Economy shows signs of persistent growth thanks to domestic housing, autos, energy and manufacturing
- Economy yielding promise thanks to domestic housing, autos, energy and manufacturing.
- The millennial generation, a burgeoning consumer group and possible source of demand for consumer goods over next decade.
- Managing risk continues to be top priority.
- A focus on higher quality, more profitable companies has challenged Fund performance.
- We remain constructive on the U.S. outlook and will continue to look for opportunity across the mid-cap spectrum.
Kimberly Scott, CFA
THE U.S. ECONOMY CONTINUES TO YIELD PROMISE on the foundation of a stable and rebounding housing market, increased auto sales, abundant opportunity for growth in energy exploration and production, and a trend toward increased domestic-based manufacturing. In this portfolio perspectives, Kimberly Scott, Waddell & Reed Advisors New Concepts Fund portfolio manager, shares her view of the current market environment and her outlook for the months ahead.
Generally, we remain constructive in our outlook for the U.S. economy for the remainder of 2013 and into 2014, both absolutely, and relative to prospects and expectations for growth in other regions of the world. European economies continue to remain weak, but we are encouraged by the European Central Bank’s recent affirmation of its ongoing accommodative monetary policy. It also appears the growth rate in China is clearly moderating and we believe fears over a lack of credit availability and a consequent “hard landing” will prove to be overblown.
Interesting domestic trends give way to opportunity
We think the positive developments in the U.S. around housing and autos, growth in oil and gas exploration and production, and a trend toward increased domestic manufacturing, closer to sources of demand and inexpensive energy supplies, are all supportive of growth in the domestic economy. We are also seeing small business development beginning to percolate again, as supported by encouraging lending statistics, and pent-up demand by consumers for autos and other capital goods. Budget deficits are beginning to contract at the state/federal level and tax receipts are growing.
Another interesting and developing source of U.S. economic activity is associated with the millennial generation, as this large group of Americans starts down the road of household and family formation. The economic tailwind that these individuals can create has the potential to be a significant source of demand for an array of consumer goods over the next decade, and another reason to remain quite positive on the prospects for many of the domestic companies within the mid-cap growth universe.
Searching for quality growth
Waddell & Reed Advisors New Concepts Fund continues to seek high-quality, mid-cap growth domestic companies. It seeks to own companies that have very profitable business models, strong capital structures and long runways of visible growth that can be invested in for a three- to five-year time horizon.
As we purchase securities, we apply a degree of valuation sensitivity to the opportunities that we see in the market. Largely, we build the portfolio from a bottom-up stock selection perspective, however, we also recognize that there are certain environments when macroeconomic factors and strategic exposures are crucial to our line of thinking. During specific economic and business cycles, top-down input will dominate the portfolio’s activity and exposures. If we think the economy/earnings cycle is getting better, we may become more constructive and invest more in the front end of the economy. If we have concerns, we may become more defensive, add cash to the portfolio and step away from some of the Fund’s cyclical growth companies.
Risk management is always top of mind
One of the key factors about the way we invest is our keen focus on risk management. Risk management is something that we apply to our process with the types of companies we own. This is why we are so focused on owning quality growth companies. We also feel it is important to keep a sharp eye on valuation sensitivity as we invest across the growth spectrum. The Fund’s growth spectrum consists of areas we have identified by their characteristics as Greenfield Growth, Stable Growth and Unrecognized Growth companies.
An example from the Stable Growth category would be Henry Schein, Inc. Headquartered in New York, the company is the world’s largest provider of health care products and services to office-based dental, animal health and medical practitioners. In September, Henry Schein became the exclusive provider of the new Precise SH P Diode Laser from The CAO Group, a world-leading, high-technology dental company.
Next, we layer in Greenfield Growth or highly innovative growth companies with long runways for opportunity. These types of companies tend to be more expensively priced as they are in the early stages of their growth life cycles. An example of a Greenfield Growth company we recently added is Tumi Holdings, Inc. It designs, produces and markets a range of travel/business products and accessories, such as luggage and briefcases. Traditionally, the company has sold products through the wholesale channel but it has been rolling out new stores and we continue to see opportunity as Tumi adds retail stores in the U.S. and internationally.
Lastly, we look for companies that are considered Unrecognized Growth companies. These companies may have been former growth darlings that made mistakes. They may also have had their growth trajectories interrupted for some reason and investors are questioning their ability to provide growth in the future. We think Unrecognized Growth companies have the potential to deliver or reassert growth.
In this space, we have added Gentex Corp., which develops advanced electronic products and features for the automotive, aerospace and fire protection industries. Gentex is also known for its rear-view camera display technology. Just a couple of years ago, it appeared that the U.S. government was going to make rear-view camera displays mandatory in all automobiles, thereby creating a significant boost to Gentex sales. As the economy faltered, this particular piece of legislation did not come to pass and Gentex’s stock price was under pressure.
We believe car manufacturers are still interested in this technology to boost safety ratings. Given this potential opportunity, and others within the automobile, we think Gentex is on the leading edge of technological advances in this area and see the potential for growth to reassert itself.
