Ivy Small Cap Core Fund – Investment Update
Commentary as of July 8, 2020
Walk us through this quarter from a performance perspective and point out your biggest takeaways.
Underperforming by 800 basis points (bps) is a tough number to digest and is something we clearly aren't happy about. In down markets we tend to do better, so fortunately we had a little bit of a lead that helps offset that from the first quarter. Second quarter was tough for active managers, where the average small blend manager underperformed the Russell 2000 Index, the Fund’s benchmark, by about 200 bps. We would expect to struggle in a period where the market goes into risk-on environment. However, we are surprised by the magnitude of this. We think there are three key reasons to what drove underperformance for the period.
First, let's take a look at how the Fund is structured and what to expect over a full market cycle. The Fund has a higher average market capitalization by design based on higher concentration and liquidity. Over time, it also has a higher quality bias, as well as a lower beta just by the nature of how we manage the portfolio, which equates to lower risk. Unfortunately, those elements went right against us in the type of environment we faced in the second quarter. Stocks within the smallest quintile of the benchmark in terms of market cap had twice the return as the highest quintile for the quarter. This was similar for return on equity, where low return on equity outperformed, as well as for beta, where high beta stocks outperformed. The lowest quintile for beta returned -6 bps for the quarter while the highest quintile returned just under 7%. So you can see that it was very much a risk-on environment.
There were also some structural aspects in the quarter for which we take responsibility in terms of how we approached the drawdown. Most notably, we did not think that the market was going to snap back as quickly as it did. We figured that there would be more time needed in waiting for the numbers to settle out before experiencing this upturn in the market. What proved us to be wrong was the aggressive policy response from the U.S. government, which had a dramatic effect on how the market responded. The government responded much quicker than it did back in 2008, with an unprecedented amount of stimulus, and this was not something that we expected. Are we out of the woods? We wouldn't necessarily say so, but we think the majority of the move is behind us. It's possible that we could continue to see low quality lead the way, but we believe that this trend is mostly over.
In shorter timeframes with a concentrated portfolio, the top holdings of the portfolio can either work for or against you. Unfortunately, the top of the portfolio was not able to bail us out this quarter. In fact, it was a further detractor from performance. Historically, we've done quite well with our top holdings, and they've been a source of positive attribution, but they weren't for the quarter. We are still strong believers in having conviction and concentration within the portfolio and that this will work for us over time. It happens that concentration combined with the risk-on environment further exacerbated the underperformance for the quarter.
Overall it was a challenging quarter, and we look to learn from it. We still firmly believe in our process and hope to recover over the remainder of the year.
While there has been some encouraging news coming out for economic data in the U.S., the market has seemed to not take very much time in ramping back up. How are you thinking about this potential disconnect between the U.S. economy and the stock market?
It's really all been about stimulus. The market clearly didn't wait for estimates to settle out before running higher. For example, if you look at the S&P 500 Index's earnings, which are easier to cite because the data is out there and is much clearer to everyone, the numbers seemed to bottom out in mid-May and have bounced up a little since then. The market is forward looking, but to say the expectations of the near future are clear would be a massive exaggeration. We think that expectations are probably about as wide as we've ever seen when it comes to individual companies and what drives consensus. There' clearly a lot of uncertainty in the market.
In terms of sequential improvement, it's clear that there's room for sequential improvement considering how far numbers have already dropped. When we see numbers like a hotel going from 50% to 60% occupancy, it's hard to get too excited. As we get further along and the stimulus subsides somewhat, the real question is when will we get back to where we were at when we entered the year and what will the growth look like going forward? The market seems to believe the government has its back and will support it if it falters, which we think is probably true, but we also think that is the consensus.
We also believe that the market feels that things will get back to normalcy quicker as the death rate has decreased some based on the number of the cases. You don’t have to shut down markets to get people to take their own actions, and we're seeing this right now in states where there have been a pop in cases. It is still a very uncertain market still, and as we get to the back half of the year, we should have a clearer view of the economic numbers as we come off of this stimulus.
One thing to keep in mind is that we were at full employment and transitioning to unemployment in the mid-to-high teens is dramatic. It seems like the unemployment rate will stay in the high single-digits to end the year, but this is still rather unclear as well. With the vast amount of stimulus, companies are encouraged to keep people employed, but if the business doesn't recover, it makes for a different story. For example, in the airline industry most employers have promised to keep employees until September, but there is uncertainty about what happens afterwards. We still think there are a lot of questions to be answered on this subject.
