While the pace of the economic recovery was somewhat better than expected during the quarter, we continued to keep our primary focus on the long-term fundamental attributes that make companies profitable. While attentive, we are not swayed by the macro-economic details underpinning global market events. By emphasizing the long-term view, we can make the subtle, opportunistic adjustments to company positions over time that keep portfolio turnover low and tax consequences in check. Our first mutual fund, the Mairs & Power Growth Fund, founded in 1958, provides a good illustration of this approach, which is employed by the Mairs & Power Balanced and Mairs & Power Small Cap Funds as well. Portfolio turnover for the Growth Fund, compared to its peers, the Morningstar U.S. Large Cap Blend category, was substantially lower for each of the past 10 years. As a result, the Fund’s annual realized taxable capital gains exceeded $1.00 in only two of the past 10 years.
As measured by the Standard and Poor’s Total Return (TR) Index, the stock market advanced 5.23% for the quarter ending June 30, 2014. The market’s strength occurred against a mixed backdrop characterized by a downbeat adjustment to the Gross Domestic Product (GDP) (a key barometer of economic health), a rekindling of the War in Iraq, and hints that higher inflation and rising yields might be just around the corner.
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The quarter’s biggest economic news was the unexpectedly sharp downward revision of the first quarter’s GDP growth rate from -1% to -2.9%. Like a house guest who won’t leave, the effects of winter’s record cold snap endured and played a major role in depressing the benchmark growth measure, which opened up questions about the long-term hardiness of the U.S. recovery.
Meanwhile, as the Iraq War began appearing on the front pages again, the markets experienced some déjà vu: Would this be like 2003 all over again, when America first conquered Baghdad? The answer turned out to be a “no.” Shrugging off short-term inflationary fears from rising energy prices, the markets behaved with much more equanimity than they did 11 years ago when America’s energy independence goals were still far in the future. Instead, our energy selections were able to benefit from new access to cheaper domestic oil reserves as well as growing demand for improved technologies related to fracking.
Concerns about rising yields and the inflation rate were short-lived as well. Analysts found their expectations subverted when the benchmark 10-year Treasury rate declined from a high of more than 2.80% earlier in the quarter to 2.53% by the end of the period, and the Barclays Capital Government/Credit Bond Index gained 1.92%. Elsewhere, the Fed continued to dial back its monthly bond purchases by an additional $10 billion more per month. In short, the combined threats of the seemingly everlasting Polar Vortex, the Iraq War and inflationary fears could not dampen investor enthusiasm for stocks during the second quarter.
Everybody likes a winner. And, if the stock market was any gauge during the second quarter, there was a lot to like. Stocks extended their winning streak for the sixth consecutive quarter, as measured by the Standard & Poor’s 500 Index – a phenomenon surpassed only six other times since 1928. After such historic gains, though, should cautious investors grow concerned about the second half of the year? We don’t think so. Successful investment approaches never depend on the positive or negative market performance of any single quarter. At Mairs and Power, we base our portfolio decisions on the facts about companies, not the markets. In particular, we endeavor to identify and invest in those companies that have shown their ability to achieve consistent, above-average growth from a position of demonstrable and durable competitive advantage.
Looking toward year-end, we will continue to closely evaluate corporate earnings and revenue against the multiples we view to be still slightly above historical levels. The price/earnings (P/E) multiple of the S&P 500, a key gauge of corporate earnings health, stood just above its long term average of around 15.5 at quarter-end, almost exactly where it ended the first quarter. This is further proof to us that stock prices continue to be influenced more by actual, organic company earnings and revenue growth than by the Federal Reserve’s waning stimulus program.
While we believe economic conditions appear sufficiently strong to support this current, positive earnings trend, a market correction in the near term would not surprise us. The advantages of investing in well-diversified portfolios, rebalanced regularly, provide one of the better, more reliable routes for meeting long-term goals regardless of the quarter. By focusing our attention on companies and how they perform, we remain confident in our ability to identify, over the course of a full market cycle, those profitable, well-managed firms likely to outperform their competitors regardless of marketplace events.
Growth Fund Performance
For the second quarter and six months ending June 30, 2014, The Mairs & Power Growth Fund gained 2.87% and 4.18% respectively; underperforming its benchmark, the Standard and Poor’s 500 Total Return (TR) Index, which gained 5.23% and 7.14%, and the Lipper Multi Cap Core, its peer group, at 4.52% and 6.25%, for the periods.
The world’s leading supplier of energy industry technology solutions, Schlumberger (SLB) was a top contributor to performance for both the past quarter and the past six months through June 30, gaining 20.97% and 30.90%, respectively. America’s move to greater energy independence that began more than a decade ago has continued to benefit firms like Schlumberger whose businesses are concentrated in the area of oil and gas exploration. Many factors, however, like global economics and shifting political allegiances can affect both energy prices and exploration budgets. Since 2008, Schlumberger has endeavored to temper the impact of such cyclical influences through major investments in technology innovations, product reliability and better processes. As it gains market share, Schlumberger continues to hold leading market positions in proprietary software, patents, and major equipment.
Freight shipper and global supply chain consultant C.H. Robinson Worldwide, Inc. (CHRW) gained 21.76% and 9.34% respectively for the second quarter and first six months, and was a strong contributor to Fund performance. The firm’s efforts to better service high-end customers resulted in a favorable report in the first quarter and helped reverse a lackluster, two-year performance trend. As the requirement for “just-in-time” freight delivery becomes increasingly important to a company’s profitability, customers will turn to third-party logistics firms like C.H. Robinson to coordinate shipments and generate the information customers need in real time to manage their inventories and deliveries.
Healthcare company Medtronic, Inc. (MDT) also contributed to performance, gaining 3.61% and 11.10% for the second quarter and first six months, respectively. Pending a shareholder vote later this year or in 2015, however, Medtronic is expected to merge with medical device supplier Covidien Plc and change its legal domicile to Ireland. Once completed, the merger will create a taxable event for Fund shareholders who will realize a long-term capital gain estimated at $60 million or $1.50 a share. We also anticipate the Fund may realize another $1.50 per share in non-Medtronic capital gains by year- end. As you know, Mairs and Power is committed to a policy of low portfolio turnover, and reduced tax exposure; and we consider this tax event to be an anomaly. Through our long-term approach, we make adjustments to company positions over time that keep portfolio turnover low and tax consequences in check. The Fund, founded in 1958, actually provides a good illustration of this approach. Compared to its Morningstar U.S. Large Cap Blend category, portfolio turnover for the Fund was substantially lower for each of the past 10 years, while realized annual taxable capital gains exceeded $1.00 in only two of the past 10 years.
The largest detractor from performance during the quarter was Cray Inc. (CRAY), a major super computer manufacturer. However, given our long-term view of the company, we took advantage of this attractive valuation to increase our position. A number of other industrial companies in our portfolio detracted from performance, including Toro Company (TTC), a major provider of landscape maintenance equipment. Due, in part, to last winter’s unseasonably cold weather, the firm lowered earnings expectations. Prior to the disappointing earnings report, we had scaled back our position somewhat, while retaining the firm as a top 10 holding based on our conviction that Toro’s strong product lineup is likely to deliver revenue growth later in the year.
While we continue to be enthusiastic about the long-term prospects of three other industrial companies, Pentair (PNR), Graco (GGG) and 3M (MMM), we trimmed our positions as they approached full value. Should future valuation look attractive, we would again add to our positions with confidence. Here, too, our portfolio adjustments are part of our overall strategy; to keep portfolio turnover low, while still taking advantage of opportunities when the market presents them to us.
Mark L. Henneman
William B. Frels