Market Perspectives

Headwinds seen easing as tide turns toward quality growth

Headwinds seen easing as tide turns toward quality growth

09.08.2017

We believe the first six months of 2017 can be best described as the return of growth and, to a fair degree, a return of momentum. This current push doesn’t appear quite as strong as it did in mid-2015 but we are definitely seeing an impact to the performance of many the strategy’s holdings. Over the past several months, we noticed that a number of the strategy’s truly differentiated, unique and innovative company holdings are participating in some of this momentum. This doesn’t seem surprising as these firms appear to have good earnings and growth prospects as witnessed by their quarterly reports, balance sheets and future projections. From a broader standpoint of being able to discount the market at strong valuations given the current state of interest rates, the environmentt still remains constructive for growth.

In addition, we think the public’s expectations of what Washington might do are subsiding and believe it is encouraging that the market has been able to forge ahead even with diminished expectations. This positive situation points to a U.S. economy that appears sound and the market seems to be taking a lot of its cues from economic growth as opposed to political actions.

One of the things that we’ve discussed over the past three to five years is the persistent headwind to the strategy’s process of investing in high-quality companies versus those with high levels of indebtedness. In 2016, we started to see that headwind abate, and as we turned the page into calendar year 2017, those headwinds have continued to diminish. Companies with the most levered balance sheets in the mid-cap growth universe are now underperforming the Russell Midcap Growth Index by about 300 basis points year to date.

This trend has helped the strategy’s performance versus the benchmark. What we find encouraging about this is if we think about 2016, we saw interest rates increasing while at the same time becoming less of a headwind to the strategy. So far in 2017, interest rates have been flat to down and we are still seeing those companies with high amounts of leverage underperforming. We are hopeful this is an indicator from a performance perspective that the pressure the strategy was experiencing is truly in the rearview mirror and we are now able to focus on the organic growth of individual companies versus companies that are financially engineering earnings growth.

Over the period, technology was the strategy’s strongest performing sector and largest overweight position. Across technology we have a number of strong software names. The strategy’s second strongest performing sector was consumer staples.

Beyond technology and consumer staples, we have seen some outperformance from the industrials sector. The strategy’s industrials exposure made a slight positive contribution to relative returns, primarily due to strong stock selection. Our lack of holdings in the real estate sector, an underperformer for the benchmark, provided the strategy with a little bit of upside relative performance over the period.

From materials to financials and health care to consumer discretionary, sector performance has ebbed and flowed, but by far, the strategy’s biggest underperformer was energy. This is where, from a relative basis, we have had the most pressure and not enough to offset the strength that we were seeing elsewhere. During the first half of the year, we reduced some of the strategy’s energy exposure. We don’t expect to see any kind of crash in the sector but rather, it appears more likely that it is going to be very difficult for the price of oil to go too high and stay there for too long. There is just too much supply. We think that the amplitude of gains and drops in the price of oil is probably dampening out secularly for a while and the strategy’s exposure to energy will probably not increase in the near future.

Health care was a slight overweight in the strategy and was a source of slight relative underperformance — despite, some of the best performance on an absolute basis coming out of this sector. We believe health care includes a fertile group of growth companies within the mid-cap space, and the group is quite diversified. We have made a few changes here and there with a couple of additional names, but for the most part, the bulk of the strategy’s exposure remains with names that have been in the portfolio for quite some time.

Consumer discretionary was an area where the strategy was underweight as there have been a number of secular changes that are happening for companies within this space, particularly within retail. Retail has been a very difficult area. We don't think a day goes by that there isn’t news regarding threats of or actual store closings or problems with mall traffic. While we still had exposure to what we consider to be some of the marquee names and brands in the space, we didn't fully anticipate the speed and ferocity with which the problems in retail would play out. As a result of these problems, many company profits have been compromised and these stocks have really struggled to the downside. We have sold a number of our retail names because we decided that while these could be good unrecognized growth prospects with positive cash flow, they just didn’t have enough proprietary product to be able to effectively compete with online retailers. While retail makes up a fairly sizable component of the benchmark, we anticipate maintaining an underweight position in strategy for the foreseeable future.

There are areas within consumer discretionary aside from retail that appear to be doing well and we plan to add names to the strategy’s sector exposure in the near future.

Outlook

We have expected the market to deliver positive returns in 2017, and thus far, have not been disappointed. We think the markets can move higher based on accelerating economic growth around the globe, vastly improved U.S. corporate profits as compared to the last two years, and the potential benefits of pro-growth, pro-cyclical policies that can enhance an already positive environment.

Economic activity in the U.S. is continuing at a low but stable pace, as housing demand continues to improve, and consumption in general remains firm tied to ongoing strength in jobs and wage gains. Global industrial production is stronger than in recent years as evidenced by the Purchasing Managers Index in many countries.

Interest rates, while increasing, still seem supportive of investment and growth, as does the credit environment. The valuation on the market has expanded with last year’s gains, but levels are reasonable to support further market appreciation as we discount additional increases in corporate profits. We think the factor that should provide underlying support for a corporate profit and stock market outlook that was encouraging even pre-election is the pro-growth stance of the Trump administration, should it get organized enough to effect change.

A more supportive regulatory and taxation environment and a drive to invest in the U.S. could lift an already improving economic and profit picture to a higher level. The response from credit markets will be important to monitor, as higher interest rates could have a dampening impact on a stronger growth scenario.

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KEY TAKEAWAYS

  • We believe the first six months of 2017 can be best described as the return of growth and a return of momentum.
  • Technology was the Fund’s strongest performing sector and largest overweight position.
  • Energy was the Fund’s biggest underperformed.

Investment Strategy

Investment Team

Kimberly A. Scott, CFA

Senior Vice President, Portfolio Manager

Ms. Scott is co-portfolio manager of the firm's Mid Cap Growth investment strategy and has served as portfolio manager of the strategy since 2001. She assumed co-portfolio manager responsibilities for the firm's Ivy Mid Cap Income Opportunities Fund in 2014. She joined Waddell & Reed in 1999 as an equity investment analyst and covered industries in the Consumer Discretionary, Consumer Staples and Information Technology sectors.

Ms. Scott's lengthy background in fundamental research contributed to her development of the firm's Mid Cap Growth philosophy in 2001. Her extensive experience at various levels of fundamental research in positions throughout her career date to 1987 with the following companies:  Bartlett & Company, NBD Bank, Johnson Investment Counsel, Inc. and the University of Cincinnati Medical Center. Ms. Scott provided sector coverage for consumer non-durables, technology, retail, food and beverage, and tobacco.

Ms. Scott earned an MBA from the University of Cincinnati and a BS in Microbiology from the University of Kansas. She is a CFA charterholder.

Nathan A. Brown, CFA

Vice President, Portfolio Manager

Mr. Brown is co-portfolio manager of the firm's Mid Cap Growth investment strategy, appointed to this role in 2016. He served as assistant portfolio manager to the strategy since 2011. He assumed co-portfolio manager responsibilities for the firm's Ivy Mid Cap Income Opportunities Fund in 2014. He joined Waddell & Reed as an equity investment analyst in 2003 and covered industries in the Consumer Discretionary, Consumer Staples and Industrials sectors.

Prior to joining Waddell & Reed, Mr. Brown interned with Morgan Keegan. From 1999 to 2001 he completed five rotations in General Electric-Aircraft Engine’s financial management program.

Mr. Brown earned an MBA from Vanderbilt University and a BBA from the University of Iowa. He is a CFA charterholder.