Oil industry faces short-term hurricane impact
While it’s too early to know the full economic and human toll of Hurricane Harvey, we expect a relatively short-term impact on the U.S. energy industry.
To date in 2017, the Ivy Mid Cap Growth Fund has experienced double-digit returns. The Fund’s performance as of June 30, 2017 (before the effects of sales charges) was better than both the Russell Midcap Growth Index (the Fund’s benchmark) and a number of its mid-cap growth peers. Strong stock selection, particularly in the technology and consumer staples sectors, has been the driving force behind the Fund’s recent relative outperformance. Below, Portfolio Managers Nathan Brown, CFA and Kimberly Scott, CFA discuss the Fund’s performance for the first six months of 2017 and investment opportunities they are seeing in today’s market.
For the first six months of 2017 the Fund outperformed the Russell Midcap Growth Index and a number of its mid-cap growth peers. Active managers have also seen a recovery in performance as more than 65% of mid-cap growth managers have outperformed the benchmark year-to-date, according to Lipper.
We believe the first six months of 2017 can be best described as the return of growth and, to a fair degree, a return of momentum. This current push doesn’t appear quite as strong as it did in mid-2015 but we are definitely seeing an impact to the performance of many the Fund’s holdings. Over the past several months, we noticed that a number of the Fund’s truly differentiated, unique and innovative company holdings are participating in some of this momentum. This doesn’t seem surprising as these firms appear to have good earnings and growth prospects as witnessed by their quarterly reports, balance sheets and future projections. From a broader standpoint of being able to discount the market at strong valuations given the current state of interest rates, the environment still remains constructive for growth.
In addition, we think the public’s expectations of what Washington might do are subsiding and believe it is encouraging that the market has been able to forge ahead even with diminished expectations. This positive situation points to a U.S. economy that appears sound and the market seems to be taking a lot of its cues from economic growth as opposed to political actions.
One of the things that we’ve discussed over the past three to five years is the persistent headwind to the Fund’s process of investing in high-quality companies versus those with high levels of indebtedness. In 2016, we started to see that headwind abate, and as we turned the page into calendar year 2017, those headwinds continued to diminish. Companies with the most levered balance sheets in the mid-cap growth universe are now underperforming the Russell Midcap Growth Index by about 300 basis points year to date.
This trend has helped the Fund’s performance versus the benchmark. What we find encouraging about this is if we think about 2016, we saw interest rates increasing while at the same time becoming less of a headwind to the Fund. So far in 2017, interest rates have been flat to down and we are still seeing those companies with high amounts of leverage underperforming. We are hopeful this is an indicator from a performance perspective that the pressure the Fund was experiencing is truly in the rearview mirror and we are now able to focus on the organic growth of individual companies versus companies that are financially engineering earnings growth.
Technology was the Fund’s strongest performing sector and largest overweight position. Across technology we have a number of strong software names. The standout in this group during the first half of the year was Mobileye, a global leader in the development of vision technology for Advanced Driver Assistance Systems (ADAS) and autonomous driving. While Mobileye is no longer a Fund holding — we sold it once Intel made an offer to buy the company — it contributed a fair degree to the technology sector’s performance.
Lately, we found several good secular growth companies within the technology space. Some of them are older companies that have been in the portfolio for a while like Electronic Arts (EA), which is benefiting dramatically from a shift from physical games to digital downloads. There is a nice margin benefit that EA gets when a consumer downloads a game from a retail website or Xbox store versus buying it from a local Wal-Mart or Target. The web aspect of EA’s business has been a great benefit to the company’s bottom line.
ServiceNow was another Fund holding during this period that is providing software-as-a-service solutions for some of the world’s largest companies. It started out as a relatively niche product for IT help desks but has since continued to grow its menu of products for all of its customers. We have a group of companies within the mid-cap space that we continue to take advantage of within the software-as-a-service model, as the technology shift has moved from on-premise to off-premise and licensed business models.
The Fund’s second strongest performing sector was consumer staples. This sector’s performance was driven by Whole Foods, which received a buyout offer from Amazon in June. Whole Foods is a name that has been in the Fund’s unrecognized growth bucket since late 2015. The grocery store retailer has been so successful with its business model that it created an industry within an industry for organic and natural foods. Whole Foods has performed very well and contributed to strong sector performance.
Beyond technology and consumer staples, we have seen some outperformance from the industrials sector. The Fund’s industrials exposure made a slight positive contribution to relative returns, primarily due to strong stock selection. Two strong names were IDEX Corp., a diversified industrial technology company, and Fortune Brands Home and Security. Our lack of holdings in the real estate sector, an underperformer for the benchmark, provided the Fund with a little bit of upside relative performance.
From materials to financials and health care to consumer discretionary, sector performance has ebbed and flowed, but by far, the Fund’s biggest underperformer was energy. This is where, from a relative basis, we have had the most pressure year to date and not enough to offset the strength that we were seeing elsewhere. During the first half of the year, we reduced some of the Fund’s energy exposure. We don’t expect to see any kind of crash in the sector but rather, it appears more likely that it is going to be very difficult for the price of oil to go too high and stay there for too long. There is just too much supply. We think that the amplitude of gains and drops in the price of oil is probably dampening out secularly for a while and the Fund’s exposure to energy will probably not increase in the near future.
