Leverage plays a key role in driving performance across the mid-cap growth universe

Ivy Mid Cap Growth Fund
04.30.18

The extended period of low interest rates often meant companies could gain an advantage by refinancing balance-sheet debt at low cost. As a result, leverage became an important variable in driving the performance of stocks across the mid-cap growth universe. What are the implications and potential opportunities for Ivy Mid Cap Growth Fund now that interest rates are rising?

Impact of low rates and leverage

The market has been in an extended period of low interest rates since the financial crisis in 2008. Between 2009 and the second half of 2016, many companies added leverage to their balance sheets because interest rates were so low. During this time, it was often advantageous for these companies to refinance their balance sheets to take on debt at a very low cost. From Dec. 31, 2008, through Dec. 31, 2017, the debt-to-capital ratio of the Russell Midcap Growth Index (the Fund’s benchmark) grew from 32.2% to 47.3%. During the same period, the Fund’s debt-to-capital ratio grew much less, rising from 25.3% to 31.5%. This was due to its emphasis on companies with a judicious outlook toward using debt. The Fund’s debt-to-capital ratio continues to remain well below the benchmark.

Period when highly levered companies outperformed

Our philosophy was at odds with the market environment from 2012–2015 and it helps explain the Fund’s relative underperformance from 2012–2015 when macro headwinds created significant challenges. Between 2012 through 2015, highly levered companies were rewarded by the stock market. High-debt companies returned 17.3%, while the lowdebt companies returned 12.9%. The Fund was overweight to lower-debt companies and materially underperformed the benchmark from 2012 to 2015. The chart entitled “Between 2012 and 2015, highly levered companies outperformed (%)” shows the performance of high-debt companies versus low-debt companies within the benchmark and the comparison to the Fund’s performance beginning in 2007 through March 31, 2018.

Tide turns toward quality

The Fund had strong absolute and relative performance in 2017. It outperformed its benchmark by 200 basis points (before the effects of sales charges) and ranked within the top quartile of Morningstar’s Mid Cap Growth peer group at year end. 2018 is off to a positive start as well. For the quarter ended March 31, 2018, the Fund outperformed the benchmark by 250 basis points.1

This performance was a direct result of adhering to the Fund’s investment philosophy — investing in companies with strong profitable business models, supported by sound capital structures with an eye toward valuation sensitivity. When evaluating sound capital management structures, we tend to look closely at the debt-to-capital ratio. We seek to find companies that are either debtfree or using debt judiciously. We typically look for companies with debt-to-capital ratios of less than 35% or if it is greater than 35%, we seek to understand the fundamental and structural circumstances that cause the ratio to be higher.

Between 2012 and 2015, highly levered companies outperformed (%)
Year High-debt Companies Low-debt Companies High-debt Companies Outperform Low-debt Companies Outperform Ivy Mid Cap Growth Fund
(Class I) Performance
Russell Midcap Growth Index Performance Ivy Difference

2007

10.14

12.79

+2.65

2.24

0.41

+1.82

2008

-43.72

-44.85

+1.13

-37.80

-44.32

+6.53

2009

43.79

48.36

+4.57

49.01

46.29

+2.72

2010

22.68

29.78

+7.10

30.38

26.38

+4.00

2011

-2.90

-0.17

+2.73

-0.31

-1.65

+1.34

2012

19.41

12.21

+7.20

13.45

15.81

-2.35

2013

37.68

33.76

+3.92

30.12

35.74

-5.62

2014

13.83

10.06

+3.77

8.20

11.90

-3.71

2015

1.11

-1.50

+2.61

-5.80

-0.20

-5.60

2016

7.02

7.65

+0.63

6.37

7.33

-0.96

2017

23.46

27.22

+3.76

27.31

25.27

+2.04

1Q2018

1.07

3.39

+2.32

4.74

2.17

+2.57

* Last six months of 2007. Source: Russell Midcap Growth Index — FactSet, FTSE Russell, Jefferies. The debt-to-capital ratio of all the companies within the Russell Midcap Growth Index are ranked from highest to lowest. The largest two fractiles (fractiles 1 and 2) are the high-debt companies and the lowest two fractiles (fractiles 4 and 5) are the low-debt companies. Fractile 3 is not included.

Data quoted is past performance and current performance may be lower or higher. Past performance is no guarantee of future results. Investment return and principal value of an investment will fluctuate, and shares, when redeemed, may be worth more or less than their original cost.

Class I shares are sold without any front-end sales load or contingent deferred sales charges.

In 2016, interest rates began to rise marginally. At that time, we think the market reached a point where slowly increasing interest rates neutralized the debt-to-capital ratio factor and it was no longer as advantageous for companies to refinance their balance sheets to take on debt at a very low cost. As a result, for the first time in four years, lower-debt companies outperformed. In fact, when you take a look at the margin of outperformance by lower-debt companies in 2017 the return was 376 basis points.

