Mid Cap Growth

For the Period Ending: 06/30/2016



Investment Philosophy

Our Mid Cap Growth philosophy is based on a belief that high quality growth companies that have sound capital structures and attractive valuations will provide significant opportunities for outperformance. We believe the market will generally apply a growth rate fade factor that will overestimate the deceleration in future growth over a 3-5 year time horizon. It is this market inefficiency that the strategy attempts to isolate and generate alpha.

Other tenets of the Mid Cap Growth philosophy are:

  • Quality growth defined as profitable growth
  • Emphasis on valuation
  • Seek to be early in recognizing growth potential
  • Utilize a medium to long term mindset
  • Avoid a “benchmark driven” approach to portfolio construction
  • Bottom-up stock selection as primary source of value added

Investment Process Overview

Initial Universe
Investment Universe
Mid Cap Growth Portfolio
Idea Generation
Company Selection
Quality Growth Opportunities
Screen for:
  • Profitability metrics
  • 12 month cash flow trends
  • Valuation metrics
  • Estimate revisions
Qualitative Sources:
  • Interaction and discussion
    with W&R investment
    team resources
  • Meet with companies’
    management
  • Quarterly earnings reports
    and calls
  • Conferences, research reports
Primary Criteria:
  • Sustainable growth
  • Durable financials
  • Effective management
Conditional Criteria:
  • Valuation
  • Cash flow trends
  • Informational edge
  • Top-down factors
Greenfield Growth -
Innovators, Repeat Revenues,
Global Reach, Long Runways
for Growth

Stable Growth -

Durable business models
producing moderated, yet solid
revenue and earnings growth

Unrecognized Growth -

Undiscovered or interrupted
growth, Low institutional
following, Contrarian holdings,
Seeking early ownership

Investment Process Detail

Idea Generation – The initial broad universe consists of all U.S. companies within the range of companies in the Russell Midcap Growth Index. We become aware of initial candidates through a variety of sources:

  • Interaction and discussion with Waddell & Reed analysts and portfolio managers
  • Meetings with company managements
  • Quarterly earnings reports and calls
  • Conferences, research reports

From this population we look at the following quantitative factors for each company:

  • Profitability metrics. Gross margins (above 50%)
  • 12 month cash flow trends
  • Valuation metrics
  • Estimate revisions

While this initial quantitative analysis is designed to filter the opportunity set, we do not use hard limits on any of the metrics. It is our belief that it is important to first understand the business model as some opportunities may be screened out during the initial quantitative screen as a result of skewed measures due to nuances or other factors inflating/deflating the quantitative metrics. This could limit the ability to potentially invest in strong companies with adequate financials despite some inconsistencies among metrics. The team may secure a security with limited quantitative measures where they feel the business model and fundamentals suggest future growth.

Company Selection - Bottom-Up, Fundamental AnalysisWe believe the most significant value-add to the process is to remain very well rooted in the analytical understanding of the business models in which we seek to potentially invest. The investment process is centered on bottom-up analysis that focuses on businesses’ fundamentals, such as new or innovative products or services, adaptive or creative management, strong financial and operational capabilities to sustain growth, stable and consistent revenues, earnings and cash flow and market and profit potential.

All research is a joint venture between the portfolio management team and the firm’s research analyst team. We leverage the firm’s deep investment resources of 80+ investment professionals to thoroughly analyze all fundamental aspects of each company.

The team assesses each company’s qualitative factors utilizing a proprietary matrix based on primary criteria and conditional criteria. They evaluate and score each company on a rating of one through five, with one being the strongest/highest. Although not a strict quantitative scoring system, this matrix helps to evaluate holdings from a glance and is also used in determining weightings.

Primary Criteria:

  • Sustainable growth – Assess the business model and industry for long-term growth opportunities
  • Durable financials – Low debt, conservative accounting and profitability
  • Effective management – Visionary, honest and shareholder-driven

Conditional Criteria:

  • Valuation
  • Cash flow trends
  • Informational edge
  • Top-down factors

Valuation/Diversification – Valuation is a vital part of the approach. We believe it serves as the second layer of risk management to the investment philosophy: buying high quality growth companies at appropriate valuations that have a growth rate fade factor that is less than the market is currently discounting with an investment horizon of at least 3-5 years. We attain forecasts for each security through various resources including (in order of use):

  • Internally generated forecasts from our analysts and the mid cap growth team
  • Specific company outlooks
  • Sell-side research

Metrics evaluated include P/E and cash flow yields to select stocks that can capitalize on near-term valuation anomalies. We look for valuations that are at or below average relative to its history and the broader market.

