Waddell & Reed

Portfolio Perspectives


Gaining perspective on the road traveled

Story Highlights

  • Investors’ search for yield drove valuations last year.
  • A focus on higher quality, more profitable companies has challenged Fund performance.
  • Focusing on mantra, “quality growth is profitable growth.”
  • Managing risk continues to be top priority.
  • We remain constructive on the U.S. outlook and will continue to look for opportunity across the mid-cap spectrum.
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Investment Team

Kimberly Scott, CFA

Portfolio Manager

Broad issues were at play over the past 12 months, when equity markets trended upward. The biggest and most impactful issue in 2013 was the risk-on environment that favored lower quality business models and balance sheets, and exceptionally strong differentiated growth, both real and perceived. When this situation is specifically applied to the Waddell & Reed Advisors New Concepts Fund, it is a tale of holding too much technology, not enough health care and consumer staples exposure, poor stock selection in industrials and technology, as well as a consistent cash position drag. In a nutshell, all of these issues impacted performance in 2013. In this commentary, Portfolio Manager Kimberly Scott, CFA, provides insight into the current risk-on market environment.

2013: Lower quality, non-earners and higher debt companies outperformed

We fought three main battles last year, the biggest and most impactful being the risk-on environment that favored lower quality business models and balance sheets, and exceptionally strong differentiated growth, both real and perceived. Non-earners, low return on equity and higher debt-to-total capitalization companies soared in value relative to the rest of the market in 2013. The charts below show the return and contribution of these factors in relation to the performance of the Russell Midcap Growth Index.

Companies with non-earnings stories and lower earnings strongly outperformed those with higher earnings

P/E (Price-to-Earnings) Quintile

Return

Contribution

Q1 (Lowest)

56.9%

6.0%

Q2

36.8%

6.5%

Q3

31.4%

5.7%

Q4

29.6%

5.6%

Q5 (Highest)

28.5%

6.2%

Non-earner stories

71.8%

2.0%

 

Companies with the lowest return on equity had the largest return

ROE (Return on Equity) Quintile

Return

Contribution

Q1 (Highest)

38.7%

9.4%

Q2

32.0%

6.8%

Q3

35.1%

5.9%

Q4

24.2%

3.3%

Q5 (Lowest)

48.9%

6.8%

Characteristics of the Russell Midcap Growth Index for the 12-month period ended 12/31/13.
Source: BofA Merrill Lynch; Russell Investment Group. Past performance is not a guarantee of future results.

 

Challenges in technology, industrials

The other battles we fought and lost last year included the ongoing micro-cyclical and larger secular pressures in the technology sector, an underperforming group in which we remained overweight and exposed to some names that performed poorly, including Teradata, Fusion I-O, Aruba and F5 Networks. We also owned weak performers in the industrials space, which posted a banner year in the index, and we didn’t own enough consumer staples stocks. This was a group that generated a 38% return as investors sought out dividend income, and had a renewed interest in the grocery store sub sector; an area that we think is now experiencing too much capital investment.

Investors’ search for yield drove valuations in consumer staples, Fund’s underweight

The final battle now seems like a footnote on the year, given the market’s white hot risk-on trade into year-end. The frenzied reach for yield in the spring of 2013 that drove valuations to very high levels in some of the most stable and predictable sectors of the economy, consumer staples and traditional areas of health care, left us as onlookers. We were unwilling to own many of those stocks and unconvinced that we could find a reasonable balance of valuation and growth to deliver a return to our shareholders over our three-to-five year time horizon.

The broad issues of a lower quality, strong risk-on market made it difficult for us to deliver market-beating performance, but fewer selfinflicted wounds certainly would have made the difference between underperforming and outperforming. The combination of the cash drag and our three worst performing stocks, Teradata, Fusion IO, and Polypore, were the difference between underperformance and outperformance in 2013. We had many good stocks in the portfolio, but our experience as strong stock pickers did not shine through last year, especially with the weak links in the portfolio.

