Cynthia Prince-Fox, CFA
Waddell & Reed Advisors Continental Income Fund – January 2012
Recent stock market volatility, driven largely by Europe’s sovereign debt crisis and fear that the global economy could slip back into recession, has created a difficult market environment for investors and fund managers alike. Here, Waddell & Reed Advisors Continental Income Fund Manager Cynthia Prince-Fox shares her perspective on the current economic and market environment, outlines her strategies for protecting capital while positioning the portfolio to capitalize on volatility-driven opportunities and provides her outlook for the months ahead.
The volatility that has roiled the investment markets in the past five years is unprecedented in my 28 years of investment experience. We have made slight adjustments to the portfolio that we believe are in the best interest of the Fund’s investors, both in response to and in anticipation of global and market events. However, despite this prolonged volatility, we have not changed the fundamental strategies we apply in managing Waddell & Reed Advisors Continental Income Fund, which has consistently delivered on its objective to provide total return through a combination of capital appreciation and current income. Over time, the Fund has produced competitive returns.
Striking a prudent balance
Waddell & Reed Advisors Continental Income Fund seeks to provide income and long-term appreciation of capital by investing generally in medium to large-cap, well-established, U.S.-based companies that exhibit strong growth potential, undervalued companies whose asset values or earnings power has not been recognized, and high-quality fixed-income securities with minimal credit risk. Historically, the Fund’s allocation ranges have been between 50 and 75 percent in stocks and between 25 and 50 percent in fixed income.1 Right now, equities generally look attractive to us and prospects for fixed-income returns are less compelling. We think the interest-rate risk on the bond portion of the portfolio is low. We believe this low interest-rate environment could persist for some time, as political and headline risk is likely to last well into 2012. The Fund’s current allocation reflects this longer-term view; it maintains a higher weight in equities, with approximately 69.2 percent of investments in equities, 27.7 percent in fixed-income securities and the remainder in cash, as of December 31, 2011.
Waddell & Reed Advisors Continental Income Fund differentiates itself from other balanced funds due to its higher-quality bias — a characteristic that has proved advantageous against the market’s sustained volatile backdrop. We limit the number of holdings in both equities and fixed-income securities. The Fund currently maintains about 50 equity positions. With respect to the fixed-income portion of the portfolio, we have been predisposed to corporate debt vs. Treasuries, given the low interest-rate environment. This proved to be a good strategy through the first half of 2011, but somewhat less effective in the third quarter as Treasuries rallied on the flightto-quality trade. Nonetheless, the fixed-income portion of the portfolio has performed relatively well and generally in line with the equity portion in 2011. Importantly, due to our quality bias, the fixed-income portion provided ballast during the big market sell offs we’ve seen recently.
Europe has been a major force in driving market direction for some time. We responded to the region’s debt crisis and subsequent fallout by decreasing the Fund’s exposure to more economically sensitive sectors. A strong profit cycle, huge profit recovery and the lack of excesses in the economy led us to a more pro cyclical stance; now we’re moving toward more structural growth. We have taken some risk off the table, which is why the Fund’s cash level is around 3.1 percent. We have attempted to gear the portfolio to outperform in the current volatile environment by protecting on the downside and participating on the upside when those swings occur. We are looking to increase the Fund’s yield slightly, not only through fixed-income holdings but also through higher-yielding stocks, where we are not seeking capital appreciation so much as a strong dividend yield. Note: Dividend-paying investments may not experience the same price appreciation as non-dividendpaying investments.
We think the debt crisis in Europe will continue to steer the markets and will continue to impact sentiment and economic growth, the two levers that drive equity markets, well into 2012. Until some type of resolution is achieved in Europe, a lack of confidence will weigh on the global economy. Moving forward, we will keep our focus trained on Europe’s economy. Many U.S. companies are highly dependent on their businesses in Europe, which is why we’ve positioned the equity portion of the Fund slightly more defensively.
Technology companies are among our greatest areas of concern. Many technology companies have significant exposure to Europe and rely on that exposure for a large portion of their revenues. Our strategy in this area has been to focus on companies whose profits are not heavily dependent on their European exposure, i.e., they have healthy revenues from other sources. We have scaled back exposure in technology as well as in the industrials sector, where again, many companies are heavily dependent on their European exposure. Health care is yet another sector that is vulnerable to Europe’s troubles. For example, for a period of time the Fund had exposure to a dental supply company that had 48 percent exposure to the European market. In Europe, dental expenditures are discretionary, as they are here in the U.S., so we reduced exposure there.
Sometimes, a company’s European exposure isn’t readily obvious, but most multinational companies rely heavily on their European business. Occasionally, that’s not a problem. One such example is McDonald’s, which has significant exposure to Europe and is among the Fund’s 10-largest holdings (representing 2.0 percent of net assets as of Dec. 31, 2011). Despite the economic turmoil, this fast food giant’s European sales have been robust, much as they were here in the U.S. throughout the 2008/2009 recession. People trade down; they still want to go out to eat, but instead of opting for the white-tablecloth types of restaurants, they’ll opt for McDonalds, which has always offered good value and currently has a strong pipeline of new product offerings.
