Market Overview | Third Quarter 2021
All this year we’ve been talking about why we’re upbeat about the economy, earnings, and the market. This past quarter’s market and economic performance hasn’t dimmed our optimism.
In particular, there’s the stubborn tenacity of the coronavirus. As the vaccines rolled out earlier this year and proved their efficacy, it appeared that the economy would quickly reopen as people felt liberated to return to the office, go out on the town, and dust off their travel plans. Unfortunately, all of this activity has slowed again thanks to the Delta variant, which has caused some people to dial back their entertainment and travel plans. The Delta variant was also one of the chief culprits behind August’s softer-than-expected employment numbers with particular weakness in the restaurant and retail sectors. Inflation and supply shortages have also caused some concern.
It’s not surprising then that the markets posted a lackluster quarter. That said, year-to-date performance remains very strong. The S&P 500 Total Return (TR) Index rose 0.58% in the third quarter of 2021, while the Dow Jones Industrial Average TR Index declined 1.46%. Year to date, the S&P 500 TR Index is up 15.92% and the DJIA TR Index has gained 12.12%. In the fixed-income market, the Bloomberg Government/Credit Bond Index rose 0.04% in the third quarter, though it is down 1.93% so far this year.
Future Outlook
Most economic indicators point to continued solid growth. Both the manufacturing and service PMIs (Purchasing Managers Indices) have remained at high levels, and several regional indices moved up last month from already high levels. The housing market remains very healthy, and consumer and small business confidence is high. Despite softer job growth in August, job openings remain at a record high level, and they’re expected to stay high for some time.
But what about inflation? Though the rate of inflation slowed in August, businesses and consumers are experiencing increased prices as demand has risen and supply struggles to keep up. Labor shortages have pushed wages higher, resulting in higher prices as businesses try to offset increased costs. Yet the Federal Reserve (Fed) has consistently used the term “transitory” to describe the current inflationary environment. In fact, August inflation numbers were below what most economists expected. This was an early indication that the Fed might be right. What’s more, prices have eased in some previously hot markets like airfare, housing, and used cars.
In any case, the bond and stock markets clearly believe that higher inflation is transitory. Weakening or not, inflation certainly isn’t hurting corporate earnings. Third-quarter S&P earnings are expected to be up 25% year-over-year, and it won’t be a shock if third-quarter growth ends up higher than that. The full year 2021 consensus estimate for S&P 500 earnings calls for growth of 44% versus 2020, 23% above the previous earnings peak in 2019. While earnings growth will likely slow back toward more sustainable levels, the outlook remains good. We expect 10% growth in 2022. Strong earnings growth has brought the market’s valuation lower. Currently, the price/earnings ratio for the S&P 500 based on the 2022 earnings estimate, is 20.2, a level that, given low interest rates, seems reasonable.
Though the markets posted a lackluster performance in the third quarter, the year-to-date numbers remain strong, and they’re expected to stay that way for the rest of 2021. We also believe interest rates will remain low, although there are hints that the Fed will raise rates sometime in 2022.
Here’s another reason for optimism: The federal Infrastructure Investment and Jobs Act, better known as the Infrastructure Bill. Assuming the bill ultimately passes, it will pump roughly $1 trillion into the nation’s roads, bridges, broadband networks, and power plants. It’s true that the bill’s effects will not be instantaneous. Still, it will help to improve the structural and economic foundations we all rely on, while adding another increment to economic growth. The bill should also benefit Minnesota’s Industrial companies, many of which we hold in the Fund.
Performance Review
In the third quarter, the Mairs & Power Growth Fund slid very slightly, losing 0.03%. During the same period, the S&P 500 Total Return (TR) benchmark rose .58%, and the Morningstar Large Blend Peer Group lost .24%. Year to date, the Fund is up 16.70% while its primary benchmark has gained 15.92%.
So far in 2021, stock selection has been a bigger driver of relative performance than sector allocation. Underweights in the underperforming Utilities, Consumer Discretionary, and Consumer Staples sectors all helped relative performance, but not enough to offset other sector headwinds. Namely the lack of exposure to the Energy sector, which rendered the Fund unable to benefit from the rally in oil prices.
The Fund’s overweight in Industrials also has weighed on relative returns with both the sector and our Industrial holdings underperforming. Industrials were hit hard in the third quarter due to a myriad of supply chain challenges. Facing wide-scale material and labor shortages as well as transportation delays, businesses have been unable to meet customer demand. Input prices have also skyrocketed as companies scramble for limited resources. For instance, steel prices have climbed more than 200% over the past year. While the surge in raw materials will likely crimp margins in the short term, we firmly believe that our companies will eventually be able to push through pricing to restore their profitability.
The top stock contributors to the Fund’s relative performance so far this year have been Alphabet (GOOG, Financial) and Bio-Techne (TECH, Financial). Since we’ve highlighted these companies in previous letters, we believe a couple of other top contributors deserve mention.
One is Chicago-based Motorola Solutions (MSI, Financial), which provides integrated communication systems to emergency responders. It has combined and simplified the hardware and software used by dispatchers to provide a more efficient solution than what has historically been available. The stock has benefited recently as orders for its cloud-based software offering have accelerated. In addition, the finances of many of the company’s municipal customers have improved.
Minnesota-based industrial adhesives manufacturer H.B. Fuller (FUL, Financial) has been another strong contributor to year-to-date performance. Over the past several years, management has built out an impressive new business line — Engineering Adhesives. These high-performance products have bolstered the company’s competitive advantage and driven outsized organic growth thanks to the segment’s exposure to several attractive end markets including: clean energy, electronics, and transportation. Fuller’s management executed extremely well during the pandemic, and the company has recently posted strong results despite severe supply chain constraints.
Among the biggest detractors to Fund performance this year is Hormel (HRL, Financial), which like many Consumer Staple companies has struggled to keep up with this year’s strong market snapback. This wasn’t unexpected, and it has given us the opportunity to add to our position. Qualcomm (QCOM, Financial) also continues to be a significant drag on the Fund’s relative performance. The semiconductor industry supply constraints that hurt the company earlier this year haven’t abated, and in some cases, they’ve gotten worse. Over time, we believe that investments are being made to improve the industry supply chain, and we’re confident that Qualcomm’s longer-term growth will return.
The Fund invests across the entire market cap spectrum, and we continue to find compelling opportunities in the small-cap space. In the third quarter, we added Minneapolis-based bed manufacturer Sleep Number (SNBR, Financial) to the portfolio. While the company operates in a fiercely competitive industry, we believe its unique technology and its retail experience give Sleep Number a leg up on their competition. Its partnership with the Mayo Clinic should help drive further innovation.
Each year seems to bring with it its own unique set of challenges and this year has been no different. While it’s important to keep a watchful eye on these temporary headwinds—inflation, supply chain disruptions, labor shortages, and the Delta variant, we remain committed to our long-term focus that has served us well decade after decade. With this viewpoint, temporary headwinds inevitably provide opportunities, and even now, we continue to add to certain holdings at compelling valuations.
As a reminder: we expect to report a 2021 capital gains estimate in mid-November, please check our website then for the estimate.
Andrew R. Adams, CFA, CIC
Lead Manager
Pete J. Johnson, CFA
Co-Manager
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 investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance of the Fund 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%.
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.
