Mairs & Power Balanced Fund Q4 2014 Commentary

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Mar 31, 2015

Investors could be forgiven if they looked back on 2014 as a year of mixed signals. Concerns about slowing growth in China, a possible recession across Europe and increasing tensions with Russia over their aggressive moves against Ukraine all contributed to market uncertainty. On the other hand, earnings continued to exceed expectations and the rapid decline in energy prices put a tailwind behind the U.S. economy, rewarding investors with the sixth year in a row of positive returns and the longest run since the bull market of the 1990s.

With crude oil down more than 40 percent for 2014 (and continuing to fall in the first weeks of the New Year), we believe this will be the biggest driver of the U.S. markets and economy over the next several quarters. GDP growth in Q3 was revised upward to a healthy five percent annual rate, even before the stimulus of lower gas prices had fully kicked in, revealing continued momentum to the domestic economy as we enter 2015.

Such a rapid shift in the price of oil is, by definition, disruptive, creating winners and losers. As investors, we see both risks and opportunities as a result. A Goldman Sachs report recently estimated that the $1-plus drop in gasoline prices since last year will cut $125 billion from consumers’ fuel bills over the coming twelve months. Assuming low gas prices hold for the next several quarters, we see a healthy economic stimulus benefitting consumer- facing companies such as retailers, restaurants and entertainment. We also see industrial manufacturers and transportation benefiting from lower raw material and fuel costs.

Investment opportunities are created at times like this for those willing to “go against the flow” and at Mairs & Power we attempt to see opportunities where others may not. For example, one of our portfolio holdings, Wisconsin-based flexible package manufacturer Bemis Company, announced that a veteran within the company would succeed its retiring CEO last summer. We began talking to the new management early on and heard the new CEO articulate a clear understanding of the company’s opportunities and challenges as well as a good formula for success. In addition, we believe the company stands to benefit from falling oil prices. Ethylene prices, a key part of their raw material costs, have not yet responded, so the company can look forward to lower costs in the future. We feel the price advantage of flexible packaging relative to rigid packaging will accelerate the long-term shift away from cans and bottles to the more robust packaging that Bemis manufactures. As a result, we substantially increased our already established position. Once the rest of the market recognized what we had seen, the stock responded with a nearly 20% rise in the fourth quarter.

Future Outlook

We expect interest rates to begin rising sometime in 2015 which will have several effects that bear watching. We do not believe that a slight increase in rates would, by itself, end the current cycle. However, the advantage stocks have enjoyed over fixed income securities in the current low interest rate environment will be lessened as rates rise and investors find more places that offer yield.

The rate of growth for both revenue and earnings among small and large companies continues to be impressive. Furthermore, we believe that low energy prices will continue to benefit the U.S. economy over the next several quarters. When we look at the U.S. economy, we see no significant weaknesses. With the current cycle entering its seventh year and price to earnings ratios above their historic averages, we can expect positive, but muted equity returns for this year.

Balanced Fund Performance

The Balanced Fund performance was ahead of its benchmark composite (60% S&P 500 Total Return (TR) Index and 40% Barclays Government/ Credit Bond Index) for the quarter while it underperformed for the full year. The Fund was up 3.80% and 8.04% for the quarter and full year, respectively, while the benchmark composite rose 3.68% and 10.63% in each period.

The relative underperformance of small, mid and medium cap stocks compared with the large cap stocks of the S&P 500 was one factor that caused the Balanced Fund, with a blend of small, mid, medium and large cap stocks, to lag the benchmark for the full year. The rapid decline in global oil prices in 2014 was a major factor in the Fund’s performance for both the fourth quarter and full year. The Fund’s overweight position in energy related stocks – the worst performing sector in both periods – was a negative factor in Fund performance for the quarter and the year. An overweight position in industrials and underweight position in the information technology sector were also negative factors in Fund performance for the year.

The market became convinced that the merger of Medtronic (MDT) and Covidien (COV) would go through and Medtronic was among the top performers for both the quarter and the year. Declining raw material and fuel costs benefitted industrial manufacturers such as 3M Company (MMM), which hit an all-time high in December and was a top performing stock for the quarter. Similarly, the drop in gasoline prices funded increased consumer discretionary spending, benefitting companies such as Target Corp (TGT), which also hit an all-time high in December and was also a top performer for the quarter. On the other hand, energy-related stocks such as Schlumberger (SLB) and Exxon (XOM) were among the poorest performers in the Fund for the fourth quarter and full year 2014, declining to valuation levels not seen in more than a decade.

Mairs & Power Balanced Fund (MAPOX) Fourth Quarter Results (9/30/14 - 12/31/14)

TOP PERFORMERS
FOURTH QUARTER (9/30/14 - 12/31/14) YEAR TO DATE (12/31/13 - 12/31/14)
Target Corp. 21.11% Eli Lilly & Co. 35.27%
Medtronic, Inc. 16.55% Corning Inc. 28.68%
3M Company 15.98% C.H Robinson Worldwide, Inc. 28.37%
United Parcel Service, Inc., Class B 13.10% Home Depot, Inc. 27.48%
Deluxe Corp. 12.85% Medtronic, Inc. 25.81%
WEAK PERFORMERS
FOURTH QUARTER (9/30/14 - 12/31/14) YEAR TO DATE (12/31/13 - 12/31/14)
Schlumberger, Ltd. -16.01% Pentair Ltd. -14.48%
MDU Resources Group, Inc. -15.50% Emerson Electric Co. -12.04%
International Business Machines Corp. -15.48% General Electric Co. -9.85%
ConocoPhillips -9.75% Exxon Mobil Corp. -8.65%
Exxon Mobil Corp. -1.70% Schlumberger, Ltd. -5.22%

While the Fund did not hold any U.S. Treasuries, a very strong performing sector of bonds for the year, it did have exposure to agencies and corporate bonds. As a result of the longer duration of both high quality agencies and corporate contributions the portfolio had positive returns in 2014. The Fund is currently very selective on the fixed income side, viewing the market as fully priced and is looking to add positions on the equity side where current valuations do not fully represent a stock’s long-term value.

At regularly scheduled meetings in December, the Mairs & Power, Inc. Board of Directors and the Mairs & Power Funds Trust (Trust) Board of Trustees approved a number of changes to the company’s executive ranks and to the officers and trustees of the Trust. Among the changes, Kevin Earley joins lead manager Ronald Kaliebe as co-manager of the Balanced Fund, effective January 1st. Mark Henneman was also appointed President of the Trust, effective December 31, 2014. These executive changes culminate a long-term succession plan which began several years ago in anticipation of William Frels’ mandatory retirement on December 31, 2014 as co-manager of the Growth and Balanced Funds and Trustee and President of the Trust. The Mairs & Power Mutual Funds employ a deliberate and disciplined succession planning process to ensure consistency in the investment philosophy over time. Press releases detailing all the changes are available on the Mairs & Power website.

Ronald L. Kaliebe Kevin V. Earley
Lead Manager Co-Manager

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