Waddell & Reed

Portfolio Perspectives

No escape from the long arm of macroeconomics

Kim Scott, CFA
Portfolio Manager

Waddell & Reed Advisors New Concepts Fund – July 2012

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Kimberly Scott, portfolio manager of Waddell & Reed Advisors New Concepts Fund, shares her thoughts on the current market environment, mid-cap growth stocks in general and specific issues impacting the Fund over the course of second quarter 2012.

Mid-cap growth stocks, as measured by the Russell Mid Cap Growth Index, struggled in the second quarter of 2012, losing 5.60 percent of their value. The most significant loss for mid caps came in May, when the stocks fell 7.36 percent, but the drop was mitigated by a slight 1.90 percent rebound in June. Mid-cap growth stocks were still up a solid 8.10 percent for the calendar year as of the end of June, having seen a strong 14.52 percent increase in the first quarter. The only sector in the benchmark to post a positive return in the quarter was health care, which experienced a notable gain after coming off of a very strong return in the first quarter. Other sectors of the benchmark to outperform in the quarter were telecommunications, financials, consumer staples and materials, but all with negative absolute returns. The consumer discretionary, industrials, utilities, information technology and energy sectors all underperformed the benchmark. The energy sector was the weakest with a negative 12.30 percent return.

Tough to hide from the macro

The sector laggards of second quarter 2012 speak to renewed macroeconomic concerns around the globe. The considerable optimism of the first quarter gave way to decided risk aversion as European economies deteriorated at what seemed to be an accelerating pace and China’s economy threatened to slow to a growth rate that is underwhelming relative to expectations. The concerns of the macroeconomic environment have finally become reality for microeconomics. Many U.S. companies are caught in the crosshairs as weaker activity from business partners in Europe and Asia puts downward pressure on their sales and earnings outlooks. Further, U.S. economic strength during the first quarter appears to have been closely related to very favorable weather trends that pulled forward demand and boosted activity. The follow-on has been more tepid demand in the U.S. in the second quarter, an alarming and confusing confluence of events in concert with the weakness in Europe and Asia.

The Fund struggled in the second quarter, as its exposure in the information technology and consumer discretionary sectors was detrimental to performance in the face of growing macroeconomic concerns. Stock selection was problematic in both sectors, and the Fund’s overweight position in the weak information technology sector added insult to injury in the quarter. The Fund’s networking equipment stocks were hit particularly hard. These included Aruba Networks, Inc., Acme Packet, Inc., F5 Networks Inc., and Riverbed Technology, Inc. Lam Research Corp. and Trimble Navigation Ltd. were also quite weak. Exposure to the auto industry hurt the Fund in the consumer discretionary sector, including the stocks of Borg Warner, Inc., CarMax, Inc. and Harman International Industries, Inc. Netflix, Inc. stock was another source of weakness for this group.

The health care sector was the largest contributor to the Fund’s underperformance in the quarter, due to untimely security selection and a slight underweight position in this outperforming group. Accretive Health, Inc. fell sharply in the quarter as a lawsuit from the Minnesota Attorney General brought into question the company’s business practices. We were unable to confidently analyze the ongoing opportunity for the company and sold the stock. Varian Medical Systems, Inc. and Mettler-Toledo International, Inc. were other notable health care underperformers in the quarter. Gen- Probe, Inc. made a strong positive contribution to performance, as that firm received a bid to be purchased by Hologic, Inc.

A challenging time for stock selection

Our usual strength in stock selection was not born out during the second quarter. Besides the weakness in health care, consumer discretionary and information technology, stock selection issues also hit returns in the Fund’s exposure to the materials and financials sectors.

We did see good returns from both stock selection and the Fund’s sector exposures in both the consumer staples and energy groups, which was helpful, as these were the best and worst performing groups, respectively, in the second quarter. We increased our exposure somewhat to consumer staples in the quarter, adding Church & Dwight Co, Inc., which contributed positively to performance. Boston Beer Company, Inc., Brown-Forman Corp. and Whole Foods Market, Inc. were all strong stocks during the time period.

