Market Overview Second Quarter 2020
After the storms of the first quarter, the financial climate felt a little more settled in the second quarter. True, there is still a great deal of uncertainty in the air. Companies are still reporting layoffs, earnings remain under pressure, and the novel coronavirus is yet to be contained. But there are some hopeful signs. One notably encouraging sign, of course, is the overall market’s dramatic recovery in the second quarter.
The numbers tell a tale of two very different quarters. The S&P 500 Total Return (TR) Index rose 20.54% for the second quarter, compared to being down 19.60% in the first quarter, and was down 3.08% year-to-date. The Dow Jones Industrial Average TR Index was up 18.51% for the second quarter, down 22.73% in the first quarter, and down 8.43% for the first six months of 2020. Overall, the Technology and Healthcare sectors have posted the highest gains year-to-date. Energy and Financial have been the weakest sectors.
By contrast, in the fixed-income market, the Bloomberg Barclays U.S. Government/Credit Bond Index returned 3.71% and 7.21% for the second quarter and first six months, respectively.
Future Outlook
Several governmental actions provided a measure of stability to the economy in the second quarter. The Federal Reserve (FED) has kept interest rates low and used several monetary tools to provide liquidity and assure efficient trading of financial instruments, especially corporate bonds. And the federal Paycheck Protection Program (PPP) has allowed numerous smaller businesses to keep their lights on and their employees paid. The support to the economy that has come from massive stimulus, both fiscally (via the federal government) and monetarily (through the FED), has certainly boosted the confidence of the markets.
We have a long way to go to get to full recovery, but there are several data points that give us reason to feel hopeful. The June jobs report provided some particularly good news. The unemployment rate continues to fall -- from 13.3% in May to 11.1% -- and the economy gained 4.8 million new jobs.
While a broad portion of the economy was all but shut down following the onset of the pandemic, a great deal of corporate and consumer money sat on the sidelines. The personal savings rate in April, for instance, was an astounding 33%. But in May, local economies began the process of gradual reopening, and the May retail sales report was significantly stronger than expected, posting a record 18% jump. This suggests that there is a great deal of pent-up demand. People want to get out and resume their normal lives, go to restaurants and spend money.
Complicating economic recovery locally and around the globe is, of course, the novel coronavirus. There have been some positive signs. European infection and death rates have declined significantly from where they were a few months ago in countries including Spain, Italy and France. In the U.S., it’s a mixed picture, with some states showing significant improvement, while others see cases spike to new highs. There have been signs that some states reopened too quickly, or with insufficient care regarding social distancing and mask wearing. The resulting spikes in COVID-19 infections have caused some states to institute or reinstitute restrictions. We need to get the virus under control before we can have a true recovery.
In addition, the economic effects of the social unrest following George Floyd’s death in late May have yet to play out. So far, they’ve fallen mostly on those who are already economically vulnerable. Businesses, government and the public will need to work together to address and ameliorate these effects.
So how do we explain the market’s strong comeback in the second quarter? There was some volatility, to be sure, due mostly to the ups and downs in COVID-19 infection-rate reports. In general, we believe that the market is looking past what’s likely to be a weak economy and lower profits in 2020 and focusing instead on recovery and accelerating growth in 2021. The market might seem expensive, if valuations are based on this year’s depressed earnings. But it’s a different story if we have recovering earnings in 2021, making valuations look more reasonable.
As for the fixed income market, it has settled down after the uncertainties of the first quarter. In general, returns here have been steady.
Performance Review
The Mairs & Power Growth Fund’s performance reflects the tale of two quarters we noted earlier. The Fund gained 17.36% in the second quarter, but is down 4.75% for the first six months of 2020. The Fund’s benchmarks tell the same story. The S&P 500 Total Return (TR) benchmark was up 20.54% and down 3.08% over the same periods, while the Lipper Multi Cap Core Funds Index of peers has posted a gain of 23.14% in the second quarter and a decline of 3.46% year-to-date.
The Growth Fund managed to stay fairly close to the S&P 500 in terms of performance despite a number of macro headwinds. Our bias toward small and mid-cap stocks relative to the S&P 500 has hurt relative performance so far this year, with the mid-cap index trailing the larger S&P 500 index by nearly 10% year-to-date. Historically, investors have been rewarded for holding smaller stocks, since they have typically exhibited better growth characteristics. While smaller stocks have significantly underperformed large stocks over the last five years, we are expecting the pendulum will eventually shift back to favor smaller companies, and so we have been adding to positions in some of the smaller firms we hold.
A second headwind to relative performance is the result of the fund investing more heavily in Industrial sector stocks while being underweighted in the Technology sector. For several years, we have been reducing the size of that relative “bet” as we have purchased Technology stocks that we find attractive for the long term. The two largest holdings in the fund now being Microsoft (MSFT, Financial) and Google parent Alphabet (GOOGL, Financial). At the end of the second quarter, those stocks represented 6.7% and 6.2% of the total portfolio, respectively. The Technology sector has outperformed the Industrial sector so far this year by nearly 30%. We believe this gap will narrow as the economy recovers and industrial activity accelerates; the Fund could benefit in the future if that happens.
We also added two new technology stocks earlier this year that has already contributed to the Fund’s performance. One is Workiva (WK, Financial), a software-as-a-service technology company based in Iowa. We have held it for years in the Mairs & Power Small Cap Fund, but saw the opportunity with the market correction earlier this year to add it to the Growth Fund as well. Workiva provides software designed to ease the burden of regulatory reporting for corporations of all sizes. This year, it is expanding aggressively into Europe as new regulatory reporting requirements are being put in place over there.
The other is Activision (ATVI, Financial), one of the largest video game companies in the world. We believe it has a strong competitive position as its franchises -- which include World of Warcraft, Call of Duty and Candy Crush -- have attracted legions of loyal fans. Sheltering in place has provided a short-term benefit to the company, but will likely lure new customers to try out the games, and thus grow the video game industry overall. The longer we stay sheltered in place, the more Activision will likely benefit.
Another fairly recent addition to the fund in the Technology sector is Nvidia (NVDA, Financial). This California-based designer and manufacturer of computer graphics processors was the largest contributor by far to the Fund’s performance in the first half of the year, posting a share price gain of 61%. Its competitive advantage stems from its share and scale in the graphics card industry and the head start it has in providing chips being utilized for machine learning and artificial intelligence.
The largest detractor to relative performance in the fund in the first half was U.S. Bancorp (USB, Financial). The combination of lower interest rates and credit concerns has hit the banking industry hard this year. But we believe U.S. Bank continues to have one of the best underwritten loan portfolios, and that it will emerge from the economic downturn in a better position than the vast majority of its competitors. We have taken advantage of the stock’s weakness to add to our position.
During the quarter, we eliminated our small position in the Energy sector, namely the Fund’s holdings in petroleum industry services provider Core Laboratories (CLB, Financial). The sector’s long-term prospects are bleak.
Andrew R. Adams, CFA, CIC
Lead Manager
Mark L. Henneman, CFA, CIC
Co-Manager
Pete J. Johnson, CFA
Co-Manager
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.
