Portfolio Commentary

For the Period Ending: 06/30/2016

Click an investment style below to access our most recent quarterly commentary. For additional information on these and other investment styles visit Institutional Strategies.


Core Equity

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.


Large Cap Growth

Manager(s):
Phil Sanders, CFA
Daniel P. Becker, CFA

Portfolio Review
The financial markets continued their recent trend of swift and volatile intra-quarter moves both up and down during the second quarter of 2016. Coming off the first quarter where the Federal Reserve signaled a much more gradual move upwards in short-term interest rates, it seemed like the global currency and fixed income markets were set to improve, which would provide a calming effect on the equity markets. The potential for a reduction in capital market volatility came to an abrupt end late in June with the surprise negative United Kingdom referendum result which will likely result in the U.K. leaving the European Union (EU). The result of the so-called Brexit vote produced a huge performance shock to almost all equity market participants. After a dismal first quarter, active managers in general continued to underperform across styles and capitalization ranges during the second quarter, and have experienced one of the worst relative performance slumps since the dot-com era. Our performance, while relatively strong through most of the quarter, experienced a significant negative impact from the aftermath of the Brexit vote, when volatility and correlation spiked and investors flocked to defensive, safe and low volatility assets around the world. After mounting a relative recovery in the past few years, our portfolio has now underperformed the Russell 1000 Growth Index in each of the first two quarters of 2016. During the quarter, growth stocks generally underperformed value stocks, and smaller stocks outperformed larger companies. Safety dramatically outperformed risk during the second quarter as it did for much of the first quarter.

The degree of panic and movement into assets perceived as safe has also been reflected in bond yields. Yields of government securities moved further into negative interest rate territory throughout Europe and Asia, with nearly $14 trillion of government bond principal exhibiting negative yields by quarter-end. And although the Bank of Japan has continually reduced short-term rates into negative territory, the recent extreme flight to safety boosted the Yen materially, overwhelming the central bank’s effort to depreciate the currency.

Our performance was significantly impacted by these events due to an under-representation in the defensive sectors of the market such as Consumer Staples and Telecommunications, as well as high dividend yield and low beta stocks. In the second quarter we also experienced underperformance from key portfolio holdings. Defensive stocks performed better but could not compensate for our overweight to growth. Biotechnology stocks as a group did not perform well, while other parts of the Health Care sector, some areas within Financials, and Consumer Staples companies generally drove the index.

At first glance, the Brexit vote appears negative for global GDP growth as it may place corporate investment decisions on hold in Europe. The vote could also pave the way for other countries to leave the EU. As we see it, the recent negative shock to capital markets marks the 11th massive volatility event investors have endured since the Great Recession. High government debt levels across countries combined with already low interest rates have made the global economy more vulnerable to unexpected shocks, which almost always result in a large short-term flight to safety as we saw last quarter. In past episodes, the flight to safety gradually dissipated over time as investors once again saw opportunities in riskier assets. We view the most recent shock as mostly similar to those of the past seven years, albeit with some anomalies. Our current thinking is focused on how to capitalize on the opportunities created by these recurring dislocations while identifying and avoiding their dangers.

Outlook
The most glaring result of the recent shock is that the price of safety, low beta, and low volatility has jumped, causing some of the highest valuations that we have seen in many years. We think parts of the global capital markets are out of sync with economic reality, including negative interest rates, the valuation of Consumer Staple stocks, the valuation of high dividend yield stocks or the correlations inherent in all the above relationships. As growth is fairly stable around the world, especially in the U.S., the disconnect between the fixed income market implied forecast and what we learn from company contacts makes little sense to us. It seems to be driven more by the massive amount of money managed for day-to-day investment mandates, low-risk mandates or absolute return mandates, along with the proliferation of ETF’s, computer algorithms, and the current vulnerability of the economy. The result has been a huge shift away from beta in both growth and value stocks. As we see it, the choice now is much less about value or growth and more about risk or safety.

We have acted on our views and increased exposure to holdings we feel are great growth companies and have been overlooked or oversold. We continue to avoid areas that have high correlations to the bond markets as bond proxies and maintain our underweighting of the safe Consumer Staples areas. Some of these companies considered safe now have free cash flow valuations near those of companies that grow at much faster rates. Another way we look at the valuations and relative fear in the market is through price momentum. Normally the stocks with the most price momentum are drawn from many areas of the economy, but now most price momentum leaders are stocks often thought of as “safe.” While we don’t know when the current rotation to safety will end, or how it will end, we think there is more risk in the “riskless” or “safe” part of the market than any other sector, group or part.

Looking ahead, we continue to expect a slow rate of economic growth, low inflation and moderate and improving profit growth, usually ideal conditions for growth stocks. We maintain conviction in our largest holdings and believe such companies can thrive in this environment. We continue to selectively increase exposure to some of these holdings and other stocks which have been depressed by recent weakness.

