With ISIS on the march, the Eurozone’s fits and starts and a potential U.S. confrontation with Russia in the air, third quarter performance could have been expected to take a time-out from this year’s domestic advances. Instead, the Standard & Poor’s Total Return Index rose 1.13% for the third quarter gaining 8.34% year-to-date. Then, defying the consensus of market analysts who thought rates would go up and bond prices would decline, the Barclay’s Government/Credit Index also delivered a slight gain of 0.17% for the period with a 4.12% advance year-to-date.
While inflation conveniently remained in check for the quarter, the low rate environment continued to bring inexpensive credit – and liquidity – into the market. This contributed to the S&P 500 Index’s extended rise to a near three-fold increase over the span of the last 5 1/2 years.
The U.S. economy continued to lead the world on a relative basis for the period, as a revised number for domestic Gross Domestic Product (GDP) brought second quarter growth up to 4.6% on an annualized basis. Overseas, geopolitical unrest and uncertainty over the impact of foreign Central Bank interventions added a touch of volatility to the bond and currency markets.
At this point in a maturing business cycle, we find the market slowing down, leveling off a bit, yet still with the ability to surprise on the upside. Our commitment to identifying companies that demonstrate consistent, above-average growth over the long-term is critical. Pinpointing such companies during periods of moderate-to-flat growth prospects, especially after a lengthy run-up in prices, can be especially challenging. A pattern of divergence seeps in between what a company is actually earning and how the market perceives that company’s valuation. A steady rise in shortterm equity prices can obscure the fact that one of the truest measures of a company’s valuation, its price-to-earnings ratio (P/E), needs to be viewed in a long-term context for this metric to be accurate – not just for the period of the market advance.
A case in point is portfolio holding Donaldson & Co., Inc. (DCI, Financial), one of the leading international manufacturers of high-tech filtration solutions for engines. For the past century, despite interestrate shocks, stock market corrections and world wars, Donaldson has prospered and grown. Faced with a global slowdown in construction projects, Donaldson’s sales growth slowed and its stock price declined – while earnings held their ground and even increased slightly. To Mairs & Power, nothing fundamental changed for Donaldson. Our assessment of the firm’s long-term growth prospects is still supported by the quantitative data and our qualitative findings that matter most in our selection process. Rather, the impact of short-term, negative market perceptions on consistently growing companies like Donaldson offers us an incentive to add to a position we already like at an attractive price.
Future Outlook
While the fundamentals of the economy and markets remain strong heading into 2015, we have become somewhat more cautious given our sense that valuations may be somewhat elevated. It’s a fact that a moderately overvalued market can still deliver strong total returns for years. Normal valuation levels can fluctuate significantly over time, and there’s no guarantee that the past will be an accurate gauge of the future. Over a long enough investment time horizon, common stocks are almost certain to outperform bonds and cash, especially considering current interest rates.
Meanwhile, the European Central Bank and Bank of Japan, hampered by slow growth, are getting ready to loosen up their own credit policies and turn on the tap to get overseas liquidity flowing. If inflation remains tame, as many investors expect, Treasury yields are likely remain low and the prices of commodities such as fuel and metals are likely to fall. This couldgive consumer spending, economic growth and many asset prices a welcome shot in the arm. As we proceed through the final quarter of 2014, we will continue to do what we do best: advocate for patience and invest in companies, not markets. The advantages of investing in well-diversified portfolios, rebalanced regularly, provide one of the better, more reliable routes for meeting long-term goals regardless of the quarter. By focusing our attention on companies and how they perform, we remain confident in our ability to identify, over the course of a full market cycle, those profitable, well-managed firms likely to outperform their competitors. When the book for this business cycle is written, we are confident that our selections will have been shown to have delivered an attractive level of risk-adjusted return to our shareholders. Meanwhile, the impact of short-term, negative market perceptions on consistently growing companies, continues to offer us incentives to add to positions we already like at prices that are even better.
