Waddell & Reed

Portfolio Perspectives

Look to balance risk, reward in a complex environment

Story Highlights

  • Balanced funds can be a straightforward, uncomplicated choice for balancing potential risk and reward.
  • Consumer confidence and housing appear to be improving.
  • Business spending is down due to uncertainty surrounding fiscal cliff; however, purse strings could loosen as issues are resolved.
  • Fund’s largest sectors are consumer discretionary, consumer staples and information technology; also adding to the energy sector.
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Investment Management

Manager Name

Cynthia Prince-Fox

Portfolio Manager

Slowing growth in China, uncertainty in Europe, months of stock market volatility, the recent U.S. election and the looming fiscal cliff have created a difficult environment for investors. When it seems like there is nowhere to hide, an interesting option emerges that points to a straightforward, uncomplicated choice for balancing potential risk and reward in today’s complex world.

Since 1970, Waddell & Reed Advisors Funds has offered the Waddell & Reed Advisors Continental Income Fund, a strategic asset mix of stocks, debt securities and short-term instruments, which we believe may provide the potential for a smoother ride during periods of market volatility. Here, Fund Manager Cynthia Prince-Fox, a nearly 30-year industry veteran, shares her perspective on the current market environment and provides her outlook for the months ahead.

Improving consumer confidence, U.S. housing

In the week ended Nov. 11, the Bloomberg Consumer Comfort survey’s index consumer comfort advanced to a seven-month high as Americans are becoming less pessimistic about the U.S. This improved bout of confidence appears to be encouraging consumers to spend. A budding housing recovery and cheaper gasoline are also helping to shore up household wealth, while confidence among women and individuals 65 older is on the rise.

The housing market also looks to be on the upswing because of the uptick in household formation through marriage, the addition of children and individuals getting jobs and moving out on their own. According to the minutes of the Oct. 23-24 meeting of the Federal Reserve’s Federal Open Market Committee, there was some discussion about improvement in the housing market. “Participants generally agreed that a recovery in housing activity now appears to be under way, citing increases in house prices, sales and construction in many areas. Most saw the low levels of mortgage interest rates as an important factor contributing to increased housing demand.”

From a business perspective, interesting things are happening as well. Public companies appear to be refinancing balance sheets at very attractive long-term rates. But what’s lacking on the business side is confidence, which can be seen in core capital spending that remains right around the recession-level. Although, we think, again, there’s some pent-up demand there. We believe once the uncertainty of the fiscal cliff issue is behind us and there is some clarity going to happen, we should see an increase in business spending.

Balanced funds offer opportunity

Waddell & Reed Advisors Continental Income Fund seeks to provide total return through a combination of capital appreciation and current income by looking for:

  • Medium to large, well-established companies that usually issue dividends, in order to provide possible appreciation of capital and some dividend income;
  • Equity securities that we believe possess attractive business economics, are in a strong financial condition, and are selling at attractive valuations both on a relative and absolute basis; and
  • Primarily high-quality, debt securities that are either U.S. government securities or investment-grade corporate bonds.

Historically over the past 10 years, the Fund’s allocation ranges have generally been 60 to 75 percent in equities and 25 to 40 percent in fixed income and cash.1 The allocation between equities and fixed income is generally determined based on our evaluation of the 3- to 5-year investment horizon and whether it will be a better economic environment for stocks or bonds. With the Standard & Poor’s 500 Index (S&P 500) trading at what we feel are relatively cheap levels based on the trailing 12 months Price/Earnings Ratio (defined as the price of a stock divided by its earnings per share; it indicates how much an investor is paying for a stock’s earnings power) of 17.2 (as of 10-31-2012) and the 10-year Treasury trading below 2 percent, we think equities in general look more attractive while the prospects for fixed-income returns are less compelling. We believe this low interest rate environment could persist, as political and headline risk is likely to last and into 2013. As such, we think the interest rate risk to the bond portion of the portfolio should remain low. The Fund’s current allocation reflects this longer-term view; it maintains a higher weight in equities, with approximately 69.7 percent of investments in stocks, 19.4 percent in fixed-income securities and the remainder in cash, as of Sept. 30, 2012.

We feel the Waddell & Reed Advisors Continental Income Fund differentiates itself from other balanced funds due to its higherquality bias — a characteristic that has proved advantageous against the market’s sustained volatile backdrop. We tend to follow a vigorous fundamental investment process that results in a portfolio that is built stock by stock from the bottom up. We believe in a total return, conservative approach of focusing on high-quality, dividend-paying stocks. When focusing on dividend payers, we look for dividend growth, not necessarily high-paying dividends. Our approach leans toward hitting singles and doubles rather than swinging for the fences, a strategy that has helped us manage risk over time.

Typically, the Fund holds around 50 stock positions with the largest holding typically less than 5 percent. The portfolio has a low annual turnover, as evidenced by a 40 percent average over the past 5 years. With respect to the fixed-income portion of the portfolio, we are interested in high-quality, fixed-income securities with minimal credit risk. Typically, the focus is on investment grade, but if the opportunity exists, the Fund can have some exposure to high-yield. At the moment, we have been predisposed to corporate debt vs. Treasuries, given the low interest rate environment. The duration is short because we believe that the next move for interest rates is upward.

