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1Q18 Letter to Shareholders: Drip, Drip, Drip

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DEAR FELLOW SHAREHOLDERS:

There are some bear markets that can best be described as being like the maddening drip, drip, drip of water—sometimes referred to as Chinese water torture. Inexplicably, stocks decline almost every day and they do so without regard to any significant relevant news. Our last bear market, now a decade in the past, was not like that. Yes, stocks went down on a near daily basis but bad news also arrived on an almost daily basis. It was easy for investors to understand why stocks were going down.

During much of the past year, we were in—and perhaps still are in—what I call a “reverse Chinese water torture market.” That is, until the increased volatility of the first quarter, stocks had been going up on an almost daily basis but generally not based on any significant positive news. This led investors to suffer FOMO (fear of missing out). One-way markets, whether they’re moving down or up, provide investors with a quandary. The weakness of a one-way bear market leads investors to ask, “Is it too late to sell?” The strength of a one-way bull market leads investors to ask, “Is it too late to buy?” In both cases, the correct answer is initially “no” but at some point the correct answer changes. That’s because one-way markets always demand a change in strategy at some point. Early in a one-way bear, the right answer is “No, it’s not too late to sell.” Early in a one-way bull, the right answer is “No, it’s not too late to buy.”

In a one-way market, it is important for investors to understand that at some point they must change their strategy. Determining that point is difficult. But it is critical as most one-way markets end in capitulation. Bears end in a final surge of selling until “everyone” has thrown in the towel. Bulls end in a final surge of buying until “everyone” is all in.

The notion of a one-way market suggests a market that’s somehow come loose from its more stable economic moorings. To be sure, the economy rises and falls but it almost always does so in a series of ebbs and flows, working its way higher or lower rather than moving “high” or “low” in a straight line. A useful way to determine how close a market is to the capitulation stage is to try to understand where the market is relative to the economy.

ECONOMY

In our one-way up market, the economy has generally been growing stronger with the cherry on top being the recent tax cuts. Now, however, there are some signs of a shift.

  • While stronger-than-expected economic indicators were the norm in the second half of 2017, this year economic indicators are coming in closer to their targets. A recently revised estimate showed real gross domestic product (GDP) for the fourth quarter of 2017 increased at an annual rate of 2.9%, notably softer than the 3.2% reported for the third quarter. Also, as of March 29th, the Federal Reserve Bank of Atlanta’s GDPNow model forecasted first-quarter 2018 U.S. GDP growth of just 2.4%—down from an earlier estimate of 5.4% on February 1st.
  • Employment data had been particularly strong for January and February sparking fears of inflation. In contrast, March data was unexpectedly weak showing only 103,000 jobs, much lower than the expected 193,000 jobs.
  • Credit spreads and other measures of the cost of risk fell throughout the past year. Now they’re starting to bottom. Widening credit spreads are likely to disincentivize more marginal borrowers.
  • The Federal Reserve raised interest rates in March and seems intent on doing so twice more this year, and three times instead of two times in 2019. That’s throwing sand into the gears of the economy and a reason to be more cautious on the market.

Don’t get me wrong. None of this suggests that an economic peak is imminent. But it does suggest that the economy is transitioning from “accelerating” to “stabilizing.” If this is happening to the economy, it seems a distinct possibility that a shift in the market might also be forthcoming. Certainly the episodes of sharp sell-offs in stocks we endured in recent months reminded us of what capitulation can look like. However, to the extent these corrections simply fade into the background and the market resumes “melt-up” behavior, I’d see it as a significant disconnect between the economy and the market.

That’s when investors can’t afford to lose their bearings—because the time of capitulation is likely approaching. At such a time, I believe the appropriate response is to emphasize quality in an investment portfolio. It’s no good to just step to the sidelines. How does one determine the right time to get back in? And the risk of missing out on long-term gains is too great. But one can make adjustments to one’s investment portfolio to emphasize characteristics that generally have been favorable through and after historical points of inflection. To me, that means a focus on quality first and foremost.

MARKETS

Taking the first quarter of 2018 as a whole, markets were flattish. Fading confidence in the near-term economic outlook dashed expectations of a surge in late-cycle value stocks. Instead, growth stocks outperformed value stocks across the market-capitalization spectrum. The uncertain environment favored Wasatch’s bottom-up investment approach, which seeks quality companies as evidenced by strong earnings growth, sustainable competitive advantages and experienced management teams.

In the U.S., newly announced tariffs on aluminum and steel—as well as separate measures directed specifically at China—hung over the market during March as investors weighed the likely repercussions across various industries. Because smaller U.S. companies typically have less direct exposure to international trade, small-company stocks and micro caps outperformed large-cap issues during the quarter. Additionally, smaller U.S. companies currently tend to be valued more attractively than their larger peers, and smaller companies’ domestic focus leaves them well-positioned to benefit from a lower corporate tax rate.

In the U.S., the large-cap S&P 500® Index was down slightly for the first quarter, logging a three-month loss of -0.76%. The technology-heavy Nasdaq Composite Index fared better, up 2.59% for the quarter. The Russell 2000® Index of small caps was relatively flat, down -0.08% for the quarter.

U.S. bond markets suffered. The intermediate-term Bloomberg Barclays US Aggregate Bond Index declined -1.46% for the quarter. The long-term Bloomberg Barclays US 20+ Year Treasury Bond Index fell -3.36% for the quarter.

International stock markets were mixed. The MSCI World ex USA Index was down -2.04% for the quarter, but the MSCI Emerging Markets Index rose 1.42% for the three-month period.

