The Virtus Small-Cap Sustainable Growth Fund invests in a select group of small-cap growth companies that exhibit a competitive advantage, have strong management and low financial risk, and that are able to grow over market cycles.
Virtus Small Cap Sustainable Growth Fund
2Q 2016 COMMENTARY
During the second quarter, small-cap stocks rallied, though growth companies were outpaced by value companies as investors favored defensive sectors.
The Fund delivered positive returns for the quarter, strongly outpacing the benchmark year to date. Consumer discretionary and producer durable stocks were the largest contributors to returns. Two online businesses, Shutterstock and MercadoLibre, were the top-performing holdings.
Looking ahead to the second half of the year, the U.K.’s “Brexit” from the European Union and U.S. presidential elections are likely to be sources of volatility. However, they will not distract us from our focus on investing in high-quality businesses as our firm has done for over 30 years.
The Russell 2000® Growth Index rose a healthy 3.24% during the second quarter, partly offsetting the first quarter’s decline. The Index is now down 1.59% over the first half of 2016. Notably, the Russell 2000 Growth Index lagged the Russell 2000® Value Index by 7.67% year to date, reflecting a rebound in commodity-related companies as well as a preference among investors for defensive groups.
In terms of sector performance, utilities (+10.97%), consumer staples (+9.89%), and materials and processing (+7.43%) outperformed during the quarter, while the consumer discretionary (-0.92%) and energy (+0.31%) sectors lagged.
The Fund returned 2.63% (Class A NAV) in the quarter, compared with the Russell 2000 Growth Index, which returned 3.24%. Year to date, the Fund meaningfully outperformed the Index, 9.25% (Class A NAV) versus -1.59%. The most prominent gains in the portfolio during the quarter were in the consumer discretionary and producer durables sectors, while the weakest sectors were consumer staples and technology.
The stocks that contributed the most to performance during the quarter were two online businesses: Shutterstock, a global marketplace for licensed imagery and music, and MercadoLibre, which hosts e-commerce platforms in Latin America.
- Shutterstock’s shares came under pressure near the end of 2014 after Adobe announced it was entering the online stock photo business via its acquisition of Fotolia. Recent results, including Q1 2016, have shown no erosion in Shutterstock’s competitive position or business results. As Shutterstock continues to report strong quarterly results, investor concerns regarding Adobe are abating and the share price is increasing.
- Shares of MercadoLibre increased as the company reported another strong quarter of growth in revenue and the number of transactions completed in its marketplace. Given the economic turmoil in Brazil, the company’s largest market, these results were impressive. We believe the company’s strong competitive position as the largest online marketplace in Latin America remains intact. Additionally, the company’s growth opportunity is significant driven by the Latin American market with a combined population of 550 million people and rapidly growing Internet penetration.
The stocks that contributed the least to performance in the quarter were Chinese car website Autohome and specialty food distributor Chefs’ Warehouse.
- Autohome continued to be hurt by macro concerns over slowing new car sales and a weakening Chinese consumer, which was compounded by management’s decision to grow the newer transactions-based business unit at the expense of near-term margins. Additionally, recent uncertainty about the corporate ownership and management structure has hurt the shares. However, Autohome’s core business metrics remain robust and the long-term potential of the Chinese car market is significant so we remain owners of the business.
- A recent acquisition caused Chefs’ Warehouse’s first-quarter profitability to be lower than expected and led management to reduce its full-year profit guidance. Business performance remains uneven as the company continues to digest significant operational investments and an expansion into the protein category. We believe Chefs’ core competitive advantage remains in place and expect profitability to improve over time.
PURCHASES AND SALES
During the quarter, we purchased Fox Factory Holding Corp. No complete sales were made in the quarter.
- Fox designs and manufactures premium suspension products for use on mountain bikes, all-terrain vehicles (ATVs), off-road trucks, snowmobiles, and motorcycles. The company possesses a durable competitive position through its brand recognition and reputation for high performance in a product category that is perceived as important to the performance of the end product among loyal and enthusiastic users. Fox’s brand has been developed over decades of prominence and innovation in its markets and is cultivated through sponsorships with widely recognized riders and racers. As a result of these characteristics, the company enjoys high market share, pricing power, and healthy profitability.
We believe the domestic economy will grow at a modest rate in the range of 1.5% to 2.5%, and corporate earnings will grow in the mid-single digit range. Our confidence is growing that oil has finally hit bottom because domestic shale producers and major international oil companies have announced dramatic reductions in capital spending on the order of 40% to 70%. These supply reductions, combined with natural depletion rates, will ultimately reduce excess supply. Importantly, stability in the price of oil and the U.S. dollar will help stabilize reported profits for companies in the S&P 500, which have been sliding downward over the last two years due to the impact of weak oil and a strong U.S. dollar. This stability is needed in order for equity markets to generate returns in line with earnings growth.
As we have experienced thus far this year, it is likely to continue to be a volatile year for financial markets. Repercussions from the U.K.’s Brexit vote to leave the European Union and our own presidential elections are likely to cause continued market volatility. However, we will remain steadfast in our high-quality focus as we have always done through good and bad times over the last three decades.
Class A operating expenses are 1.50% and gross operating expenses are 1.58%. Operating expenses reflect a contractual expense reimbursement in effect through 7/31/2017. Operating expenses do not include indirect expenses incurred by the underlying funds in which the Fund invests.
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® Growth Index is a market capitalization-weighted index of growth-oriented stocks of the smallest 2,000 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.
For each fund with at least a three-year history, Morningstar calculates a Morningstar Rating™ based on a Morningstar Risk-Adjusted Return measure that accounts for a variation in a fund’s monthly performance (including the effects of sales charges, loads, and redemption fees), placing more emphasis on downward variations and rewarding consistent performance. The top 10% of funds in an investment 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 fund is derived from a weighted average of the performance figures associated with its 3-, 5-, and 10-year (if applicable) Morningstar Rating metrics. Ratings are for the A Shares as shown only; other share classes bear different fees and expenses, which affect performance.
Load-waived A share star ratings do not include any front-end sales load and are intended for those investors who have access to such purchase terms (e.g., plan participants of a defined contribution plan). Not all A share mutual funds for which Morningstar calculates a load-waived A share star rating may actually waive their front-end sales load. Therefore, Morningstar strongly encourages investors to contact their investment professional to determine whether they are eligible to purchase the A share without paying the front load.
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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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