Investment Update – Ivy Mid Cap Growth Fund
Commentary as of March 18, 2021
Over the long term, the mid-cap space has produced higher annualized returns versus its large-cap and small-cap counterparts. What do you like most about investing in the mid-cap universe?
Kim Scott: We like to call the mid-cap universe the “sweet spot” for investing in the U.S. economy. We find a lot of opportunity in the space to invest in innovative companies that provide not only consistent and stable capital appreciation but also have long potential runways of growth. We believe it’s a very productive space with numerous opportunities to invest for the portfolio.
Nathan Brown: We really appreciate the dispersion of returns and diversification within the mid-cap universe. For example, as of the end of February 2021, the top 10 names in the large-cap universe constituted nearly 25% of the Russell 1000 Index, while the top 10 names formed less than 5% of the Russell Midcap Index. We tend to invest in companies where we have real conviction, not because they constitute a big portion of the Fund’s benchmark. We think there is a broader opportunity set within the mid-cap space to invest in companies that have the potential for growth and innovation.
Source: Evercore and Ivy Investments. Data: 01/02/1996 to 02/26/2021. Past performance is not a guarantee of future results. This chart illustrates $10,000 invested equally between large-, mid- and small-capitalization companies in the Russell 3000 Index.
The Ivy Mid Cap Growth team considers itself quality investors, investing across the growth spectrum. This spectrum consists of three buckets of growth: Greenfield Growth, Stable Growth and Unrecognized Growth. Tell us about your investment philosophy and approach as well as how and why you invest in companies across the growth spectrum.
Kim: We like to manage the Fund as a “progressive growth Fund that is managed prudently.” We equate quality growth to profitable growth, which introduces the idea of risk management into the beginning of the investment process while we are looking for the best opportunities to deliver return. Both the quality bias as well as the valuation sensitivity that are integral to our investment process are key to delivering higher risk adjusted returns for our investors.
The Fund’s portfolio construction can be considered this way. The Stable Growth bucket is the ballast in the portfolio. It has historically been 40-60% of the Fund’s allocation. We then layer in the more innovative, faster growing Greenfield Growth companies, which we consider to be leading-edge opportunities, not necessarily bleeding-edge opportunities. Finally, we keep an eye out for Unrecognized Growth companies. These are the businesses where investors are disenchanted by some decision the company’s management took or where there is generally a lack of focus on the opportunity the company presents to re-assert growth in the future. We think Unrecognized Growth companies are great compounders when identified early, and we have had great success in the past with investing in these types of companies.
Could you give us insight into your investment process regarding Unrecognized Growth and provide a couple of examples of companies that fit within this bucket?
Kim: For companies in the Unrecognized Growth bucket, we assess the productivity of these business models in terms of earnings and cash flow. There are some factors that are common across these stocks. One change agent we often encounter is “change in management” – a new management comes in and inspires innovation internally and takes advantage of it externally.
Nathan: In February 2014, we purchased video game publisher Electronic Arts (EA) as a distrusted, Unrecognized Growth company. At the time, the company was quite challenged by its business model where it only sold its video games through retailers such as Target, Walmart, and Best Buy.
We did our due diligence and started investing in the company after it brought in a new, more experienced chief financial officer. Following this hire, EA began leveraging newer technologies to grow its business. The company’s new business model allowed gamers to download video games directly through Xbox and PlayStation digital stores. This helped EA improve profitability and connect with consumers directly. This “direct to consumer” model allowed the company to establish another source of revenue. The company then founded the EA Sports FIFA community, which accounts for more than a quarter of its annual revenues. With the new business model, EA’s cash flows have compounded, and it has moved out of the Unrecognized Growth bucket and into the Stable Growth bucket of the portfolio.
Kim: In the early years of the Fund, we purchased Apple Inc. stock, positioning it within the Unrecognized Growth bucket of the portfolio. We invested in Apple when it was a mid-cap company with a single-digit stock price. While we didn’t fully understand the future for iPhones and iPads at the time, we appreciated the changing computing paradigm from utility to media-driven capabilities. While Apple was distrusted in general by the market, we purchased the stock because we believed it was well suited to leverage changing and developing computing needs.
More recently, the Unrecognized Growth companies we hold have performed well and have helped to balance the Fund’s portfolio as markets have been rotating away from growth investing. Overall, we think growth investing at compelling valuations in different types of companies across the growth spectrum is the backbone of our process and is key to delivering consistently high risk-adjusted returns.
Since 2001, we have remained true to the Fund’s investment process. However, between 2013 and 2015, the Fund faced headwinds as the low interest rate environment challenged our pro-quality investment approach and rewarded companies that piled on debt. We are once again in a low interest rate environment, but this time, the Fund has performed well versus its benchmark, the Russell Midcap Growth Index. Why do you think the result is different today?
