Investment Update

11.04.20

Investment Update – Ivy Mid Cap Growth Fund

Commentary as of November 4, 2020

Throughout this year in the large-cap growth universe, high-growth companies that were uniquely positioned to benefit from pandemic trends were mostly unprofitable. This segment of the Russell 1000 Growth Index included companies with negative price-to-earnings ratios, meaning companies with negative earnings outperformed the index by quite a margin.

In the Russell Mid Cap Growth Index, firms with durable financials, mainly high profitability and low leverage, have outperformed since the lows reached on March 23. Ivy Mid Cap Growth Fund has outperformed the benchmark by nearly 11% year to date through the end of Sept. 2020. Over standard time periods, the Fund has strong rankings relative to its peers for key metrics, including the information ratio, which can be thought of as a measure of a portfolio manager’s skill at generating strong risk-adjusted returns relative to the benchmark.

Figure 1: Ivy Mid Cap Growth Fund has exhibited strong risk-adjusted returns
Chart Showing Ivy Mid Cap Growth Fund has exhibited strong risk-adjusted returns

Source: Ivy Investments, Morningstar data as of 10/31/2020. Past performance is no guarantee of future results. Morningstar Ranking / # of Funds in category displays the fund's actual rank within its Mid-Cap Growth Morningstar Category. Information Ratio: 3- , 5- and 10- year rank: 10/556, 15/498 and 70/379, respectively. Alpha: 3- , 5- and 10- year rank: 59/556, 68/498 and 120/379, respectively. Sortino Ratio: 55/556, 54/498 and 86/379, respectively.

Kim: I think a trend has been seen in the mid-cap universe and across the markets – in which companies, particularly in the Software As a Service (SAAS) space and some in the health care sector, have outperformed despite negative earnings. However, companies with durable financials – high profitability and low leverage – have continued to outperform. This trend was particularly prominent in the early part of the pandemic when investors were risk-averse and there was uncertainty regarding revenue generation and companies being able to service their debts. We have seen the trend continue as economic uncertainty underpins financial markets and the possibility of credit stress remains.

I have been calling this a risk-aversion rally. The rally has been driven by the safest companies that are not closely linked to the economic cycle or have benefitted from the current environment due to the pandemic. We have companies in our portfolio that have benefitted from this risk-averse rally.

In this environment, we have stuck to our investment philosophy’s key tenets – investing in companies with durable financials – healthy profitability and low leverage – with attractive valuations and a focus on the long-term.

For example, we have held Intuitive Surgical (ISRG) in the portfolio for over a decade. Intuitive Surgical is a poster child for when we discuss investment in companies with durable growth, high profitability, robust cash flows, and low leverage with a long runway for growth driven by innovation. The company developed the surgical robotic market over the past two decades and until today has only very limited competition. In the early days, the value proposition was not well understood by the market. However, we believed in the risk/benefit of the technology and that the adoption rate for certain medical procedures was likely to increase over time.

Figure 2: The Fund’s investment philosophy led to a long-term position in a high-quality business with a long runway for growth
Chart Showing The Fund’s investment philosophy led to a long-term position in a high-quality business with a long runway for growth

Source: Ivy Investments, Bloomberg. Past performance is no guarantee of future results. Stock price as of 12/31/2019.

Our interest in Intuitive Surgical grew as we identified automation in the health care sector as an area with a long runway for growth. In line with our view, we have held the company in the portfolio since 2009. The company has a vision to incorporate real-time imaging into the procedures. While competition is increasing, we feel confident the competitor’s technology is years, if not decades, behind. We believe, the company’s business model deserves a higher multiple that more appropriately reflects the growth potential for investors.

Nathan: Another company that we would like to highlight is Chipotle as this investment illustrates our process. We discover companies, take time to understand their fundamentals and management teams, and then patiently wait to find the right time and valuation to add them to the portfolio.

We owned Chipotle in 2007 and exited our investment in 2010 due to excessive valuation. However, we continued to watch the stock as we believed it was a good business model. In 2015, the company’s valuation suffered as investors grew weary of the stock after the food safety incident. We started our due diligence as valuations became more reasonable, and new management was brought in. Brian Niccol, the ex-CEO of Yum Brands, was brought in to steer the company back to growth.

