Listen to Mike Marzolf, Lead Manager of the Mairs & Power Small Cap Fund, Chris Strom, Co-Manager, and Andy Adams, CIO and Co-Manager as they gave an update on the market, economy and impact to the Mairs & Power Small Cap Fund so far in 2023, as well as gave an outlook for rest of 2023. This was recorded on July 25, 2023.
Fund Manager Update
Mairs & Power is pleased to announce the transition of Michael (Mike) C. Marzolf into the role of lead manager for the Mairs & Power Small Cap Fund (MSCFX). Andrew (Andy) R. Adams shifted into a co-manager role on the Fund. These management changes were effective at the close of business on June 30, 2023. Christopher (Chris) D. Strom will continue in his role of co-manager for the Fund.
Andy Adams has led the Small Cap Fund for most of the last 12 years, since its launch back in 2011. Mike and Chris were brought in to help support Andy’s management of the Fund and this decision will allow Andy more time to focus on the Mairs & Power Growth Fund. The Growth Fund also has a significant small cap component and utilizes a lot of the stocks that originated in the Small Cap Fund that then feed into the Growth Fund. As CIO, working closely with both Funds only serves to strengthen the overall investment process at Mairs & Power.
Since joining the firm, Mike has worked extremely well with the team, bringing a wealth of industry knowledge, small cap experience, and a phenomenal work ethic. The Small Cap team did not miss a beat when he was added at the end of 2021, and we believe that will continue with his promotion to lead manager.
Despite considerable turbulence in the market, primarily related to the banking sector, the Mairs & Power Small Cap Fund performance during the last 12 months has outpaced each of the relative indices and its peer group, as measured by the Morningstar Small Blend Category Index. The one-year annualized return for the Small Cap Fund is 12.75%, compared to 9.75%, 12.31%, and 12.40% for the S&P 600, Russell 2000, and the peer group, respectively. Additionally, year-to-date performance for the Small Cap Fund is 6.43%, while the S&P 600 is 6.03% and the Russell 2000 is 8.09%. The peer group is up 7.42%.
These performance numbers are despite an overweight to the banking sector, which is a testament to the entire portfolio and the long-term philosophy of Mairs & Power.
Mixed Economic Indicators
As referenced earlier, macroeconomic indicators are sending mixed signals. Input prices shot up during COVID, pressuring margins for manufacturers and forcing companies to raise prices, which drove up inflation. In response, the Federal Reserve raised interest rates and the prices on materials have begun to fall.
However, the labor market remains tight and labor costs remain sticky. Yes, inflation is slowing, but as we talk to companies, we consistently hear about the difficulty in hiring talent. We are seeing the backlog of orders beginning to ease, and there are some positive signs on the labor front as well, but it’s going to take time. We do believe the Fed is winning its fight against inflation, though it’s not happening overnight.
What's Happening in the Market?
Both stocks and bonds have rallied this year, moving out of bear territory, and many are anticipating the Fed will loosen its tightening strategy.
On the valuation front, prices are slightly elevated above long-term averages when using the S&P 500 as a reference. However, when looking at the S&P 600, we find significantly lower valuations. In fact, as of June 30, the S&P 600 traded at a 29% discount to the S&P 500, and a 21% discount to its 10-year average. This highlights the outsized impact of momentum growth stocks and how it has created a narrower list of highly valued companies. But when it comes to small cap companies, the opportunities remain. While the outlook for earnings has softened a bit, most small cap companies are still projecting growth in the coming years.
All of this points to good opportunities to buy the stocks of small cap companies with durable competitive advantages at attractive valuations.
The Small Cap Fund benefitted from relative outperformance within the Industrials, Healthcare, and Real Estate sectors, as well as the absence of Energy stocks in the Fund. For Industrials, manufacturers’ ability to supply their production lines and deliver on backlogs improved. In Health Care, funding concerns over new innovation and procedure volume improved, and in Real Estate, the sector held on to some relative strength from the first quarter. As a result, the Fund has selectively trimmed from positions as valuations have become extended.
Those contributors were partially offset by headwinds in the Financials, Consumer Discretionary, Materials, and Utilities sectors. As was mentioned previously, the turmoil in the banking industry caused our holdings in banks to perform poorly. Banks were under significant pressure, particularly in the first quarter, due to the Fed’s raising interest rates and its impact on asset values, margins, and banks needing to pay more for their deposits. As a result, valuations for bank stocks declined to levels we believe are near trough for this cycle. Because of that, we have added to Financials in the period.
Individual Stock Performance
Three names with particularly positive performance year-to-date are Altair Engineering (ALTR), AZEK Company (AZEK), and Entegris (ENTG).
Altair provides software and cloud solutions for simulation, Internet of Things (IoT), high performance computing, data analytics, and artificial intelligence (AI). The company allows customers to save money via simulating real-world scenarios for their engineering needs and we are increasingly excited about the opportunity Altair has across its business, including the ability to utilize an increased focus on AI.