In managing a core strategy, you obviously have opportunities on both sides of the style spectrum between value and growth. How are you currently viewing value and growth?
When looking at value and growth, we think it's very important to pay attention to large differences in sector exposures between the Russell 2000 Value Index and the Russell 2000 Growth Index. On the growth side, health care makes up about 34% of the index, whereas it is about 6% on the value side. Information technology comprises 21% of the Russell 2000 Growth Index and only 6% of the Russell 2000 Value Index. Conversely, financials make up only 4% on the growth index, but account for nearly 28% on the value side. Health care and information technology have been market leaders while financials have been underwhelming. This alone shouldn't make the divergence we've seen in performance between value and growth to be too surprising.
If you believe that growth is going to accelerate off the bottom and this will lead to some inflation, this most likely cause some steepening of the yield curve, which would likely put tremendous pressure on longer duration assets. For example, many investors are rushing towards tech and biotech companies due to a lack of other growth prospects which puts a lot of value on the companies' terminal value. If rates go up, it wouldn't shock us if we were to see some compression in the multiples we see in growth. We don't see a massive rip coming out of value, but we think the relative performance could be key. Banks haven't done well which is logical because the curve is rather flat and there are concerns around the credit cycle.
We think you have to participate in the growth right now because that's where all the market action is, but we are much more selective and concerned about valuation. We don't think this disparity can last forever and that growth may run out of steam to some extent. On the other side, we also think it's prudent to have some value exposure because it really is not crystal clear what is to come next. However, as we stand now, the market bias is definitely leaning towards the growth side of the spectrum.
With that being the case, the greatest pain could be experienced if we see that flipping, and that is something that we're thinking about all the time. There's a good reason why we've seen a large difference in returns between these two indices, and the tension still remains.
You are very deliberate in wanting to maintain style integrity and staying within the Morningstar small blend style box. What obstacles have you faced there, and with the coming changes at October’s month end, how do you think this will change things?
The Morningstar small-blend box has not approximated that of the benchmark of small-blend managers. To our understanding, Morningstar is changing the methodology of how funds and securities are placed within its style box. If you look at a Russell 2000 Index exchange-traded fund (ETF), it has not been uncommon for it to end up in the small growth style box rather than small blend. Obviously that is a strange dynamic and provides a tremendous amount of challenge as a core manager, when your benchmark isn't in your own style box. If everything remained the same, it appears to us that generally securities will move left and down in the box. So it sounds like the top end of the box is rising a little bit, but there's still a lot that remains unseen given the limited visibility at the moment. There is some literature on Morningstar's website that can help to explain the change. Hopefully the change will take some of the challenges away for us in managing our strategy and will be something to pay attention to as we see the change comes about at the end of October.
Are there any life fundamentally change all these things will be different in the future because of pandemic, anything that's intriguing to you in terms of lifestyle change?
We do think there are a number of things that are going to change. One of the things that we've had a hard time getting comfortable with in this market is how a number of concepts have snapped back such as hotels, restaurants, casinos and travel. We think that until there's a vaccine, there's an element of people not returning to these types of businesses. Business travel will most likely change dramatically. Even if there is a vaccine, some businesses are likely to reevaluate efficiency and determine that is more efficient to operate in a different fashion. We understand that people want to get out and want to do things, but in this current environment of uncertain economic conditions and social distancing measures, it seems odd to us that investors are so interested in these companies with incredible leverage. It's not that we don't think that these types of businesses won't ever recover, but it doesn't make complete sense to us in this environment.
Eating at home is a trend that we think can stand to benefit in this environment. Treehouse Foods, Inc. is a private label food company and an example of a portfolio holding where we feel that we can capture upside with this trend. We think that people underappreciate that when you have a company with a lower growth rate to begin with, like Treehouse, that moderate changes to trends can have profound effects for periods of times. So when you have a company that generates a nearly 10% free cash flow yield, we don't understand how that wouldn't be favorable for it. We understand investors want to take on risk because they think the Federal Reserve has their back, but a company with attractive fundamentals like that should have some favorable outcomes in this environment.
Another example is 2U, Inc., which provides one of the few software platforms available to colleges for online education. We think the uncertainty around students returning to school in the fall will cause schools to modify how they operate. Schools will likely be looking for different sources of revenue. Even if they bring students back, the pressure that has been put on international students by the U.S. government will have profound effects on universities. People may not realize that there's a significant amount of international students that attend U.S. colleges. If there isn't an opportunity for international students in this country, then this is going to put pressure on these universities. We think 2U could benefit from this evolving landscape for schools.
