Small Cap Growth

For the Period Ending: 06/30/2016



Investment Philosophy

  • We seek successful small cap growth companies with strong business models that we feel have the potential for large market opportunities
  • We believe that a disciplined application of quality criteria generates superior return characteristics
  • We invest with an emphasis on optimal diversification; invest with conviction to allow best ideas to impact results, but enough diversification to moderate risk and deliver small cap equity return characteristics

Investment Process

The Small Cap Growth strategy focuses on the diversified selection of small capitalization growth companies. The primary objective is to achieve maximum capital appreciation via the selection of companies with above average profitability characteristics. Through bottom-up fundamental analysis, we attempt to build a portfolio of companies that combine high-quality characteristics with substantial growth potential, higher operating margins, lower debt, and better asset efficiency.

Bottom-Up Fundamental Research with Quality Focus

The initial universe of securities is narrowed by identifying companies that exhibit characteristics that we believe define higher quality companies. From both a qualitative and quantitative approach we further narrow the universe, looking at a variety of fundamental factors.

Qualitative factors:

  • Company management visits. Meeting with company management teams we gauge the extent to which they are focused, purpose-driven and properly aligned with respect to compensation incentives.
  • Organic-driven growth and identifiable drivers of revenue.
  • Revenues less volatile (subscription based, high market share, pricing power).
  • Strong financial position.

Quantitative measures:

  • Assets efficiently deliver operating profit. (EBIT / Total Assets – Cash)
  • High levels of profitability.
  • Capital structure not stressed with debt.
  • Low GAAP to NON-GAAP earnings estimate dispersion.

Diversification across Growth Spectrum

Throughout the portfolio construction process we are at all times aware of our allocation across our proprietary spectrum of types of growth companies. Any of these categories may assume market leadership, so we strive to maintain exposure to each. The growth spectrum is comprised of four major categories (listed in descending order of valuation and typical ownership percentages): Aggressive Growth, Accelerating Growth, Consistent Growth and Out of Favor Growth.

The result of the fundamental research process above is a relatively concentrated portfolio of 45-55 stocks, but yet still diversified across types of growth categories. We believe this smaller size allows us to understand portfolio companies thoroughly and comprises only our highest conviction securities.

Characteristics of portfolio construction include, but are not limited to, the following:

  • Minimum market cap of $200 million; upper range generally in line with the Russell 2000 Growth Index.
  • Number of securities 45-55.
  • Sectors +/- 50% of the Index.
  • Individual position sizes generally trimmed when they reach 5%.

Minimum Assets Accepted: $20 million


Total Returns


Total Returns1,2,3 Annualized
  YTD3 1 Year 3 Years 5 Years 10 Years
Small Cap Growth - Gross1 10.92% -1.14% 11.29% 10.39% 9.82%
Small Cap Growth - Net1 10.45% -1.98% 10.35% 9.45% 8.89%
Russell 2000 Growth Index2 -1.59% -10.75% 7.74% 8.51% 7.14%

Calendar Year Returns


Calendar Year Returns 1,2,3,4
  Small Cap Growth
Gross1
Small Cap Growth
Net1
Russell 2000 Growth Index2
2Q164
7.73%
7.50%
3.24%
YTD3
10.92%
10.45%
-1.59%
2015
-2.47%
-3.30%
-1.38%
2014
4.22%
3.34%
5.60%
2013
46.81%
45.57%
43.30%
2012
12.21%
11.26%
14.59%
2011
-4.39%
-5.20%
-2.91%
2010
35.29%
34.17%
29.09%
2009
44.43%
43.24%
34.47%
2008
-35.32%
-35.89%
-38.54%
2007
8.91%
7.99%
7.05%
2006
7.17%
6.26%
13.35%

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 Small Cap Growth composite consists of institutional portfolios seeking to provide growth of capital. Portfolios within the composite primarily invest in U.S. common stocks of small capitalization companies. For purposes of the composite, small capitalization companies typically are companies with market capitalizations within the range of companies in the Russell 2000® Growth Index at time of acquisition. Portfolios within the composite emphasize relatively new or unseasoned companies in their early stages of development, or smaller companies positioned in new or emerging industries where the investment manager believes there is opportunity for higher growth than in established companies or industries. The Small Cap Growth composite was created March 28, 2005. The performance presentation is in U.S. dollars.

Effective July 1, 2015 the composite was redefined to include only institutional accounts within the composite, and was redefined to reflect a broader, higher level investment mandate, objective, and strategy, rather than reflecting a specific investment process. Even though the composite definition was redefined, the investment strategy of the composite did not change and did not warrant a new composite to be created.

