To Our Shareholders: December 31, 2016
The Growth Fund finished the year well ahead of its benchmark index and peer group, gaining 15.38% compared to 11.96% for the S&P 500 Total Return (TR) benchmark and 12.27% for the Lipper Multi Cap Core Funds Index of peers, respectively. For the fourth quarter the Fund gained 2.54%, compared with 3.82% for the S&P 500 Total Return (TR) and 3.81% for the Lipper Index.
Stock selection drove portfolio performance in 2016, with acquisitions, exposure to industrials and our multi-cap approach being the most important factors. The announced purchases of Valspar (VAL, Financial) by Sherwin Williams (SHW, Financial), St. Jude (STJ, Financial) by Abbott Labs (ABT, Financial) and G&K Services (GK, Financial) by Cintas (CTAS, Financial) helped performance early in the year and we are working hard to find replacements for these three very fine companies. Our exposure to industrial stocks, which had lagged significantly in 2014 and 2015, paid off early in the year as the market realized that the sector had become too cheap. Portfolios also benefited from our multi-cap strategy where several small and mid-cap stocks, such as Donaldson (DCI, Financial), Toro (TTC, Financial), and Badger Meter (BMI, Financial), were strong performers.
The market rally in the second half of the year, and particularly at year-end following the election, was driven by strong performance in the financial sector based on a rising interest rate environment and expectations that the new administration and Congress will enact more favorable tax and regulatory policies. Financial holdings in the portfolio benefited but the Fund did not fully participate as more defensive health care and consumer stocks in particular were weak. We still like the companies we hold in these overlooked sectors and view the recent weakness as an opportunity to selectively add new names and increase existing positions.
Speaking of the financial sector, U.S. Bank (USB, Financial) was a top contributor to performance in both the fourth quarter and the full year (the Fund’s 6th top performer year-to-date) and is our largest holding. While valuations among financial stocks, including USB, are at the high end of their trading range, we remain comfortable with our position. The bank is well run and consistently posts lower (better) efficiency ratios and its return on assets and return on equity are leading among its peers. While a large multi-state bank and one of the largest in the U.S., it escapes the most intensive regulatory microscope the very largest banks of over $750 billion in assets operate under. In addition, we believe U.S. Bank is very well positioned under several different economic scenarios. If the expectations for lower corporate taxes, a lighter regulatory touch and a rising and steepening yield curve bear out as the market expects, the bank will benefit. But given its operating strengths and solid management, even if the most optimistic scenario does not pan out we believe the bank will perform well.
Our long-term investment approach allows us to get to know management teams and observe closely how they build on opportunities and face challenges under a variety of conditions. Toro (TTC, Financial) is one example. The stock was a top performer in both the quarter and the year. While Toro is currently “priced for perfection,” we still like the stock but are using the current rich valuation as an opportunity to lighten up and deploy the profits where we find other opportunities. C.E.O. Mike Hoffman, who retired in 2016, and his executive team have executed extraordinarily well over the years. Another exemplary C.E.O. who also retired this year is Jeff Ettinger at Hormel (HRL, Financial), another long-term portfolio holding. Both executives stepped into their respective C.E.O. roles about the same time and deserve credit for building excellent companies, strong management teams and enviable records. Their shareholders have been amply rewarded by their stewardship. Toro under Mike Hoffman’s tenure has averaged 14.94% annual return and Hormel under Jeff Ettinger has averaged 17.47%, compared with the S&P 500 which averaged 7.43% over the same period. We wish them both well.
Given the relatively small number of technology companies in our region, it is one sector for which we look at a broader geographic area to find exposure in the sector. One new name we added in the technology sector in 2016 is Alphabet (GOOG), the holding company parent of Google, the leader in on-line search. While the company is headquartered outside of the Upper Midwest where many of our investments are located, it is an example of a stock that fits our investment approach in most other ways. The company enjoys above-average growth, maintains a durable competitive advantage globally and is attractively valued.
We also exited some positions in 2016. When MTS Systems (MTSC) announced the acquisition of sensor maker PCB Group for $580 million, we decided it was time to exit the stock. In addition to our concerns about execution of the current business, we did not believe the strategy behind the acquisition was sound. It added to the company’s existing sensor business, where the company does not enjoy a strong competitive advantage, it diluted MTS’ durable competitive advantage in its core test business, and added substantial leverage to the balance sheet.
Mark L. Henneman Andrew R. Adams
Lead Manager 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.