Third Quarter Market Overview- September 30, 2019
In August we noticed our local home improvement store had stocked the aisles with Halloween decorations. This early start to the end of October holiday reminds us that the trick-or-treat ritual is now second only to Christmas as a crucial selling season for U.S. retailers.
More to the point for investors, it underlines the importance of consumer spending which makes up nearly 70% of the U.S. economy. And it also reminds us that the stock market is betting on the consumer to continue pulling the economy forward.
The S&P 500 Total Return (TR) Index was up 1.70% and 20.55% for the third quarter and the first nine months of 2019, respectively. The Dow Jones Industrial Average TR Index was up 1.83% and 17.51% and the Bloomberg Barclays U.S. Government/Credit Bond Index return was 2.64% and 9.72% over the same periods.
The market is facing some challenges. The tax cut induced earnings boost last year has made for difficult comparisons this year. In addition, tariffs imposed by the Trump administration combined with softness in manufacturing are having a noticeable impact on corporate earnings, putting companies “between a rock and a hard place” as they absorb higher costs but have, for the most part, been reluctant to pass those costs on to their customers in the way of higher prices. The result is revenue growth without earnings growth with stocks in the Industrial and Manufacturing sectors particularly hard hit.
In the second quarter, earnings for the S&P 500 declined 0.4% following a slight decline in the first quarter. This marks the first time since the first and second quarter of 2016 that we’ve seen year-over-year earnings declines two quarters in a row. We are writing this letter before third quarter earnings are all in, but as we saw in the second quarter, the deceleration in economic growth continues and earnings expectations continue to ratchet downward with expectations for lazy, slow growth as we end the year. Valuations (e.g.: dividend yield, price to cash flow, price to earnings ratios) while down from recent highs, remain slightly above their long-term averages. Given low interest rates, this seems warranted.
Future Outlook
As we move into the last quarter of the year, we continue to see mixed signals on the economy.
For example, the ISM (Institute for Supply Management) Manufacturing Index has fallen sharply and, for the first time since 2015, now stands below 50%, indicating contraction in the manufacturing sector. Expectations of continued trade conflicts and cutbacks in capital spending will likely continue to put pressure on the global economy as activity worldwide slows down. However, manufacturing represents only about 10% of U.S. GDP (gross domestic product) and less than 10% of total employment, so even if we have a recession in the manufacturing sector, it may not necessarily bleed over into the wider economy. And the ISM Services Index remains above 50%, indicating potential continued growth for the services sector, which makes up a much larger portion of the economy. While the Consumer Confidence Index declined sharply in September following a slight decline in August, retail sales remained healthy, however, and have continued to grow. Wages continued to move higher, unemployment remained low and job growth was generally healthy. The housing market continued to improve, supported by lower mortgage rates.
After raising interest rates four times in 2018, the Federal Reserve (FED) quickly reversed course with interest rate cuts in both July and September. The central bank is not signaling any future cuts, instead, stating that from here it will be data driven. Even so, investors expect up to four rate cuts over the next twelve months and are counting on the FED to keep the current expansion alive.
Performance Review
The Mairs & Power Growth Fund gained 1.72% for the third quarter and is up 18.17% for the nine months year-to-date. The S&P 500 Total Return (TR) benchmark is up 1.70% and 20.55% while the Lipper Multi-Cap Core Funds Index is up 0.49% and 18.74% for the third quarter and year-to-date respectively. For the first time in recent memory value stocks outperformed growth stocks in the third quarter, which benefited the Fund and which we view as a positive sign.
The single largest factor in the Fund’s relative underperformance so far this year has been 3M Company (MMM, Financial), one of the larger positions in the Fund. The global industrial giant has struggled this year as we’ve discussed in the past, hurt by slowing overseas economies. Relative performance was helped by stock selection in the Materials sector, where EcoLab (ECL, Financial) was the top contributor year-to-date. Our underweight position in the struggling Energy sector has also been a positive factor in relative performance.
