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.
In the current market environment, the mid-cap space is being led by growth companies and value is lagging. In the past, you have shared that the rally has been driven by the safest companies, those that are either not closely linked to the economic cycle or those that have benefitted from the pandemic-induced work from home mandate. At the same time, second quarter 2020 data has indicated, by a small margin, that higher debt companies have outperformed lower debt companies.
Here are three questions related to this backdrop:
Kim: In my view, valuations are becoming extended. I think all companies – even the ones that are very popular in these new normal times – are getting impacted by the ongoing pandemic. Importantly, while many of our investments have been resilient, we are aware that uncertainty around COVID-19 continues to cloud the outlook for companies in our universe. I still believe that companies with business models supported by the work from home mandate will continue to benefit, but we may see an evolution within investors’ appetites toward attractive business models with more compelling valuations.
In the Ivy Mid Cap Growth Fund, investing across the growth spectrum is the backbone of our process as it helps us diversify and work toward delivering high risk-adjusted returns. The Stable Growth bucket – the mature core growers – is the ballast in the portfolio. Historically, this bucket has usually formed about 40-60% of the portfolio. Next, we layer in the more innovative, faster growing companies within the Greenfield Growth bucket. Finally, we seek companies within the Unrecognized Growth bucket. This bucket is comprised of companies where there is general investor disenchantment due to a particular management decision or a lack of company focus on an opportunity that had the potential to re-assert growth.
In terms of recent investment opportunities, we are uncovering companies within the small-cap space that are maturing into mid caps. The Unrecognized Growth bucket has also provided us with what we feel are some great investment options at reasonable valuations. This is supported by healing within various parts of the U.S. economy. These are areas that have not yet been recognized by the wider investor base. While this bucket is not the biggest part of the Ivy Mid Cap Growth Fund’s portfolio, the diversifying aspect of investing across the growth spectrum is designed to help us to effectively manage risk in these uncertain times.
Regarding your final question … with the backdrop of extremely low interest rates and the amount of liquidity the Federal Reserve has pumped into the economy, I am not surprised by the outperformance of higher debt companies in the second quarter of 2020. However, I want to reiterate our view that in the current stage of the economic cycle and given the stresses in the credit market, 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 that our strategy of focusing on better quality companies should continue to perform well in the future.
Recently, the Ivy Mid Cap Income Opportunities Fund has performed well versus its Morningstar peer group. However, during this same period, the Fund underperformed its Russell Midcap Index benchmark. Given the Fund’s dividend component and the attention it pays to valuations, we expect it to outperform the U.S. market during downturns. Please provide your thoughts on why the Fund’s performance deviated from expectations during this period?
Nathan: A key aspect to keep in mind is the Fund’s construct. While the Fund may be officially in the Morningstar Midcap Value category, we typically seek core growers that are able to pay dividends. It is this dividend component that pushes us into the Morningstar Midcap Value category. Given the performance of value and our investment in dividend-paying core growers, we have considerably outperformed our Morningstar peer group during this time period, though absolute returns for both were negative. At the same time, our benchmark, index has limitations in representing our Fund. Recently, the rally in the index has been driven by growth companies that do not pay any dividends (example, technology companies such as DocuSign). In keeping with our investment mandate, our emphasis on dividend-paying securities can weigh on the performance of the Fund relative to the index.
The environment we are currently in is very different from anything we have experienced in the past. In previous market downturns, dividend-paying stocks were rewarded, but recently, growth companies have been favored. These growth companies are benefitting from the work from home mandate but as we discussed earlier, we are unable to invest in them as these companies typically don’t pay dividends.
During 2020, we exited some of our holdings in the mid-cap space – specifically some of those within the energy and utilities sectors where we felt these companies might be unable to regain their pre-pandemic dividend levels. Is there a hard rule you follow for exiting companies that don’t match the Fund’s 0.5% minimum dividend yield threshold? Also, given the uncertainty around the virus and the fact that revenues may stay lower for longer, how are you currently positioning the portfolio and where are you seeking investment opportunities?
Nathan: We have a dividend threshold framework that guides our investment strategy over a vast majority of market cycles and conditions. However, in extreme environments, like the one we are currently experiencing, we have been flexible and adaptable with our dividend policy.
Under normal circumstances, in the relatively short term, if we believe a company will be unable to return to its past dividend policy levels, we will likely move away from it. We don’t want to get ourselves in a box with what exactly “relatively short term” means because we want our companies to do what is right for their businesses.
However, given the current circumstances, revenues for many companies have fallen to 0 or close to 0. Today, we are working closely with the management of these firms to understand and deeply analyze the outlook of their businesses and expected dividend policies as economic activity starts to normalize. For many of these businesses (such as Wyndham Destinations), we expect that by the end of 2021, dividends will be reinstated at the pre-pandemic levels.
We are long-term investors and in these extremely uncertain environments, we are looking for sustainable business models that would be back to their pre-pandemic dividend levels as we emerge from this uncertain market environment. For the portfolio as a whole, we are still working to generate the dividend payment and divided growth that our investors expect.
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 5, 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.
Ivy Mid Cap Growth Fund - Top 10 holdings (%) as of 06/30/2020: Chipotle Mexican Grill, Inc. 3.6, CoStar Group, Inc. 3.3, Electronic Arts, Inc. 3.2, MarketAxess Holdings, Inc. 3.1, DexCom, Inc. 3.0, Teradyne, Inc. 2.8, Square, Inc. 2.7, DocuSign, Inc. 2.7, Twilio, Inc. 2.6 and Fastenal Co. 2.6.
Ivy Mid Cap Income Opportunities Fund - Top 10 holdings (%) as of 06/30/2020: Leggett & Platt, Inc. 3.0, Quest Diagnostics, Inc. 2.9, Scotts Miracle-Gro Co. 2.9, Wyndham Destinations, Inc. 2.9, Snap-on Inc. 2.9, C.H. Robinson Worldwide, Inc. 2.9, Hasbro, Inc. 2.9, Paychex, Inc. 2.9, Packaging Corporation of America 2.9 and Sonoco Products Co. 2.9.
The Russell Midcap Index measures the performance of the mid-cap 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. Ivy Mid Cap Growth Fund: Investing in mid-cap stocks may carry more risk than investing in stocks of larger, more well-established companies. Ivy Mid Cap Income Opportunities Fund: Investing in mid-cap stocks may carry more risk than investing in stocks of larger, more well-established companies. The Fund’s emphasis on dividend-paying stocks involves the risk that such stocks may fall out of favor with investors and underperform non-dividend paying stocks and the market as a whole over any period of time. In addition, there is no guarantee that the companies in which the Fund invests will declare dividends in the future or that dividends, if declared, will remain at current levels or increase over time. The amount of any dividend the company may pay may fluctuate significantly. In addition, the value of dividend-paying common stocks can decline when interest rates rise as fixed-income investments become more attractive to investors. This risk may be greater due to the current period of historically low interest rates. The Fund typically holds a limited number of stocks (generally 35 to 50). As a result, the appreciation or depreciation of any one security held by the Fund will have a greater impact on the Fund’s net asset value than it would if the Fund invested in a large number of securities.
Diversification cannot ensure a profit or protect against loss in a declining market.
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.