As we exit quantitative easing and the extended period of the low interest rates that began in 2009, we believe we are entering an environment that is more conducive to the Fund’s investment philosophy. The headwind of rewarding highly levered companies versus companies with less indebted balance sheets appears to be fading. The winds of change that started in 2016 became stronger in 2017 and have transitioned into 2018. Last year, we saw three interest rate hikes and anticipate the possibility of additional increases in 2018.

Our quality growth strategy

Historically, the Fund seeks to generate performance from its bottom-up stock selection process. As interest rates rise, the amount of debt assumed by companies is going to become increasingly important, as we have seen over the past 18 months.

Given that the Fund focuses on quality growth companies with lower debt, we are optimistic that we are moving into a favorable period for our investment philosophy given our focus on companies with profitable business models, sound capital structures and sensible valuations. Recent examples of the Fund’s quality growth holdings include MarketAxess Holdings Inc., Sprouts Farmers Market, Inc. and Arista Networks.

MarketAxess Holdings Inc. is the leading electronic trading platform for fixed-income instruments. The large fixedincome market is undergoing a major structural shift due to regulatory and market trends. Overall, the electronic trading market share is growing but we believe that MarketAxess is still in the early stages of market penetration. The company is focused on increasing share in existing credit products, promoting open trading protocols and growing the European trading, data and post-trade business. We believe MarketAxess has a superior financial model with strong cash flow and significant operating leverage. Specifically, the company currently has gross margins at 88% — we believe these are strong margins as every new trade comes in at no cost. In addition, the company has zero debt and pays a dividend. MarketAxess fits into the Fund’s “Greenfield Growth” bucket as we think it has a long runway for growth and repeatable revenues. Only about 20% of the bond market is traded electronically at this point. Factor in, if yields go up and bond turnover picks up this would likely increase the number of trades. MarketAxess was added into the Fund during the fourth quarter of 2016 and we have continued to add to the position size.

Sprouts Farmers Market is a healthy grocery store rooted in fresh, natural and organic foods at value prices. It is one of the largest and fastest growing natural and organic retailers in the market. We initiated a position in Sprouts during the third quarter of 2017, shortly after the announcement of Amazon’s intention to acquire Whole Foods. Grocery store stocks and their valuations struggled significantly on the news. At the time, we owned Whole Foods because we liked the trend of healthy eating and believed that the huge sell off in the grocery industry, gave us an opportunity to buy Sprouts at a cheap valuation. Net sales have been growing steadily from 2013–2017 (the compound annual growth rate is 18%) and its gross margins are 26%, which for a grocery store is competitive with its industry. It also has strong cash flow generation and growing store base. Sprouts sits in the Fund’s “Unrecognized Growth” bucket.

Arista Networks provides Cloud networking solutions for large data center storage and computing environments. Currently, there is a huge transition from on-site servers to Cloud-based servers and large-cap companies like Amazon, Google and Microsoft have reaped the benefits. While Cisco has historically dominated the routing and switching markets, its designs are less relevant in Cloud computing environments, leading customers to look for less cumbersome switches. Arista is managed by former Cisco employees who have developed switches and routers that work better in the Cloud. Microsoft is already a client of Arista and the company is gaining market share in this fast growing area. From a financial viewpoint, Arista has strong gross margins at 65%, operating margins at 29% and no debt. This type of company fits into the Fund’s “Greenfield Growth” bucket. We first added this stock to the portfolio in first quarter of 2017.

Outlook

The Fund continues to take an economically constructive and optimistic view, with a more assertive pro-growth, less defensive stance — although slightly less so than earlier in 2017. In relation to the Fund’s benchmark, we are currently overweight the consumer discretionary, health care, financials and industrials sectors. We have a healthy exposure to technology, but have moved to an underweight position, having seen valuations increase dramatically in this sector. Technology valuations are more reasonable post the recent stock market down draft, so we have renewed interest in adding exposure to that sector. We are also overweight the health care sector, more from a stock selection standpoint, rather than a defensive posture, as there are names in this group where we expect solid growth and stock appreciation over time. We are underweight materials, and we have no exposure to the telecommunications, real estate, utilities and energy sectors, which represent a combined 5.7% of the index. We have recently added energy to the “no exposure” list, as the secular trends for growth and efficient capital deployment in that sector are challenged, and we think we can invest more productively elsewhere. While the Fund’s portfolio represents an economically constructive point of view, our investment approach is essentially balanced based on stock selection as opposed to overt sector allocations. From a broader macroeconomic factor perspective, we expect a stable-torising interest rate environment to be generally positive for our approach, related to our focus on profitable business models and sound capital structures. The time of quantitative easing was a challenge to our returns, as lower interest rates played to the benefit of companies with lesser quality business models and/or capital structures. We expect the change in this trend to favor our investment style in months ahead.



Past performance is no guarantee of future results. 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 April 2018, 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.

Class I shares are only available to certain types of investors.

Risk factors: The value of the Fund’s shares will change, and you could lose money on your investment. Investing in mid-cap growth stocks may carry more risk than investing in stocks of larger more well-established companies. 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.