Core Equity

For the Period Ending: 06/30/2016



The Core Equity investment process is driven by the core belief that changes in expectations for long-term earnings power drive stock prices. Therefore, the goal is a relatively concentrated portfolio of companies expected to produce long-term earnings power above expectations and stable to improving competitive advantages. Sources of competitive advantage include, but are not limited to, superior technology, brand, scale and capital advantages. The managers believe that focusing on companies with such advantages increases the likelihood that an earnings catalyst is likely to materialize and helps to manage downside risk.

The managers focus on two distinct groups of companies that they feel are likely to produce long-term earnings in excess of expectations. The first group of companies are the dominant participants in an underappreciated theme and are expected to produce long-term earnings power in excess of market expectations. Examples of such themes include industries at cyclical inflection points, major macro-economic/political forces, changes in consumer behavior and shifts in technology.

The second group of companies benefit from company-specific drivers which the managers believe are likely to cause the firm to exceed earnings forecasts on a multi-year basis. Company-specific drivers include, but are not limited to, new products, cost restructuring, improved management execution and positive cyclical changes in business trends.

The team utilizes analysis from daily morning meetings with the entire equity staff to assist in idea generation and identification of new opportunities. In addition, research analysts prepare formal action reports for the portfolio management team to assist in company-specific research.

The result is a relatively concentrated portfolio of approximately 40-50 securities expected to produce long-term earnings power above expectations.

Characteristics of portfolio construction include, but are not limited to, the following:
  • Minimum market capitalization generally $5 billion
  • Generally 40-50 stocks
  • Initial position sizes of <2%, generally trimmed if they reach 6%
  • Moderate turnover
  • Sector weights generally range from ½ to 2 times the benchmark weights and are typically highly dependent on emphasized themes
  • International companies may compose up to 10% of portfolio holdings

Minimum Assets Accepted: $15 million


Total Returns


Total Returns1,2,3 Annualized
  YTD3 1 Year 3 Years 5 Years 10 Years
Core Equity - Gross1 -0.21% -1.19% 10.33% 10.92% 8.56%
Core Equity - Net1 -0.56% -1.88% 9.63% 10.23% 7.90%
S&P 500 Index2 3.84% 3.99% 11.66% 12.10% 7.42%

Calendar Year Returns


Calendar Year Returns 1,2,3,4
  Core Equity Gross1 Core Equity Net1 S&P 500 Index2
2Q164
1.53%
1.35%
2.46%
YTD3
-0.21%
-0.56%
3.84%
2015
0.46%
-0.19%
1.38%
2014
10.61%
9.95%
13.69%
2013
35.42%
34.61%
32.39%
2012
19.61%
18.90%
16.00%
2011
1.90%
1.29%
2.11%
2010
21.63%
20.91%
15.06%
2009
23.47%
22.74%
26.46%
2008
-33.70%
-34.11%
-37.00%
2007
15.24%
14.56%
5.49%
2006
17.10%
16.41%
15.79%

Past performance is no guarantee of future results. Returns are presented on a dollar-weighted basis and may be impacted by ongoing market volatility. Please inquire for more current performance information.

1 The Core Equity composite consists of portfolios seeking to provide capital growth and appreciation. Portfolios within the composite primarily invest in U.S. common stocks of large capitalization companies, which are typically companies with market capitalizations of at least $10 billion at time of acquisition. Portfolios within the composite invest in securities that have the potential for capital appreciation or that are expected to resist market declines. Portfolios within the composite invest in securities of companies across the valuation spectrum, including securities issued by both growth and value companies. The Core Equity composite was created March 28, 2005. The performance presentation is in U.S. dollars.

Effective July 1, 2015 the composite definition/description was revised in order to provide further clarity of the composite’s investment strategy.

