Ivy Mid Cap Income Opportunities

Ivy Mid Cap Income Opportunities Fund
09.30.17

Market Sector Update

  • Investors in the stock market continue to be well rewarded with another quarterly gain experienced in the third quarter of 2017, marking eight consecutive quarters of positive performance. Much of the investment backdrop for the year has remained consistent. So far, the U.S. government has been unable to deliver on any of the early year optimism around a much more pro-business backdrop. Late in the quarter, slightly more optimism grew around early discussions on tax reform. While Washington has been a disappointment, it has been replaced with better economic prospects in both the U.S. and international economies. The areas of greatest operating leverage, energy and industrials, have seen a rebound in activity throughout 2017. Finally, the falling U.S. dollar should help domestic domiciled multi-nationals translate foreign earnings at a higher rate. This is a significant reversal of trend versus a persistently stronger U.S. dollar since mid-2014.
  • During the quarter, the Russell Midcap Index (Fund’s benchmark) increased 3.47%. The most economically sensitive sectors produced the best performance, with technology, energy, materials, industrials and financials all beating the broad benchmark. Similarly, the less economic sensitive sectors all underperformed. Consumer discretionary continues to underperform given long-term concerns around changing consumer consumption patterns, particularly within retail and media.
  • High dividend yielding stocks, those with yields greater than 2.8%, significantly underperformed their non-dividend paying or lower dividend paying brethren in the quarter. Long-term interest rates ended the quarter flat with the start of the quarter.

Portfolio Strategy

  • The Fund slightly underperformed the benchmark during the quarter as high-income producing stocks remained out of favor. Dividend income produced 89 basis points of performance in the quarter. Sector allocation was a positive with strong overweight allocations to technology, industrials and materials coupled with an underweight in real estate. During the quarter, we made some adjustments to our sector positions. We increased our weighting in industrials moving it from an underweight to an overweight position. This increase came from a reduction in the overweight position across consumer discretionary, technology and energy. We remain underweight real estate, financials and utilities.
  • The Fund underperformed in half of the sectors in the quarter with the worst relative performance in energy, consumer discretionary and consumer staples. Within energy, we had acute pressure from Plains All American Pipeline, which announced a significant profit reduction in its supplies and logistics business causing the dividend to become under review. We sold the position upon this announcement, but our ownership moving into the announcement caused relative pressure within that sector despite solid gains from our other oil infrastructure stock, Targa Resources.
  • Many of the equities we own within consumer discretionary were weak during the quarter. Leggett & Platt negatively preannounced its quarter due to increased steel prices and the associated lag embedded in its customer contracts that will pressure profitability for the rest of 2017. This caused the stock to be weak, although we view the event as transitory. Cracker Barrel Old Country Stores was also weak as many of its competitors have fallen short of profit expectations given a challenging environment for restaurants. To its credit, the company has been able to beat profit expectations, but the industry pressures have increased concern about all competitors in the space. We have maintained our position in both Cracker Barrel and Leggett & Platt. We have sold our underperforming position in Mattel after another disappointing quarter.
  • Similar to the competitive issues within the restaurant industry, our underperformance within consumer staples was driven by the competitive set versus specific holdings issues. Kellogg and Clorox both underperformed despite producing better than expected earnings. The dramatic changes with the packaged food companies around health and wellness, increased pressure from the retailers, and e-commerce costs have caused many to have difficult quarters. Kellogg’s stock was weak despite strong earnings driven by cost controls and a changing distribution method. Clorox experienced weakness late in the quarter after the hurricanes as investors became concerned about increased packaging costs given industry data points on pressure from resin suppliers.
  • We saw nice positive performance in industrials and technology. We experienced outperformance with most of our industrials stocks. Similarly within technology, most of our names outperformed, but the lion’s share can be attributable to Harris, a radio manufacturer.

Outlook

  • Since inception of the Fund, we have been watching several key variables to determine positioning. These variables (domestic economic growth, change in interest rates, change in commodity prices and foreign economic growth) have remained consistent and continue to be monitored.
  • We believe that some of the near-term U.S.economic numbers will present a slightly more opaque view given the hurricane impact across two major economic regions, but also expect economic growth to be aided as those regions rebound. In addition, we are mindful of that we are nearing the end of very easy comparisons in the industrials and energy sectors that have boosted year-over-year growth throughout much of 2017. With that said, many of the economic and consumer surveys that measure optimism remain at or near all-time highs. The U.S. government has the ability to further improve the sentiment and corporate profitability with significant tax reform if it can show any ability to push through legislation. Valuations in the market have increased given the eight consecutive quarters of stock market gains, but we believe the underlying economic fundamentals justify a higher valuation.
  • The Federal Reserve (Fed) has begun the great unwind of its quantitative easing stance by beginning to sell down its fixed-income holdings. We are hopeful the market takes this policy change in stride, but are keeping a watchful eye for any stress points. Who will hold the Fed chairperson’s role in February 2018 when the new term begins also remains a question. We are hopeful for a smooth transition. We believe the prospects for higher interest rates remain but understand that some technical factors may limit the pressure. Nonetheless, we continue to believe we can provide an attractive dividend yield versus those available in the fixed-income markets. The Fund has transitioned slightly to companies with even greater growth prospects.

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 Sept. 30, 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. Past performance is not a guarantee of future results.

Top 10 holdings (%) as of 09/30/2017: HNI Corp. 3.0, Glacier Bancorp, Inc. 3.0, Sonoco Products Co. 3.0, Cracker Barrel Old Country Store, Inc. 3.0, National Instruments Corp. 3.0, V.F. Corp. 2.9, Arthur J. Gallagher & Co. 2.9, Rockwell Automation, Inc. 2.9, HealthSouth Corp. 2.9 and CH Robinson Worldwide, Inc. 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.

Risk factors: The value of the Fund’s shares will change, and you could lose money on your investment. 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. 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. These and other risks are more fully described in the Fund’s prospectus. Not all funds or fund classes may be offered at all broker/dealers.