Focusing on quality in volatile times

Ivy Large Cap Growth Fund
03.18.19

Our view: Current environment, key drives

Markets started 2018 on a good note and stock prices continued to march higher through the first three quarters of the year. Large-cap growth stocks also performed particularly well. The Fund’s benchmark, the Russell 1000 Growth Index, returned over 17% during the same timeframe. Performance was strongest for profitability, momentum and earnings quality factors. Value and yieldoriented factors like dividends and buybacks generally underperformed. Even after the benchmark’s 15.9% decline in fourth-quarter 2018, long-term growth investors could have had a good run with cumulative returns for the index topping 400% since March 2009.

As 2018 unfolded, the Fund’s portfolio decision-making was influenced by several issues:

  • We were deep in an interest rate hike cycle that appeared likely to continue through the end of the year.
  • Trade outcomes were becoming difficult to predict, but history shows protectionism doesn’t typically end well for investors.
  • Markets were likely to experience more price volatility and correlation swings, characterized by what we consider irrational selling, which occurred in December 2018, and irrational buying, which occurred in January 2019. We thought multiple compression was more likely than further multiple expansion, given increased volatility and controversy about the duration of economic cycle.
Growth has outperformed value for more than 10 years
Chart Showing The cost of missing the market can be significant
Chart Showing The cost of missing the market can be significant

Source: Morningstar Direct. Cumulative returns of Russell 1000 Growth Index and Russell 1000 Value Index, Mar. 1, 2009 – Jan. 31, 2019, assuming reinvestment of dividends. The Russell 1000 Growth Index measures the performance of the large-cap growth segment of the U.S. equity universe. The Russell 1000 Value Index is an unmanaged index comprised of securities that represent the large-cap value sector of the stock market. It is not possible to invest directly in an index. Index returns may not be indicative of the Fund’s returns. See the Fund’s standardized performance information. Past performance is no guarantee of future results.

Against this backdrop, our goal was to improve the overall quality profile of the Fund. We are mindful of traditional metrics like return on equity, return on assets, leverage and margins, but also want to be aware of factor exposures within the portfolio. Our stock selection boosted relative performance during the year, and exposure to more quality-oriented factors proved to be well-timed.

Portfolio adjustments in 2018, the move to higher quality

As the year progressed, notable adjustments were made to the Fund’s portfolio in an effort to better prepare it for the increase in volatility that occurred as the economy slowed. Here are the highlights:

  • We reduced the Fund’s relative overweight position in information technology with the sale of two cyclical technology names, Applied Materials and Lam Research.
  • We reduced exposure to the financials sector as those stocks appeared to be too highly correlated with changes in the yield curve versus stock-specific drivers.
  • We increased exposure in consumer discretionary, focusing on strong consumer brands like Nike and Ulta Beauty that we believe are positioned for more sustainable growth regardless of the market environment, rather than sectorspecific beta. (Beta is a measure of a stock’s volatility relative to the overall market.)
  • We increased exposure in health care, targeting multi-year accelerating growth stories and companies that we believe have strong open-ended growth opportunities.
  • We decreased active beta factor exposure (relative to the benchmark) and exposure to earnings quality and profitability improved.
  • While the Fund’s growth exposure moderated, it remained higher than the benchmark.

The Fund primarily uses a bottom-up strategy focusing on companies we believe have dominant market positions and established competitive advantages. These characteristics can help to mitigate competition and lead to more sustainable revenue and earnings growth. Over time, we want and expect stock selection to be the primary driver of excess returns. At the same time, we know all factor exposures cannot be eliminated, and we work hard to ensure the factors expressed in the portfolio are intentional.

Given our views that volatility was likely to increase and growth would moderate over the coming quarters, we improved the overall quality of the portfolio by owning companies with better returns on equity and assets, higher margins and lower leverage.

The charts below illustrate the Fund’s improvement in quality over the past 12 months.

Fund's quality profile
as of Dec. 31, 2018 (%)
Chart Showing Fund's quality profile
Fund's quality profile — percentage point change
Dec. 31, 2017 versus Dec. 31, 2018 (%)
Chart Showing The cost of missing the market can be significant

Relative strength — Growth performance during periods of lower GDP

From a historical perspective, growth investors have tended to fare well in periods of lower U.S. GDP growth. The chart below illustrates historical relative performance for growth versus value (as measured by the Russell 1000 Growth Index and Russell 1000 Value Index) from Dec. 1978 to Dec. 2018. When the line is ascending, growth is outperforming on a relative basis versus value. When the line is descending, value is outperforming.

As shown, three of the past four periods in which growth stocks outperformed value stocks (denoted by solid oval), the U.S. economy experienced GDP growth of less than 2%. The remaining period of growth outperformance (denoted by a dotted line oval) coincided with the Dot-com boom and bust. This was the only period where growth outperformed and GDP was greater than 2%.

Relative strength — Russell 1000 Growth Index versus Russell 1000 Value Index
Chart Showing GROWTH HAS OUTPERFORMED VALUE FOR MORE THAN 10 YEARS
Chart Showing GROWTH HAS OUTPERFORMED VALUE FOR MORE THAN 10 YEARS

Source: Morningstar. *Cumulative returns: Russell 1000 Growth Index ÷ Russell 1000 Value Index (number is positive if growth is outperforming; number is negative if value is outperforming). Past performance is no guarantee of future results.

Snapshot: Average annualized returns (%) — GDP, Russell 1000 Growth Index and Russell 1000 Value Index
July 1979 — December 1980 October 1988 — December 1991 January 2006 — September 2018

Real GDP Growth

0.58

1.83

1.68

Russell 1000 Growth Index

35.62

23.20

10.81

Russell 1000 Value Index

19.73

12.48

7.51

Difference between indices

15.89

10.72

3.30

Chart sources: Morningstar, U.S. Bureau of Economic Analysis, Real Gross Domestic Product [GDPC1], retrieved from FRED (Federal Reserve Bank of St. Louis). Past performance is no guarantee of future results.

Outlook

Given the relative strength of growth-oriented stocks, some have asked whether their outperformance over value could continue in the coming. In our view, the answer is yes. We believe the market becomes more discerning as cycles age and sustainable growth is more difficult to find, ultimately rewarding higher-quality businesses that can continue to deliver durable revenue and earnings growth. Valuation is always relevant, but we are willing to pay more for the right combinations of growth and quality in later stages of the market cycle. We think our continued focus on higherquality businesses seems prudent.

We don’t believe a recession is imminent. Despite the aging cycle, many of the excesses that often precede a recession are hard to find. These include consumer debt, surplus inventories, corporate debt, and excess business investment, which were very muted this cycle. It is possible that later in the year, and into 2020, the growth deceleration could lead to a shallow economic recession.

The trade war remains a wild card as it is putting a dent in business and consumer confidence. There is currently no sign of a trajectory change on the issue, which bodes poorly for the durability of economic growth. The Trump Administration may react to the softening economic growth with more progress on a trade war resolution, but there is little indication of that right now.

Barring a legitimate economic recession, we think that the current modest growth environment remains supportive of durable, long-term growers, and a quality bias still seems appropriate considering potential for increased volatility. We believe a slowdown in growth would likely narrow investors’ focus on stocks with these characteristics, hopefully driving continued outperformance for growth styles.

Fund Performance
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Past performance is no guarantee of future results. The opinions expressed are those of the Fund’s managers and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through February 2019, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This commentary 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.

Class I shares are only available to certain types of investors.

The S&P 500 Index is an unmanaged index of common stocks. It is not possible to invest directly in an index.

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 then an investment with greater diversification. 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.