Core Equity composite is comprised of 33 accounts that had $9,186.8 million in total assets as of 6/30/16. • Returns reflect the reinvestment of all dividends and other earnings. Portfolio returns are net of all foreign reclaimable and nonreclaimable withholding taxes, if applicable. Withholding taxes are recognized on an accrual basis or cash basis depending on client and/or account type. Additional information regarding treatment of withholding taxes is available upon request. Returns shown gross of fees reflect the deduction of commissions paid, but are gross of all other expenses. Net-of-fees returns are calculated by deducting the highest applicable advisory fee from the monthly gross composite return. The actual fees paid by a client may vary based on assets under management and other factors. A client’s return will be reduced by investment management fees and other expenses incurred in the management of a client’s account. Investment advisory fees are described in Part 2 of the ADV. Investment returns and the actual value of each client account will fluctuate, and at any given time an account could be worth more or less than the amount invested. • The benchmark selected for the composite is intended to provide a method to compare the composite’s performance to an index including securities that are generally similar to those that are included in the composite. However, composite holdings (and, accordingly, risk and volatility) may differ significantly from the securities tracked by its benchmark.

2 Benchmark returns have been taken from published sources.

3 As of June 30, 2016.

4 Actual composite return from April 1, 2016 through June 30, 2016.

5 Data regarding holdings reflects current ownership information only and is not intended to represent any past, present or future investment recommendation.

6 Data regarding sector diversification reflects current ownership information only and is not intended to represent any past, present or future investment recommendation.

7 Supplemental data: The Core Equity percentages reflected are based on the holdings of 1 of 33 composite accounts without client specific investment restrictions and may not be reflective of the Core Equity composite as a whole or of any other Core Equity account currently, or in the future, included in such composite.


10 Largest Holdings 5,7
Halliburton Co.4.1%
Phillip Morris International Inc.4.0%
Microsoft Corp.3.3%
Applied Materials, Inc.3.2%
American Tower Corp.3.2%
Kraft Heinz Co.2.9%
Amazon.com Inc.2.9%
Teva Pharmaceutical Industries ADR2.9%
Shire Pharmaceuticals ADR2.7%
Adobe Systems Inc.2.7%


CoreEquitySD

Past performance is no guarantee of future results. Returns are presented on a dollar-weighted basis and may be impacted by ongoing market volatility. Please inquire for more current performance information.

1 The Core Equity composite consists of portfolios seeking to provide capital growth and appreciation. Portfolios within the composite primarily invest in U.S. common stocks of large capitalization companies, which are typically companies with market capitalizations of at least $10 billion at time of acquisition. Portfolios within the composite invest in securities that have the potential for capital appreciation or that are expected to resist market declines. Portfolios within the composite invest in securities of companies across the valuation spectrum, including securities issued by both growth and value companies. The Core Equity composite was created March 28, 2005. The performance presentation is in U.S. dollars.

Effective July 1, 2015 the composite definition/description was revised in order to provide further clarity of the composite’s investment strategy.

Core Equity composite is comprised of 33 accounts that had $9,186.8 million in total assets as of 6/30/16. • Returns reflect the reinvestment of all dividends and other earnings. Portfolio returns are net of all foreign reclaimable and nonreclaimable withholding taxes, if applicable. Withholding taxes are recognized on an accrual basis or cash basis depending on client and/or account type. Additional information regarding treatment of withholding taxes is available upon request. Returns shown gross of fees reflect the deduction of commissions paid, but are gross of all other expenses. Net-of-fees returns are calculated by deducting the highest applicable advisory fee from the monthly gross composite return. The actual fees paid by a client may vary based on assets under management and other factors. A client’s return will be reduced by investment management fees and other expenses incurred in the management of a client’s account. Investment advisory fees are described in Part 2 of the ADV. Investment returns and the actual value of each client account will fluctuate, and at any given time an account could be worth more or less than the amount invested. • The benchmark selected for the composite is intended to provide a method to compare the composite’s performance to an index including securities that are generally similar to those that are included in the composite. However, composite holdings (and, accordingly, risk and volatility) may differ significantly from the securities tracked by its benchmark.

2 Benchmark returns have been taken from published sources.

3 As of June 30, 2016.

4 Actual composite return from April 1, 2016 through June 30, 2016.

5 Data regarding holdings reflects current ownership information only and is not intended to represent any past, present or future investment recommendation.

6 Data regarding sector diversification reflects current ownership information only and is not intended to represent any past, present or future investment recommendation.

