Mairs & Power Growth Invests the Minnesota Way

As more investors cast their gaze and money abroad, one fund has prospered by being provincial.

Fund investors have been buying international funds and selling domestic offerings, but that doesn't bug  Mairs & Power Growth  (MPGFX) comanagers Bill Frels and Mark Henneman. They stay close to home, typically holding between 35 and 50 stocks of companies, many of which are located in or near their home base in Minnesota.

It may seem like folly to be so rigidly local as markets get more global and complex, but the approach has been rewarding. The fund's 10- and 15-year returns are more than 300 basis points better than the large-blend category average and the S&P 500 Index.

They pull it off by keeping things simple. Frels and Henneman rely heavily on meetings with the senior management, and they scour the state and its Midwestern neighbors for companies that span the market-cap spectrum. On the company level, Frels and Henneman prefer industry leaders with sustainable competitive advantages, which is visible in the holdings' moat ratings. Morningstar equity analysts designate moat ratings, which reflect a company's ability to keep the competition at bay. Each stock is given a wide, narrow, or no moat rating. Of the stocks in the portfolio that are rated, nearly 90% had either a wide or narrow moat rating. Meanwhile, roughly 70% of S&P 500 constituents and 67% of stocks in the typical large-blend fund sport either a wide or narrow moat rating.

A handful of top holdings, including blue chips  3M (MMM) and  Johnson & Johnson (JNJ), boast wide moats and have been in the portfolio for more than a decade. And over the years, the fund's turnover has been miniscule. It's clocked in between 1% and 4% per year during the past several years whereas the typical figure for a large-blend fund is about 80%. The low turnover is a reflection of the managers' three- to five-year outlook with every addition to the portfolio.

Patience Pays
Their tenacity has been clear lately as they've stuck with medical-device maker  Medtronic (MDT) as its stock price has crumbled. The managers say that the stock is cheap given its position as a global leader in medical devices. Thus, they think the firm should be able to handle any changes that might occur to the U.S. health-care system, such as possible cuts to Medicare reimbursement rates, which would crimp its medical-device sales.

When Frels and Henneman do trade, they're often adjusting an existing position. But they have also added two new names to the portfolio lately. They bought  Western Union (WU) because they know the wire-transfer business well (they've owned competitor  MoneyGram International (MGI) in the past) and think its strong cash flows mitigate its less-than-ideal balance sheet. They also picked up medical-instrument supplier  Baxter International (BAX), which they've owned in the past, because they like its product pipeline and thought the price was right.

Steady as She Goes
While Medtronic and Baxter International both posted double-digit losses for the year to date through Nov. 12, some of their multiyear holdings in the industrial materials and equipment firms have done very well.  Valspar Corporation's  stock has climbed by 22% so far this year thanks to increased sales of its paints and coating products among both industrial and retail clients. Landscape-maintenance equipment manufacturer Toro Company (TTC), which has boasted high returns on equity and gross margins relative to its industry peers, climbed by nearly 42% for the period. And revenues for industrial equipment and components manufacturer  Emerson Electric (EMR) came in higher than expected for the third fiscal quarter thanks to its climate and industrials business segments, fueling the stock's 36% surge for the time frame.

Such picks helped the fund keep pace with its peers during this year's ups and downs. (For the year to date through Nov. 12, its 9.5% gain was on par with the category norm and the S&P 500.) The fund isn't likely to set the world on fire during strong rallies because Frels and Henneman stick with modest growing industry leaders. Instead, investors can generally expect the fund to outshine its peers in difficult markets.

In 2008, for example, the fund experienced a harsh 28.5% loss, but that was far better than the 37% loss posted by the typical peer and the bogy. The fund held up well because it was light on energy and heavy on industrial materials, which fared relatively better. Frels and Henneman also had taken the edge off their financials exposure by owning some of the less hard-hit names such as  Wells Fargo (WFC) and  U.S. Bancorp (USB). And rewinding back to the previous bear market of 2000 to 2002, the fund also lost a lot less than its peers.

Staying light on energy and other more-cyclical fare is simply a result of the managers' focus on sustainable competitive advantages as well as the slim pickings among such firms in Minnesota and nearby Midwestern states. So, the fund is handicapped when these sectors outperform. (It posted subpar relative returns in the 2005, 2006, and 2007 calendar years as energy firms continued on their tear.)

Conclusion
True, this fund is quite concentrated from a regional and holdings standpoint. But Frels and Henneman have proved that getting to know their holdings well and giving their stocks plenty of time to pay off wins out over the long haul. In the 72 five-year rolling periods since Frels took the helm in December 1999 through October 2010, the fund came out ahead of the category norm and the S&P 500 more than 90% of the time. That resulted in a 7% annualized gain for the time frame, much better than the category norm and index, which were only slightly in the black on an annualized basis. True, that record excludes the go-go growth period of the late 1990s, when the strategy didn't fare as well under the watch of Frels' predecessor, but it's still impressive.

A version of this article appeared previously in Morningstar FundInvestor.