Bill Frels' Mairs & Power Growth Fund Q3 2014 Commentary

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Oct 20, 2014

With ISIS on the march, the Eurozone’s fits and starts and a potential U.S. confrontation with Russia in the air, third quarter performance could have been expected to take a time-out from this year’s domestic advances. Instead, the Standard & Poor’s Total Return Index rose 1.13% for the third quarter gaining 8.34% year-to-date. Then, defying the consensus of market analysts who thought rates would go up and bond prices would decline, the Barclay’s Government/Credit Index also delivered a slight gain of 0.17% for the period with a 4.12% advance year-to-date.

While inflation conveniently remained in check for the quarter, the low rate environment continued to bring inexpensive credit – and liquidity – into the market. This contributed to the S&P 500 Index’s extended rise to a near three-fold increase over the span of the last 5 1/2 years.

The U.S. economy continued to lead the world on a relative basis for the period, as a revised number for domestic Gross Domestic Product (GDP) brought second quarter growth up to 4.6% on an annualized basis. Overseas, geopolitical unrest and uncertainty over the impact of foreign Central Bank interventions added a touch of volatility to the bond and currency markets.

At this point in a maturing business cycle, we find the market slowing down, leveling off a bit, yet still with the ability to surprise on the upside. Our commitment to identifying companies that demonstrate consistent, above-average growth over the long-term is critical. Pinpointing such companies during periods of moderate-to-flat growth prospects, especially after a lengthy run-up in prices, can be especially challenging. A pattern of divergence seeps in between what a company is actually earning and how the market perceives that company’s valuation. A steady rise in short- term equity prices can obscure the fact that one of the truest measures of a company’s valuation, its price-to-earnings ratio (P/E), needs to be viewed in a long-term context for this metric to be accurate – not just for the period of the market advance.

A case in point is portfolio holding Donaldson & Co., Inc. (DCI), one of the leading international manufacturers of high-tech filtration solutions for engines. For the past century, despite interest- rate shocks, stock market corrections and world wars, Donaldson has prospered and grown. Faced with a global slowdown in construction projects, Donaldson’s sales growth slowed and its stock price declined – while earnings held their ground and even increased slightly. To Mairs & Power, nothing fundamental changed for Donaldson. Our assessment of the firm’s long-term growth prospects is still supported by the quantitative data and our qualitative findings that matter most in our selection process. Rather, the impact of short-term, negative market perceptions on consistently growing companies like Donaldson offers us an incentive to add to a position we already like at an attractive price.

Future Outlook

While the fundamentals of the economy and markets remain strong heading into 2015, we have become somewhat more cautious given our sense that valuations may be somewhat elevated . It’s a fact that a moderately overvalued market can still deliver strong total returns for years. Normal valuation levels can fluctuate significantly over time, and there’s no guarantee that the past will be an accurate gauge of the future. Over a long enough investment time horizon, common stocks are almost certain to outperform bonds and cash, especially considering current interest rates.

Meanwhile, the European Central Bank and Bank of Japan, hampered by slow growth, are getting ready to loosen up their own credit policies and turn on the tap to get overseas liquidity flowing. If inflation remains tame, as many investors expect, Treasury yields are likely to remain low and the prices of commodities such as fuel and metals are likely to fall. This could give consumer spending, economic growth and many asset prices a welcome shot in the arm.

As we proceed through the final quarter of 2014, we will continue to do what we do best: advocate for patience and invest in companies, not markets. 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. When the book for this business cycle is written, we are confident that our selections will have been shown to have delivered an attractive level of risk-adjusted return to our shareholders. Meanwhile, the impact of short-term, negative market perceptions on consistently growing companies, continues to offer us incentives to add to positions we already like at prices that are even better.

Growth Fund Performance

For the third quarter and nine months ending September 30, 2014, The Mairs & Power Growth Fund declined 2.40% and gained 1.68% respectively; underperforming its benchmark, the Standard and Poor’s 500 Total Return (TR) Index, which gained 1.13% and 8.34%, and the Lipper Multi Cap Core, its peer group, which lost 0.84% and gained 5.36%.

This year, many of the companies held by the Fund have been challenged by the maturation of the current domestic business cycle. While our portfolio companies generally exhibited strong above- average growth characteristics, a number of them were not fully participating in the economic expansion now underway.

An overweight to companies with small-to-mid-size capitalizations proved subtractive to performance. The small cap sector, represented by the S&P 600 SmallCap® Total Return Index, declined by 6.73% for the quarter versus large-cap companies, as measured by the S&P 500 Total Return Index, which eked out a 1.13% gain. Over longer periods, small cap companies have tended to rebound quickly from their underdog status and eventually outperform their larger counterparts.