7 Supplemental data: The Core Equity percentages reflected are based on the holdings of 1 of 33 composite accounts without client specific investment restrictions and may not be reflective of the Core Equity composite as a whole or of any other Core Equity account currently, or in the future, included in such composite.


Erik R. Becker, CFA   Erik R. Becker, CFA
  Senior Vice President, Portfolio Manager

Mr. Becker is co-portfolio manager of the firm’s Core Equity investment strategy and has served in this role since 2006. He has been affiliated with the strategy since 2003 when he assumed assistant portfolio manager responsibilities. He joined the firm as an equity investment analyst in 1999 and covered industries in the Consumer Discretionary and Industrials sectors.

Prior to joining Waddell & Reed in 1999, Mr. Becker was affiliated with Nicholas Company, Inc. as a research analyst intern.

Mr. Becker earned a MS in Finance and a BBA in Finance from the University of Wisconsin-Madison. He is a CFA charterholder.


Gus C. Zinn, CFA   Gus C. Zinn, CFA
  Senior Vice President, Portfolio Manager

Mr. Zinn is co-portfolio manager of the firm’s Core Equity investment strategy and has served in this role since 2006. He began his career with Waddell & Reed in 1998 as an equity investment analyst and covered industries in the Consumer Discretionary, Industrials and Information Technology sectors. Mr. Zinn assumed assistant portfolio manager responsibilities for the firm’s Science and Technology mutual funds from 2003 to mid-2006.

Mr. Zinn earned a Masters in Finance and a BBA in Finance from the University of Wisconsin-Madison. He is a CFA charterholder.


Aditya Kapoor, CFA   Aditya Kapoor, CFA
  Assistant Vice President, Assistant Portfolio Manager

Mr. Kapoor is assistant portfolio manager of the firm’s Core Equity investment strategy and assists the co-portfolio managers in idea generation, research, portfolio construction, and risk management efforts. He has been a member of the team since 2014. Mr. Kapoor is also a member of the firm’s equity research team, covering large cap core securities, consumer discretionary (cable, media, internet, internet and catalog retail), and health care (health care providers and services, health care technology).

Prior to joining Waddell & Reed in 2008 as an equity investment analyst, Mr. Kapoor was a summer associate at JPMorgan Chase & Co. in 2007 and from 2002 to 2006 he was affiliated with Sapient Corp. as a technology consultant.

Mr. Kapoor earned an MBA from The Johnson School at Cornell University and a Bachelor of Technology from the Indian Institute of Technology (IIT-Delhi). He is a CFA charterholder.

Manager(s):
Erik R. Becker, CFA
Gus C. Zinn, CFA

Portfolio Review
The second quarter return for the S&P 500 Index was 2.5%, a slight improvement over the first quarter return of 1.35%. While these returns look pedestrian, the real story of the quarter was the continued action in bond markets where 10-year Treasury yields plummeted 30 basis points to end the quarter at 1.49%. At June 30, the same 10-year Treasury bond yielded 84 basis points less than a year ago, while the rate of real economic growth in the U.S. has averaged 2.1% over the past four quarters and inflation has run hotter than last year, averaging about 2.3% in the first half of 2016 versus 2% for all of 2015 (using core CPI which excludes the volatile food and energy components). Average hourly earnings appear on an upward trajectory, rising 2.6% for the most current reading versus 2% a year ago. The culprit for the dislocation between economic fundamentals and bond prices, we believe, lies with central bank policies around the world leading to more than $10 trillion in negative-yielding sovereign bonds in places such as Germany, Japan, Switzerland, and The Netherlands. Governments are buying bonds aggressively in an effort to lower interest rates across the credit curve, increase risk-taking, devalue currencies versus key trading partners, inflate asset prices, or a combination of all four. We believe the results of these aggressive policy moves have been more negative than positive, however. Despite efforts from the Bank of Japan, for example, the Yen has appreciated meaningfully versus the U.S. Dollar. In addition, equity markets in those countries that have implemented negative interest rate policies have fallen (on average), and large banks whose very business model is dependent on making a spread on money lent have been crushed. The market response, we believe, has added fuel to the argument that Central Banks no longer have the ability to prop up troubled economies and are serving only to undermine confidence in the financial system.