We visited the company several times and became comfortable with the new management’s growth plans. In 2017 we added the company back to our portfolio, and in our view, under the new management, Chipotle has transformed itself with great initiatives.

Chipotle has embraced an omni channel approach by improving its digital platform, while it expanded delivery and shifted marketing spending in 2018, fueling a 4% same-store sales gain. We believe the initiatives will continue to fuel gains.

The company pioneered the two-lines of production operational concept that has allowed it to continue to deliver as effectively and efficiently to customers in the restaurant as it does to those that order through digital channels.

Also, we believe that Chipotlanes may fuel incremental sales. The addition of drive-thru pickup windows at new Chipotle stores will likely fuel an incremental sales boost that may become a sizable long-term opportunity, in our view. Quick-service and fast-casual restaurants typically generate 60-70% of sales at the drive-thru.

Figure 3: We reinvested in Chipotle in 2017 as new management transformed the business
Chart Showing We reinvested in Chipotle in 2017 as new management transformed the business

Source: Ivy Investments, Bloomberg. Past performance is no guarantee of future results. Stock price as of 12/31/2019.

Those two examples underline the investment philosophy’s long-term horizon and the focus on fundamental research to make investment decisions. It seems that the Greenfield Growth bucket’s weight is getting heavier. As of Sept. 30, the bucket’s weight was at 44.9%, slightly heavier as compared to historical norms of between 20-40%. What does that mean for risk in the portfolio? And going forward where do you see most opportunities?

Kim: First, I want to highlight that the allocation ranges are historical averages. And while we would like to continue to be in those ranges, we look in our universe of companies for the best risk-reward dynamics across the quality growth buckets of Greenfield Growth, Stable Growth and Unrecognized Growth the last of which focuses on companies where investors are disenchanted by some decision that the management took.

Having said that, the above has been a trend that we have noticed in the broader financial market. As we learned in 2013-2015, the Unrecognized Growth bucket of our investments provided considerable opportunity, which included Chipotle. But in the recent times, we have observed that these companies are unable to keep up with the changes and evolution happening in the broader economy and in other parts of the market. So, as we invest for the best growth opportunities at attractive valuations, we are finding opportunities in other parts of the markets including in the Greenfield Growth bucket.

The companies in the Greenfield Growth bucket are above-market risk as valuations are higher. But if you look at the companies in the bucket – Intuitive Surgical, DocuSign, Twilio – we think the business model risk is not higher. Most of these companies have strong financials and are in the Greenfield Growth bucket as they are still developing and expanding their business, providing us an opportunity to be invested in them for the long term.


Ivy Mid Cap Growth Fund Top 10 holdings (%) as of 09/30/2020: CoStar Group, Inc. 3.6, Chipotle Mexican Grill, Inc. 3.6, DocuSign, Inc. 2.9, Electronic Arts, Inc. 2.9, MarketAxess Holdings, Inc. 2.8, DexCom, Inc. 2.8, Twilio, Inc. 2.6, Fastenal Co. 2.5, Monolithic Power Systems, Inc. 2.5 and Teradyne, Inc. 2.3.

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 Nov. 4, 2020, 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.

The Russell Midcap Index measures the performance of the mid-cap segment of the U.S. equity universe. It is not possible to invest directly in an index.

The Russell 1000 Growth Index measures the performance of the large-cap growth segment of the U.S. equity universe. 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.

Diversification cannot ensure a profit or protect against loss in a declining market.

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.

Information ratio illustrates how much risk (tracking error) is being taken per unit of alpha, and it is often considered a measure of portfolio manager’s skill.

Sortino Ratio is a calculation that measures the amount of downside risk taken per unit of excess return over the risk-free rate. In other words, it’s a risk-adjusted return measure which doesn’t punish investment managers for upward stock price movements.

Alpha is a measure of a fund's actual returns and expected performance, given its level of risk (as measured by beta).