Market Overview | First Quarter 2020
On Feb. 19, the S&P 500 closed at an all-time high of 3,386. Not many days before, on Feb. 12, the Dow Jones Industrial Average (DJIA) set a new closing record of 29,551. Then the astounding 11-year bull market came to a screeching halt. We are all too familiar with the reasons. The novel coronavirus and the COVID-19 illness it caused was the trigger, as the entire world came face to face with a pandemic whose length and breadth remain uncertain. The social distancing, shelter-in-place orders, closing of retailers and restaurants, and massive layoffs are wreaking havoc on the domestic and global economies. In addition, Saudi Arabia decided to start a price war with Russia for crude oil. And then there is the additional uncertainty caused by the upcoming Presidential election.
All that noted, there are two factors in particular that have given us a great deal of reassurance during the first quarterâs market tumult. Government response is one. The Federal Reserve (FED) has been acting very aggressively to support the U.S. financial system. Cutting the federal funds rate to near zero has been just one of them. On March 19, for instance, the FED backstopped the market for unsecured promissory notes issued by businesses to meet short-term liabilities. That same day, it created a âliquidity facilityâ to ensure that money market funds could withstand sudden redemptions by investors. The central bank has indicated that it will use all its resources to ensure that the countryâs financial system continues to function properly. In addition, the Federal government has passed a stimulus package of $2 trillion, an unprecedented commitment to help support the economy.
Another factor providing reassurance is the underlying strength of the banking system. Banks arenât over levered now, as they were in 2008-â09. Capital levels are much higher, and stricter lending standards mean that loan portfolios are of much higher quality. In fact, several of the larger banks have announced a âno layoffâ policy.
Despite these positive factors, we donât see any way the economy can avoid two quarters of negative gross domestic product (GDP) growth, the technical definition of a recession. But history suggests that this recession, while it might be very deep, is also likely to be relatively short. That has often been the case when a major disruption triggers a downturn. A good example is the Gulf War recession of 1990-â91. The market sold off very hard. But the recession was short, and the market recovered fairly quickly.
Certainly, there is a wide range of possible outcomes, a longer downturn with a slower recovery being one of them. But we expect that as the pandemic recedes, pent-up demand will help the economy snap back quickly.
We also want to emphasize that the Funds we manage are designed with the intent to successfully maneuver through the storm. We can point to our long history, our commitment to long-term investing, and the quality of the companies we hold.
Future Outlook
The market is likely to remain volatile through the second quarter.
For many investors, this will be unnerving. But we believe the broad-based, somewhat indiscriminate selloff has created a lot of attractive investment opportunities. With these opportunities, we will be building upon the Fundâs fundamental strengths. We believe this will allow us to pass through this downturn and emerge more strongly positioned to prosper.
Those strengths start with the companies we hold. The Fundâs investment philosophy continues to be focused on investing in companies with strong competitive positions for the long term. With that in mind, we are taking advantage of what we think is short term volatility in the stocks of companies that we know very well. In some cases, we have selectively added to positions in companies we have followed for years and even decades. We believe we have a good understanding of how their businesses and their end markets will be impacted in a downturn. In the last quarter, we have also added a few new names. These are companies weâve been following closely over the past few years and waiting for a pullback in their share price for an attractive entry point. Based on our research, weâve determined that these companies may have the competitive advantages and financial durability to come through a downturn stronger than before.
In addition, we continually and closely monitor the underlying strength of the companies in which we invest. We regularly assess the balance sheet quality of all the stocks in all of our funds. We focus on the operating leverage the companies have exhibited in past market downturns, and the amount of financial leverage they currently have. We identify which companies are more highly levered than is appropriate, and limit our positions in them, sometimes quite meaningfully.
Today, there is a lot of uncertainty. We expect the situation to be clearer in three to six months. In the meantime, we will continue to think and act for the long term. Our managersâ actions reflect the fact that we are extremely confident in the economy and its ability to recover.
Performance Review
The Mairs & Power Growth Fund was down 18.84% in terms of total return (TR) in the first quarter of 2020. The S&P 500 TR benchmark was down 19.60%, while the Lipper Multi-Cap Core Funds Index was down 21.60% in the first quarter.