Through this process, the universe becomes filtered to the securities in the portfolio (60-70) with an additional 70-90 at advanced stages of thesis development and research. As a result of the primarily bottom-up investment process, the securities are diversified across three “buckets” or categories of securities.

We seek to discover exploitable, quality growth opportunities in different types of companies:

  • Greenfield Growth (20-40%)
    Innovators, repeat revenues, global reach, long runways for growth
  • Stable Growth (50-70%)
    Durable business models producing moderated, yet solid revenue and earnings growth
  • Unrecognized Growth (20-40%)
    Undiscovered or interrupted growth, low institutional following, contrarian holdings or those seeking early ownership

Minimum Assets Accepted: $20 million


Total Returns


Total Returns1,2,3 Annualized
  YTD3 1 Year 3 Years 5 Years 10 Years
Mid Cap Growth - Gross1 2.73% -5.93% 8.20% 8.05% 9.77%
Mid Cap Growth - Net1 2.29% -6.73% 7.28% 7.13% 8.84%
Russell Midcap Growth Index2 2.15% -2.14% 10.52% 9.98% 8.12%

Calendar Year Returns


Calendar Year Returns 1,2,3,4
  Mid Cap Growth
Gross1
Mid Cap Growth
Net 1
Russell Midcap
Growth Index2
2Q164
3.07%
2.86%
1.56%
YTD3
2.73%
2.29%
2.15%
2015
-4.79%
-5.60%
-0.20%
2014
9.19%
8.26%
11.90%
2013
31.64%
30.52%
35.74%
2012
14.40%
13.43%
15.81%
2011
0.77%
-0.08%
-1.65%
2010
33.20%
32.07%
26.38%
2009
51.01%
49.73%
46.29%
2008
-36.55%
-37.09%
-44.32%
2007
15.09%
14.12%
11.43%
2006
10.38%
9.45%
10.66%

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 Mid Cap Growth composite consists of portfolios seeking to provide growth of capital. Portfolios within the composite primarily invest in U.S. common stocks of mid-capitalization, growth-oriented companies that the investment manager believes are high quality and/or offer above-average growth potential. For purposes of this composite, mid-capitalization companies typically are companies with market capitalizations within the range of companies in the Russell Midcap® Growth Index at the time of acquisition. The Mid Cap Growth composite was created July 1, 2015. The performance presentation is in U.S. dollars.

Mid Cap Growth composite is comprised of 9 accounts that had $5,926.9 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 Russell Investment Group is the source and owner of the Russell Index data contained or reflected in this material and all trademarks and copyrights related thereto. The presentation may contain confidential information and unauthorized use, disclosure, copying, dissemination or redistribution is strictly prohibited. This is a presentation of Waddell & Reed Investment Management Company (WRIMCO). Russell Investment Group is not responsible for the formatting or configuration of this material or for any inaccuracy in WRIMCO’s presentation thereof.

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 Mid Cap Growth percentages reflected are based on the holdings of 1 of 9 composite accounts without client specific investment restrictions and may not be reflective of the Mid Cap Growth composite as a whole or of any other Mid Cap Growth account currently, or in the future, included in such composite.


10 Largest Holdings 5,7
Fastenal Co.3.3%
Intuitive Surgical, Inc.3.0%
Zoetis Inc.2.9%
CoStar Group Inc.2.8%
Mead Johnson Nutrition Co.2.7%
Microchip Technology Inc.2.7%
Electronic Arts Inc.2.5%
CME Group Inc.2.5%
Northern Trust Corp.2.4%
Fortune Brands Home & Security Inc.2.2%


MidCapGrowthSD

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 Mid Cap Growth composite consists of portfolios seeking to provide growth of capital. Portfolios within the composite primarily invest in U.S. common stocks of mid-capitalization, growth-oriented companies that the investment manager believes are high quality and/or offer above-average growth potential. For purposes of this composite, mid-capitalization companies typically are companies with market capitalizations within the range of companies in the Russell Midcap® Growth Index at the time of acquisition. The Mid Cap Growth composite was created July 1, 2015. The performance presentation is in U.S. dollars.