Effective July 1, 2015, the name of the composite changed from Small Cap Growth Select composite to the Small Cap Growth composite. Effective October 1, 2010, the name of the composite changed from the Small Cap Growth II composite to the Small Cap Growth Select composite.

Small Cap Growth composite is comprised of 7 accounts that had $382.4 million in total assets as of 6/30/16. • Effective October 1, 2010, the portfolio management objective of 25 portfolios changed, resulting in the transfer of those portfolios into this composite. The historical performance of these 25 portfolios prior to October 1, 2010 is not included in this update. • 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 7Supplemental data: The Small Cap Growth percentages reflected are based on the holdings of 1 of 7 composite accounts without client specific investment restrictions and may not be reflective of the Small Cap Growth composite as a whole or of any other Small Cap Growth account currently, or in the future, included in such composite.


10 Largest Holdings5,7
Tyler Technologies, Inc.5.0%
Middleby Corp./The4.7%
DexCom Inc.4.2%
Veeva Systems Inc. CI A4.0%
HealthEquity, Inc.3.5%
Kate Spade & Co.3.3%
PRA Group Inc.3.3%
Five Below, Inc.3.2%
Trex Company, Inc.2.9%
Manhattan Associates, Inc.2.8%


SmallCapGrowthSD

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 Small Cap Growth composite consists of institutional portfolios seeking to provide growth of capital. Portfolios within the composite primarily invest in U.S. common stocks of small capitalization companies. For purposes of the composite, small capitalization companies typically are companies with market capitalizations within the range of companies in the Russell 2000® Growth Index at time of acquisition. Portfolios within the composite emphasize relatively new or unseasoned companies in their early stages of development, or smaller companies positioned in new or emerging industries where the investment manager believes there is opportunity for higher growth than in established companies or industries. The Small Cap Growth composite was created March 28, 2005. The performance presentation is in U.S. dollars.

Effective July 1, 2015 the composite was redefined to include only institutional accounts within the composite, and was redefined to reflect a broader, higher level investment mandate, objective, and strategy, rather than reflecting a specific investment process. Even though the composite definition was redefined, the investment strategy of the composite did not change and did not warrant a new composite to be created.

Effective July 1, 2015, the name of the composite changed from Small Cap Growth Select composite to the Small Cap Growth composite. Effective October 1, 2010, the name of the composite changed from the Small Cap Growth II composite to the Small Cap Growth Select composite.

Small Cap Growth composite is comprised of 7 accounts that had $382.4 million in total assets as of 6/30/16. • Effective October 1, 2010, the portfolio management objective of 25 portfolios changed, resulting in the transfer of those portfolios into this composite. The historical performance of these 25 portfolios prior to October 1, 2010 is not included in this update. • 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 Small Cap Growth percentages reflected are based on the holdings of 1 of 7 composite accounts without client specific investment restrictions and may not be reflective of the Small Cap Growth composite as a whole or of any other Small Cap Growth account currently, or in the future, included in such composite.


Gil C. Scott   Gil C. Scott, CFA
  Senior Vice President, Portfolio Manager

Mr. Scott is portfolio manager of the firm’s institutional Small Cap Growth investment strategy. He has been a member of the Small Cap Growth team since 2000 and was named portfolio manager for institutional portfolios in 2010. From 2003 to 2010, Mr. Scott was portfolio manager for the firm’s retail Small Cap Growth mutual funds. He joined Waddell & Reed in 1997 as an equity investment analyst and covered industries in the Consumer Discretionary, Financials and Information Technology sectors.

Prior to joining Waddell & Reed, Mr. Scott was affiliated with Hallmark Cards as a project manager in Strategy/Marketing Finance. From 1991 to 1993 he was a member of the GE Capital audit staff. From 1989 to 1991 he was a financial analyst for GE Medical Systems, during which he completed GE’s Financial Management Program with top honors.

Mr. Scott earned an MBA from the University of Texas and a BBA in Finance from the University of Massachusetts. He is a CFA charterholder.


Bradley P. Halverson   Bradley P. Halverson, CFA
  Vice President, Assistant Portfolio Manager

Mr. Halverson is assistant portfolio manager of the firm’s institutional Small Cap Growth investment strategy. He was appointed assistant portfolio manager in 2014 and assists Mr. Scott in idea generation, research, portfolio construction and risk management efforts. Mr. Halverson joined the firm as an equity investment analyst in 2008 covering small capitalization securities and the commercial services and supplies and diversified consumer services industries.

