2021 Midyear Outlook: Navigating through the recovery
Listen in as we discuss our outlook on the US recovery and the Federal Reserve’s new framework, including its impact on inflation, interest rates and growth.
In 2020, investors had to choose between quality and growth. When we were forced to pick, the Ivy Large Cap Growth Fund team chose quality every time. Over the past 12 months, many quality companies have been cast aside by investors in favor of hyper-growth alternatives. This has created opportunity to invest in durable growers at what we believe are attractive prices. We think high-quality business models, those with real competitive advantages, are best equipped to experience sustainable growth and deliver results for investors over the long term.
How does the Ivy Large Cap Growth team define quality?
Brad: We believe growth is fleeting. Many companies in this growth universe have attractive margins, strong growth profiles and big addressable markets. Those characteristics can invite significant amounts of competition and disruption. Over time, and this is borne out in the data, expectations investors put on growth companies are typically not realized. We refer to this as flameout risk. Investing blindly in growth, or growth at any price, can introduce significant amounts of risk.
As active long-term fundamental investors, we believe this creates an opportunity for us to do something different. In our view, quality is much more persistent than growth. So, we look for something in a business model that creates a moat or barrier to entry, some unique attribute that allows the company to retain those attractive rates of growth. Starting with quality allows us to retain persistent growth and remain focused on longer-term investment horizons.
Here are examples of companies that may help illustrate this line of thinking. Microsoft is a company with an embedded position in operating systems and server software that has allowed it to open additional addressable market opportunities. Coca Cola is a global marketing powerhouse with an incredible brand. In addition to these competitive advantages, the company has a global bottling and distribution network that helps keep competitors at bay. Nike has a world-class brand that resonates on issues like diversity and inclusiveness for all athletes. This brand strength enables Nike to reinvest in research and development to capitalize on the move to a digital economy. These are just a few notable examples that help illustrate the types of competitive advantages we find extremely attractive right now.
Quantitative screens can be helpful tools to help us filter the huge pool of potential investments for those financial characteristics that align with quality. Margins, returns on assets and returns on capital can all be clues regarding business model durability. Trends matter, too. Are these characteristics improving or deteriorating? It’s important to understand how the business has evolved over time, and the dynamics that influenced what we ultimately see in the data.
At the same time, we believe relying too heavily on quantitative screens can be too exclusionary, potentially overlooking good opportunities where the real story isn’t visible in the numbers. Cerner is a good example. This is a company moving electronic records onto a software as a service (SaaS) model, which should be accompanied by wildly different margins. Quantitative screens won’t identify that information, so it’s important for us to complement quantitative methods with our fundamental work.
How did an emphasis on quality companies influence returns in 2020?
Brad: Quality typically trails coming off market bottoms and major selloffs. Investors look for rapid or cyclical growth and those attributes usually are not attached to quality. The types of companies that outperformed most in 2020, particularly after the March lows, were companies with the highest growth, highest risk, highest volatility and lowest profitability. In our minds, this situation won’t persist over the long term. Last year, investors were forced to choose between quality and growth. In normal environments, growth and quality are often tied together, which makes sense to us. Quality businesses should be good growers over time if they’re investing their capital appropriately. At some point, we expect markets will normalize and the Fund is positioned well for when that time comes.
We also mentioned the idea of flameout risk. From starting points where multiples like price-to-earnings (P/E) ratios are high in a historical context, flameout risk grows. Not to sound like an alarmist, but it seems relevant given the current environment.
Trends from 2020 have largely remained during the first two months of this year, with one major wrinkle. Investors are pushing deeper into cyclical companies with greater belief in reflation, rising interest rates, and massive amounts of stimulus. So, we still see two tails – a hyper-growth tail and a more cyclical tail benefitting from faster gross domestic product (GDP) growth – leading in the first part of 2021. The higher quality businesses in which we invest usually fall somewhere between these two tails. We like to own secular growers that don’t depend on sentiment that can change on a day-to-day basis.
