Investors facing growing uncertainty in the sixth year of a bull market finally saw the long anticipated correction in the third quarter, with a ten-plus percentage point drop unfolding in one tumultuous week in late August. Though the market recovered in Q4, the last day of trading for the year pushed both the Dow and S&P 500 into slightly negative territory before dividends, the first down market since 2008. (The indices’ total returns for Q4 were positive, including dividends).
In 2015, oil prices fell to their lowest level in more than a decade, the dollar continued to strengthen against other currencies, Europe remained weak and economic growth in China slowed. These factors resulted in persistent underperformance in the Industrial, Energy and Materials sectors. The collapse in oil prices led to a sell off in high yield energy debt, putting fixed income markets on edge. Even in the face of this pressure, the U.S. economy continued its steady improvement with Gross Domestic Product (GDP) growth inching above two percent. Nominal unemployment fell to near pre-recession levels, buoying consumer confidence and spending which drove solid performance in the Consumer Discretionary and Consumer Staples sectors as well as the Information Technology and Telecom sectors. We exited 2015 with signs of a modest recovery in Europe, unprecedented negative interest rates in several industrialized countries and continuing concerns about the impact of slowing growth in China on the global economy. Late in the year, the U.S. Federal Reserve (Fed) increased rates for the first time in a decade, reversing a six year run of near zero interest rates.
Future Outlook
The New Year has started off badly for the stock market. While the Fed communicated the likelihood of a series of rate increases in 2016, that doesn’t seem quite as likely now given concerns over global economic conditions. The U.S. markets have reflected this uncertainty early this year.
The dividend yield is back above the yield on 10 year treasuries, favoring income stocks as an attractive asset class. Small cap stocks are trading in line with large caps on an earnings basis, essentially erasing the historical premium that faster growing small caps typically have enjoyed. This positions them to potentially perform well relative to large caps as they regain that premium. In another historical perspective, Industrials start working when things look most grim for the sector and well ahead of any evidence of improvement. We don’t pretend to know when that turn will happen but, in our pinion, investors get paid for being patient.
2015 was a year of two markets engaged in a tug-of-war, where consumer-facing companies did well while energy, commodities and export-oriented manufacturing companies struggled. The big question for U.S. investors in 2016 is: Who wins this tug-of-war? Will the pressure felt by the industrial sectors overwhelm the economy and push us into a slowdown or will strong job growth, low interest rates and persistently ow oil prices buoy consumer confidence and spending, extending the current cycle? We remain positive, viewing the latter as more likely, with potential upside if some of the current headwinds begin to abate.
Growth Fund Performance Review
The Mairs & Power Growth Fund gained 6.14% in the fourth quarter, and finished down 3.07% for the year compared with the benchmark S&P 500 Total Return (TR) which gained 7.04% for the quarter and 1.38% for the year, and the Dow Jones Industrial Average (DJIA) TR which gained 7.70% for the quarter and 0.21% for the year.
Our multi-cap approach proved a major factor affecting the Growth Fund’s relative performance in 2015 as mid cap and small cap stocks lagged large cap stocks. Because both the DJIA and S&P 500 indices are made up exclusively of large cap stocks, our comparative performance lagged these large cap benchmarks. As patient investors, we remain comfortable with our multi-cap approach which includes a long-term bet on smaller companies that we expect to grow faster than larger companies.
The top contributor to Fund performance in both the fourth quarter and full year was Hormel (HRL) which gained 24.91% and 51.79% respectively. The Fund’s relative performance also benefited from an overweight positon in the Health Care sector, which performed well in both the fourth quarter and the full year. In addition, relative performance benefited from an underweight position in the Energy sector which remained under pressure throughout the year.
Stratasys (SSYS, Financial) and Qualcomm (QCOM, Financial) were among bottom contributors to performance in both the quarter and the year. Stratasys is well positioned in the additive manufacturing space, but that market is currently under pressure as manufacturers are holding back expansion. Qualcomm lost a major customer and has had to negotiate lower prices to Chinese manufacturers. An overweight position and the under performance of certain stocks in the struggling Industrial sector detracted from the Fund’s relative performance for the year. In addition, an extremely narrow group of large cap information technology stocks that we do not hold, Amazon (AMZN, Financial), Alphabet (GOOGL, Financial) and Microsoft (MSFT, Financial), dominated performance in 2015 in the Information Technology and Consumer Discretionary sectors as well as the broader market.
With the S&P 500 price-to-earnings ratio above its long-term average, margins trending down and an expectation for only moderate sales and earnings growth in 2016, the market is not cheap. The equity market is currently being led by a narrow group of stocks showing strong revenue growth. This market has given us the opportunity to build long-term positions in very good companies at attractive valuations. As some investors pay too much for short-term performance, we are trimming selectively in stocks such as Hormel, Toro (TTC, Financial) and Fiserv (FISV, Financial). At the same time we are adding to positions in quality names, especially in the beaten down Industrial sector. One such stock we have added is Proto Labs (PRLB, Financial) which we feel is well positioned in direct digital manufacturing.
One of our portfolio companies, Fastenal (FAST, Financial), will likely be an early indicator of improving conditions in the Industrial sector. Fastenal competes in the highly fragmented industrial distribution market, serving customers in manufacturing and non-residential construction industries. Because of weakness in manufacturing, the stock declined 14% in 2015. The company is not standing flat-footed, however. Fastenal continues to invest in its business in order to strengthen its durable competitive advantage, and we like that. With more than 2,600 stores (four times as many as the next largest competitor), the company enjoys broad market coverage as it takes share from smaller regional players. Fastenal’s product breadth, market penetration and in-house distribution capabilities provide both cost and pricing leverage, delivering above industry average margins. In addition, with more than 54,000 on-site industrial vending machines and plans to aggressively add to this network in 2016, Fastenal is able to grow incremental revenue while building “sticky” customer relationships. Earnings have grown 22% and the dividend 23% annually over the last five years. While not classically cheap, the stock is nevertheless very inexpensive relative to intrinsic value, providing an opportunity to add selectively to our position. When the sector begins to recover, we believe that Fastenal’s strength and our patience will reward investors.
Mark L. Henneman
Lead Manager
Andrew R. Adams
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 Growth Fund as of December 31, 2015: Alphabet Inc Class C 0.00%, Amazon.com, Inc. 0.00%, Baxter International Inc. 1.42%, CH Robinson Worldwide, Inc 2.17%, Cray Inc. 1.45%, Donaldson Co., Inc. 2.65%, Ecolab, Inc. 4.76%, Emerson Electric Co. 2.01%, Fastenal 1.55%, Fiserv, Inc. 1.99%, Hormel Foods 2.52%, General Electric Co. 1.77%, Medtronic, Inc. 3.82%, Microsoft Corporation 0.00%, Pentair Ltd., 2.15%, Principal Financial Group 2.04%, Proto Labs 0.25%, Qualcomm 1.23%, Schlumberger Ltd., 2.65%, Stratasys 0.60%, St. Jude Medical, Inc. 2.60%, Target Corporation 2.72%, Toro Co. 2.89%, Valspar Corp. 3.82%.
Price-to-earnings Ratio is the ratio of a company’s share price to its per-share earnings.
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.
