Mairs & Power Small Cap Fund Q4 2014 Commentary

Investors could be forgiven if they looked back on 2014 as a year of mixed signals. Concerns about slowing growth in China, a possible recession across Europe and increasing tensions with Russia over their aggressive moves against Ukraine all contributed to market uncertainty. On the other hand, earnings continued to exceed expectations and the rapid decline in energy prices put a tailwind behind the U.S. economy, rewarding investors with the sixth year in a row of positive returns and the longest run since the bull market of the 1990s.

With crude oil down more than 40 percent for 2014 (and continuing to fall in the first weeks of the New Year), we believe this will be the biggest driver of the U.S. markets and economy over the next several quarters. GDP growth in Q3 was revised upward to a healthy five percent annual rate, even before the stimulus of lower gas prices had fully kicked in, revealing continued momentum to the domestic economy as we enter 2015.

Such a rapid shift in the price of oil is, by definition, disruptive, creating winners and losers. As investors, we see both risks and opportunities as a result. A Goldman Sachs report recently estimated that the $1-plus drop in gasoline prices since last year will cut $125 billion from consumers’ fuel bills over the coming twelve months. Assuming low gas prices hold for the next several quarters, we see a healthy economic stimulus benefitting consumer- facing companies such as retailers, restaurants and entertainment. We also see industrial manufacturers and transportation benefiting from lower raw material and fuel costs.

Investment opportunities are created at times like this for those willing to “go against the flow” and at Mairs & Power we attempt to see opportunities where others may not. For example, one of our portfolio holdings, Wisconsin-based flexible package manufacturer Bemis Company, announced that a veteran within the company would succeed its retiring CEO last summer. We began talking to the new management early on and heard the new CEO articulate a clear understanding of the company’s opportunities and challenges as well as a good formula for success. In addition, we believe the company stands to benefit from falling oil prices. Ethylene prices, a key part of their raw material costs, have not yet responded, so the company can look forward to lower costs in the future. We feel the price advantage of flexible packaging relative to rigid packaging will accelerate the long-term shift away from cans and bottles to the more robust packaging that Bemis manufactures. As a result, we substantially increased our already established position. Once the rest of the market recognized what we had seen, the stock responded with a nearly 20% rise in the fourth quarter.

Future Outlook

We expect interest rates to begin rising sometime in 2015 which will have several effects that bear watching. We do not believe that a slight increase in rates would, by itself, end the current cycle. However, the advantage stocks have enjoyed over fixed income securities in the current low interest rate environment will be lessened as rates rise and investors find more places that offer yield.

The rate of growth for both revenue and earnings among small and large companies continues to be impressive. Furthermore, we believe that low energy prices will continue to benefit the U.S. economy over the next several quarters. When we look at the U.S. economy, we see no significant weaknesses. With the current cycle entering its seventh year and price to earnings ratios above their historic averages, we can expect positive, but muted equity returns for this year.

Small Cap Fund Performance

While the Small Cap Fund underperformed relative to its benchmarks in the fourth quarter, the Fund continued to outpace its index and peer group for the full year, finishing 2014 up 6.73% while the S&P SmallCap 600 Total Return (TR) Index was up 5.76% and the peer group as measured by the Lipper Small-Cap Core Funds Index was up 4.09%. For the fourth quarter, the Small Cap Fund was up 6.78%, while the S&P SmallCap 600 TR Index was up 9.85% and the Lipper Small-Cap Core Funds Index was up 7.68%.

Sector allocation had little impact on relative performance both year-to-date and for the fourth quarter. Although the Fund was underweight in stocks categorized in the energy sector, the precipitous drop in energy prices had a significantly negative impact on relative Fund performance in the fourth quarter. Portfolio holdings Chart Industries (an industrial stock) and MDU Resources (a utility), while not categorized in the energy sector, still have businesses that are sensitive to energy prices and their stocks were down significantly in the fourth quarter.

For the full year, energy and industrial sector weightings had the biggest impacts on relative performance. Holding an underweight position in the energy sector -- the worst performing sector by far for the year -- helped the Fund’s full year relative performance. Conversely, an overweight position in the industrial sector, which modestly underperformed the index for the year, negatively impacted relative performance.

Vasco Data Security (VDSI) (password authentication hardware and software) led Fund performance for both the quarter and the year. While the company derives most of its revenue outside the U.S., headlines of data breaches at major U.S. corporations are driving consumer demand for better protection of their private information, and Vasco’s data security products are helping the company penetrate the U.S. market.

Mairs & Power Small Cap Fund (MSCFX) Fourth Quarter Results (9/30/14 - 12/31/14)

Gentherm (THRM) (heating and cooling technology primarily utilized in automobile seats) was also a top performer for the year, though the stock was among the lowest performers in the fourth quarter as some of its business is tied to energy efficiency. Longer term, the company still appears well positioned regardless of what happens with oil prices.

Oasis Petroleum (OAS) (oil exploration and production) was the worst performing stock for the year. While the company was able to earn phenomenal returns on wells drilled in North Dakota’s Bakken at $100+/barrel oil prices, the economics significantly degrade when oil is less than $50 a barrel.

In the fourth quarter the Fund was particularly active, selling completely out of two stocks (TCF Financial (TCB) and Kodiak Oil and Gas (KOG)) while adding three new stocks (Cardinal Financial, Physicians Realty Trust and Donaldson). Cardinal (CFNL), based in Mclean, Virginia, is a regional bank serving primarily the Washington D.C. area, one of the financially strongest in the country. Physicians Realty Trust (DOC) is a healthcare real estate investment trust (REIT) which owns properties leased to physicians, hospitals and healthcare delivery systems. The Milwaukee- based firm’s stock carries a dividend yield over 5%. Minneapolis-based Donaldson (DCI) is a long time Mairs and Power holding, familiar to the firm but new to the Small Cap Fund. The manufacturer of filtration systems and replacement parts in a variety of industries was affected by recent weakness in off-highway vehicle (and Donaldson filters) sales creating an attractive opportunity for the Small Cap Fund to initiate a position in the stock.

At regularly scheduled meetings in December, the Mairs & Power, Inc. Board of Directors and the Mairs & Power Funds Trust (Trust) Board of Trustees approved a number of changes to the company’s executive ranks and to the officers and trustees of the Trust. Among the changes, Allen Steinkopf joins lead manager Andrew Adams as co-manager of the Small Cap Fund, effective January 1st. Mark Henneman was also appointed President of the Trust, effective December 31, 2014. These executive changes culminate a long- term succession plan which began several years ago in anticipation of William Frels’ mandatory retirement on December 31, 2014 as Trustee and President of the Trust. The Mairs & Power Mutual Funds employ a deliberate and disciplined succession planning process to ensure consistency in the investment philosophy over time. Press releases detailing all the changes are available on the Mairs & Power website.

Continue reading here.