The Fed shifts on inflation – What does it mean?
The Fed unveiled a revision to its monetary policy, allowing for higher inflation to help support the labor market. We believe this action could keep interest rates low for years.
The Russell 1000 Growth Index, the Ivy Large Cap Growth Fund’s benchmark, just completed its best four-month run of performance in history. As of August 14, 2020, the index has returned over 60% since the March lows and is 10% higher than the previous peak in February. Ivy Large Cap Growth Fund Portfolio Manager Brad Klapmeyer shares some observations from the market’s recent strength.
The aggressive V-shaped market recovery is an amazing feat given the economic slowdown caused by the pandemic. We are clearly disappointed that we didn’t outperform, but our strategy isn’t built to outperform in these early stage recoveries. Our philosophy of owning high quality, sustainable business models means we avoid owning a couple types of companies, those typically found in what we consider the tails of the market.
The first tail includes hyper, unproven growth companies, many of which have returned over 100% since March market lows. Companies in this group have benefitted from the perception of wildly scarce growth. The high-growth tail is also characterized by expensive valuations as investors pull forward multiple years of growth. As a result, expectations are higher and there is little room for error. Granted, some of these companies will prove to be long-term winners but having the ability to repeatedly identify those companies ahead of time is very challenging and, in our view, unnecessarily risky. Returns of higher quality businesses won’t keep up in that environment, but we think that works to our benefit over the long term as it’s a more sustainable process.
The second tail includes some of the deeply cyclical, low valuation (i.e. “cheap”) businesses. Companies in this group are usually very dependent on gross domestic product (GDP) growth and rally aggressively in an economic recovery. Circumstances around this year’s recovery were a bit unique. Prospects for GDP growth did not get materially better, but the Federal Reserve took aggressive steps to reinforce liquidity, support small business employment, and increase the likelihood that these companies continue to exist as a concern. Many of these businesses were in dire straits, but once the market believed they wouldn’t be allowed to fail, they rallied aggressively off the bottom.
Exhibits 1 and 2 illustrate this point. Exhibit 1 breaks the Russell 1000 Growth Index into 11 groups based on price-to-earnings (P/E) ratios for the current fiscal year (P/E FY1), and a final group of companies with negative earnings we’ll call the “non-earners.” Companies in one of the most expensive baskets, represented by P/E ratios between than 45 and 50, outperformed the index by nearly 50%. The basket with the lowest P/E multiples outperformed by 39%, and, even more telling, non-earners represented one of the best performing basket by beating the benchmark by 32%. The rest of the index generally performed in-line with the benchmark’s return for the period. Exhibit 2 breaks the index into deciles based on 3-year estimated sales growth, with each grouping having the same number of stocks. Companies with highest expected sales, many of which fall within the hyper, unproven growth basket mentioned above, outperformed the benchmark by 48%. Returns for businesses with average or slower growth expectations (deciles 5-10) typically lagged by 7-28%.
In these types of environments, we work hard not to react to near-term trends. Empirical evidence suggests large companies with high-growth profiles and expensive valuations have a high rate of attrition. Profitability is attacked by disruptors and growth often decelerates, pushing valuations lower. History also suggests the pace of attrition accelerates as expectations rise. Our philosophy is designed to mitigate these risks by owning more durable business models that can deliver sustainable growth over a longer investment horizon.
For example, Tesla has performed extraordinarily well in 2020 and would fall in the hyper-growth category outlined above. Perhaps Tesla can dominate the electric vehicle market for decades to come or expand markets in which it competes. If the company is able to earn a 20% earnings before interest, taxes, depreciation, and amortization (EBITDA) margin on a $40,000 vehicle sale, when other auto manufacturers are typically earning single-digit EBITDA margins, competitors will come rushing in. Ferrari, on the other hand, has built a valuable luxury brand over the course of decades. It certainly isn’t the only company capable of producing a high-quality car, but its brand strength allows it to generate very attractive profit margins. And its customers likely feel good knowing the residual value of their purchase will improve over time. We believe companies like Ferrari with more sustainable competitive advantages are a better fit for our style.
Strategy performance during the second quarter was also influenced by the uniqueness of the recovery. Steady growers like Coca-Cola or Motorola Solutions are good examples. In more typical recessions, people still buy soft drinks at restaurants and gas stations. Obviously, this time was different as consumers could not go out to eat or fill up a fountain drink. As economies around the world start to re-open and we return to some form or normalcy, we would expect sales of Coke’s products to improve significantly. Motorola Solutions operates in the public safety market, which is very high-touch, and the inability to see clients created a negative environment. Shares were further pressured due to concerns regarding the needs of health care infrastructure taking temporary priority over public safety infrastructure and calls for police defunding. We think both of these companies have very stable core businesses and attractive growth opportunities, creating opportunity for longer-term investors.
The strategy’s process will not outperform in every environment, and the second quarter was a good example of that scenario. We’re pleased that we could participate in most of the recovery without taking what we deem excessive risks or making reactionary adjustments based on short-term trends. As we look forward to the second half of 2020 and beyond, we continue to look for opportunities to invest in durable, competitively advantaged business models capable of withstanding disruption. We believe this will serve shareholders well over the long term.
Relative Returns vs. Russell 1000 Growth Index – (03/23/2020 to 08/15/2020)
Source: Factset, Ivy Investments. Past performance is no guarantee of future results. Relative returns are based on a sub-sector of the index. For the first chart, each group contains companies whose P/E FY1 ratio falls within that respective range. Example: For the > 50 group, stocks had P/E FY1 ratios greater than 50 on 03/23/2020. Returns shown are that group’s return +/- the index’s return. Note: Similar methodology for the estimated sales growth group was used, except the index was divided into deciles with an equal number of companies in each group. Companies lacking data have been excluded.
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 15, 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.
Top 10 holdings (%) as of 06/30/2020: Microsoft Corp. 9.9, Apple, Inc. 7.3, Amazon.com, Inc. 6.2, Visa, Inc. 4.7, Alphabet, Inc. 4.0, Facebook, Inc. 3.4, Adobe, Inc. 3.3, Motorola Solutions, Inc. 3.3, Coca-Cola Co. 3.1 and Cerner Corp. 2.9.
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.
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 than an investment with greater diversification. The Fund typically holds a limited number of stocks (generally 40 to 60), and the Fund’s portfolio manager also tends to invest a significant portion of the Fund’s total assets in a limited number of stocks. As a result, the appreciation or depreciation of any one security held by the Fund may have a greater impact on the Fund’s NAV than it would if the Fund invested in a larger number of securities or if the Fund’s portfolio manager invested a greater portion of the Fund’s total assets in a larger number of stocks. 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.