Health care was a slight overweight in the Fund and was a source of slight relative underperformance — despite, some of the best performance on an absolute basis coming out of this sector. We believe health care includes a fertile group of growth companies within the mid-cap space, and the group is quite diversified. We have made a few changes here and there with a couple of additional names, but for the most part, the bulk of the Fund’s exposure remains with names that have been in the portfolio for quite some time, such as: Intuitive Surgical, Zoetis, Align Technology and Edwards Lifesciences. We still see positive prospects for these companies going forward.
Consumer discretionary was an area where the Fund was underweight as there have been a number of secular changes that are happening for companies within this space, particularly within retail. Retail has been a very difficult area. We don't think a day goes by that there isn’t news regarding threats of or actual store closings or problems with mall traffic. While we still had exposure to what we consider to be some of the marquee names and brands in the space like Tiffany & Co., Burberry Group and lululemon athletica, Inc., we didn't fully anticipate the speed and ferocity with which the problems in retail would play out. As a result of these problems, many company profits have been compromised and these stocks have really struggled to the downside. We have sold a number of our retail names because we decided that while these could be good unrecognized growth prospects with positive cash flow, they just didn’t have enough proprietary product to be able to effectively compete with online retailers like Amazon. While retail makes up a fairly sizable component of the benchmark, we anticipate maintaining an underweight position in Fund for the foreseeable future.
There are areas within consumer discretionary aside from retail that appear to be doing well and we plan to add names to the Fund’s sector exposure in the near future.
MarketAxess and Allegion are two holdings that we have recently added to the Fund’s portfolio. MarketAxess is a fixedincome electronic trading platform for institutional investors and broker dealers. The company’s patented electronic platform enables fixed-income market participants to source competitive and executable bids or offers in the broadest range of cash credit and credit derivatives. MarketAxess has tremendous cash flow because it’s basically a tollbooth for bond trading. It has very little capital need, strong cash flow and is growing rapidly by taking share of a big market. Best of all, the company is doing all of this with no indebtedness. MarketAxess is also growing its dividend, and we believe this should be a productive investment. If the valuation remains supportive and the investment thesis continues to play out as we suspect, we should be long-term investors in the company.
Allegion manufactures and sells mechanical and electronic security products and solutions worldwide. It offers numerous types of locks; door closers and controls/exit devices; electronic security products and access control systems; time, attendance, and workforce productivity systems; doors and door frames; and other accessories. We bought the stock because there has been a secular shift going on from just mechanical locks. Simple key locks are turning into electrical-mechanical locks that can be opened with a key card or cell phone. There has been this significant shift going on from a safety perspective, which should help drive the company’s business. This shift means the company can sell locks for three times the revenue of the standard mechanical lock, and they have the exact same gross margins. If you do the math, this means you are getting three times the dollars on the new gross profit line that you did from the old one.
We have expected the market to deliver positive returns in 2017, and thus far, have not been disappointed. We think the markets can move higher based on accelerating economic growth around the globe, vastly improved U.S. corporate profits as compared to the last two years, and the potential benefits of pro-growth, pro-cyclical policies that can enhance an already positive environment.
Economic activity in the U.S. is continuing at a low but stable pace, as housing demand continues to improve, and consumption in general remains firm tied to ongoing strength in jobs and wage gains. Global industrial production is stronger than in recent years as evidenced by the Purchasing Managers Index in many countries.
Interest rates, while increasing, still seem supportive of investment and growth, as does the credit environment. The valuation on the market has expanded with last year’s gains, but levels are reasonable to support further market appreciation as we discount additional increases in corporate profits. We think the factor that should provide underlying support for a corporate profit and stock market outlook that was encouraging even preelection is the pro-growth stance of the Trump administration, should it get organized enough to effect change.
A more supportive regulatory and taxation environment and a drive to invest in the U.S. could lift an already improving economic and profit picture to a higher level. The response from credit markets will be important to monitor, as higher interest rates could have a dampening impact on a stronger growth scenario.
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 August 2017, 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.
Through July 31, 2018, Ivy Investment Management Company (IICO), the Fund’s investment manager, Ivy Distributors, Inc. (IDI), the Fund’s distributor, and/or Waddell & Reed Services Company, doing business as WI Services Company (WISC), the Fund’s transfer agent, have contractually agreed to reimburse sufficient management fees, 12b-1 fees and/or shareholder servicing fees to cap the total annual ordinary fund operating expenses (which would exclude interest, taxes, brokerage commissions, acquired fund fees and expenses and extraordinary expenses, if any) as follows: Class A shares at 1.31%. Prior to that date, the expense limitation may not be terminated without the consent of the Board of Trustees (Board).
Class R6 shares were renamed Class N on March 3, 2017.
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.