The other major event of the quarter, of course, was the June 23 referendum in the U.K. whereby citizens voted to leave the European Union (EU). And while the U.K. was arguably the least integrated of the major EU nations, the vote has led many to question the very viability of the European Union, particularly in an era of subpar economic growth and significant discourse over future immigration policies and real terrorism threats. The immediate macro effects of the so-called Brexit vote were to perpetuate many of the trends discussed above. Sovereign bond yields fell further into negative territory across many parts of Europe while domestic rates contracted as well. Unfortunately, nationalistic movements are not unique to Europe, as the U.S. has seen an improbable candidate, Donald Trump, become the presumptive nominee on a platform of immigration restrictions and greater trade barriers. We believe fiscal stimulus is needed more than monetary stimulus, but the former is usually a tough sell politically in most parts of the world. One possible silver lining of the U.K. vote to leave the European Union is the realization by all member countries that the sanctity of the EU is dependent on the ability of individual countries to respond to flagging economic growth and external threats without over-burdensome constraints. Whether fiscal policies will shift as the result of the latest crisis remains to be seen, but we hope that politicians are now more aware of the damaging effects of anti-growth policies on both sides of the Atlantic. We are somewhat optimistic that a new administration in the U.S., whoever that is, will work with Congress on common sense and pro-growth reforms on issues such as corporate taxes and infrastructure spending.

The continued shift toward negative interest rates combined with the effects of Brexit further intensified many of the adverse equity trends that negatively impacted our portfolio over the course of the last 18 months, specifically a further flight to safety and yield almost regardless of valuation or growth characteristics. The playbook to some may seem simple, because a major flattening in the yield curve typically signals growing risks of economic recession. An outright inversion in the yield curve, whereby longer-term interest rates are below nearer-term rates, has historically been a strong indicator of recession and forced the Fed to cut rates. In flattening yield curve scenarios, defensive stocks often outperform with Utilities, Staples and Telecom generally leading the pack. Looking beyond industry exposures, stocks with low volatility earnings streams, low financial leverage, and low beta have been rewarded versus their counterparts with opposite characteristics. So while we have been in the camp of slow (but continued) growth and “lower for longer” as it relates to interest rates – leading to consistent over-weights within defensive growth industries like Staples and Health Care – we have not embraced a full-on tilt to yield and low volatility investing as we view these characteristics as prohibitively expensive right now. We believe that current stock price action and relative valuations overly discount the probability of a continued, albeit slow growth world where companies with attractive growth opportunities can and will be rewarded versus those with static business models, high payout rates, and increasingly unattractive yields on an absolute basis.

The vast majority of our underperformance during the second quarter occurred within the Health Care sector. While Health Care stocks performed well (up 6.3% as a sector versus the 2.5% gain in the S&P 500), our stocks largely did not participate relative to other benchmark names. Many of our stocks had outright declines, particularly our holdings in specialty pharmaceuticals and biotech. The events described above led investors to the perceived safety of large-cap pharma and medical devices, and away from the more volatile and lower-yielding biotech and specialty pharmaceutical areas. Our strategy of emphasizing companies undergoing transformative M&A in the sector has been out of favor in a risk-off world. Additionally, regulatory reviews have taken far longer than even we had expected, compounding uncertainty for investors and postponing the earnings thesis underlying our holdings. Many of our Health Care names with significant growth potential now have a lower valuation than the S&P 500, which increases our confidence that these stocks will be a source of positive performance in coming quarters. Our underexposure to Utilities and large-cap Telecom also negatively impacted performance while our holdings within Energy, Staples, Technology and our significant underweight within Financials aided performance for the period.