We also own Generac Holdings, Inc. In California, there have been tremendous concerns around power disruption. If you are stuck in your house, the last thing you want to deal with is having a power outage. Generac manufactures generators on the fuel side, as well as battery backup for solar, which is a booming market. We've seen some positive trends leading into hurricane season. If you're a senior with all of the COVID-19 cases in Florida, you most likely wouldn't want to be out in public area in the case of a hurricane.
Overall, yes, we do see fundamental changes to these business models. Regardless if there's a vaccine or not, some of these trends have some potential. If you get in a routine and change, you might not go back to those old behaviors at all if you've discovered a better way of going about something.
From a cash standpoint, have you raised more cash for upcoming quarters since you expect volatility?
No. Our underperformance wasn't an asset allocation issue relative to cash. It was based on the Fund's positioning and the types of securities the Fund holds. We didn't make an asset allocation decision to cash that got us in trouble. We were exposed to the market, but we weren't exposed to the right areas.
Considering the Fund is designed to be lower beta and higher quality generally and that contributed to a large portion of the underperformance for the quarter. Could you provide examples of stocks that we don't own that are higher in beta and lower in quality that outperformed to contrast what you do?
To provide a rough idea, one example is El Dorado Resorts Inc. which is a casino. The stock was as high as $70, fell to the single digits and rebounded back to the $30s. A lot of companies that were viewed as bankruptcy risks were sold off, which helped us on the way down, but the lift off were pretty dramatic. It's not that our stocks weren't going up; it's that they weren't going up as much as the Index. When you're in a risk-on environment, many of the shakiest companies have a tendency to really move. It's typically a lot of the penny stocks that double and triple. Obviously if the environment settles out over time, that could work in our way going forward. In an expansion, this isn't unprecedented.
This looks similar to 2009, where many of these lower quality companies that come off the bottom like rocket ships. Are we heading into a prolonged expansion? What will the economy look like when we come out on the other side of this? Will stimulus translate to job creation or full employment again? These are the important questions to be asking.
We believe many businesses are either damaged or will soon be gone. JC Penney is example of a company that moved dramatically off the bottom, but we don’t think it is likely to be one of the next growth companies. We believe it is likely to shrink, or may not exist in the coming years.
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 subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This informa¬tion 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. The views are current through July 8, 2020, and are subject to change at any time based on market or other conditions.
Risk Factors:The value of the Fund’s shares will change, and you could lose money on your investment. Investing in small-cap growth and value stocks may carry more risk than investing in stocks of larger, more well-established companies. Growth stocks may be more volatile or not perform as well as value stocks or the stock market in general. Value stocks are stocks of companies that may have experienced adverse developments or may be subject to special risks that have caused the stocks to be out of favor and, in the opinion of the Fund’s manager, undervalued. Such security may never reach what the manager believes to be its full value, or such security’s value may decrease. The Fund typically holds a limited number of stocks (generally 40 to 60). As a result, the appreciation or depreciation of any one security held by the Fund may have a greater impact on the Fund’s net asset value than it would if the Fund invested in a larger 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.
The Russell 2000® Index is a float-adjusted market capitalization weighted index that measures the performance of the small-cap segment of the U.S. equity universe. The Russell 2000® Index is a subset of the Russell 3000® and includes approximately 2,000 of the smallest securities based on a combination of their market cap and current index membership. The Russell 2000® Growth Index and the Russell 2000® Value Index are float-adjusted market capitalization weighted indexes that measure the performance of the small-cap growth and small-cap value segments of the U.S equity universe, respectively. The S&P 500® Index is a float-adjusted market capitalization weighted index that measures the large-capitalization U.S. equity market. It is not possible to invest directly in an index.
Top 10 equity holdings as a % of net assets as of 06/30/2020: Switch, Inc., Class A 4.3, TreeHouse Foods, Inc. 4.3, Chemed Corp. 3.2, Knight Transportation, Inc. 3.0, Coherent, Inc. 3.0, Encompass Health Corp. 2.9, TCF Financial Corp. 2.8, Halozyme Therapeutics, Inc. 2.6, Kemper Corp. 2.6, Encore Capital Group, Inc. 2.6.
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. The duration of the COVID-19 outbreak and its effects cannot be determined with certainty.