Brighter spots in the U.S.
The positives are that the Fund has been able to exploit the U.S. economy and corporate profits. Corporate America is doing well, and the profit recovery has been tremendous. The savings rate has gone up, despite persistent high unemployment, although it has probably capped given where interest rates are currently. The ratio of household debt payments to disposable personal income in the first quarter of 2008 was 13.8 percent. The ratio had fallen to 11.5 percent by the first quarter of 2011 and total outstanding consumer debt also had declined.2 We don’t think there’s a lot of economic downside for the U.S. at this point in time, unless we were to see some unsavory event in Europe.
A third round of quantitative easing by the U.S. Federal Reserve has been a source of speculation recently. In our view, such an event would be dwarfed by any number of things that may happen in Europe. The issues in the U.S., such as unemployment, are more structural than cyclical, so we don’t think the Fed will have much impact. It basically has run out of bullets, so any additional easing would, in our view, be a positive but short-term event.
Several months ago, we were more pro-cyclical, largely because what typically drives us into a recession is an over-build or overheating in different areas of the economy. Spending on housing has not yet recovered enough to push gross domestic product lower, with new home sales rising just 1.3 percent in October, but spending on autos, conversely, has been one of the few bright spots in spending. From an employment standpoint, productivity coming out of this cycle has been extremely strong. Corporations have cut to the bone, and further cutting from this point seems difficult. During the last recession the U.S. lost more than 8.5 million jobs; since the bottom, only a fraction of that number has been added. However, corporate profitability remains high and balance sheets are the strongest they have been in decades, with low levels of debt and high cash balances. In this environment, it is difficult to find excesses such as high inventories, aggressive hiring or capacity expansions. Capital expenditures (cap ex) have been one of the few areas of strength in the economy, but the amount of capacity that has been built since the recession has been negligible. Estimates for capacity in the system have just started to grow after declining since the recession, so much of the cap ex early on seems to have been primarily maintenance cap ex, and the need for capacity just doesn’t seem to be there.
As much as we’d like to think differently, we think Europe’s problems are likely to persist for some time and will continue to cast a shadow over global markets. There have been some deficit discussions, but now action is necessary. The European Union (EU) finance ministers have met to discuss how to implement the European Financial Stability Facility guarantees, and additional meetings are scheduled for European leaders to discuss deficit reduction. If irrational politicians scuttle the talks, stocks are likely to reverse. But we could also see the opposite. Clearly, there is no way Europe is going to avoid a recession; it’s just a matter of how deep it will be.
We believe the dynamics that are in place have created a number of uncertainties that are unlikely to be resolved anytime soon. That may not sound like particularly good news; however, we recognize that periods of volatility and a changing global economy create new investment opportunities. We believe the current uncertainty has created an opportunistic time for investors to consider the role that Waddell & Reed Advisors Continental Income Fund could play in their portfolio. In times of market volatility and uncertainty, Waddell & Reed Advisors Continental Income Fund’s focus on quality, consistent, disciplined approach and a defined mix of equity and fixed income securities and is designed to help keep investors from dramatic swings while seeking to provide a stream of current income and long-term appreciation of capital.
Data quoted is past performance and current performance may be higher or lower. Investment return and principal value of an investment will fluctuate and shares, when redeemed, may be worth more or less than their original cost. Please visit www.waddell.com for the Fund’s most recent month-end performance.
Performance at net asset value (NAV) does not include the effect of sales changes. Class A share performance, including sales charges, reflects the maximum applicable front-end sales load of 5.75 percent. S&P 500 is an unmanaged index of common stocks. Citigroup Treasury/Govt Sponsored/Credit Index is an unmanaged index comprised of securities that represent the government and corporate bond markets. It is not possible to invest directly in an index.
1The Fund may invest up to 20 percent of its total assets in non-investment-grade debt securities which may include several bank loans or floating rate notes.
2Source: Reports on "Household Debt Service and Financial Obligation Ratios" and "Consumer Credit," U.S. Federal Reserve Board, June 2011.
Past performance is not a guarantee of future results.
The opinions expressed are those of the Fund’s manager and are not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through December 31, 2011, and are subject to change due to market conditions or other factors. Data quoted is past performance and current performance may be higher or lower. Investment return and principal value of an investment will fluctuate and shares, when redeemed, may be worth more or less than their original cost. Please visit www.waddell.com for the Fund’s most recent month-end performance.
Consider all factors. 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. 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. As with any mutual fund, 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. 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.
Investors should consider the investment objectives, risks, charges and expenses of the Fund carefully before investing. For a prospectus, or if available, a summary prospectus, containing this and other information for the Fund, call your financial advisor or visit us online at www.waddell.com. Please read the prospectus or summary prospectus carefully before investing.