The Fed shifts on inflation – What does it mean?
The Fed unveiled a revision to its monetary policy, allowing for higher inflation to help support the labor market. We believe this action could keep interest rates low for years.
Third quarter was fairly volatile, which can sometimes present some opportunities for repositioning within an investment portfolio. Did the investment team make any changes to the Fund during the quarter?
Tim Miller: We haven't made any dramatic changes to the portfolio. We've been dealing with these sentiment swings in the market where the focus has been on more defensive companies or businesses that have accelerated during the COVID-19 pandemic. We've had these periodic situations where there's confidence in a recovery in 2021, which would make it more likely that some of the companies that have not done particularly well in the crisis to do better. This has caused us to reassess some of the exposure in the portfolio to get more exposure in the industrials and consumer sectors, which are more cyclical in nature. In financial services, banks are under significant pressure with interest rates at zero for the foreseeable future. As such, we have de-emphasized our exposure to that sector to make room for areas like industrials and consumer discretionary, where if the economy does recover, we will see some strong earnings recovery from some of those companies.
Broadly speaking, consumers has been affected significantly by the impacts of COVID-19 and the economy. However, stocks within the consumer-focused sectors clearly have had mixed results. What do you think investors should be paying attention to what’s happening in these sectors?
Quite a few areas within the consumer discretionary are doing well in areas like active, outdoor lifestyle-related businesses. One of our holdings, Fox Factory, Inc. is an example of this. One thing that we've been seeing is that there are companies that had already made some significant changes to their business, and those changes were really helped by the pandemic. One example is Wingstop, Inc., which also is portfolio holding. This company was already developing its delivery and takeout business and the digital effort around it prior to the crisis, which has provided extraordinary same-store sales for the past few quarters. We think the sector has pockets of strength that will continue to be healthy. It's more a question of timing of when or if there is a COVID-19 vaccine or something that gets consumers back to travel, entertainment, and hotels – we aren’t willing to bet on those areas yet. We're generally sticking with the strong growth companies that are seeing some benefit from healthy consumer spending in spite of this crisis.
You mentioned Fox Factory. Can you tell us more about its business model?
Fox is a premium suspension provider for bicycles, which started with mountain bikes, and their products are at the very high end of the market, and it's had a lot of success there. The bicycle market has been very strong during this crisis. Fox has migrated to ATVs, snowmobiles, and off-road vehicles. In the past few years, they have made progress in the auto industry, being included on the Ford Raptor, Jeep Mojave, and Toyota Tundra. We like the stock because Fox is penetrating more markets and have made acquisitions in the aftermarket business and is a very well-run company. It had manufacturing issues that have been resolved with a new plant in Georgia. Its CEO is a manufacturing specialist who we think can lead to positive surprises in profitability over the next few years.
Health care has been a sector that recently has garnered a lot of investor interest given the developments around COVID-19. However, this has been an area where we’ve had conviction for some of the long-term secular trends within the sector. What is your thinking on the health care space?
Ken McQuade: Within the small-cap universe, we typically look for companies that offer cutting-edge products or services that can penetrate an established market niche, which are generally dominated by a larger conglomerate. Many times, these larger companies are everywhere, but may have lost focus on specific innovation. These opportunities give us more visibility because the disruptors are targeting a specific market and the competition hurdles are already known. We have several holdings that would fit this description. We've owned iRhythm Technologies, Inc. for a long period of time. This innovative company provides cardiac monitoring technology that replaces technology that has been in place for more than 50 years. We've owned CareDx, Inc., which tests organ transplant recipients from a blood draw rather than a surgical biopsy.
When these opportunities present themselves, they're a little more secular in nature than focusing on a singular clinical trial, hospital volumes, or government pricing sentiments. Today, it's a little more tough because of COVID-19's impact on hospitals and doctor's offices. This affects inpatient personal visits and the ability to see and covert doctors to these newer technologies. Sometimes these tougher environments spur the healthcare system to need more efficient and better outcome solutions, which is where we are focused and have holdings previously mentioned.
