The market continued its nervous advance with the only consensus opinion being “uncertainty.” For the quarter and the first nine months, the S&P 500 Total Return (TR) was 3.85% and 7.84% respectively and the Dow Jones Industrial Average TR was 2.78% and 7.21%. Our other key benchmark, the Barclays Government/Credit Bond Index Return was 0.40% and 6.66% for the third quarter and year-to-date.
Economic indicators continued to deliver mixed signals in the third quarter. Industrial production and manufacturing output both softened in the quarter and capacity utilization in the industrial sector dipped 0.4 percentage points in August to 75.5 percent, 4.5 percentage points below its long run (1972 – 2015) average. Reflecting strength on the consumer side of the economy, interest rates moved up a bit in the quarter. Financial stocks performed well on the expectation that the Federal Reserve (Fed) would raise rates in Q3. But like Lucy pulling the football away from Charlie Brown one more time, the central bank deferred action and Fed chair Janet Yellen’s most recent comments have led us to conclude that they will take no action on rates until December at the earliest. As a result, the market remains focused on two key questions: “What is the Fed going to do?” and “When is it going to do it?”
While no one knows with certainty the direction of earnings or the timing of interest rate hikes, the large political uncertainty hanging over the markets will be taken away with the presidential election occurring in early November.
Future Outlook
As the third quarter’s earnings reports are coming in, the outlook is not sunny, with earnings expectations for the S&P 500 down year-over-year for the sixth straight quarter.
But we see some brightening on the horizon as we expect that earnings growth or the S&P 500 will turn positive in the fourth quarter and revenues will post positive owth for the first time in several quarters. While the industrial side of the economy ains soft, consumers continue to do well. The economy appears to be approaching full employment and wage gains are tracking higher. Consumer confidence is high and spending has been growing at a healthy pace. Overall economic growth continues at a moderate pace. And, while oil prices have begun to recover from their precipitous drop, sustained weakness in the energy sector continues to pull down aggregate corporate earnings for the broader market. Persistently sluggish economic growth along with low interest rates have fueled merger and acquisition (M&A) activity as companies uy” growth through acquisitions and we expect increased M&A activity to continue as long as these conditions persist. We remain optimistic about the U.S. economy long- erm and the outlook for stocks of good companies for which we are always on the lookout. Near term, the S&P 500 appears slightly expensive based on the next twelve months arnings outlook, so we remain watchful and cautious.
Small Cap Fund Performance Review
The Small Cap Fund has posted a strong showing so far this year, up 16.48% for the first nine months, and has thus far outperformed both the index and its peers. The S&P 600 Small Cap Total Return Index is up 13.88% in the first nine months of 2016 and the peer group as measured by the Morningstar Small Cap Core Index is up 10.09%. In the third quarter, the Fund gained 4.13% while the S&P 600 Index and peers rose 7.20% and 6.97% respectively.
Outperformance of the Fund relative to its index for the first three quarters of 2016 has been driven primarily by stock selection, with sector allocation also playing a role. An underweight position in the consumer discretionary sector, one of the poorer performing sectors this year, has helped performance. A small underweight in the healthcare sector also added to relative performance. The Fund’s overweight position in the industrial sector also slightly aided relative returns.
The positive contribution from stock selection in the first three quarters of the year was driven by companies like Agree Realty (ADC, Financial) and Oshkosh Corp. (OSK, Financial). As interest rates declined, Agree’s 4%+ dividend looked quite attractive to the market, benefiting the stock. Looking forward, we also believe Agree has a well-positioned commercial real estate portfolio with smaller footprints in high-traffic urban areas. Oshkosh Truck has benefited from strong end markets in fire and emergency vehicles and a more stable end market in construction-related aerial lift platforms. But the business development we are most excited by is their win of the joint forces light tactical vehicle contract to replace an aging Humvee fleet for the U.S. military. While this contract will take time to ramp up, we believe it will be a significant piece of business for Oshkosh over the next decade.
The most underperforming stocks year-to-date were Cray (CRAY, Financial) and Gentherm (THRM, Financial). Both companies have been strong performers longer-term, but have given up some of that performance this year. Cray lowered its earnings outlook for the year due to a softening high performance computing end market. Importantly, it continues to win more than its fair share of the new business that is still out there and this share gain will be even more evident when the end markets start to improve. Gentherm likewise lowered its guidance for the year as heated and cooled automotive seating has not grown as quickly as anticipated. We believe penetration is still relatively low and growth should improve in this key market. We are also excited by the company’s new product that will help regulate battery temperature in hybrid cars, improving battery productive life. It’s worth noting we had trimmed both positions on previous strength and are now taking advantage of current weakness to buy back some of those shares at more reasonable valuations.
The Fund saw very strong cash flow from existing and new investors following its five-year anniversary on August 11th and prior to its soft close on September 30th. With that cash flow, we added an abnormally high five new stocks to the portfolio in the 3rd quarter. Most of these new positions will replace stocks that are in the process of being acquired this year and next, so we don’t expect the number of stocks in the portfolio to change dramatically.
The decision to limit new investment into the Mairs & Power Small Cap Fund was made primarily to protect existing shareholders. Small cap stocks trade fewer shares than larger stocks. The lower trading volume limits how much of a stock can be bought or sold without significantly impacting the price of that stock. By limiting the amount of assets we manage, we are better able to trade into and out of stocks as opportunities arise without being significantly disadvantaged by the sheer volume of shares we would need to trade. In the long-run, we felt this was the right step to take to protect the interest of our shareholders. For more details regarding the soft close of the Fund please visit www.mairsandpower.com
Stocks added in the quarter include: Cullen Frost Bankers (CFR, Financial), a conservatively run Texas bank benefitting from strong demographic trends; Glacier Bancorp (GBCI, Financial), a Montana based bank also conservatively managed, with significant room to grow geographically; Premier, Inc. (PINC, Financial), the second largest Group Purchasing Organization in the United States, helping hospitals and physicians’ groups negotiate better pricing with suppliers; Tennant Company (TNC, Financial), a Minneapolis-based commercial cleaning equipment company with strong new telemetry technology that tracks equipment productivity and maintenance as well as robotic technology under development; and Tile Shop Holdings (TTS, Financial), a Twin Cities-based flooring retailer with a high return store model that should be deployable over a much larger geographic footprint. Like our other two Funds, the Small Cap Fund eliminated the remainder of its position in MTS (MTSC, Financial) during the quarter following the company’s dilutive acquisition of PCB Group.
Small cap stocks have continued to rebound relative to larger cap stocks over the last several quarters and their valuations are now in line with their historical average premium to large cap stocks. Now that the valuation gap has closed we expect small stocks to perform more in line with large cap stocks from here.
Andrew R. Adams
Allen D. Steinkopf
Lead Manager
Co-Manager
