Q4 2022 Small Cap Fund Update Recording

Q4 2022 Small Cap Fund Update Recording

January 19, 2023

As we start a new year, we invite you to listen in as Andy Adams, Mike Marzolf, and Chris Strom provide an update on the economy, performance of the Mairs & Power Small Cap Fund, and an investment outlook for 2023.

But first, we have a firm update. We are sad to report that Allen Steinkopf, our friend, partner, and colleague, passed away on December 21, 2022. He played a large role in the success of Mairs & Power during his nine years with the firm. Allen spent time leading the Mairs & Power Small Cap Fund (MSCFX), managing advisory accounts, and providing insightful opinions on companies and investments.

As part of planning for his retirement at the end of 2023, Allen had been working with backup investment managers for his separately managed accounts and sharing coverage of the companies he follows with the other 13 investment professionals who are on the investment committee. Since 2019, we have strengthened the bench of the Small Cap team by bringing on Chris Strom and Mike Marzolf to join Andy Adams, lead manager of the Small Cap Fund. Chris joined the firm in 2017 and officially joined the Small Cap team in 2021. Mike Marzolf, a seasoned professional with over 30 years of investment experience, joined the firm and Small Cap team in 2022. Andy Adams will continue in his capacity as CIO and lead manager of the Small Cap Fund.

Allen cared deeply about research, managing investments, and learning about the companies in which we invest. He also made sure his clients knew they were valued and appreciated. He brought so much more than his keen intellect and thoughtful analysis. Allen was passionate about coaching and mentoring younger staff to enable them to believe in themselves. He touched people’s hearts and changed their lives. He will be greatly missed by all of us who had the privilege of knowing him.

Executive Summary

It was a difficult year for the stock market in 2022. High interest rates, the continued war in Ukraine, COVID-19 variants, and inflation are difficult conditions for any company and that was reflected in the stock market.

Our longstanding philosophy is that high-quality companies outperform through full economic cycles because they can withstand downturns. This view was supported in 2022 as the Mairs & Power Small Cap Fund outpaced its benchmarks. On an absolute basis, the Mairs & Power Small Cap Fund was down 13.93% in 2022, outperforming its primary benchmark, the S&P 600, by 2.17%, and the Russell 2000 by 6.51%.

Inflation, and the Federal Reserve’s aggressive rate hikes in response, and the tight labor market are a few macro factors that had an impact on the portfolio in 2022.

Because we focus on companies with pricing power, most have been able to pass along their increased costs and that’s why the Fund outperformed. However, if the Fed’s actions to curb inflation don’t continue to have the intended impact, further rate increases could mean many companies pull back on their growth plans. Another element of inflation that we do expect to remain present is the tight labor market. We anticipate wage inflation to continue and have incorporated this expectation into investments as we favor companies that can help alleviate the labor bottleneck.

A few examples are Clearfield Communications and John Bean Technologies, which are both recent additions to the Small Cap Fund. Both companies sell tools that help assist employers or their customers improve efficiency.

Sector Performance

Technology was a headwind for the Fund in 2022. The sector performed well in 2021 as demand from consumers and businesses for cloud service providers surged. As a result, estimates and evaluations got ahead of themselves, and in 2022, both needed a reset.

This process will probably take a few more quarters, but the long-term fundamentals in our Technology holdings look good to us.

Industrials was also a headwind. Supply chain issues continued to impact companies’ ability to sell products and that slowed revenue growth. At the same time, inflation drove the cost of raw materials and freight higher, which stressed margins. Companies are offsetting these pressures with price increases, but the results tend to lag and improvements are likely in 2023.

Our sole holding in Materials, HB Fuller, underperformed the sector as valuation was somewhat elevated and concerns emerged in some of its end markets.

A final negative contributor to mention was the Energy sector. Our lack of exposure to Energy was a meaningful drag on our relative performance for the year and amounted to an almost 2.5% headwind. Energy was by far the best performing sector in the benchmark and was up nearly 50% in 2022. However, we believe the Energy sector faces long-term headwinds and we will avoid investing there.

On the encouraging side, we saw positive sector attribution from the Consumer Staples and Utilities sectors. These are two sectors that often underperform in good times and outperform in periods of stress, and it held true in 2022 to the benefit of the Small Cap Fund.

Individual Stock Performance                    

Looking at the positive contributors, Digi International (DGII) was up 49% for the year, MGP Ingredients (MGPI), a supplier of distilled spirits and branded spirits, was up 26%, and Casey’s General Stores (CASY), a long-time holding in the Small Cap Fund, was up 14%.

On the downside, Sleep Number Corporation (SNBR), Catalent, Inc. (CTLT), and AZEK Company, Inc. (AZEK) were key detractors for the Fund. Sleep Number was down 66% in 2022 and faced several headwinds, including supply chain issues and consumer demand softening. Catalent was down 65% due to biotech funding and vaccine demand headwinds which were previously tailwinds. Finally, AZEK was down 56% due to rising interest rates slowing the housing market.

While these three stocks fell in 2022, we think the long-term prospects for all three are positive and believe they remain good investment opportunities at lower valuations.

Market Outlook

Our market outlook is shaped by current economic conditions and what we’re hearing from our companies. Economic evidence suggests a recession may occur in 2023.

In addition, inflation could remain a challenge for the Federal Reserve, even with the rate hikes already put in place.

Though we’ve seen raw materials like steel, aluminum, gasoline, and freight roll over, the labor market has remained tight and wage pressures will be a key focus for the Fed. This potential for economic weakness could mean lower earnings per share for companies in 2023, but valuations for small and mid-cap stocks continue to look very attractive.

We are still long-term focused. We believe stock selection will drive investment performance over full economic cycles and we focus on companies with durable competitive advantages, or the potential to develop them. We then look to invest in those companies at reasonable valuations and we believe our investment process is particularly well-suited for the current market conditions.

Firm Updates 

Due to capital gains being elevated for the last few years, we’ve entered a relationship with ReFlow Fund, LLC. There are ancillary benefits to working with ReFlow, like access to cash flow, lower cash position, and lower trading activity, but the main goal is to decrease the annual capital gains distribution that shareholders receive over the long term.

Finally, as we begin 2023, Mairs & Power has moved from the First National Bank Building to the Wells Fargo Place, also in downtown St. Paul. We’re happy to all be working on one floor, providing more space for collaboration, and staying true to our St. Paul roots since 1931. Our new address is 30 East 7th Street, Suite 2500, St. Paul, MN 55101.


Top 10 Fund Holdings (subject to change)

Mairs & Power Small Cap Fund 

Expense ratio: 0.95%

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.  

Earnings per share (EPS) is a company’s net profit divided by the number of common shares it has outstanding.

The Consumer Price Index (CPI) is an index that measures the monthly change in prices paid by U.S. consumers.

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.