Virtus Small-Cap Core Fund
4Q 2016 COMMENTARY
MARKET — Small-cap stocks ended 2016 with a strong finish, surging in the fourth quarter to outpace large-cap stocks for the year.
PERFORMANCE — The Fund delivered a positive return in the quarter, with the biggest contributors being underweight exposure to the health care sector combined with strong stock selection within health care, as well as an overweight position in the producer durables sector. The top-performing holdings in the portfolio were Primerica and Old Dominion Freight Line.
OUTLOOK — Looking to the year ahead, there is a fair amount of economic uncertainty as the country awaits the arrival of the new administration. If the policy changes put forward by the president-elect come to fruition, we believe the economy and equity markets stand to benefit.
The U.S. small cap market advanced sharply during the fourth quarter. The broad small-cap benchmark, the Russell 2000® Index, gained 8.83%, bringing its year-to-date rise to 21.31%. The surge in the quarter pulled small-capitalization stocks ahead of large caps for the year, as the Russell 1000® Index gained 12.05% and the S&P 500® Index returned 11.96% in 2016.
Sectors leading the market’s advance for the full year include materials and processing (+44.34%), energy (+34.10%), and financial services (+31.14%). The health care sector lagged, returning -7.06%.
The U.S. election was one of the most significant economic events of 2016, as it turned some sector losers into winners, and vice versa. For example, the industrials/materials, energy, financials, and consumer discretionary sectors all increased sharply after the election, as investors bet that those sectors would benefit from President-elect Trump’s policies. Other sectors, including utilities, real estate, and technology, have lagged since the election.
For the quarter, the Fund returned 6.65% (Class A NAV), compared with the benchmark, the Russell 2000® Index, which returned 8.83%. For the full year, the Fund (Class A NAV) returned 17.08% and the benchmark returned 21.31%.
For the quarter, the portfolio benefited from both an underweight in the health care sector and strong stock selection within the sector, and an overweight in the producer durables sector. Negative stock selection in the consumer discretionary sector, and negative stock selection and an underweight in financial services detracted from performance.
Positions that contributed most positively to performance during the quarter were Primerica and Old Dominion Freight Line.
- Primerica’s shares were under pressure for the first half of 2016 due to concern over how the Department of Labor’s Fiduciary Standard Rule would impact the retirement investment account industry. With the Trump administration expected to drastically reduce federal regulation, those fears have been pushed aside, allowing investors to focus on the fundamentals of the business, which continues to report earnings per share (EPS) growth in excess of 20%.
- Old Dominion’s less-than-truckload (LTL) business has been more resilient than expected amid a glut of truckload supply and weak freight demand. Revenue rose in the most recent period despite a decline in industry-wide freight volume. Shares also rose following the presidential election amid an overall rise in transportation-related stocks on the expectations for more robust economic activity.
The companies that contributed the least to performance during the quarter were Shutterstock and MarketAxess.
- Softness in Shutterstock’s most recent quarterly results was due to changes the company made in some of its subscription plans, as well as distractions caused by the upgrade of their technology infrastructure. We believe these issues are transitory and that ample opportunity remains for the company to profitably grow.
- MarketAxess has generated excellent financial results, as the company has gained market share in its core high grade fixed income trading market, as well as other fixed income areas that the company has entered more recently. After a meaningful rise through the first nine months of the year, the shares declined in the fourth quarter as investors assessed the threat of new product offerings from a small competitor.
PURCHASES AND SALES
Trading activity was modest during the quarter, with one new purchase, Old Dominion Freight Line, the fourth-largest LTL trucking company in the U.S. We like Old Dominion because of the density of its network, as Old Dominion is one of the largest LTL carriers and has a high volume of freight per service center, which allows for efficient and low per-unit handling costs and, in turn, attracts more customers’ freight. What’s more, Old Dominion has developed a reputation for high service levels, including on-time delivery and undamaged goods, which garners a premium price.
We exited our position in Computer Programs & Systems. We saw the health and financial stability of the company’s major clients — rural hospitals — continue to erode as larger urban hospitals continue to garner greater revenues from the Affordable Care Act (ACA) as their utilization increases. The company has also seen its business model devolve from a pure electronic medical records company to an acquisitive player in revenue cycle management and consulting.
