QUARTERLY FUND COMMENTARY

POSTED 12.31.13
Ivy Mid Cap Growth Fund

Market Sector Update

  • Mid-cap growth stocks, in general, continued their torrid pace in the fourth quarter, closing out the year with strong appreciation. During the quarter, cyclical sectors produced the strongest returns with industrials, consumer discretionary, financials and materials posting the strongest appreciation. Energy materially underperformed while information technology and health care showed more modest underperformance.
  • The strength in the market and individual sectors was an extension of the first three quarters, where modest earnings growth was met with sizable multiple expansion.
  • The best performance during the quarter and 2013 occurred in the lower quality capital structure companies. Stratifying by quintile, companies carrying the highest amount of debt relative to their equity outperformed those with the lowest level of debt.
  • In addition, non-earners and the lowest P/E (price-to-earnings) multiple stocks have strongly outperformed those with higher earnings. We believe this is an indication of the risk-on type investor psyche that was apparent throughout 2013.

Portfolio Strategy*

  • The dual pressure of more leveraged companies and non-earners created a significant headwind to our investment philosophy of investing in profitable growing companies that are supported by sound capital structures. The Fund underperformed the benchmark for the quarter.
  • In the 4th quarter and 2013, the Fund’s underperformance in industrials was the largest negative variance in the portfolio. Underperformance in the transportation sub-sector coupled with negative returns in two stocks, Polypore International, Inc. and Fastenal Company, explain the difference. Information technology was also a detractor from performance primarily due to stock selection. Teradata Corp. and Fusion-io, Inc. drove the underperformance.
  • The largest positive contribution for the quarter and 2013 was the strong stock selection in financials with sizable appreciation in Signature Bank. Despite sector underperformance and the Fund’s slightly overweight position, energy produced a positive contribution with solid stock selection led by Patterson-UTI Energy, Inc. in the quarter and Continental Resources, Inc. and Cabot Oil & Gas Corp. for 2013. For both the quarter and year, the Fund’s 2.5% to 4.5% cash weighting was a drag on performance.

Outlook

  • We remain fairly optimistic about 2014 in terms of economic growth both here and abroad. We see little in the way of excesses that built during the expansion that could create problems. Consumer lending remained subdued during this expansion and inventory levels across industrial companies remain below normal levels.
  • Despite increased interest rates, housing appears to us to be set to continue to be a positive contributor to growth. Domestic energy production has been positive and we now believe it will present growth to other energy derivative companies that are set to take advantage of the lower input costs, such as chemical companies. Finally, it appears consumers are becoming more comfortable with revolving debt as it has begun to grow for the first time in multiple years.
  • With all that said, the performance of the market in 2013, and more specifically, the multiple expansion that occurred during the year, has made us a bit more concerned about market performance into 2014.
  • Given the rapid pace of IPO (initial public offering) issuances (something in which this Fund does not participate), the performance of lower quality non-earners and the very high valuations for some of the high-octane growth stocks, we believe 2014 could be a more difficult year for the market.
  • We believe success should be driven primarily by stock selection and we have taken a more neutral view of sector allocation, albeit remaining underweight materials, telecommunications and utilities.

*Polypore International, Inc., Fastenal Company, Teradata Corp., Fusion-io, Inc. Signature Bank, Patterson-UTI Energy, Inc., Continental Resources, Inc. and Cabot Oil & Gas Corp. (1.5%, 2.2%, 1.6%, 0.8%, 2.2%, 1.2%, 1.4% and 1.3% of net investments at 12/31/2013, respectively).

The opinions expressed in this commentary are those of the Fund’s manager and are current through Dec. 31, 2013. 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.

Risk Factors. As with any mutual fund, the value of the Fund’s shares will change, and you could lose money on your investment. Investing in mid-cap growth stocks may carry more risk than investing in stocks of larger more well-established companies. An investment in the Fund is not a bank deposit and is not insured or guaranteed by the Federal Deposit Insurance Corporation or any other government agency. Not all funds or fund classes may be offered at all broker/dealers. These and other risks are more fully described in the Fund’s prospectus.

Investors should consider the investment objectives, risks, charges and expenses of a fund carefully before investing. For a prospectus, or if available a summary prospectus, containing this and other information for the Ivy Funds, call your financial advisor or visit us online at www.ivyfunds.com. Please read the prospectus or summary prospectus carefully before investing.

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INVESTMENT TEAM

Kimberly A. Scott, CFA
Portfolio Manager

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