Kim: Historically, the Fund’s preference for lower leveraged companies has consistently resulted in a significantly lower debt/cap ratio than its benchmark. Between 2013 and 2015, a low interest rate environment caused many companies to increase their debt levels considerably and the market rewarded them relative to our holdings in the Ivy Mid Cap Growth Fund. During this period, the Fund underperformed on a relative basis. This was primarily because we stuck to our quality biased investment process and philosophy of investing in companies with sound capital structures with lower debt. Over time, quality has performed better as shown in the charts below, Russell Midcap Growth Index High vs. Low Gross Margin and Russell Midcap Growth Index Low vs. High Debt/Market Cap Ratio.
Fast forward to today. Interest rates are low again, but we are not facing the same headwinds as we did between 2013 and 2015. In the current stage of the economic cycle, we believe the environment and motivation for companies to add leverage might not be the same as it was in the past. Therefore, we believe our strategy of focusing on better quality companies should continue to perform well into the future.
Nathan: Let’s talk about the past 12 months. During the pandemic, there were several companies that saw their revenues and cash flows evaporate. In this kind of uncertain environment, it is unlikely for investors to reward those companies whose limited cash flow is going toward servicing high levels of debt. And while short-term returns can be very attractive, we focus on longer term investment horizons and thus spend a significant amount of time evaluating the business model and balance sheet risk of the companies in which we invest. Because we seek to remain true to our investment process and philosophy, we are unlikely to invest in higher debt companies as we believe, in the long run, higher quality companies should outperform their counterparts.
Kim: In the end, we believe it is about a company’s soundness of capital use given where equity investors stand in the capital structure.
Ivy Mid Cap Growth Fund’s quality bias: Quality companies with higher gross margins and lower debt-to-cap ratios have outperformed their counterparts over time as shown below.
Source: Evercore and Ivy Investments. Data: 01/01/1995 to 02/01/2021. Past performance is not a guarantee of future results. The portfolio illustrated in these charts is constructed on a “sector neutral” basis.
With fixed-income yields rising, we have seen a rotation out of growth and momentum and into value and cyclical companies. Given this situation, what changes have or are you making to the portfolio and how are you positioning the Fund for the future? In addition, what is your view on information technology sector exposure in the portfolio?
Kim: We strive to invest in companies that have strong cash flows across all environments and market cycles. However, in times like these (year-to-date through Feb. 26, 2021, the Russell Midcap Value Index has returned 7.3%, while Russell Midcap Growth Index has returned 1.3%), some investors have been rotating away from growth companies and toward cheaper, laggard companies that stand to catch up on revenues and earnings as the economy re-opens.
The Fund’s portfolio diversifies holdings across the growth spectrum by investing in companies within the three buckets of growth, as previously discussed. The Unrecognized Growth companies in the portfolio act as balancers – you can think of them as not necessarily value but value within our growth universe. So, the companies in the Fund’s Unrecognized Growth bucket can work to balance the portfolio and provide support when growth investing is in an out-of-favor market cycle.
Nathan: We are not “growth at any valuation” investors. We care about valuation in the context of the relative growth opportunity forthcoming for a company. And if a company gets too expensive to be owned across any of the buckets, we will exit that company even when we believe that it has low business risk.
Kim: The world now rides on the rails of technology. In the current expansionary cycle, expensive technology names have been market underperformers. This situation is allowing us to dig into technology names within the mid-cap universe to find entry points into potential long-term investment opportunities. We can now step into positions at better prices due to the prevailing winds of sentiment in the market, not necessarily because of erosion in the fundamentals of the companies that have our interest.
Source: Ivy Investments. Data: 01/19/2019 to 02/19/2021.
Fund’s standardized performance.
Fund’s most current top 10 holdings.
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 March 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.
Risk factors: The value of the Fund’s shares will change, and you could lose money on your investment. Investing in mid-cap growth stocks may carry more risk than investing in stocks of larger more well-established companies. 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 Midcap Index measures the performance of the mid-cap segment of the U.S. equity universe. The Russell Midcap Growth Index measures the performance of the mid-cap growth segment of the U.S. equity universe. The Russell Midcap Value Index measures the performance of the mid-cap value segment of the U.S. equity universe. The Russell 2000 Index measures the performance of approximately 2,000 small-cap companies in the Russell 3000 Index, which is made up of 3,000 of the biggest U.S. stocks. It is not possible to invest directly in an index. The Russell Top 200 Index is an index of the largest 200 companies in the Russell 3000 Index. It is commonly used as a benchmark index for U.S.-based ultra large-cap (mega-cap) stocks with the average member commanding a market capitalization of upwards of $200 billion. The Russell 3000 Index is a market-capitalization-weighted equity index that provides exposure to the entire U.S. stock market. It tracks the performance of the 3,000 largest U.S.-traded stocks, which represent about 98% of all U.S. incorporated equity securities.
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.
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.