AZEK, based in Chicago, is the second largest composite decking company and we believe the company has a long runway for growth as the average deck age continues to increase, and consumers prefer lower maintenance materials. Last year was a difficult one for the company as it faced rising input costs and increased inventory. As the stock sold off, it gave us an opportunity to build up our position and that has paid off nicely. The company’s management team has done a nice job of pushing through price increases to offset commodity costs and navigated the inventory issues very well.
A final top contributor to highlight is Entegris. We believe this is one of the best positioned companies in our portfolio. It provides highly engineered materials that are used throughout the production of semiconductors. We know the business well after following it for many years back to its roots in Chaska, Minnesota, and view the business as a picks and shovels provider in a very attractive industry with long-term growth potential.
On the negative side, Clearfield (CLFD), First Interstate Bancsystem (FIBK), and Glacier Bancorp (GBCI) detracted from Fund performance.
Clearfield is based in Brooklyn Park, Minnesota, and provides fiber optic components for building out communications networks. We started purchasing Clearfield at the end of last year after a series of meetings with management and confidence around its core business, which drive meaningful labor savings for the installation of fiber. In addition, we see a long-term opportunity for the company to help build out the broadband footprint in the U.S. to reach many underserved rural areas. While the industry has since faced excess inventory challenges, which has impacted the stock, it has allowed us to purchase a larger position at what we think is a bargain price.
We also wanted to highlight a couple of banks that were detractors from performance in the period. The spike in interest rates following the Fed’s actions and the fallout from Silicon Valley Bank and First Republic spooked investors related to regional banks. We think the industry will face increased funding costs, and bank deposit rates need to increase to compete with alternatives like money market funds. However, we really like Glacier Bank as its footprint is within some of the fastest growing markets in the U.S., such as Montana and Idaho. In addition, the management team has done a good job of executing and the companies’ balance sheets and what we believe is a rock bottom valuation make them an attractive name.
Finally, we continue to find attractive investment opportunities in Minnesota. During the period, we started a position in Piper Sandler, which is a boutique mid-market investment bank based out of Minneapolis. We have followed the company for years, noting its ability to take market share within its Mergers & Acquisitions advisory business, and have a lot of respect for the management team.
Looking to the Future
Economic and market turbulence is not new to us. For more than 90 years, we have invested for entire market cycles.
The valuation discounts we are seeing in small cap companies are often present during turbulent parts of an economic cycle, when abnormal conditions are normalizing. Having watched these valuation patterns in other cycles, we believe this phase too shall pass, and companies with durable competitive advantages, as well as the growth, profitability, and cash flows to reinvest in new products and initiatives, will outgrow and outearn their peers, driving robust returns for long-term investors. We remain confident that our long-term approach to investing is particularly well-suited for current conditions, where many high-quality companies’ shares are trading at a discount.
As always, we keep a long-term view of the market. Our outlook for the market remains positive, even if there may be some turbulence in the near term.
Top 10 Fund Holdings (subject to change)
Expense ratio: 0.92%
The statements and opinions expressed are those of the speakers and are as of the date of this call. All information is historical and not indicative of future results and subject to change.
Cash flow is the net amount of cash and cash equivalents being transferred in and out of a company.
S&P Small Cap 600 TR Index is an index of small-company stocks managed by Standard and Poor’s that covers a broad range of small cap stocks in the U.S. The index is weighted according to market capitalization and covers 3-4% of the total market for equities in the U.S. It tracks both the capital gains of a group of stocks over time and assumes that any cash distributions, such as dividends, are reinvested back in the index.
Russell 2000 TR Index is a small-cap stock market index of the smallest 2,000 stocks in the Russell 3000 Index.
Morningstar Small Blend Category, as defined by Morningstar are stocks in the bottom 10% of the capitalization of the U.S. equity market which are defined as small cap. The blend style is assigned to portfolios where neither growth nor value characteristics predominate.
All investments have risks. The Small Cap Fund is designed for long-term investors. Equity investments are subject to market fluctuations and the Fund’s share price can fall because of weakness in thebroad market, a particular industry, or specific holdings. Investments in small and midcap companies generally are more volatile. International investing risks include among others political, social or economic instability, difficulty in predicting international trade patterns, taxation and foreign trading practices, and greater fluctuations in price than United States corporations. The Small Cap Fund may invest in initial public offerings by small cap companies, which can involve greater risks than investments in companies which are already publicly traded.
The investment return and principal value of an investment will fluctuate so that an investor’s shares, when redeemed, may be worth more or less than their original cost. Current performance of the Funds may be lower or higher than the performance
quoted. For the most recent month-end performance figures, visit the Funds’ website at www.mairsandpower.com, or call Shareholder Services at (800) 304-7404.The Funds’ investment objectives, risks, charges and expenses must be considered carefully before investing. The prospectus and summary prospectuses contain this and other important information about the Funds, and may be obtained by calling Shareholder Services at 800-304-7404, or by visiting www.mairsandpower.com. Read the prospectus and summary prospectuses carefully before investing.
Performance data quoted represents past performance and does not guarantee future results. The investment return and principal value of an investment will fluctuate so that an investor's shares, when redeemed, may be worth more or less than their original cost. Current performance of the Fund may be lower or higher than the performance quoted. Performance as of the most recent month end is available by calling 800-304-7404. Click Here for standardized performance.