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Mairs and Power Growth Fund 2nd-Quarter Shareholder Letter

Second Quarter Market Overview - June 30, 2019

As it entered its eleventh year, the longest bull market in history found its attention drawn overseas. Worries over economic growth and trade have increased investors' nervousness and added a dose of volatility. Tariff hikes and deteriorating global trade relations have turned a "trade tiff" into a troubling source of uncertainty for companies with international exposure. In addition, there was a notable deceleration in global economic growth from the first to the second quarter.

The S&P 500 Total Return (TR) Index rose 4.30% for the second quarter and 18.54% year-to-date. This despite a 6.35% decline in May. Talk about volatility! The Dow Jones Industrial Average TR Index was up 3.21% and 15.40% and the Bloomberg Barclays U.S. Government/Credit Bond Index returned 3.53% and 6.90% for the second quarter and first six months respectively.

Unlike last year when the Information Technology (IT) sector pulled the rest of the market along, all sectors have posted gains year-to-date. The Health Care and the Energy sectors have been the weakest so far, with Energy stocks losing ground in the second quarter.

Future Outlook

After solid gains in the first half, we expect a choppy second half, therefore our outlook for 2019 remains cautious.

On the positive side, mortgage rates have recently fallen below 4% from more than 5% plus last fall, causing housing starts to rebound a bit off two-year lows. Lenders are responding to expectations that the Federal Reserve (FED) will cut the Federal Funds Rate by 25 to 75 basis points, which could bring it back around 2% by the end of 2019. Citing increased economic uncertainty and muted inflation following the FED's June meeting, Board Chairman Powell suggested that interest rate cuts will be used, if necessary, to sustain the current economic expansion. After having seen nine interest rate hikes since 2015, the market now expects that FED easing will keep the current bull market going.

On the "worry" side of the ledger, economic indicators continued to soften in the quarter. The ISM (Institute of Supply Management) Manufacturing Index, which manufacturing output nationwide, is approaching a neutral 50%, indicating little, any, growth in the manufacturing economy. In addition, the New York Empire State Manufacturing Index, a widely watched index for insights on the state and direction manufacturing in the key New York State region, recorded its largest decline ever single month, plunging 26 points to -8.6, the first negative reading in more than Capital spending started to fall in the second quarter as companies delayed in new capacity, concerned about uncertainty in the trade arena. Cautiousness has affected the outlook for corporate earnings, where growth estimates continue to particularly among large multinationals exposed to international markets. The most outlook pegs corporate earnings growth at 3% for the full year 2019, down from estimates of 5%-7% and off substantially from the tax cut-driven 23% growth 2018. Hiring may be affected as well. The economy added only 75,000 jobs in below expectations, before bouncing back in June, with 224,000 new jobs. Adding investor concerns, the tax cut-fueled budget deficit is ballooning and the Congressional Budget Office (CBO) is now projecting it to reach $896 billion for 2019, on a pace $1 trillion in the next year or two.

Some market forecasters believe the trade tensions are making a deteriorating economy even worse, potentially tipping us into a global recession. Others observe that the world's major economies were already cooling before the trade battles Whatever the causes, we are seeing real impacts in the global economy. Imports China from the U.S., Japan and Korea fell in May, with the largest drop of 27% in from the U.S. Europe economic growth is slowing as well amid uncertainty regarding Britain's exiting the European Union.

Valuations, while down from recent highs, remain toward the high end of their trading range and above the ten-year average, meaning the market remains slightly expensive. However, given low interest rates, we view valuations as reasonable at time. Small Cap stocks, which usually trade at a premium to large caps, are currently 5% discount, presenting opportunities for Small Cap investors.

While the equity markets are sending mixed signals, the bond markets are flashing warning lights. The inverted Treasury yield curve, where short term rates are higher long term rates, has persisted for more than 90 days. An inverted yield curve is associated with economic slowdowns or even recessions.

The Mairs & Power Growth Fund gained 2.74% in the second quarter and 16.17% for the first six months of 2019. The S&P 500 Total Return (TR) benchmark gained 4.30% and 18.54% over the same periods while the Lipper Multi Cap Core Funds Index of peers gained 3.62% and 18.16%.

The single largest factor contributing to relative underperformance for both the second quarter and first half of the year was the decline in 3M (NYSE:MMM) stock, one of the largest holdings in the Fund. The global industrial company's shares are off more than 20% from their 52- week high. Management cited weakness in the automotive sector, consumer electronics and the Chinese market. Investor concerns over rising environmental liability and the price paid for a recent acquisition put additional selling pressure on the stock through the second quarter. 3M's seasoned management team has a track record of successfully navigating business challenges such as these and remains a core position in the Fund.

Ecolab (NYSE:ECL) is another long-term holding of the fund and one of its largest positions as well. After a stellar 2018, the stock has continued to climb higher this year, up more than 30% in the first six months. In our opinion, Ecolab has one of the strongest durable competitive advantages in our stock universe, and we remain impressed with the management team. Earlier this year, management announced that the company would spin off its upstream energy business, a highly cyclical business dependent largely upon the price of oil, and the market welcomed the news. That said, valuation has become stretched, and we have been trimming back our position.

We remain positive on the Health Care sector long term although the sector stumbled in the second quarter, partly in reaction to news that some presidential candidates are calling for expansion of Medicare. This hurt most, but not all, names in the sector. UnitedHealth Group (NYSE:UNH), the largest private health insurance provider, was particularly hard hit, presenting an opportunity to add to our position. Two other names in the sector deserve mention as well. BioTechne Corp (NASDAQ:TECH), a company we have discussed in the past, has been the top contributor to performance year-to-date. A new name in the sector, Elanco Animal Health (NYSE:ELAN), recently appeared in the Fund as the result of its spin-off from Eli Lilly and Co (NYSE:LLY). It holds a strong market position with a diverse product portfolio across both production animals (cattle, pigs, etc.) and pets, giving the company an attractive durable competitive advantage. In addition, the animal health and veterinary medicine market enjoys greater pricing power and less competition than in the pharmaceutical market for humans. With the spin-off, management has the opportunity to improve margins as a smaller standalone company. As a result, we expect strong earnings growth. We also expect to add to our Elanco position over time.

NVIDIA Corporation (NASDAQ:NVDA) is another interesting new name we added in the second quarter after watching the California tech company for some time. They are the market leader in video cards (graphic processor units in industry jargon) for home PCs and their products are also used in technical computing environments for machine learning and artificial intelligence applications such as autonomous vehicles and in the mining of crypto currencies. The company has established a durable competitive advantage with a strong market position built on solid technology and we like the opportunity longer term. The stock ran up a year and a half ago when glowing headlines about Bitcoin and other emerging crypto currencies generated investor excitement. When the bubble burst this year, NVIDIA's price was cut in half, giving us our opportunity to take a position.

We sold much of our position in Wisconsin-based Bemis Company (BMS), a long-standing portfolio holding, when Australian competitor, Amcor PLC (AMCR), announced it was acquiring the consumer packaging company. Supercomputer maker Cray Inc. (CRAY) was eliminated from the portfolio as it is being acquired by Hewlett Packard Enterprise Co (HPE). We also eliminated Snap-on Inc (SNA) in the quarter, finding more attractive opportunities elsewhere.

Andrew R. Adams

Lead Manager

Mark L. Henneman


Peter J. Johnson


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 pre-dictions, forecasts, outlooks, expectations or beliefs are guaranteed.

This article first appeared on GuruFocus.