Mid Cap Growth composite is comprised of 9 accounts that had $5,926.9 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 Russell Investment Group is the source and owner of the Russell Index data contained or reflected in this material and all trademarks and copyrights related thereto. The presentation may contain confidential information and unauthorized use, disclosure, copying, dissemination or redistribution is strictly prohibited. This is a presentation of Waddell & Reed Investment Management Company (WRIMCO). Russell Investment Group is not responsible for the formatting or configuration of this material or for any inaccuracy in WRIMCO’s presentation thereof.

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 Mid Cap Growth percentages reflected are based on the holdings of 1 of 9 composite accounts without client specific investment restrictions and may not be reflective of the Mid Cap Growth composite as a whole or of any other Mid Cap Growth account currently, or in the future, included in such composite.


Kimberly A. Scott   Kimberly A. Scott, CFA
  Senior Vice President, Portfolio Manager

Ms. Scott is portfolio manager of the firm’s Mid Cap Growth investment strategy and has served in this role since 2001. She joined Waddell & Reed in 1999 as an equity investment analyst and covered industries in the Consumer Discretionary, Consumer Staples and Information Technology sectors.

Ms. Scott’s lengthy background in fundamental research contributed to her development of the firm’s Mid Cap Growth philosophy in 2001. Her extensive experience at various levels of fundamental research in positions throughout her career date to 1987 with the following companies: Bartlett & Company, NBD Bank, Johnson Investment Counsel, Inc. and the University of Cincinnati Medical Center. Ms. Scott provided sector coverage for consumer non-durables, technology, retail, food and beverage, and tobacco.

Ms. Scott earned an MBA from the University of Cincinnati and a BS in Microbiology from the University of Kansas. She is a CFA charterholder.


Nathan A. Brown   Nathan A. Brown, CFA
  Vice President, Assistant Portfolio Manager

Mr. Brown is assistant portfolio manager of the firm’s Mid Cap Growth investment strategy. He has served in this role since 2011 and assists Ms. Scott in idea generation, research, portfolio construction and risk management efforts. He joined Waddell & Reed as an equity investment analyst in 2003 and covered industries in the Consumer Discretionary, Consumer Staples and Industrials sectors. Mr. Brown assumed co-portfolio manager responsibilities of the firm’s Mid Cap Income Opportunities mutual fund in 2014.

Prior to joining Waddell & Reed, Mr. Brown interned with Morgan Keegan. From 1999 to 2001 he completed five rotations in General Electric-Aircraft Engine’s financial management program.

Mr. Brown earned an MBA from Vanderbilt University and a BBA from the University of Iowa. He is a CFA charterholder.


Manager(s):
Kimberly A. Scott, CFA

Portfolio Review
The Russell Midcap Growth Index gained 1.56% in the second quarter of 2016 during a considerably less volatile market environment than we witnessed in the first quarter of the year. Most sectors outperformed the benchmark’s overall return, including Energy, Telecommunications Services, Consumer Staples, Health Care, Utilities, Financials, Materials and Information Technology. The Consumer Discretionary and Industrials sectors were weak relative to the benchmark, with Consumer Discretionary stocks notably weak. The Energy sector’s gain in both the first and second quarters was in stark contrast to its significant weakness in 2015. The ongoing search for income within the equity market drove positive returns in the Consumer Staples, Telecommunications Services, and Utilities sectors.

Waddell & Reed’s Mid Cap Growth strategy outperformed the benchmark for the quarter, with strength residing in three key sectors – Information Technology, Health Care and Energy. We were overweight each of these outperforming sectors, and stock selection also helped in the case of both Information Technology and Health Care. Information Technology made the strongest contribution to returns with help from moves by two stocks of internet-based companies that have been weak for some time. In Health Care, all but one of our stocks generated positive returns, and our sector return handily beat that of the benchmark. Our Energy names were strong again in the second quarter, building on significant outperformance in the first quarter, and generally benefiting from the recovery in oil prices from February lows.