We also sold Landstar, a transportation services company specializing in third-party logistics. Landstar is a high quality business where profitability is excellent and long-term growth has been reasonably healthy. The company also steadily repurchases its stock, pays a modest dividend, and avoids acquisitions. However, we sold our position in favor of Old Dominion Freight Line, which we also view as a high-quality business with somewhat greater growth prospects.
As we peer into 2017, we believe there is more than a usual amount of economic uncertainty. President-elect Trump has no public office track record for us to assess and judge how effective he will be in getting changes accomplished. It does seem highly likely that some form of corporate and personal tax reform, partial ACA repeal, increased infrastructure spending, and less regulatory burden for many businesses will occur over the next two years. However, the timing of these changes is unclear. If these events were to occur, we believe the economy should accelerate and grow in the 2.5% to 3.5% range for the next couple of years. We also believe that the S&P 500 EPS growth should pick up from the low single-digit range to the mid-to-high single-digit growth range as economic growth increases over the next year.
The fund class gross expense ratio is 1.37%.
Average annual total returns reflect the change in share price and the reinvestment of all dividends and capital gains. Net Asset Value (NAV) returns do not reflect the deduction of any sales charges. POP (Public Offering Price) performance reflects the deduction of the maximum sales charge of 5.75%. A contingent deferred sales charge of 1% may be imposed on certain redemptions within 18 months on purchases on which a finder’s fee has been paid.Performance data quoted represents past results. Past performance is no guarantee of future results and current performance may be higher or lower than the performance shown. Investment return and principal value will fluctuate so your shares, when redeemed, may be worth more or less than their original cost. Please visit Virtus.com for performance data current to the most recent month-end.Index:
The Russell 2000® Index
is a market capitalization-weighted index of the 2,000 smallest companies in the Russell Universe, which comprises the 3,000 largest U.S. companies. The index is calculated on a total return basis with dividends reinvested. The index is unmanaged, its returns do not reflect any fees, expenses, or sales charges, and it is not available for direct investment.
Equity Securities: The market price of equity securities may be adversely affected by financial market, industry, or issuer-specific events. Focus on a particular style or on small or medium-sized companies may enhance that risk.
Limited Number of Investments: Because the fund has a limited number of securities, it may be more susceptible to factors adversely affecting its securities than a less concentrated fund.
Industry/Sector Concentration: A fund that focuses its investments in a particular industry or sector will be more sensitive to conditions that affect that industry or sector than a non-concentrated fund.
Prospectus: For additional information on risks, please see the fund's prospectus.
The Morningstar RatingTM
for funds, or "star rating", is calculated for managed products (including mutual funds, variable annuity and variable life subaccounts, exchange-traded funds, closed-end funds, and separate accounts) with at least a three-year history. Exchange-traded funds and open-ended mutual funds are considered a single population for comparative purposes. It is calculated based on a Morningstar Risk-Adjusted Return measure that accounts for variation in a managed product's monthly excess performance, placing more emphasis on downward variations and rewarding consistent performance. The top 10% of products in each product category receive 5 stars, the next 22.5% receive 4 stars, the next 35% receive 3 stars, the next 22.5% receive 2 stars, and the bottom 10% receive 1 star. The Overall Morningstar Rating for a managed product is derived from a weighted average of the performance figures associated with its three-, five-, and 10-year (if applicable) Morningstar Rating metrics. The weights are: 100% three-year rating for 36-59 months of total returns, 60% five-year rating/40% three-year rating for 60-119 months of total returns, and 50% 10-year rating/30% five-year rating/20% three-year rating for 120 or more months of total returns. While the 10-year overall star rating formula seems to give the most weight to the 10-year period, the most recent three-year period actually has the greatest impact because it is included in all three rating periods.
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The commentary is the opinion of the subadviser. This material has been prepared using sources of information generally believed to be reliable; however, its accuracy is not guaranteed. Opinions represented are subject to change and should not be considered investment advice or an offer of securities.
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