Market Sector Update
- It has been tough sledding for small-cap growth stocks in 2014 after a banner year in 2013.
- The third quarter saw a sharp correction in July followed by a nice rally in August and then right back down to a new low in September. The grind of 2014 is flushing out the valuation excesses that existed at the beginning of the year.
- One day the fear is that a strong domestic economy will cause the Federal Reserve to raise interest rates sooner than expected. The next day concern rises over the impact a European recession and slowdown in China might have on the domestic economy. These issues stalled the momentum in the small-cap market and by raising the risk profile, significantly pressured price to earnings (P/E) ratios.
- During the quarter, energy took the biggest beating after being a leading sector year-to-date. The more defensive consumer staples and health care sectors were the leaders for the quarter
- The Fund underperformed the benchmark for the quarter.
- The sharp up and down movement of the small-cap index throughout the quarter caused risk fears to rise again, and this pressured a number of the Fund’s larger positions in technology, industrials and consumers. Large positions that were hit hard included many companies where we have a high conviction level on the fundamental outlook through 2015. These companies are Demandware, Matrix Service, Kate Spade, and Portfolio Recovery Associates.
- On the positive side, one of the Fund’s energy exploration and production companies was acquired, and strong gains were returned by Vail Resorts and Landstar System. In terms of sectors, health care and technology caused the shortfall for the quarter, with gains in consumers, energy and industrials not enough to offset.
- Repeating from our first quarter commentary, the most noteworthy move made in the first half was the elimination of the Fund’s exposure to small-cap biotech/pharmaceutical stocks. This was accomplished via a sale of the biotech swap held by the Fund as well as the sale of individual biotech/pharmaceutical stock holdings. For most of the second quarter the move was quite beneficial, but biotechs rallied sharply in June which partially reversed the Fund’s advantage.
- We believe the Fund is positioned to perform better with an improving economy and modest upward pressure on interest rates.
- The largest Fund overweights are in industrials and financials – with the latter comprised of banks that should see margins rise as interest rates rise, and a few specialty finance and asset management companies.
- Health care exposure remains well below the benchmark with most of the deficit due to an underweight in biotechs, although the Fund did initiate a biotech position and reacquired a position in the biotech swap.
- The consumer sectors have been out of favor, but we think many companies in this sector face very easy comparisons in the second half of 2014 and they should benefit from an improving employment environment. In preparation, the Fund has added a number of restaurants and apparel/retail names to the portfolio.
*Top ten holdings as of 09/30/2014: Vail Resorts, Inc. 3.3%, Ultimate Software Group, Inc. 3.0%, SVB Financial Group 2.5%, Landstar System, Inc. 2.4%, DexCom, Inc. 2.3%, Cepheid 2.2%, Jack Henry & Associates, Inc. 2.2%, Portfolio Recovery Associates, Inc. 2.2%, Bank of the Ozarks, Inc. 2.1% and Waste Connections, Inc. 2.0%.
The opinions expressed in this commentary are those of the Fund’s managers and are current through Sept. 30, 2014. The managers' views are subject to change at any time based on market and other conditions, and no forecasts can be guaranteed. Past performance is no guarantee of future results.
Risk factors. As with any fund, the value of the Fund’s shares will change, and you could lose money on your investment. Investing in small-cap stocks may carry more risk than investing in stocks of larger, more well-established companies. 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. These and other risks are more fully described in the Fund’s prospectus. Not all funds or fund classes may be offered at all broker/dealers.
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 us online at www.waddell.com. Please read the prospectus or summary prospectus carefully before investing.