Prior to joining Waddell & Reed, Mr. Halverson was an equity research analyst with Northpointe Capital and responsible for growth stocks across micro, small, and mid cap portfolios. From 2002 to 2004 he was an associate in health care investment banking for A.G. Edwards & Sons, Inc. He also was employed by PricewaterhouseCoopers, LLP from 1995 to 2000.

Mr. Halverson earned an MBA from the University of Michigan and a BS and MS in Accounting from Brigham Young University. He is a CFA charterholder.


Additional Small Cap Resources


Timothy J. Miller, CFA   Timothy J. Miller, CFA
  Senior Vice President, Portfolio Manager

Mr. Miller is part of the firm’s broader Small Cap team. He has been portfolio manager of the firm’s Small Cap Growth mutual funds, Waddell & Reed Advisors Small Cap Fund and Ivy Small Cap Growth Fund, since 2010. He joined the firm in 2008 as portfolio manager of the Small Cap Value mutual funds, holding those responsibilities until 2010.

Prior to joining Waddell & Reed, Mr. Miller managed his personal funds in a hedged equity style from 2004 to 2007. From 1992 through mid-2004 he was affiliated with INVESCO Funds Group, including serving four years as its chief investment officer, five years as head of the growth funds group, and from 1993-2004 as lead manager of the INVESCO Dynamics Fund. Early in Mr. Miller’s career, he spent 13 years affiliated with Mississippi Valley Advisors in St. Louis, as assistant director of equity research and co-manager of a small cap value fund.

Mr. Miller earned an MBA from the University of Missouri/St. Louis and a BSBA in Finance from St. Louis University. He is a CFA charterholder.


Kenneth G. McQuade   Kenneth G. McQuade
  Senior Vice President, Portfolio Manager

Mr. McQuade is part of the firm’s broader Small Cap team. He has been portfolio manager of Ivy Funds VIP Small Cap Growth since 2006. He has been affiliated with the small cap investment strategy since 2003 when he assumed assistant portfolio manager responsibilities. Mr. McQuade joined the firm in 1997 as an equity investment analyst covering industries in the Financials and Health Care sectors.

Prior to joining Waddell & Reed, he was affiliated with A.G. Edwards and Sons as a health care investment analyst.

Mr. McQuade earned a BS in Finance from Bradley University.


Kenneth G. Gau   Kenneth G. Gau
  Vice President, Portfolio Manager

Mr. Gau is part of the firm’s broader Small Cap team. He has been portfolio manager of the firm’s Small Cap Value investment strategy since 2014. From 2011 through August of 2014 he was assistant portfolio manager of Small Cap Growth institutional accounts, before being appointed to his current role as portfolio manager of the Small Cap Value strategy. Mr. Gau has been affiliated with the small cap strategy since 2006. He joined the firm in 2000 as an equity investment analyst covering industries in the Consumer Discretionary, Consumer Staples, Energy and Materials sectors.

Mr. Gau earned an MBA from Cornell University Johnson Graduate School of Management and a BS in Finance from The Pennsylvania State University Smeal College of Business Administration.

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.

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 Small Cap Growth composite consists of institutional portfolios seeking to provide growth of capital. Portfolios within the composite primarily invest in U.S. common stocks of small capitalization companies. For purposes of the composite, small capitalization companies typically are companies with market capitalizations within the range of companies in the Russell 2000® Growth Index at time of acquisition. Portfolios within the composite emphasize relatively new or unseasoned companies in their early stages of development, or smaller companies positioned in new or emerging industries where the investment manager believes there is opportunity for higher growth than in established companies or industries. The Small Cap Growth composite was created March 28, 2005. The performance presentation is in U.S. dollars.

Effective July 1, 2015 the composite was redefined to include only institutional accounts within the composite, and was redefined to reflect a broader, higher level investment mandate, objective, and strategy, rather than reflecting a specific investment process. Even though the composite definition was redefined, the investment strategy of the composite did not change and did not warrant a new composite to be created.

Effective July 1, 2015, the name of the composite changed from Small Cap Growth Select composite to the Small Cap Growth composite. Effective October 1, 2010, the name of the composite changed from the Small Cap Growth II composite to the Small Cap Growth Select composite.

Small Cap Growth composite is comprised of 7 accounts that had $382.4 million in total assets as of 6/30/16. • Effective October 1, 2010, the portfolio management objective of 25 portfolios changed, resulting in the transfer of those portfolios into this composite. The historical performance of these 25 portfolios prior to October 1, 2010 is not included in this update. • 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 Small Cap Growth percentages reflected are based on the holdings of 1 of 7 composite accounts without client specific investment restrictions and may not be reflective of the Small Cap Growth composite as a whole or of any other Small Cap Growth account currently, or in the future, included in such composite.