Balanced Fund Performance
For the third quarter ending September 30, 2014, The Mairs & Power Balanced Fund declined 1.73%; underperforming its benchmark composite index (60% S&P 500 Stock Index and 40% Barclays Capital Government/ Credit Bond Index), which gained 0.76%. For the nine months ending September 30, 2014 the Mairs & Power Balanced Fund lagged its benchmark 4.08% to 6.70%.
The recent period proved to be a strangely irresolute, directionless time for the bond market. Both 10-year and 30-year Treasuries saw their yields drop, while a slight increase in yield took place on the shorter-duration portion of the yield curve. The fixed-income markets retreated somewhat over the recent period as currency swings in particular contributed to volatility. While our bond selections proved generally flat for the quarter, the most dramatic impact appeared in the high yield sector where a sudden “risk off” sentiment prevailed and pushed high yield bond prices downward. Still, the Fund’s portfolio wasn’t overly affected by events during the quarter.
From a global macro-economic perspective, investors may be nearing the end of the road in their quest to pursue higher yields in this environment. The pressure to keep rates low was given a boost in the third quarter as the contours of the asset purchase programs contemplated by the overseas Central Banks became more clear. Loosening of credit overseas is certain to impact our Treasury rates stateside as well. The pressure to keep rates low is likely to continue both at home and abroad.
Equity markets, growing more slowly in the third quarter, showed they are likely to continue outperforming bonds as yields appear too low and credit spreads too tight to attract much investor interest. With Europe’s experiment in loosening monetary policy just getting underway, confidence in equities could possibly strengthen.
While equity valuations became more attractive in the third quarter, our concerns about the economy have diminished a bit. Unemployment fell and finished at 5.9% by quarter-end. Mixed income and earnings information showed some improvement alongside an increase in consumer spending. The employment participation rate, as well as pressures to keep wages low, though, are still a concern for us and might impede growth.
The Fund’s selections resulting in overweight positions in energy and industrials placed a drag on performance, too. In the industrials camp, Graco (GGG, Financial) was among the portfolio’s below-average performers – even though it managed to deliver above-average growth for the year. Supplying technology and expertise for the management of fluids in both industrial and commercial settings, Graco has a global client base grounded in manufacturing, construction and maintenance. With a stock price that appeared overvalued in 2013, the company now looks much more attractive after the market knocked out some of its excess in the recent period. Despite trimming it somewhat last quarter, Graco still represents a substantial holding for the Fund.
The Fund’s holdings in Conoco (COP, Financial), Exxon (XOM, Financial) and Schlumberger (SLB, Financial) were all negatively impacted by the decline in oil during the quarter, as was our position in MDU Resources, a utility with an exposure to declining fuel prices similar to mainstream energy companies.
William B. Frels
Lead Manager
Ronald L. Kaliebe
Co-Manager
The Fund’s 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 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 Balanced Fund as of September 30, 2014: ConocoPhilips 1.78%, Donaldson Company, Inc. 0.00%, Eli Lilly & Co. 0.72%, Emerson Electric Company 2.39%, Exxon Mobil Corp. 2.38%, Graco, Inc. 0.88%, H.B. Fuller Co. 0.93%, Home Depot, Inc. 1.02%, Hormel Foods Corporation 0.93, International Business Machines Corporation 1.69%, Johnson & Johnson 1.51%, JPMorgan Chase & Co. 1.24%, MDU Resources Group 0.86%, Pentair Ltd. 1.16%, Principal Financial Group 1.90%, Schlumberger Ltd. 2.39%, Target Corporation 2.17%, United Parcel Service, Inc. Class B 2.88%, Wells Fargo & Company 1.22%.
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. Gross Domestic Product (GDP) The monetary value of all the finished goods and services produced within a country’s borders in a specific time period, though GDP is usually calculated on an annual basis. Price to Earnings (P/E) Ratio is a common tool for comparing the prices of different common stocks and is calculated by divinding the current market price of a stock by the earnings per share. The P/E ratio is not a measure of future performance or growth.