Concerns seem to be growing over valuation and potential pockets of froth. Do you think investor expectations too high?
Brad: We look at fundamentals on a company-by-company basis, and we believe this helps us think about these questions. But we are not strategists. Our research is focused on company fundamentals. We think it’s important to keep in mind that over the past two years, a significant portion of market returns have come in the form of multiple expansion, not earnings growth. This means expectations are higher and companies need to deliver higher revenues and earnings in order to justify these prices. Sustainable revenue growth of 25% or 30% is very rare. Companies that can produce this type of growth are considered diamonds in the rough. But in many cases, investors are now expecting 30% growth from some of these businesses. To us, that isn’t a realistic starting point, and judging the quality of a business based on an 11-month period in a very unique market environment seems irresponsible. When we attempt to forecast longer-term returns from some of these starting points, it seems to create a setup for very diminished returns. Some of these hyper-growth companies will ultimately emerge from the pandemic as quality businesses, and we will work to identify those that actually have a real sustainable edge.
On the flip side, we think many of the higher quality companies with sustainable growth are being cast aside by investors, giving us opportunity to invest at attractive prices. One example is Motorola Solutions. This company sells walkie talkies, or land mobile radios, for first responders like firefighters, and their position in this public safety market is dominant. Motorola Solutions is also investing in adjacent, faster growth markets like video security. During the pandemic, we learned many police call centers weren’t well prepared to work from home. Guess who has the tools for that command center solution? Motorola Solutions.
Another example is Verisign, which is a global provider of domain names. This company is a registry for the internet and its goal is to ensure the safety and stability of the internet. Verisign essentially has an exclusive position to keep the register of all .com and .net domain names. The Department of Commerce controls pricing, as does an organization called the Internet Corporation for Assigned Names and Numbers (ICANN). Once these two organizations allowed Verisign to raise pricing on an ongoing basis, we saw clear path to a durable growth business. It may sound boring, but we think it’s difficult to find a better business than that.
A look at P/E multiple expansion and earnings per share since March 2019
The trailing P/E ratio has shown consistent growth for the Russell 1000 Growth Index and S&P 500 Index over the past two years, while earnings have generally declined.
Source: FactSet. Past performance is not a guarantee of future results.
Source: FactSet. Past performance is not a guarantee of future results.
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 current through Feb. 24, 2021, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This information 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.
Top 10 holdings as a % of net assets as of 12/31/2020: Microsoft Corp. 9.7, Apple, Inc. 8.8, Amazon.com, Inc. 7.6, Visa, Inc. 4.4, Alphabet, Inc. 4.3, Facebook, Inc. 3.7, PayPal Holdings, Inc. 3.1, Adobe, Inc. 3.1, Motorola Solutions, Inc. 3.1 and Intuit, Inc. 2.9.
The Russell 1000 Growth Index measures the performance of the large-cap growth segment of the U.S. equity universe. The S&P 500 Index is a float-adjusted market capitalization weighted index that measures the large-capitalization U.S. equity market. It is not possible to invest directly in an index.
All information is based on Class I shares. Class I shares are only available to certain investors.
Risk factors: The value of the Fund’s shares will change, and you could lose money on your investment. Investing in companies involved primarily in a single asset class (large cap) may be more risky and volatile than an investment with greater diversification. The Fund typically holds a limited number of stocks (generally 40 to 60), and the Fund’s portfolio manager also tends to invest a significant portion of the Fund’s total assets in a limited number of stocks. As a result, the appreciation or depreciation of any one security held by the Fund may have a greater impact on the Fund’s NAV than it would if the Fund invested in a larger number of securities or if the Fund’s portfolio manager invested a greater portion of the Fund’s total assets in a larger number of stocks. 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 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. In addition, the impact of infectious illnesses in emerging market countries may be greater due to generally less established healthcare systems. Public health crises caused by the COVID-19 outbreak may exacerbate other pre-existing political, social and economic risks in certain countries or globally. The duration of the COVID-19 outbreak and its effects cannot be determined with certainty.