Performance data quoted represents past performance and does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investorâs shares, when redeemed, may be lower or higher than the performance quoted. For the most recent month-end performance figures, please call Shareholder Services at (800) 304-7404. Expense Ratio 0.64%.
While the Fund outperformed the index and peer group in the quarter, we would like to have seen a larger margin of victory. However, the Fund has always had a significant weight in smaller companies relative to the S&P 500. This was a significant headwind in the first quarter as the S&P 400 midcap index was down 29.70% and weighed on relative performance. Over the long term, small- and mid-cap stocks have outperformed the large-caps, but that hasnât been the case so far this year. On cash flow and earnings-based valuation measures, smaller stocks are now trading at a significant discount to their larger brethren. In fact, on some measures we havenât seen relative valuations at this level since the internet bubble of 1999-2000. This valuation gap is encouraging us to aggressively buy the smaller companies that we believe have been disproportionately hit.
Two sectors that helped the Fund in the last quarter were Energy and Healthcare. In the first quarter, the Energy sector more or less collapsed, thanks not only to the novel coronavirus but the inability of petroleum producers to slow supply. We have been underweight in Energy for a long time, and that benefited the Fundâs relative performance. In Healthcare, where weâve been overweight, our stock selection allowed us to modestly outperform the index. One notable Healthcare performer in the Fund is Roche (RHHBY, Financial). The companyâs pharmaceutical business focuses primarily on biologic and biotech treatments for cancers and immunological diseasesâconditions where delaying treatment isnât an option. Roche also has business units in diagnostics. One of its recently released products is a COVID-19 test with a four-hour turnaround.
By contrast, Financials experienced a difficult quarter. Case in point is Principal Financial Group (PFG), whose focus is small business retirement plans. A sustained recession will likely cause small business failures and therefore fewer customers and remaining customers may need to cut benefits. That said, we still like the companyâs long-term outlook, and we have added to this holding selectively during the quarterâs downturn. We believe it should be well positioned as the economy recovers.
Letâs turn to stock selection. Hormel (HRL, Financial) was a strong contributor to the Fundâs first quarter performance. Since people were dining out less and buying more at the supermarket, this should come as no surprise. Itâs well positioned for this downturn. CoreSite (COR, Financial) was another strong performer. The Denver-based REIT (real estate investment trust) is an IT outsource provider operating multiple data centers across eight large U.S. metropolitan areas. In other words, it owns real estate supporting the backbones of the Internet and its list of customers include Comcast, AT&T, and Verizon. With people staying home to work, play, teleconference, take classes, and watch streaming movies, CoreSiteâs real estate has clearly grown in demand.
Early in the quarter, we added a couple companies to the Fund. One is Workiva (WK, Financial), whose suite of enterprise applications provides data sharing and regulatory reporting via a software-as-a-service model. We believe its business should continue to sustain through a recession. Another newcomer is Activision (ATVI, Financial), a video game company.
During the quarter, we exited Generac Holdings (GNRC, Financial), Badger Meter (BMI, Financial), and Associated Banc-Corp (ASB, Financial). Generac and Badger had both been strong contributors to the Fundâs portfolio over the long term, but their valuations had become too expensive to warrant their continued inclusion.
The Fund will continue to take advantage of buying opportunities in this volatile market. As always, we will add to positions in long-established, well-run companies that have the competitive and financial advantages we seek.
Andrew R. Adams, CFA,CIC
Lead Manager
Mark L. Henneman, CFA,CIC
Co-Manager
Pete J. Johnson, CFA
Co-Manager
The Fundâs 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 by 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 March 31, 2020: Activision Blizzard Inc. 0.82%, Associated Banc-Corp 0.00%, AT&T 0.00%, Badger Meter 0.00%, Comcast 0.00%, CoreSite Realty Corp. 2.77%, Donaldson Inc. 2.47%, Generarc Holdings 0.00%, Graco Inc. 3.15%, H.B. Fuller Company 1.31%, Hormel Foods Corp 2.90%, NVIDIA Corp 2.68%, Principal Financial Group 1.76%, Roche Holdings Ltd. 3.65%, US Bancorp 4.10%, Verizon 0.00%, Walt Disney Company 2.86%, Workiva Inc. 0.07%.
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 specific 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.
