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.
Small Cap Fund Performance
The Mairs & Power Small Cap Fund turned in a solid performance for the first half of the year returning 5.61% compared to 3.22% for its benchmark, the S&P 600 SmallCap® Total Return Index. For the same period, the Lipper Small Cap Core Funds Index, its peer group, returned 3.83%. Additionally, for the quarter, the Fund gained 2.30%, outperforming its benchmark at 2.07% and slightly lagging the Lipper peer group at 2.57%.
It’s encouraging to see the Fund continue to make up lost ground on the index after last year’s modest underperformance, and continue to perform well relative to its peers. By design, sector allocation had little impact on relative performance. In keeping with Mairs & Power’s approach, it was individual stock selection that once again drove outperformance in the first half. The portfolio benefited as oil prices moved up sharply and our comparative overweight to that sector contributed to relative performance. Additionally, an underweight in the consumer discretionary sector helped performance, as the sector is actually down so far this year. Conversely, while we believe in the long term potential in many industrial companies, they detracted slightly from relative performance as that sector overall increased only slightly for the year.
Small cap stocks lagged behind larger cap stocks in the first half of 2014. This underperformance brought small cap valuations down a bit relative to large cap stocks. However, there continues to be more of a premium for small companies than historically has been the case. We believe this is justified based on the underlying revenue and earnings growth prospects for smaller companies.
Gentherm (THRM), a manufacturer of automobile seat heating and cooling equipment, contributed the most to outperformance for the six-month and second-quarter periods, through June 30, returning 65.80% and 28.02%, respectively. Gentherm continues to benefit from increased inclusion of its products on Original Equipment Manufacturer (OEM) auto platforms as well as from other applications of its proprietary technology (consider how welcome heated seats would have been during Minnesota’s brush with the Polar Vortex last winter). The password authentication hardware and software firm, Vasco Data Security (VDSI) also contributed heavily to performance for both the six-month and second-quarter periods, returning 50.06% and 53.85%, respectively. Having an already strong European consumer banking presence, Vasco has now started to make inroads into the U.S. market. Every day, new headlines trumpeting widespread data vulnerabilities help to drive up greater demand for this firm’s products.
In contrast, the radiation detection firm Landauer (LDR) proved to be the biggest laggard in the first half of the year. However, a number of recent regulatory changes that address shortfalls in U.S. hospital radiation monitoring appear likely to provide the company with an opportunity to turn their stock performance around.
Portfolio additions during the second quarter included United Fire Group (UFCS), a company based in Cedar Rapids, Iowa that writes property and casualty insurance, life insurance, and offers annuities. With a strong history of conservative underwriting, this steady performer grew its Return on Equity (ROE) 10% last year, while its stock traded at a discount to book value – considered a rare event at current valuations. Another aspect we like about this company is that its management goes out of its way to tell potential investors that, while they must report their results quarterly, they manage their company for the much longer term; music to our ears.
Andrew R. Adams