Outperformance during the initial unwind of quantitative easing

The battle, or rather, skirmish that we did win last year, came in the late spring and early summer as Treasury rates rose swiftly following tapering talk by the Federal Reserve. We outperformed the market in this relatively risk-off period of May through August, with the Fund’s strongest outperformance in the down months of June and August. Long duration, “pay me later” assets do not like rising interest rates, and we think the behavior of the market last summer is good evidence of the potential difficulties many high fliers may face when rising rates are once again a top-of-mind concern.

Fund philosophy: Quality growth equals profitable growth

The Waddell & Reed Advisors New Concepts Fund’s process focuses on owning high-quality companies with profitable business models that are supported by sound capital structures. We seek to buy companies with a significant degree of valuation sensitivity and own them for many years, given an ongoing balance of growth opportunity and valuation support.

At the core, our philosophy is “quality growth is profitable growth.” It is our leading philosophical tenet. We are always searching for highreturn business models that can grow at stable or improving rates of profitability, which should naturally be a factor for wealth creation for investors. However, the importance of this philosophical tenet is even deeper. Its ultimate emphasis in the Fund’s process grew out of my experiences as a technology analyst at the end of the tech bubble in 1999-2000, and later as a new fund manager during the 2001-2002 recession.

While the Fund is exposed to a few companies that are building their earnings streams and selling at high sales multiples or cash flow, we have largely been reluctant to invest in many of these companies, both existing and new. Why? First, we have concerns regarding their uncertain business models and return potential, and second, it is due to their valuation. Where we have decided to participate, particularly in the IPO arena, the valuation expansion has been swift and for prices where we don’t think it is prudent to build a larger position, we sold the stocks. Many of these valuations have carried on to even higher extremes. This is opportunity cost in the near term, but our “quality growth is profitable growth” mantra exists because we understand that growth with only the promise of profits is not the key to a long and healthy life in the world of investing.

Investment opportunities we find compelling

We remain committed to our strategy that demands a higher degree of certainty about earnings and cash flow, in conjunction with valuation sensitivity, to own assets that will generate strong risk-adjusted returns for our investors. We obviously have many such names in the portfolio. We continue to research and find many new names for our buy lists and wish lists. In spite of the valuation excesses in some areas, we still find attractive growth and investment opportunities in most sectors, and remain constructive on the prospects for U.S. economic growth.

Some of the most interesting names in the portfolio today include Open Table, WebMD, Signature Bank, Dunkin Donuts, Skyworks Semiconductors and Norwegian Cruise Lines. We recently added Alkermes, a biotech company focused on central nervous system disorders; Flow Serve, an old friend in the industrials space; and Panera Bread Company. Leading edge companies, like Zillow and Service Now are interesting to us as long as we continue to see a reasonably clear path toward stable earnings and cash flow streams. These high-octane companies have a place in the portfolio, but in a contained space. We have a portfolio full of companies in which we have confidence in their three- to five-year outlooks for business growth and development, at supportive return-generating valuations.

Constructive outlook: the U.S. economy has entered its second phase of recovery

We think there is broad consensus now of a halo over the U.S. economic and business climate, in addition to encouraging signs for more stable economies around the world — the so called “synchronized global expansion.” While the retail investor may not yet be fully engaged in the stock market, this is a factor that can still positively impact returns, as is the important fact of money beginning to flow out of the bond market and into the stock market. We need to work harder than ever to find companies with differentiated growth opportunities, where we can build confidence in an investment case that makes sense in a somewhat frothy market. And as long as our macro viewpoint does not see the danger of a recessionary earnings inflection, we will take any opportunity handed us to build these positions.


Top ten holdings as of 12/31/2013: Northern Trust Corporation-2.7%, Microchip Technology Incorporated-2.5%, Fastenal Company-2.2%, First Republic Bank-2.2%, Signature Bank-2.2%, Fortune Brands Home & Security, Inc.-2.1%, Vantiv, Inc.-2.1%, Varian Medical Systems, Inc.-2.1%, Expeditors International of Washington, Inc.-2.1% and Mead Johnson Nutrition Company-2.0%.

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 Feb. 15, 2014, 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.

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