The Fund was underweight the very weak energy group in the quarter, and many of our names outperformed the benchmark. We added to the Fund’s natural gas exploration and production company exposure near the end of the period, as we see the potential for gas prices to rise boosting the earnings potential of companies such as Cabot Oil & Gas Corp., Southwestern Energy Co., and Ultra Petroleum Corp., which is a longstanding position in the Fund. We think these companies should be able to take advantage of the long-term growth opportunity around supplying an inexpensive and clean fuel for industrial and transportation uses in the U.S.

A look to the future

While our long term and ongoing outlook for the U.S. has been one of a prolonged period of moderate economic growth, we also have come to think that the U.S. is in the second phase of the recovery and expansion following the recession of 2008-2009. This phase has been led by stabilization in the housing market and stronger activity in the automobile industry. Furthermore, as economic activity has weakened elsewhere around the globe, we saw the U.S. as positioned to have what we called an isolationist recovery/expansion that benefited from uniquely U.S. factors. These factors include better housing and automobile activity; vibrant oil and natural gas exploration/production environment and its resulting beneficial impact on fuel prices; greater labor and operating cost competitiveness at domestic businesses; and a more favorable dollar exchange rate.

While we think these factors continue to put a bid under domestic economic activity, the reality seems to be that the U.S. experience is not as isolationist as we had expected. European and Asian weakness is hitting larger multinational businesses first, given their greater exposure to those markets. It is also impacting smaller firms in inherently more global sectors, such as information technology. These companies are seeing real pressure on sales and earnings because of their presence in global markets.

And while more domestically focused companies, usually small- and mid-cap companies with little to no exposure outside of the U.S., will likely not experience a direct weak Euro/Asia earnings impact, their business fortunes could be nonetheless impacted by reflexivity on the part of concerned businesses and consumers. Even if the earnings pressure is specific to the multinational corporations, we think the overall market can experience price/earnings multiple contraction, such that stock prices could be broadly impacted. We have clearly seen this in recent months with most stocks under pressure and only a few squeaky-clean, U.S.-centric strong growth stories and sound counter cyclicaldividend payers seeing strength in their stocks.

Forgiveness on the way?

The market could prove forgiving should investors become convinced that there is real progress toward sound solutions on the horizon. Investors want to see significant positive measures taken to solve Europe’s debt and banking crisis and China’s ability to deliver stronger economic growth without reigniting inflation. Investors also want believe that the U.S. economy can successfully transition from the supernormal demand of the first quarter, through the lull of the second quarter, onto firmer economic footing in the back half of the year, possibly supported by better than expected housing activity.

We think, however, that the threat to earnings is real, and possibly more significant than the market is currently considering. This, in front of the brewing storm of a contentious political season, the debt ceiling debate and the dangerous fiscal cliff, make us increasingly cautious and more defensively inclined in the Fund’s portfolio. We will continue to invest in companies that have multi-year growth opportunities, but we will search for those with less cyclicality in their businesses at this time of earnings risk in the economy. We are likely to reduce exposure to the information technology sector, in particular, and to be slow to invest excess cash in the portfolio. We don’t want to compromise the focus on owning high-quality, differentiated long-term growth companies, but we do believe this is an important time to prudently balance long-term opportunity against near-term risk.

Percent of net investments as of 6/30/2012: Aruba Networks, Inc. - 0.50%, Borg Warner, Inc. - 0.53%, Boston Beer Company, Inc.- 1.14%, Brown-Forman Corp.- 1.03%, Cabot Oil & Gas Corp. - 0.41%, CarMax, Inc. – 1.01%, Church & Dwight Co Inc. - 1.09%, Harman International Industries, Inc. - 1.28%, Lam Research Corp – 1.02%, Mettler-Toledo International, Inc. - 0.50%, Southwestern Energy Co. - 0.25%, Trimble Navigation Ltd. - 2.25%, Varian Medical Systems, Inc. - 2.49% and Whole Foods Market, Inc. - 1.57%. Not a holding of the Fund: Accretive Health, Inc., Acme Packet, Inc., F5 Networks, Inc., Gen-Probe, Inc., Hologic, Inc., Netflix, Inc., Riverbed Technology, Inc. and Ultra Petroleum Corp.

Russell Mid Cap Growth Index is an unmanaged index comprised of securities that represent the mid-cap sector of the stock market. 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 July 16, 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.

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