Big innovators among small companies

Ivy Small Cap Growth Fund
09.24.19

After a strong start in 2019, small-cap holdings have lagged their large-cap counterparts for most of the year. However, we believe the potential for stronger earnings and sales among smaller companies is likely to improve in the waning months of the year and going forward in 2020. For investors seeking growth opportunities, we believe an allocation to small caps make sense.

Our approach: A tilt toward innovation

Our process focuses on growth companies in the small-cap universe we believe have the potential to become mid-cap stocks over a period of years. We want to own companies with the ability to pursue large markets, and have business models with identifiable competitive advantages over peers. Some of the metrics we use to assess these qualifying candidates are strong management teams, the sustainability of their profitability and the capacity to balance above-average returns and below-average volatility over time.

One common characteristic of many of the portfolio’s holdings is a tilt toward innovation, particularly in the health care and information technology sectors. The Fund’s largest weightings are in these two sectors and combine to make up about half of the portfolio’s composition.

Big believers in SaaS

Within IT, the Fund has a strong conviction and overweight to software stocks, which has benefitted from significant secular tailwinds, such as cloud-based and automation efficiency transformations. Over the past decade, companies of all sizes have gravitated toward SaaS applications where software is sold and continually improved, making these products more evergreen while enabling organizations to efficiently refresh their technology platforms. SaaS companies have large addressable markets, particularly vertical industries like banking, customer-service and talent management providers.

Companies with call center services using legacy software have faced challenges with software incompatibility or integrating newer communication preferences like text and chat to engage customers. SaaS providers appear to be shifting that paradigm.

One such company is Five9, Inc., a leading provider of enterprise contact center software that replaces legacy on-premise contact center systems by delivering its platform via the cloud. The company has delivered double-digit sales growth for seven consecutive years and has a very reliable and transparent management team, which affirms our high conviction on this holding.

Chart Showing HISTORICALLY, INNOVATION HAS DRIVEN IT STOCK SELECTION AND PERFORMANCE
Chart Showing HISTORICALLY, INNOVATION HAS DRIVEN IT STOCK SELECTION AND PERFORMANCE

Fund’s information technology allocation performance vs. Russell 2000 Growth Index information technology allocation performance, 08/31/2009 – 08/31/2019.
Past performance is no guarantee of future results. Source: Ivy Investments/FactSet. As of 08/31/2019.

Looking beyond novel therapies

Given the current divided government in Washington D.C., we believe major health care reform is unlikely before the 2020 elections. With the Affordable Care Act still available to all Americans, the percentage of insured patients should also remain stable. As a result, overall health care growth is anticipated to be slow but steady in the lower single-digits, slightly higher than U.S. gross domestic product. The sector’s minimal exposure to cyclical slowdowns and trade wars makes it more appealing as macro concerns escalate.

When we apply our process within the space, certain subsectors are more appealing to our thesis than others. As the value-based health care model — compensating providers based on patient health outcomes — and higher deductibles continue to slowly push medical costs higher, consumers are likey to seek other health care options. In addition, insurers are accelerating the shift to more costeffective settings and procedures, like ambulatory, in-office and home-based treatments. Therefore, we continue to gravitate to companies that facilitate the trend away from costly hospitals.

An example is Teladoc Health, Inc. a leading telemedicine provider that uses web-based and mobile technology to provide on-demand medical care. The company believes the accelerated adoption of the virtual care model will provide greater access to care for patients than traditional visits to inpatient facilities. We believe telemedicine companies like Teladoc could materially change health care delivery. The company is one of the largest holdings in the Fund, and we believe it could experience long-term growth and profitability.

Unlike the benchmark, we consistently underweight the biotechnology and pharmaceutical groups, which causes our health care sector weight to fluctuate. These companies typically are more discovery-based or feature single-product pipelines. They tend to have a more binary risk profile centered on an “all or nothing” reliance on clinical data or drug approval. In addition, these biotech and pharma companies often lack the profitability and operational infrastructure we seek in portfolio candidates.

Chart Showing HISTORICAL UNDERWEIGHT HEALTH CARE ALLOCATION HAS OUTPERFORMED BENCHMARK
Chart Showing HISTORICAL UNDERWEIGHT HEALTH CARE ALLOCATION HAS OUTPERFORMED BENCHMARK

Fund’s health care allocation performance vs. Russell 2000 Growth Index health care allocation performance, 08/31/2009 — 08/31/2019.
Past performance is no guarantee of future results. Source: Ivy Investments/FactSet. As of 08/31/2019.

While the small-cap category has underperformed recently, we believe the premium for high quality, fast-growing companies, mostly in the information technology and health care sectors, could be sustained in the forthcoming quarters. Given the trends of innovation we currently are seeing in these key industries, we believe our process of identifying companies with strong buisness models, attractive end markets and effective management teams provides growth potential for the Fund.

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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 August 2019, 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 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 measures the performance of the small-cap growth segment of the U.S. equity universe. It is not possible to invest directly in an index.