Seeking durable quality in a volatile market

Ivy Balanced Fund
04.22.19

The past six months has been “a tale of two quarters,” but also part of a new market reality. The Fund’s blended structure seeks to build a portfolio with equilibrium of risk and reward to withstand this type of highly volatile environment.

Forgive us for co-opting the Charles Dickens’ classic A Tale of Two Cities, but it serves as a good frame of reference for asset class performance over the last six months ending March 31, 2019.

Intense volatility throughout the fourth quarter of 2018 triggered dramatic declines across all equity indexes. This selloff was accentuated by the December performance of the S&P 500 Index, the Fund’s equity benchmark, which plummeted 9% for the month, marking its worst performance for the final month of a year since 1931. On the fixed income side, the yield curve flattened with the spread in yields between the 2-year and 10-year Treasury notes narrowing to 19 basis points (bps) at year’s end, coming uncomfortably close to inversion*. Fast forward to March 2019. The equities selloff has reversed, with the S&P 500 Index up 12% since the start of the year while fixed income markets appear to be holding steady.

(* An inverted yield curve occurs when the yield on a fixed-income instrument, or bond, with a shorter duration is higher than the yield on a bond with a longer duration. An inverted yield curve has been a precursor to every modern-era recession.)

It’s against this erratic backdrop that the Fund offers a strategy looking to optimize the equilibrium of risk and reward while seeking to manage volatility.

The Fund is a blended strategy with predictable guardrails that generally invest at least 50% of its assets in equities and at least 30% in fixed-income securities, giving investors the chance to seek consistent growth and current income while managing risk.

The equity portion of the portfolio typically holds a limited number of stocks (generally 45–55), with a maximum sector weight of 35%. We look for profitable companies and identify the fundamental drivers of those returns and the likelihood they can sustain growth projections over a two- to three-year investment horizon.

Our fixed income approach focuses on companies with solid balance sheets and cash flow metrics, with at least 70% of the fixed-income portion of the portfolio comprised of investment grade debt securities.

The Fund’s current allocation (as of 03/31/2019) is 64% equity and 35% fixed income, with the balance invested in cash. Over the course of the last six months, the Fund’s allocation was relatively stable outside of impacts from market action. These periodic bouts of volatility can be unnerving, but the Fund’s performance over the past 12 months is a reminder of the value of patient, disciplined investing with a long-term perspective.

What is durable quality?

We define durable quality as the ability for a security to exhibit above-average profitability that has the potential to persist over time. The Fund is predicated on finding investment ideas we believe demonstrate durable quality from the universe of profitable companies.

Part of our screening process includes an assessment of companies by their structural competitive advantages. These metrics can include a company’s brand equity, proprietary technology, economies of scale and capital intensity. We further narrow the list to companies we believe are trading at a reasonable valuation with visible catalysts that can help drive high performance over the next year or beyond. The remaining pool of candidates is sufficiently small and relatively stable, allowing our team to adequately vet and identify attractive investment opportunities.

Our emphasis on durable quality helps us to sharpen our focus on what we believe are successful and proven companies whose pedigree inspires our belief in them across economic cycles. Equally important, it disciplines us to reduce or divest positions when relative valuation suggests their inherent characteristics are fully appreciated by the market.

Assessing holdings with our approach

Let’s look at how we apply our durable quality investment philosophy.

Union Pacific Corp. (UNP) Yum! Brands, Inc. (YUM)

Market Cap: $120 billion

Market cap: $31 billion

Valuation: 18 times
2019 earnings estimates

Valuation: 26 times
2019 earnings estimates

Current fund holding: yes

Current fund holding: no

UNP is the most profitable U.S. railroad company with an expansive physical rail footprint. However, its operating costs, adjusted for length of haul, were above the industry average. In response, UNP implemented an efficiency strategy it believes will improve the company’s efficiency ranking to a best-in-class level over the next several years. In our view, this idiosyncratic driver of earnings growth is an underappreciated catalyst, which is not reflected in UNP’s current valuation using its forecasted 2019 earnings.

YUM is a quick-service restaurant holding company comprised of three chains: Kentucky Fried Chicken, Pizza Hut and Taco Bell. These brands have successfully brought innovation to their menus with an emphasis on value that has resulted in strong same-store sales, net new unit growth and profitability. YUM’s success has been recognized by the equity market and its valuation metrics have expanded meaningfully over the past five years. While we continue to believe in YUM’s business model, our valuation discipline motivated us to close our position in this holding after several years of profitable ownership.

While uncertainty and volatility ebb and flow, we believe a blended portfolio of assets, diversified across sectors, with security selection governed by a disciplined emphasis on finding what we believe to be durable quality will continue to be a sound approach for investors. Across economic cycles and irrespective of market moods, this approach has served investors well and our confidence in it has not waned.

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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 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.

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. Fixed-income securities are subject to interest rate risk and, as such, the net asset value of the Fund may fall as interest rates rise. The lower-rated securities in which the Fund may invest may carry greater risk of nonpayment of interest or principal then higher-rated bonds. In addition to the risks typically associated with fixed-income securities, loan participations in which the Fund may invest carry other risks, including the risk of insolvency of the lending bank or other intermediary. Loan participations may be unsecured or not fully collateralized may be subject to restrictions on resale and sometimes trade infrequently on the secondary market. 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 45 to 55). 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. The value of a security believed by the Fund’s managers to be undervalued may never reach what the manager believes to be its full value, or such security’s value may decrease. 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 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.