Detractors from performance included the Consumer Staples, Materials, Financials and Consumer Discretionary sectors. Our Consumer Discretionary exposure was our largest detractor from performance in the quarter despite our underweight there. Global economic growth concerns as well as questions about competitive positioning weighed on many names. This group remains difficult given uncertainties about competition, capital spending needs, and consumer demand. However, considerable value has developed across this sector, as investors have abandoned many stocks. Our Financials exposure detracted from performance again in the second quarter, with weakness from two holdings the main causes. One of these holdings has been weak related to concerns about their exposure to loans to the taxi sector as Uber gains share, and the other participated in the broad weakness seen in the quarter in capital markets stocks.

Outlook
Our outlook for the stock market remains cautiously constructive, as it has been for much of the year. The U.S. economy is in a growth mode, albeit slow growth. Economies elsewhere in the world remain challenged, which restricts the ultimate strength of U.S. companies and the economy. Europe has shown signs of recovery, while China has become a bigger drag on world economic progress, and Latin America remains broadly weak. There have been more stresses on the earnings outlook for U.S. companies than we have seen in a considerable period of time. While much of this stress emanated from the Energy sector last year, the negative feedback loop associated with energy-related employment and spending has had a broader impact on economic growth and corporate health across many sectors. Earnings have struggled for much of the past eighteen months, and the strengthening dollar has been another source of earnings pressure on many companies. This impact will subside as the year progresses, given current exchange rates. Labor costs are also drifting higher. The significant decline in stock prices since last May has done much to improve the valuations and investability of many stocks, but much of the market, particularly leading-edge growth companies, remain expensive by our calculations. Recent events have provided slightly more clarity about the course of rate hikes by the Federal Reserve, but this topic is likely to remain a continued source of uncertainty and volatility for the stock market.

Our cautiously constructive outlook is based on our confidence that the positives we see in the economy – greater employment, an improving housing market, low energy prices, more accommodative lending, supportive demographic trends – will be enough to offset the negatives to earnings, allowing earnings and stock prices to move higher. We think these positives will outweigh the negatives as we progress through the remainder of the year. We think that the ongoing positive but slow rate of growth in the economy will drive greater demand from investors for the stocks of clearly differentiated growth companies who can deliver superior earnings performance independent of any sluggishness in the overall economy. We think the markets will trend more defensively, as well, in terms of both earnings stability and creditworthiness. This will be a response to any increases in interest rates that might come as a result of firmer economic growth, and also because of concerns about simmering debt issues around the world. Valuation will be a concern if earnings growth is less certain and debt issues weigh, but could move upward if underlying economic trends in the U.S. continue to improve through better employment growth, a stronger housing market, and any long hoped-for improvement in capital spending. Our preference for high-quality growth companies with stable and sustainable earnings profiles and strong balance sheets should serve our investors well if the economy struggles to regain a faster growth rate in the latter half of 2016. We are overweight the Health Care sector, an area where we find many vibrant growth stock opportunities. We are happy with our Energy overweight, as we think oil prices are likely to trend higher based on downtrends in production and supply and growing demand. We are most likely to add to our weightings in the Information Technology and Consumer Discretionary sectors, and possibly Industrials, over the next three to six months.

The opinions expressed in this commentary are those of the portfolio manager and are current through June 30, 2016. The manager’s 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 Mid Cap Growth composite consists of portfolios seeking to provide growth of capital. Portfolios within the composite primarily invest in U.S. common stocks of mid-capitalization, growth-oriented companies that the investment manager believes are high quality and/or offer above-average growth potential. For purposes of this composite, mid-capitalization companies typically are companies with market capitalizations within the range of companies in the Russell Midcap® Growth Index at the time of acquisition. The Mid Cap Growth composite was created July 1, 2015. The performance presentation is in U.S. dollars.

Mid Cap Growth composite is comprised of 9 accounts that had $5,926.9 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 Russell Investment Group is the source and owner of the Russell Index data contained or reflected in this material and all trademarks and copyrights related thereto. The presentation may contain confidential information and unauthorized use, disclosure, copying, dissemination or redistribution is strictly prohibited. This is a presentation of Waddell & Reed Investment Management Company (WRIMCO). Russell Investment Group is not responsible for the formatting or configuration of this material or for any inaccuracy in WRIMCO’s presentation thereof.

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 Mid Cap Growth percentages reflected are based on the holdings of 1 of 9 composite accounts without client specific investment restrictions and may not be reflective of the Mid Cap Growth composite as a whole or of any other Mid Cap Growth account currently, or in the future, included in such composite.