The Fund had placed particular emphasis on companies that are within the Industrial sector, which as a whole detracted from performance relative to the benchmark. Having generally delivered on their earnings growth projections, however, our selections in industrials still represent consistent above-average growth potential over the long term. And, accordingly, our conviction in them hasn’t wavered.

Graco (GGG) is among the portfolio’s below-average performers, yet it still managed to deliver above- average growth for the year. Supplying technology and expertise for the management of fluids in both industrial and commercial settings, Graco has a global client base grounded in manufacturing, construction and maintenance. With a stock price that appeared overvalued in 2013, the company now looks much more attractive after the market knocked out some of its excess in the recent period. After we trimmed it somewhat last quarter, Graco still represents a substantial holding for the Fund.

Due to the expansion of its pharmaceutical business, Johnson & Johnson (JNJ) contributed better-than- expected performance during the period. Sales soared by 21% due to almost a dozen recent drug launches and improving profitability, which may support a robust acquisition strategy that could reportedly beat management’s goal of 4.5% growth in annual drug sales through 2017.

Retailer Target (TGT) experienced a positive news cycle during the third quarter due to the public enthusiasm surrounding its new CEO, Brian Cornell, who has taken the high road in announcing positive changes concerning transparency and corporate accountability. While still underperforming as of the third quarter, Target seems set to advance, and indeed the stock was already rallying later in the quarter.

Another strong contributor to performance was Wells Fargo (WFC). Having weathered the financial crisis of 2008-2009 better than most, Wells Fargo has emerged as the go-to bank for depositors in search of a safe haven. With its consumer-friendly reputation, as well as a knack for achieving significant loan and deposit growth, Wells Fargo has been able to leverage its positive brand profile to attract new customers.

Healthcare company Medtronic, Inc. (MDT) detracted slightly from performance during the period. Pending a shareholder vote later this year or in 2015, Medtronic is expected to merge with medical device supplier Covidien Plc and change its legal domicile to Ireland. Your Growth Fund portfolio managers are pleased to report that we have completed our valuation for Medtronic. As of October 7, 2014 we believe combined Medtronic/Covidien to be $8 per share more valuable than shares of Medtronic alone.

As of September 30, 2014, the market value of the Growth Fund’s holding in Medtronic was $24 per share greater than its cost basis. We estimate that our typical shareholder, that holds the Growth Fund in a taxable amount, will experience about a $6.00 per share tax liability. We do not offer tax advice; each shareholder should consult a tax advisor about his/her particular circumstance. Providing that there are no significant changes, our current thinking leads us to believe that voting for the merger is in our shareholders’ best interest. We will keep you posted as the voting date is finalized or if we learn of any other developments regarding the merger plans.

Mark L. Henneman William B. Frels
Lead Manager Co-Manager

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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 Growth Fund as of 4FQUFNCFS 30, 2014: C.H. Robinson Worldwide, Inc. 2.31%, Covidien Ltd. 0.00%, Donaldson Company, Inc. 3.14%, Emerson Electric Co. 3.29%, Fiserv, Inc. 2.04%, Graco, Inc. 2.56%, H.B. Fuller Company 2.40%, Hormel Foods Corporation 2.79%, Johnson & Johnson 3.22%, Medtronic, Inc. 3.44%, NVE Corporation 0.76%, Pentair Plc 2.65%, Schlumberger Ltd. 3.44%, St. Jude Medical, Inc. 2.26%, Target Corporation 3.34%, Toro Company 3.07%, Valspar Corporation 3.87%, Wells Fargo & Company 2.00%.

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 speciï¬c 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.

Gross Domestic Product (GDP) The monetary value of all the ï¬nished goods and services produced within a country’s borders in a speciï¬c time period, though GDP is usually calculated on an annual basis.

Price to Earnings (P/E) Ratio is a common tool for comparing the prices of different common stocks and is calculated by divinding 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.

Barclays Government/Credit Bond Index. Barclays is composed of high-quality, investment-grade U.S. government and corporate fixed income securities with maturities greater than one year. It is not possible to invest directly in an index.

The S&P 600 TR is an index of small-company stocks managed by Standard and Poor’s that covers a broad range of small cap stocks in the United States. The index is weighted according to market capitalization and covers about 3-4% of the total market for equities in the United States. It tracks both the capital gains of a group of stocks over time, and assumes that any cash distributions, such as dividends, are reinvested back into the index.