Outlook
Our base case economic view continues to be one of moderate growth in the U.S. and somewhat improving growth across some key emerging markets driven by expectations for higher commodity prices, particularly energy. Other developed economies like Japan and much of Europe should continue to post anemic growth rates. While the ultimate effects of Brexit are uncertain, our base case is a meaningful slowdown in the U.K. and a softer eurozone, maybe to the tune of 0.5% of GDP. Our portfolio is built accordingly, with a healthy dose of defensive growth companies in stable sectors AND more offensive holdings that should perform well in a muddle-along GDP scenario. Our favorite cyclical exposure today is to the energy patch, where we are confident that two years of sharp reductions in capital spending are beginning to have meaningful effects on supplies inside and outside of the U.S. As oil and gas are depleting assets (where year 2 production falls well below year 1 production and so on) and industry cash flows are still significantly impaired at $45-50 oil, the industry will be very reluctant to invest enough capital to grow production until prices rise significantly from today’s levels. Within energy we are emphasizing quality, which for production companies means the lowest cost asset base in the best shale regions in the U.S., and for service companies means meaningfully exceeding their cost of capital through a full cycle. Since last quarter, we have increased our weighting within the Energy and Industrials sectors to gain exposure to companies that should benefit from renewed investment in U.S. energy assets. Our favorite “defensive” positioning continues to be in the Staples and Health Care sectors. Within Staples, we believe that we are on the cusp of a major consolidation wave in the global food industry, led by or catalyzed by a favorite portfolio holding. Much like the consolidation of the global beer industry (led by another portfolio holding) and tobacco, food is a highly fragmented and slow-growth industry with very duplicative and inefficient cost bases ripe for an acquirer to right-size. Our view is that if companies don’t become more efficient by themselves, others will do it for them particularly in an environment where the cost of capital is so cheap. We expect to be significantly underweight Financials until our interest rate view changes. Most business models in this sector simply do not work in an interest rate environment similar to the one we are in. We believe that a smart emphasis of dividend yield in companies that possess earnings catalysts (and even modest cyclicality) will prove to be a better strategy than chasing the lowest volatility earnings streams at expensive valuations.

The opinions expressed in this commentary are those of the portfolio managers and are current through June 30, 2016. 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.

Past performance is no guarantee of future results. Returns are presented on a dollar-weighted basis and may be impacted by ongoing market volatility. Please inquire for more current performance information.

1 The Core Equity composite consists of portfolios seeking to provide capital growth and appreciation. Portfolios within the composite primarily invest in U.S. common stocks of large capitalization companies, which are typically companies with market capitalizations of at least $10 billion at time of acquisition. Portfolios within the composite invest in securities that have the potential for capital appreciation or that are expected to resist market declines. Portfolios within the composite invest in securities of companies across the valuation spectrum, including securities issued by both growth and value companies. The Core Equity composite was created March 28, 2005. The performance presentation is in U.S. dollars.

Effective July 1, 2015 the composite definition/description was revised in order to provide further clarity of the composite’s investment strategy.

Core Equity composite is comprised of 33 accounts that had $9,186.8 million in total assets as of 6/30/16. • Returns reflect the reinvestment of all dividends and other earnings. Portfolio returns are net of all foreign reclaimable and nonreclaimable withholding taxes, if applicable. Withholding taxes are recognized on an accrual basis or cash basis depending on client and/or account type. Additional information regarding treatment of withholding taxes is available upon request. Returns shown gross of fees reflect the deduction of commissions paid, but are gross of all other expenses. Net-of-fees returns are calculated by deducting the highest applicable advisory fee from the monthly gross composite return. The actual fees paid by a client may vary based on assets under management and other factors. A client’s return will be reduced by investment management fees and other expenses incurred in the management of a client’s account. Investment advisory fees are described in Part 2 of the ADV. Investment returns and the actual value of each client account will fluctuate, and at any given time an account could be worth more or less than the amount invested. • The benchmark selected for the composite is intended to provide a method to compare the composite’s performance to an index including securities that are generally similar to those that are included in the composite. However, composite holdings (and, accordingly, risk and volatility) may differ significantly from the securities tracked by its benchmark.

2 Benchmark returns have been taken from published sources.

3 As of June 30, 2016.

4 Actual composite return from April 1, 2016 through June 30, 2016.

5 Data regarding holdings reflects current ownership information only and is not intended to represent any past, present or future investment recommendation.

6 Data regarding sector diversification reflects current ownership information only and is not intended to represent any past, present or future investment recommendation.

7 Supplemental data: The Core Equity percentages reflected are based on the holdings of 1 of 33 composite accounts without client specific investment restrictions and may not be reflective of the Core Equity composite as a whole or of any other Core Equity account currently, or in the future, included in such composite.