Firm Update | Remembering Allen Steinkopf
Allen Steinkopf, our friend, partner, and colleague, passed away on December 21, 2022. He played a large role in the success of Mairs & Power during his nine years with the firm. Allen spent time leading the Mairs & Power Small Cap Fund (MSCFX), managing advisory accounts, and providing insightful opinions on companies and investments.
Allen cared deeply about research, managing investments, and learning about the companies in which we invest. He also made sure his clients knew they were valued and appreciated. He brought so much more than his keen intellect and thoughtful analysis. Allen was passionate about coaching and mentoring younger staff to enable them to believe in themselves. He touched people’s hearts and changed their lives. He will be greatly missed by all of us who had the privilege of knowing him.
Market Overview | Fourth Quarter 2022
We don’t need to tell you that the market had a rough year in 2022. It recovered some in the fourth quarter with a total return (TR) of 7.56% for the S&P 500, 16.01% for the Dow Jones Industrial Average (TR), and 1.80% for the Bloomberg U.S. Government/Credit Bond Index. However, for the full year, those indexes dropped 18.11%, 6.86%, and 13.58%, respectively.
Interest rate increases were a major factor in the market’s weak performance in 2022. The Federal Reserve (Fed) has been taking an aggressive approach in battling inflation. Last year, the Fed raised interest rates seven times, including an increase of 50 basis points at its December meeting. The federal funds rate is now at 4.5%, up from near zero a year ago, and the central bank has signaled that it will keep rates higher for longer.
The Fed’s interest rate increases have pushed mortgage rates above 6%, compared to 3% at the end of 2021. As a result, the housing market, one of the bellwether measures of economic health, has weakened significantly. Sales of existing homes declined 7.7% in November from the previous month, putting them 40% below the peak in early 2021. That marked 10 months of declines, the longest such streak since 1999.
But despite inflation, the softening housing market, and rapidly climbing interest rates, the U.S. economy has remained remarkably resilient. Just before Christmas, the U.S. Commerce Department released third quarter GDP numbers, which showed growth of 3.2% at an annualized rate, beating consensus expectations of 2.9%. Consumers’ financial health also remains fairly positive. We are seeing some increases in default rates, though from historically low levels. The savings rate declined in 2022 to a meager 2%, but the Conference Board, a private research group that tracks consumer confidence, reported that its index jumped from 101.4 in November to 108.3 in December. That’s the highest it’s been since April. In addition, recently released data from Mastercard shows that retail sales during the holiday season (Nov. 1 to Dec. 24) rose a festive 7.6% over 2021. One key reason for continued consumer confidence is the continued strength of the labor market. In December, a better-than-expected 223,00 jobs were created, and the unemployment rate declined to 3.5%.
Future Outlook
However, the housing market’s flattening is one sign that we’re likely to experience a recession in 2023. Another omen is the recent data from the Purchasing Managers’ Index (PMI). In December, the PMI for the services sector dropped to 44.4, versus 46.2 in November. In the manufacturing sector, the PMI was 46.2, down from 47.7 from the previous month, and the composite PMI, which measures all sectors, was 44.6, a decrease from November’s 46.4. Any number below 50 indicates contraction in that part of the economy.
Despite these warning signs, we’re convinced that the labor market will remain tight, thanks to an aging population, accelerated retirements, and lower immigration, among other factors. While there have been some signs of softening, businesses remain desperate for help. Job openings remain at a historically high 10.3 million vacancies. That tightness will likely remain a longer-term challenge for companies in managing labor costs and also presents a challenge to the Fed as it pursues its goal of 2% inflation. Lower unemployment typically results in higher wages, and that means higher prices. There was some helpful news on that front at the end of 2022: Wage growth in December slowed to 0.3% month over month and 4.6% versus a year ago.
There are other signs that inflation, while still high, has begun to come off the boil. Goods inflation, in particular, has rolled over the past few months. While services inflation is proving stickier, we expect that by the middle of this year, falling home prices will put downward pressure there as well. As inflation recedes, so should the upward pressure on interest rates. An end to rate hikes can begin to lay the foundation for renewed economic growth and a better stock market in the back half of 2023. In the meantime, however, the Fed will continue to raise rates. We believe that we’re returning to the “old normal” level of interest rates that were common before the Great Recession of 2008-2009.
The tight labor situation, along with the strength of the banking sector and consumer spending, are key reasons why we anticipate that a 2023 recession could be fairly mild.