Information technology stocks have consistently been known for their disruptive nature within existing business models. What opportunities are you seeing within your coverage within this sector?
Brad Halverson: The information technology sector has been a great place to be for many years and continues to be a very important part of the portfolio where we find some of the most innovative and enduring business models. We think the sector has a favorable outlook and robust backdrop. The Federal Reserve has clearly signaled it will be on hold for an extended period of time, and that's a very favorable liquidity environment that doesn't appear like it will be interrupted anytime in the near-term. Also, the interest rate backdrop remains near record lows, and that's very supportive for equities, especially small caps. The earnings revision data has also been very good out of the trough that we had. When we take things a layer deeper into what areas where we see the most opportunity, we think it's important to see what's happened in tech within the last six months. As the COVID-19 outbreak took hold and people started working from home, the best places to be were companies that enabled that transition in a very fast manner.
For example, in software, the initial beneficiaries were companies that allowed people to get – and stay – connected. We certainly have names in that category that were terrific beneficiaries, and we continue believe that they will remain as beneficiaries not just because of a pull-forward, but a transition to a new working model. Five9, Inc., which has been a strong contributor to the Fund, is an example of being in the right place at the right time during a secular movement. The company's position really boosted its opportunity set as a leading provider of cloud contact center software with the transition to a work from home environment. The idea that you could now be on a SAAS-distributed system and work from anywhere came to the forefront. The company was already winning business prior to this, and the whole market has only shifted about 10% to the on-demand model, as its still mostly on premise. We believe Five9 is likely to grow exponentially over the next several years.
In August, there was a retailer that used text messaging to promote its sale, and one in four customers made a purchase through a text message. That’s is a big shift. The number of text messages that e-commerce companies are using increased by 300% just in second quarter 2020. For most of last decade, the mega-cap technology companies have inserted themselves in between the retailers and consumers. Everyone wants to have direct access to the consumer. In the process, companies that tried to usurp that customer relationship and customer loyalty suffered was interrupted. Retailers now are trying to reclaim those customer relationships through text messaging. We have a position in LivePerson, Inc., which is uses text messaging function that is becoming increasingly popular and necessary.
Moving forward, we are looking at software in the infrastructure and back office spaces. We're looking for opportunities that will provide some level of incremental acceleration in their business in 2021 and 2022. We continue to feel strongly about areas such as security software, payments, digital banking, 5G, and the cloud. There remains a lot of different ways to express that in the sector, which remains a focus of ours. Underlying all of that, we continue to look for companies that can execute in large markets and truly become larger version of themselves.
Past performance is no guarantee of future results. This information is not meant as investment advice or to predict or project the future performance of any investment product. The opinions are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This informa¬tion is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon. The views are current through Oct. 7, 2020 and are subject to change at any time based on market or other conditions.
Risk Factors: The value of the Fund’s shares will change, and you could lose money on your investment. Investing in small-cap stocks may carry more risk than investing in stocks of larger more well-established companies. The Fund may invest in Initial Public Offerings (IPOs), which can have a significant positive impact on the Fund’s performance that may not be replicated in the future. An investment in the Fund is not a bank deposit and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Not all funds or fund classes may be offered at all broker/dealers. These and other risks are more fully described in the Fund’s prospectus.
The Russell 2000 Growth Index is an unmanaged index comprised of securities that represent the small cap sector of the stock market. It is not possible to invest directly in an index.
Top 10 holdings as a % of net assets as of 09/30/2020: Five9, Inc. 3.5, Wingstop, Inc. 2.7, Varonis Systems, Inc. 2.5, Installed Building Products, Inc. 2.4. Mercury Systems, Inc. 2.2, Monolithic Power Systems, Inc. 2.2, CareDx, Inc. 2.2, Globant SA 2.1, iRhythm Technologies, Inc. 2.1, PetIQ, Inc, 2.04.
The impact of COVID-19, and other infectious illness outbreaks that may arise in the future, could adversely affect the economies of many nations or the entire global economy, individual issuers and capital markets in ways that cannot necessarily be foreseen. The duration of the COVID-19 outbreak and its effects cannot be determined with certainty.