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 short- term 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), one of the leading international manufacturers of high-tech filtration solutions for engines. For the past century, despite interest- rate 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 to remain low and the prices of commodities such as fuel and metals are likely to fall. This could give 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.
Small Cap Fund Performance
For the first three quarters of 2014, the Small Cap Fund outperformed its index and peer group. Year-to-date, the Small Cap Fund is down very slightly (- 0.05%), while the S&P Small Cap 600 Index is down 3.72% and the peer group as measured by the Lipper Small-Cap Core Funds Index is down 3.33%. The small cap sector itself declined in the third quarter of 2014 with the S&P Small Cap 600 Index down 6.73%. The Fund held up slightly better in the third quarter, but was still down 5.36% and erased all gains from the first half of the year.
Larger cap stocks as measured by the S&P 500 outperformed small cap stocks by over seven percentage points in the quarter. The good news is that while small cap stocks still trade at a slight premium to large, that premium is now below its long term average. The significance for small cap investors is important. Both the growth rates in revenue and the earnings-per-share (EPS) for small stocks continue to outpace their larger peers despite this premium differential.
Year-to-date, the Fund’s significant overweight relative to the S&P 600 Small Cap Index in stocks in the industrial sector has been a relative drag on performance compared to the index. However, stock selection within industrials helped offset poor overall sector performance. Relative underweights in both the consumer discretionary and financial sectors helped performance as both sectors lagged on a year-to-date basis. More so than sector weights, stock selection continues to have the biggest impact on performance relative to the Fund’s benchmark.
Vasco Data Security (VDSI), a password authentication hardware and software company, continued to lead performance in the quarter and for the year. Through vigorous promotion of its competitive line of data security products, Vasco is making significant headway into the U.S. market. Well publicized data breaches at a growing list of major U.S. corporations is apparently driving consumers to seek out firms like Vasco in their urgency to find better protection for their private data. Apogee (APOG), a commercial glass plating and framing company, has been another strong contributor to performance this year. Currently, Apogee looks ready to benefit from increased demand for commercial construction thanks to a more positive employment outlook and reduced interest in off-shoring American jobs.
Chart Industries (GTLS), which manufactures compressed and liquid natural gas tanks and heat exchangers, has detracted from performance during the third quarter as well as on a year-to-date basis. Longer term, the demand for Chart’s natural gas equipment should increase as significant new natural gas discoveries in the U.S. and overseas will likely keep prices in check relative to oil and diesel alternatives. In the short term, though, the market and infrastructure for these natural gas devices has been slower to develop in the U.S. than hoped. The company’s China-based operations have slowed significantly in keeping with that country’s current economic stumbles.
During the quarter, the Fund added medical device maker Cardiovascular Systems (CSII), one of the few remaining small public medical device companies based in the Twin Cities. The company has a strong position in treating peripheral arterial disease with its proprietary atherectomy equipment. A recent approval in significantly calcified coronary arteries opens up a substantial new market opportunity that the company is working hard to commercialize.
Andrew R. Adams
Lead 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 Small Cap Fund as of 4FQUFNCFS 30, 2014: ALLETE, Inc. 2.50%, Apogee Enterprises, Inc. 3.63%, Buffalo Wild Wings 1.87%, Cardiovascular Systems, Inc. 1.92%, Chart Industries, Inc. 1.68%, Donaldson Company, Inc. 0.00%, Gentherm Inc. 2.71%, G&K Services, Inc., Class A 2.52%, Kodiak Oil & Gas Corp. 1.10%, The Manitowoc Company, Inc. 1.82%, MDU Resources Group, Inc. 3.03%, NVE Corporation 2.74%, Oshkosh Corporation 2.41%, VASCO Data Security International, Inc. 1.90%, Vascular Solutions, Inc. 2.90%, Waddell & Reed Financial, Inc. 0.67%.
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.
Earnings Per Share (EPS) is calculated by taking the total earnings divided by the number of shares outstanding.
Barclays Government/Credit Bond Index. Barclays is composed of high-quality, investment-grade U.S. government and corporate fixed income securities with maturities greater than one year. It is not possible to invest directly in an index.