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.


Large Cap Value

Manager(s):
Matthew T. Norris, CFA

Portfolio Review
Equity markets had a solid positive return for the quarter, as economic conditions in the U.S. stayed stable. However, the Russell 1000 Value Index return of 4.58% masked a lot of underlying volatility. The large cap value segment beat the S&P for the quarter, with the S&P 500 returning 2.46%. This is a shift, as growth has been leading value for the last few years. The disparity had reached an extreme, and the recent comeback of value investing is notable. It is too early to call it a trend, but there are certainly opportunities for investment. The timeframe of this trend and trend change are unknowable, but signposts to monitor include rising interest rates or slowing GDP growth.

Waddell & Reed’s Large Cap Value strategy underperformed the Russell 1000 Value, largely due to our positioning in Health Care. Our holdings of generic drug manufacturers and HMO’s trailed, as the market preferred the large branded drug makers. Energy continued its strong recent run, rising another 10.83% for the quarter. Investors are clearly expecting oil prices to continue their upward trend. Information Technology and Industrials were bright spots, with better performance out of individual stocks in these areas.

The portfolio has reduced its total number of names as we have fewer solid ideas in this environment. The market has more than tripled from the lows set in March of 2009, and high quality value ideas are scarce. Our cash holdings have been slightly higher than normal, but we continue to search diligently for areas offering returns. Investments are selected individually, but a few themes show through. The portfolio is overweighted in Insurance, Consumer Discretionary and Health Care. All of these areas share certain characteristics we like. Good companies with repeatable business models generating high rates of free cash flow, and low stock prices relative to our estimation of each company’s true intrinsic value. The portfolio has very little representation in the areas of Telecommunications and Industrials. Telecomm stocks simply don’t offer us the value we require, and Industrials business fundamentals are unclear to us at this time. However, we do think there are some emerging ideas there.

Outlook
After seven years and some stops and starts, the U.S. economy has recovered from the recession in 2008 and seems to have settled out in a low single-digit growth area. The Federal Reserve was instrumental in providing liquidity to the markets and economy, which helped facilitate the recovery. However, this can have other, undesired side effects. The next challenge will be for the Federal Reserve to tighten money policy back up, and that is something we will watch carefully. Their guidance suggests one or two further rate increases during calendar 2016. While the economic forces listed above are clearly important factors, the portfolio management team’s first approach is from the company level. We seek to find quality, growing companies whose stocks are trading below what we consider their intrinsic value. Often times this is due to short-term negative factors, and we become larger owners of a company if we feel those negatives are about to dissipate. We continue to search for and make investments one company at a time, to benefit clients over the long run.

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.


Mid Cap Growth

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.


Small Cap Growth

Manager(s):
Gil C. Scott, CFA

Portfolio Review
After a disappointing first quarter, the Russell 2000 Growth Index pushed ahead in the second quarter, finishing up 3.2%. Concerns China would devalue its currency at the same time U.S. interest rates would be rising abated. However, in late June, Britain voted to leave the European Union causing a spike in volatility, which the markets quickly recovered from, but the sense of prolonged uncertainty for the global markets remains. For now, fuel prices, interest rates and employment measures remain supportive of the U.S. consumer. Volatility is expected to stay elevated, especially for stocks levered to Europe as companies grapple with uncertainty in business activity and investment in the coming quarters.

Waddell & Reed’s Small Cap Growth strategy achieved significant outperformance vs. the benchmark for the second straight quarter. Favorable stock selection in the Health Care and Information Technology sectors contributed the majority of the outperformance. Within Health Care, breadth was impressive with important contributions from the equipment and supplies, technology and services industries. Notably, after many quarters, the biotechnology industry had no impact to performance. The software industry contributed robust performance within Technology. Financials was our weakest relative performer during the period due to adverse stock selection in diversified financial services.

Gains from Consumer Discretionary and Health Care were redeployed across most sectors. During the quarter we had three companies announce they would be acquired, and we used these events to seek out new positions in our portfolio. These additions represent attractive, well-capitalized firms in niche markets with long-term value creation possibilities. We also increased key positions on weakness across sectors.

Outlook
While the political fallout from Brexit and the upcoming U.S. election add to uncertainty and episodic market shocks, we’re hopeful that the stabilization of energy prices, low interest rates and resilience of the U.S. economy can contribute to positive earnings growth for the market in the second half of 2016. The Federal Reserve is expected to be patient in the timing and magnitude of interest rate increases given the slow growth world. In such an environment, our philosophy of owning companies with enduring growth prospects run by excellent management teams remains a key tenant to differentiate the portfolio and deliver outperformance over the market cycle.

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.