We maintain an overweight position in the Health Care sector which has been a negative factor in relative performance this year, more than offset, however, by stock selection within the sector. Public discussion of a single payer, Medicare-for-all system and price controls on prescription drugs have created what we perceive as mispricing of several Health Care sector stocks. While the debate is loud, we think any significant change is unlikely in the current divided political environment and remain positive on the sector long term.
For example, we saw a strong run up in Medtronic (MDT, Financial), as investors viewed the medical device giant as a “safe haven” in the current debate. That provided us the opportunity to take profits as the stock became fully valued. Conversely, we’ve seen a contraction of valuations among insurers and pharmaceuticals, despite having some of the strongest fundamentals of any sector based on demographic trends. The pharmaceutical giant Pfizer (PFE, Financial) is a company that has been oversold in this current market and we view this stock as attractive at the current valuation.
Another prominent Health Care stock, Minnesota-based UnitedHealth Group (UNH, Financial), was particularly hard hit, also presenting us with a buying opportunity. UnitedHealth is the largest health insurance carrier in the U.S. with a growing market share in both private insurance and Medicare Advantage plans. It also has diversified by acquiring a prescription benefits management organization and has opened urgent care centers that the company believes it can operate with greater efficiency than the competition. A driver of future growth is the Optum division, which now represents 40% of operating income. Optum has invested in data analytic technologies to harness its vast storehouse of claims experience, prescription usage, clinical outcomes and costs to help doctors, hospitals, and health science companies implement the most effective and efficient patient care decisions and product development strategies. We remain excited about the company as UnitedHealth is strategically well positioned to be part of the solution to revamping the nation’s health care system, whatever the politics of the debate.
Another name we added to in the quarter was Tennant Co. (TNC, Financial), the Minneapolis-based manufacturer of commercial and industrial floor scrubbers and sweepers. It is a company we have watched for years as they invested to bring high tech solutions to cleaning floors by adding telemetry and robotics. Labor is about 70% of the cost of floor cleaning and maintenance. With on-board telemetry, operators can track expensive equipment to monitor both usage and maintenance. Recently introduced autonomous machines can run without an on-board operator, promising large cost savings and generating a lot of buzz in the market. Until recently, however, buzz had not translated into adoption. That changed when the retailing giant Walmart (WMT, Financial) made a significant commitment to roll out autonomous cleaner/sweepers to 1,400 stores. We think this new line will be a significant driver of growth over the coming decade.
Digi International Inc. (DGII, Financial) is a new name to the Fund this year. The Twin Cities-based company holds a solid position in temperature monitoring systems for large pharmacy chains such as CVS Health Corp (CVS, Financial), Walgreens Boots Alliance (WBA, Financial) and Walmart. It is also diversifying by adding other features such as pressure, shock and humidity monitoring in a command center system, where automated real time environmental monitoring not only fulfills a critical need but also replaces less efficient clipboardtoting employees. Digi is moving into grocery stores and restaurants where automated systems have only achieved 10% to 15% penetration. The talented leadership team is transforming the company’s business model from that of a component supplier into a recurring and predictable revenue and profit generator. Digi is a little company in our backyard that reminds us of the saying: “from little acorns a mighty oak will grow.”
As the above examples show, while valuations in the overall market remain slightly above the longterm average, however we believe that there are areas of opportunity for what we hope are solid, long term investments. As a reminder, we expect to report a 2019 capital gains estimate in mid-November.
Andrew R. Adams, CFA, CIC
Lead Manager
Mark L. Henneman, CFA, CIC
Co-Manager
Pete J. Johnson, CFA
Co-Manager
This commentary includes forward-looking statements such as economic predictions and portfolio manager opinions. The statements are subject to change at any time based on market and other conditions. No predictions, forecasts, outlooks, expectations or beliefs are guaranteed.