In the first half of the year, we have seen some aspects of the growth spectrum become considerably overvalued, particularly in the Stable Growth area. A number of names in this category are income-producing stocks and we believe these stocks have been bid up as investors demanded income in the first half of 2013. As a result, we are finding limited opportunities in the Stable Growth area. We are, however, looking for companies in the Unrecognized Growth area where there may have been concerns about business strategies but these issues were largely ignored by investors. We also continue to hunt for innovative companies in the Greenfield Growth space.
Swimming against the current, the story behind performance
For much of 2013, we have seen the equity markets respond to more technical issues rather than fundamental issues. We also have seen investors grasp for yield and bid up companies exhibiting strong cash flows and high dividend yields, resulting in strong performance causing valuations, in our opinion, to be too rich and unsustainable for many companies. A majority of these names are in the consumer staples sector, an area where the Fund has been purposely underweight due to these companies’ extreme valuations. Because we view valuation as an integral part of our investment approach, we examine it over a three- to five-year time horizon. Given this perspective, we remain confident in our decision to underweight consumer staples as we believe this quest for yield will eventually unwind.
We have also been in an environment in which lower quality, non-earnings stories, higher debt/equity, low return on equity and higher beta names have been outperforming more quality companies with lower debt/equity profiles and greater earnings stories. As a result, our investment focus on higher quality, more profitable businesses has challenged performance for the Fund.
Another area that has held back performance is the Fund’s overweight in technology. The macro concerns associated with Europe and telecommunication service providers has slowed down capital expenditure spending. In addition, the U.S. government sequester has had a negative impact on spending, as the government is a big customer of technology.
It also appears that both public and private enterprises have reached the point over the past six to 12 months where they are pausing to digest the technology acquired over the past few years to determine how it can work for their current business needs. Companies and individuals have also started using software-centric technology that is displacing hardware functionality. All of these changes have created questions for old companies and opportunities for new ones.
One approach we use to invest in technology is to be exposed to service companies. The Fund owns Vantiv Inc., a payment processor, Ultimate Software Group Inc., a software company that provides payroll processing in SAS (software as a service), and Open Table Inc., a service for making online restaurant reservations. The Fund also owns a number of microchip and networking/cyber securities companies. At the end of the day, we believe this pause in technology spending will lead to pent-up demand as the “pantry” is emptied. When it needs to be replenished, we want to be positioned to capitalize on any new technology spending.
Another area of underperformance has been the health care sector, where although we maintain an equal weight to the benchmark, the Fund was underexposed to biotechnology companies (biotechs) and health care services companies, such as hospitals and managed care facilities. Although this was a deterrent to performance, it is the Fund’s general philosophy to avoid overexposure to unprofitable biotech names as we are focused on owning profitable companies with good balance sheets and those features are not easy to find in biotechs.
Early in 2013, we bought Onyx Pharmaceuticals, a biotech firm focused on cancer treatment therapies with two key drugs: Nexavar (for liver and kidney cancer) and Kyprolis (for multiple myeloma). We found the company’s pipeline of drugs very promising and worthy of including in the Fund. Since our purchase, Onyx is trading at a significant premium as Amgen, a pioneer in biotechnology since 1980, announced its intent to buy Onyx. In addition to Onyx, we are currently targeting a couple of other biotechs for possible purchase in the future and will likely continue to gain exposure to the group as it makes sense for the Fund.
We think that broadly there are a lot of positive things happening in the U.S. economy. While growth appears to be slow and moderate, we think that there are real factors out there that could cause acceleration in the economy over time, including an important demographic tailwind that should continue to increase demand for goods and services.
Although the markets could wax and wane in the near term, we think that we have a very positive five- to 10-year time horizon in terms of investing in the domestic mid-cap growth space.
We see this environment as the second act of the recovery in the U.S., one that has the potential to accelerate from merely moderate economic growth, providing an uptick in both earnings expectations and the valuations on those earnings.
We continue to look for companies across the mid-cap growth spectrum, with a specific emphasis on revenue and profit derived from domestic markets. As the second phase of the recovery gains steam based on housing, auto and general industrial strength, we will continue to emphasize stocks of companies in the consumer discretionary, information technology, industrials and financials sectors.
Top ten holdings as of 06/30/2013: CarMax Inc.-2.8%, Microchip Technology Incorporated-2.6%, Northern Trust Corporation-2.5%, Varian Medical Systems, Inc.-2.3%, Ulta Salon, Cosmetics & Fragrance, Inc.-2.3%, Vantiv, Inc.-2.2%, Pall Corporation-2.2%, Fastenal Company-2.2%, Dunkin Brands Group, Inc.-2.1% and Expeditors International of Washington, Inc.-2.1%. Amgen, The CAO Group and Apple Inc. are not holdings of the Fund.
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 Sept. 16, 2013, and are subject to change due to market conditions or other factors.
Risk factors. As with any mutual fund, the value of the Fund’s shares will change, and you could lose money on your investment. Investing in mid-cap stocks may carry more risk than investing in stocks of larger, more well-established companies. These and other risks are more fully described in the Fund’s prospectus. 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.
Investors should consider the investment objectives, risks, charges and expenses of a fund carefully before investing. For a prospectus, or if available a summary prospectus, containing this and other information for the mutual funds offered by Waddell & Reed, call your financial advisor or visit www.waddell.com. Please read the prospectus or summary prospectus carefully before investing.