Sectors and stocks

Overall sector allocation stems from our bottom-up stock selection process. Currently, the Fund’s largest sectors are consumer discretionary, consumer staples and information technology. We have also been adding to the energy sector.

One of the larger consumer discretionary holdings and a strong performer throughout 2012 has been CBS Corp., a mass media company that creates and distributes industry-leading content across a variety of platforms to audiences around the world. We find this stock appealing for the following reasons:

  • Premium TV content is currently enjoying multiple levers of growth.
  • Retransmission fees for CBS are anticipated to grow from $300 million to $1 billion over the next five years, driving growth because of 100 percent incremental margins.
  • New platforms like Netflix and Amazon are presenting new opportunities to monetize off air library content.
  • Increasing pay TV penetration globally is leading to an increased demand for premier content, which presents the network with more avenues for distribution.
  • Capital returns are increasing as management has returned a majority of cash back to shareholders in the form of dividends and share buybacks. Non-core assets for the network like CBS Outdoor, one of the world’s leading outdoor media companies, and an increasing cash balance have the potential to create a strong balance sheet.
  • We think CBS can grow free cash flow/share in the high teens from $3.20 per share to $4.50 per share levels by 2015.

As previously mentioned, we have been adding to the Fund’s exposure in energy. Earlier this year, when natural gas prices broke $2 per mmbtu (one million British Thermal Unit), we began looking for a natural gas company that could survive a low-price leading independent natural gas producer with its entire resource base located in the continental U.S., appeared to be a great fit for the Fund. In October, the company reported 40 percent production growth for 2012 with another year of similar growth forecasted for 2013. It has a great balance sheet with around 30 percent debt to capital ratio and is one of the few, if not only, gas producers spending within its cash flow and still growing production at 40 percent. It’s been a great stock for the Fund so far this year and we think it’s going to be an interesting story as we head into next year.

There are a number of times when the fundamental research and analysis of a particular company leads us to a buy both the equity and fixed-income instrument of that company. For example, for some time now, the Fund has been an equity shareholder of Limited Brands, Inc., an international retailer of apparel, personal care and beauty products mainly through its Victoria’s Secret, Pink and Bath & Body Works brands. After numerous conversations with Limited Brands’ management, exploring the company’s fundamentals and balance sheet and getting an overall feeling of comfort with management decisions regarding shareholder friendly practices such as returning cash to shareholders, we were interested in the company’s fixed-income instruments. As a result, the Fund also owns a couple of Limited Brands bonds, which have coupons of just over 6 percent annually.

We find Limited Bands, Inc. appealing for a number of reasons:

  • We believe that Victoria Secret can be a global brand based on the fact that it currently sells to 100+ countries through its direct business. The brand also advertises via its world renowned fashion show that is broadcast in more than 90 countries. This is a unique market space internationally as the number one market share is department stores/hypermarkets with no significant player at the mid-range price point.
  • Currently the company’s international business contribution to profits is less than 8 percent of sales, but we believe it will likely increase to 16 percent by 2015 with a large percentage driven by the Victoria’s Secret brand.
  • Other characteristics such as returns and margins are in areas that we find attractive. For example, the return on assets is in the low teens and the return on equity is 30 percent with gross margins at 40 percent and operating margins at 16.5 percent.
Looking ahead

The Fund is generally comprised of companies with strong balance sheets, growing cash flows and relatively modest exposure to domestic Europe. We have found attractive valuations among quality companies, where in many cases these companies have strong brands and exposure to long-term secular growth themes. We do expect volatility to continue given the still uncertain depth of the European recession, the looming U.S. fiscal cliff and sluggish economic indicators here at home. However, we will continue to look to own companies that we estimate can outlast the volatility today and be valuable contributors to investment returns over the long run.

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 portfolios. The Fund’s focus on a quality, consistent, disciplined approach, and its defined mix of equity and fixed-income securities is designed to help mitigate volatility, while seeking to provide a stream of current income with capital appreciation.

1 The 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. Loan participations carry additional risks, including the risk of insolvency of the lending bank or other intermediary.

Percent of net investments as of 9/30/2012: CBS Corp. 1.6%, Cabot Oil & Gas Corp. 1.3% and Limited Brands, Inc. 2.1%.

The S&P 500 is an unmanaged index that tracks the stocks of 500 primarily large-cap U.S. companies. The Barclays U.S. Government/ Credit Index measures the performance of U.S. dollar-denominated United States Treasuries, government-related, and investmentgrade U.S. corporate securities that have a remaining maturity of greater than or equal to one year. In addition, the securities have $250 million or more of outstanding face value and are fixed-rate and non-convertible securities. It is not possible to invest directly in an index.

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 Nov. 30, 2012, and are subject to change due to market conditions or other factors.

Consider all factors.As with any mutual fund, the value of the Fund’s shares will change, and you could lose money on your investment. 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. The lower-rated securities in which the Fund may invest may carry a greater risk of nonpayment of interest or principal than higher-rated bonds. Dividend-paying companies may choose not to pay a dividend, or the dividend may be less than expected. 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 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.

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