quarter ending March 31, 2014, performing in line with its benchmark composite index (60% S&P 500 Stock Index and 40% Barclays Capital Government/Credit Bond Index), which delivered 1.93%.
Maintaining a long-term allocation guideline of approximately 60% equities and 40% fixed income, the Fund is designed to maintain equilibrium between market exposures of these two major asset classes. Accordingly, equities generally delivered modest results for the period. With valuation multiples currently above historical levels, further increases in stock prices over the coming months will likely depend on revitalized earnings and greater corporate revenue. Meanwhile, fixed-income investments benefited from a slight decline in interest rates as well as tighter yield spreads between shorter-term and longer-term maturities.
On the equity side, Corning, Incorporated (GLW) proved to be the largest contributor to performance for the period, returning 16.84%. As a global producer of residential and commercial building materials, glass-fiber reinforcements and engineered materials for composite systems, Corning has evolved over the last decade from being a manufacturer of optical fiber and cable into a broad-based supplier of optical solutions for the communications industry. Healthcare company Medtronic, Inc. (MDT) also finished the quarter as a top five contributor to the Fund, gaining 7.23%. While emerging market revenue proved scarce for most industries during the quarter, Medtronic increased its share of revenue from the developing world by 15%, which represented 12% of the company’s revenue.
U.S. Bancorp (USB), headquartered in Minneapolis, also finished the period as one of the Fund’s top five performance contributors. While the quarter remained challenging for many other banks locked into low-margin banking activities, U.S. Bancorp advanced 6.09% for the period, with a solid performance advantage relative to its peers. While many of its competitors contend with defensive measures and diminished growth prospects, U.S. Bancorp’s principled adaptation of risk management controls following the financial crisis of 2008-2009 has placed it ahead of the competitive and regulatory curve. Recognized by both their current commercial customers and financial regulators for its integrity and financial soundness, U.S. Bancorp enjoys one of the highest credit ratings available. Over the years, U.S. Bancorp has quietly cultivated and expanded its lucrative commercial lending operations, as well. We have been steadily acquiring and holding the company’s stock for some years, purchasing at attractive prices when the market does not recognize its value.
Detracting from performance, Exxon Mobil Corporation (XOM) declined 3.48% for the quarter, as the firm continued to have difficulty finding ways to grow production quickly enough to overcome the natural lifecycle decline of existing wells, and to offset what has been a relatively poor pricing environment for energy products. However, the firm seems ready to fund 10 major new projects in 2014 – a company record. Principal Financial Group (PFG) declined 6.73% following a tremendous 2013, and we view this simply as a correction.
The majority of the Fund’s bonds proved to be additive to performance due to strong demand for Treasuries in the range of seven, 10 and 30 year maturities. Investment-grade corporate bonds posted strong performance as well, as a result of the decline in Treasury yields and narrowing credit spreads — a key metric for the additional yield that investors demand for assuming more credit risk. Inflows from pension plans further narrowed the credit spreads on long-maturity, investment-grade bonds, which reached their highest demand level since the first quarter of 2009.
Overall, we believe that the Fund’s somewhat low-key first quarter results will be surpassed by gains in the remaining quarters as the Federal Reserve continues to taper back on quantitative easing. We think the Mairs & Power Balanced Fund, with its dual exposure to equities and bonds, is especially well-positioned for transitional moments like the present, every investor will soon become reacquainted with an economic landscape that is governed more by the demands of the marketplace for stocks and bonds than by the remedial liquidity made available through Fed interventions.
Ronald L. Kaliebe
William B. Frels
The Fund’s investment objective, 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.
The stocks mentioned herein represent the following percentages of the total net assets of the Mairs & Power Balanced Fund as of March 31, 2014: Corning Incorporated 1.50%, Emerson Electric Company 2.52%, Exxon Mobil Corporation 2.43%, General Electric Company 1.76%, Medtronic, Inc. 2.66%, Principal Financial Group, Inc. 1.62%, Schlumberger Ltd. 2.61%, United Parcel Service, Inc. Class B 2.54%, U.S. Bancorp 2.52%, Wells Fargo & Company 1.33%.
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 an offer of a particular security, nor is it intended to be a solicitation for the purchase or sale of any security.
Price to Earnings (P/E) Ratio is a common tool for comparing the prices of different common stocks and is calculated by dividing the current market price of a stock by the earnings per share. The P/E ratio is not a measure of future performance or growth.
Earnings Per Share (EPS) is calculated by taking the total earnings dividend by the number of shares outstanding.