Ivy Value Fund
Commentary as of April 14, 2020
Could you please share your perspective on the large-value universe in today’s market environment?
Typically you’d expect large-cap value to be one of the best places to hide in down markets like what we experienced in March. When you look at some of the stocks that we hold in the portfolio – Lowe's, Allstate, Walmart, CVS and Bank of America – these are large companies with good business models and balance sheets that all pay dividends. Unfortunately, it didn't work out as well this time around. We think this might be because this was a virus-driven drawdown as opposed to an economic one. Large caps did their job by holding up better than small caps, but large-cap value did not do its job. It underperformed large-cap growth by a significant margin over the volatile period. We think this is most likely driven by a large allocation to financials in the Russell 1000 Value Index, the Fund’s benchmark, as well as some of the more cyclical areas like retail, industrials and information technology not keeping up in the downturn.
Does this market volatility create an enticing investment environment for you?
This really is an exciting time. The Fund performed really well from 2007-2010, another volatile time period and we need some volatility for the strategy to work well. We need some stocks to get really underpriced and others to get really expensive. From 2011 to most recently, it has been a very low volatility environment due to low gross domestic product growth and low inflation. This has made it difficult to find value opportunities. Now that is changing as volatility is returning. One company example is Capital One. The company’s stock was up last week; however, it is still down substantially year-to-date. We understand why. People aren’t spending and aren’t using their credit cards. If/when we return to some sense of normalcy, the normalized earnings power should look really attractive. So we have some heightened interest in some of these companies during this volatile period.
What are your current thoughts on portfolio construction?
Timing the market bottom is nearly impossible. We try to let stock valuations tell us the moves to make. The Fund entered this environment with some extra cash and, so far, we haven’t needed to sell any holdings to raise cash. Some companies like Target and Walmart have performed really well and their valuations are starting to reflect that. So we may need to start trimming some of the recent Fund contributors in the future; however, we don’t believe it’s time to do that yet. While the portfolio is currently overweight to more cyclical names, we want the individual nature of the stocks we own to drive potential Fund performance.
We view the sectors in offensive and defensive buckets, where the offensive bucket includes more cyclical stocks and the defensive bucket includes stocks like consumer staples and utilities that are less cyclical. We bucket the financials sector separately due to its sensitivity to interest rates. Currently the Fund has a slight overweight position to financials and offensive names, and a slight underweight position to defensive names.
We expect there to be some volatility through earnings season. We plan to build positions in companies that support the Fund’s investment philosophy over time. The strategy is to arbitrage the different time horizons investors have. Some of these valuations reflect very short-term expectations, and in that case we take a longer view.
Could you highlight some of the business models you own in financials?
Capital One is a consumer-facing credit company that we own that is very cyclical. On the other end of the spectrum, we own Allstate. It offers a required service for the nearly everyone. We anticipate that the company’s profitability should improve because people aren’t driving as much during this stay-at-home order. Thus there should be fewer auto accidents. BNY Mellon is a trust bank we own. This bank really isn’t focused on lending. It’s actually more focused on processing and servicing as more of a custodian business. It is important to note the differences between businesses within financials because they are not all the same.
How are you currently thinking about valuations?
The primary metric we use in determining what a company is worth is free cash flow compared to enterprise value. If we had an unlimited checkbook, we could go to any company and buy all of its equity and debt to own the business entirely. Before the drawdown, a company’s free cash flow to enterprise value multiple ranged from fair to slightly expensive.
Recently, cash flow has decreased dramatically for many of these companies due to their operations being stalled by COVID-19. This is making the stocks look expensive.
This environment gives us an opportunity as active investors because we are comfortable with near-term free cash flow being low as long as normalized cash flow still looks attractive. We are much more concerned with what a company's free cash flow will look like when the U.S. economy returns to more normal levels, especially when determining what a stock is worth. There are several cases where we feel that company stocks are getting punished too harshly for near-term financials when their long-term financials should still be solid. We see this trend as a buying opportunity for the Fund.
An example of this is NXP Semiconductor, which is a semiconductor company with about 40% of its business tied to automobiles, particularly electric and self-driving cars. In the current market environment, auto production has basically been shut down, and this company’s stock was punished for this. We think the cash flow of this company should return to healthy levels within a year or so, and as a result, we have added to this position within the portfolio.
How do you build a case for value stocks in a deflationary environment?
We think it is more difficult to say in the longer term, but over the next 12 months we believe value looks rather attractive. Most growth names have held up well during the drawdown while many value names are at half of their value versus their worth at the peak. One example of this is Delta Airlines. We believe this stock could easily triple in value from this point based on our view of long-term valuations. While there are many great growth businesses that will most likely continue to grow following this time period, it is unlikely that these stocks will experience the kind of upside potential that a value stock like Delta could gain over the next year or so.
Could you touch on the Fund’s investment philosophy and process a bit for those that aren't as familiar with the strategy?
The Fund’s strategy does not attempt to make sector calls, rather it focuses primarily on stock selection. We overweight or underweight sectors based on individual stock opportunity, with some limits to control risk or volatility. We believe in the philosophy that the value of any business is worth its future cash flows discounted back to the present. In the case with stocks, future cash flows are always uncertain. When a stock’s cash flow streams become more uncertain, it will tend to become inexpensive. When you find companies with high free cash flow yields, you have to ask some questions because the market believes something is wrong with the business. So, when we find an inexpensive company and believe it can be fixed within a reasonable time that represents opportunity. Other businesses are in a position where they won't recover, because they’re secularly challenged. We try to avoid those types of companies. JC Penney’s is an example of this. While this stock is currently inexpensive, we don't see a path toward it becoming relevant again in the future.
Could you share some comments on oil and energy?
For the past three to five years the Fund has been perpetually underweight energy. We have owned energy in past. However, with our philosophy of owning companies with free cash flow yields, we find that most energy companies just don't offer this type of yield. The Fund’s energy exposure has been primarily in refiners and pipelines, where cash flows are more resilient and less cyclical than actual producers.
Past performance is not a 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 April 14, 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 03/31/2020: Walmart, Inc. 4.7, Philip Morris International, Inc. 4.1, CVS Caremark Corp. 3.9, Bank of America 3.8, Exelon Corp. 3.7, Comcast Corp. 3.5, Fidelity National Information Services, Inc. 3.2, Allstate Corp. 3.2, Northrop Grumman Corp. 3.0 and Citigroup, Inc. 3.0.
The Russell 1000 Growth Index measures the performance of the large-cap growth segment of the U.S. equity universe. The Russell 1000 Value Index is an unmanaged index comprised of securities that represent the large-cap sector of the stock market. 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. The value of a security believed by the Fund’s manager to be undervalued may never reach what the manager believes to be its full value, or such security’s value may decrease. Investing in companies in anticipation of a catalyst carries the risk that certain of such catalysts may not happen or the market may react differently than expected to such catalysts, in which case the Fund may experience losses. The securities of many companies may have significant exposure to foreign markets as a result of the company’s operations, products or services in those foreign markets. As a result, a company’s domicile and/or the markets in which the company’s securities trade may not be fully reflective of its sources of revenue. Such securities would be subject to some of the same risks as an investment in foreign securities, including the risk that political and economic events unique to a country or region will adversely affect those markets in which the company’s products or services are sold. Not all funds or fund classes may be offered at all broker/dealers. 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. 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. The duration of the COVID-19 outbreak and its effects cannot be determined with certainty.