Harnessing the power of differentiated growers...A strong economic tailwind not mandatory
Kim Scott, CFA
Waddell & Reed Advisors New Concepts Fund – May 2012
The U.S. economy appears to be in a protracted period of slow to moderate growth in which we think the average company will be unlikely to deliver significant upside in earnings and cash flow. Therefore, the Waddell & Reed Advisors New Concepts Fund management team is focusing efforts on finding differentiated growers it believes are not particularly dependent on a strong economic tailwind to generate results. Kimberly Scott, the Fund’s portfolio manager, shares her view of the current market environment.
Slow to moderate growth on the horizon
We think we are in a second phase of the recovery from the recession of 2008-09. The first phase was driven by both a strong snap back in corporate profits following swift and significant restructuring moves at many companies, and by a gradual recovery in consumer spending after a steep retrenchment in late 2008/early 2009. The second phase of growth looks like it will be based on improved activity in both the housing and automobile industries. Furthermore, we are seeing activity in U.S. manufacturing based on more competitive labor, energy and exchange rates. This is a factor that we think can pay dividends to the economy not only today, but well into the future if these improvements persist.
We believe the markets will continue to struggle with the sovereign debt issues in Europe and concerns over the strength of Chinese economic growth. Investors (or “the market”) will also be digesting election rhetoric that could create concern as the year progresses. There will potentially be considerable angst regarding the possible spending cuts and tax increases to come if we enter 2013 without legislative changes.
We weigh all these factors in combination with the valuation on the market and the outlook for further profit growth. We remain constructive, in the final analysis, as we think the economy has gained real traction, evidenced by solid improvement in the labor market. We also think there is potential for corporate profits to be better than expected in 2012, a fact that could move equities to higher levels than we have seen.
Last year, we emphasized consumer discretionary, consumer staples and financial stocks as we sought out companies with better than average growth prospects selling at attractive valuations. This sector emphasis is unlikely to change significantly in the near term; however, our focus in managing the portfolio has continued to shift from the stronger macro view we applied in 2009/early 2010 toward a more typical stock-picking approach.
We think the economy has gained traction in recent months and has become self-sustaining, but we continue to expect a level of growth that is moderated from rates historically seen in periods of economic expansion after an acute downturn such as that experienced in 2008-09. As such, we expect the greater opportunities for market returns to be in companies with better than average growth prospects selling at attractive valuations. While many of these opportunities are not sector dependent, we do see a number of sectors where there are many interesting companies in which to invest, including information technology, industrials, energy and consumer discretionary. Health care is also interesting to us, and we look for companies in that sector that have innovative products and services that we believe will be in demand in spite of the utilization and reimbursement pressures affecting the industry.
Rebound offers potential benefits
Mid-cap growth stocks, as measured by the Russell Midcap Growth Index, had a very strong start to the year, gaining 14.52 percent. This was an impressive encore to an 11.24 percent gain in fourth quarter 2011.
All sectors, with the exception of utilities, had positive returns in the quarter. About half of these sectors performed well against the benchmark, the Russell Midcap Growth Index. Top sector performers were materials, consumer discretionary, health care, and information technology. Energy, industrials, consumer staples, financials, telecommunication services, and utilities all underperformed the benchmark. The strong gain by health care was notable, as this generally defensive sector had the second strongest return in the quarter among all sectors in the benchmark.
Sources of strength, weakness
The Fund’s strongest performing sector for the first quarter was consumer discretionary, where security selection and an overweight position paid off. Stocks of note included: BorgWarner Inc., Lululemon Athletica Inc., Michael Kors Holdings Ltd., which we purchased on its recent initial public offering, and Ulta Salon, Cosmetics & Fragrance, Inc. Other sectors that contributed positively to performance included financials, where CBRE Group Inc. and Greenhill & Co. were strong, and telecommunications and utilities, where the Fund’s lack of exposure was a positive as both of these sectors underperformed.1
At the same time, performance was deterred a bit by poor security selection results across four sectors: information technology, health care, energy, and industrials. A few names drove underperformance in the information technology results including: WebMD Health Corp. and Acme Packet Inc., both of which posted declines in stock price.1
With the exception of Accretive Health, Inc., which declined in price during the first quarter, all of the Fund’s health care names posted gains, but not at rates strong enough versus the sector, where a few key stocks (not holdings of the Fund) had very big moves, driving an overall strong positive return for the sector.
In the energy sector, poor performance from Ultra Petroleum Corp., a natural gas centric exploration/production company and Patterson Energy Inc., an oil services company with exposure to the natural gas drillers, hurt returns. An abundance of natural gas following years of success drilling in U.S. shale plays continues to be a source of pain in gas-oriented energy stocks.
In industrials, poor performance from Polypore International Inc., which makes materials for lithium ion batteries for electric drive vehicles and consumer electronics products, was responsible for the Fund’s negative relative results in that sector. The Fund’s small cash position was a negative contributor to performance. In a rising market, like the one we are currently experiencing, any cash position can be a deterrent.
In the months ahead
Over the course of 2012, we will focus on investing in stocks across the mid-cap growth spectrum where there appears to be an attractive combination of growth potential and compelling valuation. The Fund continues to find more opportunities and thus invests more heavily in information technology, consumer discretionary and financials. It generally will have: no exposure to utilities or telecommunications services; minimal exposure to materials; equal weight in consumer staples; and be underweight energy, industrials and health care.
We remain constructive on the economy and continue to believe there is potential for corporate profits to be better than expected this year, a fact that could move equities to higher levels than we have seen, even year to date.
1BorgWarner Inc., Michael Kors Holdings Ltd., Ulta Salon, Cosmetics & Fragrance, Inc., CBRE Group Inc., Greenhill & Co., Acme Packet Inc., Accretive Health, Inc., Ultra Petroleum Corp., Patterson Energy Inc., and Polypore International Inc. (1.8, 0.77, 2.0, 1.5, 1.5, 0.90, 0.74, 1.3, 1.0 and 1.4 percent of net investments as of March 31, 2012, respectively). Lululemon Athletica Inc. and WebMD Health Corp. are no longer holdings of the Fund.
Russell Midcap Growth Index is an unmanaged index comprised of securities that represent the mid-cap sector of the stock market.
Past performance is not a guarantee of future results. The opinions expressed are those of the Fund 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 May 23, 2012, and are subject to change due to market conditions or other factors.
Investment return and principal value will fluctuate, and it is possible to lose money by investing. Investing in mid-cap stocks may carry more risk than investing in stocks of larger, more well-established companies. These and other risks can be found in the Fund’s prospectus.
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 any of the Waddell & Reed Advisors Funds, call your financial advisor or visit www.waddell.com. Please read the prospectus or summary prospectus carefully before investing.