As for the market, it’s likely that economic weakness will result in lower earnings per share this year. In 2022, the market fell much more than earnings, which we estimate grew 5% for the year. Our expectation is that a decline in earnings in 2023 will be relatively modest. Much of last year’s market tumble was due to a contraction in valuations, and that’s not necessarily a bad thing. In fact, we believe that this contraction should result in a healthier foundation for the market going forward. Over the long term, stocks and earnings travel in tandem.
In 2021, stocks got ahead of themselves. Now, with the market having pulled back, we’re finding more opportunities for good long-term investments at reasonable valuations.
Performance Review
The Mairs & Power Growth Fund lagged the S&P 500 TR Index for the year. Absolute performance of the Fund was down 21.07% for the year while the index was down 18.11%. The Fund also underperformed its peer group, as measured by the Morningstar Large Blend Category Index, which was down 16.94% for the year.
Stock selection was the primary driver of underperformance as sector selection was a positive relative contributor for the year. Not holding stocks in the Energy sector, which was the top performing sector in 2022, was a significant drag on relative performance. As the post-Covid economy snapped back, oil prices spiked and drove the Energy sector to outperform. But this underperformance due to under allocation in Energy shares was more than offset by positive contributions from underweighting the Consumer Discretionary sector and overweighting the Healthcare and Industrial sectors. Consumer Discretionary stocks struggled to overcome macro -economic concerns, and at the same time, Healthcare benefited as it was seen as a haven from a slowing economy.
Regarding stock selection, the largest detractors from Fund performance were not concentrated in a particular industry. They included Alphabet (formerly Google), Ecolab, and Bio-Techne.
Alphabet (GOOGL, Financial) finished down 38.67% for the year. While this was not out of line with some of the other big tech communication services stocks, it still was a significant drag on Fund performance. Fundamental operations at Alphabet slowed somewhat throughout the year, but the bigger headwind appeared to be a reset in the valuations investors were willing to pay for “growthier” stocks. Alphabet started the year at a 20% premium to what was being paid for earnings of the average company in the S&P 500 and ended very close to market multiple.
Bio-Techne (TECH, Financial) also suffered from a shift away from growth stocks by investors. Despite the company’s fundamental outlook improving on a number of future growth initiatives, the stock still finished down 35.70% for the year. The Minnesota company’s investments in commercial scale biologic manufacturing and liquid biopsies, as well as ongoing investment in digital connections with customers, positions it well for the long term. A recent significant increase in the National Institute of Health budget for 2023 should also benefit the company in the near term. The Fund has added to the position on the pullback.
Another significant detractor from relative performance was Ecolab (ECL, Financial). The Minnesota-based company was down 37.11% for the year. Ecolab suffered from higher input costs due to higher energy prices in 2022. While the company was able to make some positive changes to its supply chain and do some reformulation work, it was not able to overcome the inflationary pressures and, as a result, its margins have suffered. Currency and the European economy have weighed on results as well. Ecolab is a core holding within the Growth Fund, but we are waiting for improvement in organic volume-driven growth before adding to the position.
Toro (TTC, Financial) and UnitedHealth Group (UNH, Financial) were two of the largest positive contributors to relative performance for the year. Both Minnesota-based companies were up on an absolute basis, with Toro up 14.87% for the year and UnitedHealth up 6.95%. Toro stock continued its long-term outperformance in 2022 as the company’s investment in new technologies continues to payoff. The company is seeing good opportunities in both its DitchWitch acquisition, which will benefit from increased infrastructure spending, as well as its internal investment in battery powered tools and equipment.
UnitedHealth performed well as the company’s market-leading position in managed care and healthcare technology have provided the scale to outmaneuver smaller competitors. At the same time, its recent investments in OptumHealth, its own health services offering, have paid off handsomely in terms of both revenue growth and profitability.
Both Toro and UnitedHealth remain core holdings at Mairs & Power, but the Fund has trimmed both stocks in 2022 on their positive performance and resultant extended valuations.
It was a disappointing year for the Fund and while a difficult inflationary environment was anticipated, the scale and competitive positions of Fund holdings were expected to put those companies and their stocks in a good position to weather the inflationary storm. That desire to hold companies with durable competitive positions also steered us to companies that were gaining market share and outgrowing the market. Unfortunately, as these “growthier” stocks fell out of favor in 2022, the result was Fund underperformance. However, this underperformance in stock price, but not necessarily fundamental operations, has resulted in some attractive valuations and investment opportunities. While it is difficult to gauge when the Fed will get inflation under control and investors will become more optimistic about the economy and the stock market, the Fund should be well positioned to take advantage of that change.
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 0.61%.