In several of my recent messages, I’ve made reference to a list of 145 stock, bond, municipal, U.S., foreign, target and commodity indexes found on Morningstar.com. As I wrote last time, all but 13 were positive for the fourth quarter of 2017—and all but five were positive for 2017 as a whole. That widespread positive performance has now changed. Of those same 145 indexes of various kinds, over three-quarters of them were negative in the first three months of 2018.

Here I’ll circle back to my view that none of this means a significant market correction, or even just tepid performance, is close at hand. The U.S. economy is strong. Synchronous growth is still underway around the globe. U.S. tax-cut benefits—on the order of 10 percentage points for already profitable companies—have the potential to prompt meaningful capital investments. This is a time of growth.

It’s also a time to keep your wits about you because one-way markets, whether bear or bull, don’t stay one-way indefinitely. My suggestion, once again, is to remain focused on the quality of your investments.

WASATCH

Often in these quarterly messages, I have news to share about Wasatch personnel. This quarter, the news is about me.

It’s been 43 years since I founded Wasatch in 1975. Building this firm and serving you, our investors, has been the focus of my professional life and my great privilege. Later this year, I will depart Wasatch to shift gears and join my sons Josh and Spence at Seven Canyons Advisors, an SEC-registered investment advisor recently founded by our family.

When I started Wasatch, one of my first tasks was to select an appropriate name. I wanted a name that would symbolize a firm built to outlast me—hence, Wasatch Advisors and not Stewart Advisors. I wanted to build not just a firm but also a culture that would endure irrespective of me. Together with the rest of the team at Wasatch, I’m proud that we’ve done just that.

As you may know, I stepped down from the role of CEO at Wasatch a number of years ago—almost 10, in fact. Under the continuing leadership of CEO JB Taylor and my other colleagues, Wasatch will continue to serve you with the same commitment to excellence.

Like me, my son Josh is a portfolio manager here at Wasatch. The Wasatch Funds Board of Trustees approved a plan to merge the two funds he and I manage for Wasatch—the World Innovators Fund and the Strategic Income Fund—into two new funds with similar objectives and strategies that we’ll continue to manage at Seven Canyons. The timing of that potential transition is not yet clear, but we anticipate the merger will occur during the third quarter of 2018.

Apart from Josh and me, Wasatch’s global team of portfolio managers and analysts stands at 34 investment professionals. As always, the firm is still 100% employee-owned. To be part of this outstanding place—this outstanding group of people—has been the honor of a lifetime.

With sincere thanks for your continued investment and for your trust,

Sam Stewart

 

 

Information in this document regarding market or economic trends, or the factors influencing historical or future performance, reflects the opinions of management as of the date of this document. These statements should not be relied upon for any other purpose. Past performance is no guarantee of future results, and there is no guarantee that the market forecasts discussed will be realized.

CFA® is a trademark owned by CFA Institute.

RISKS AND DISCLOSURES

Mutual-fund investing involves risks, and the loss of principal is possible. Investing in small-cap funds will be more volatile, and the loss of principal could be greater, than investing in large-cap or more diversified funds. Investing in foreign securities, especially in frontier and emerging markets, entails special risks, such as unstable currencies, highly volatile securities markets, and political and social instability, which are described in more detail in the prospectus.

An investor should consider investment objectives, risks, charges and expenses carefully before investing. To obtain a prospectus, containing this and other information, visit www.WasatchFunds.com or call 800.551.1700. Please read the prospectus carefully before investing.

The Wasatch Strategic Income Fund’s primary investment objective is to capture current income. A secondary objective is long-term growth of capital. The Wasatch World Innovators Fund’s investment objective is long-term growth of capital.

Wasatch Advisors is the investment advisor to Wasatch Funds.

Wasatch Funds are distributed by ALPS Distributors, Inc. (ADI). ADI is not affiliated with Wasatch Advisors, Inc. or Seven Canyons Advisors, LLC.

Wasatch Advisors, Inc. is not affiliated with Seven Canyons Advisors, LLC.

DEFINITIONS

A bear market is generally defined as a drop of 20% or more in stock prices over at least a two-month period.

A bull market is defined as a prolonged period in which investment prices rise faster than their historical average. Bull markets can happen as the result of an economic recovery, an economic boom, or investor psychology.

Earnings growth is a measure of growth in a company’s net income over a specific period, often one year.

Gross domestic product (GDP) is a basic measure of a country’s economic performance and is the market value of all final goods and services made within the borders of a country in a year.

Valuation is the process of determining the current worth of an asset or company.

The Russell 2000 Index is an unmanaged total-return index of the smallest 2,000 companies in the Russell 3000 Index, as ranked by total market capitalization. The Russell 2000 is widely used in the industry to measure the performance of small-company stocks.

Source: Frank Russell Company is the source and owner of the Russell Index data contained or reflected in this material and all trademarks and copyrights related thereto. This is a presentation of Wasatch Advisors, Inc. The presentation may contain confidential information and unauthorized use, disclosure, copying, dissemination or redistribution is strictly prohibited. Frank Russell Company is not responsible for the formatting or configuration of this material or for any inaccuracy in Wasatch Advisors, Inc.’s presentation thereof.

The Nasdaq Composite is a market-capitalization weighted index of the more than 3,000 common equities listed on the Nasdaq stock exchange. The types of securities in the index include American depositary receipts, common stocks, real estate investment trusts (REITs) and tracking stocks. The Nasdaq was created by the National Association of Securities Dealers (NASD) to enable investors to trade securities on a computerized, speedy and transparent system, and commenced operations on February 8, 1971.

The S&P 500 Index includes 500 of the United States’ largest stocks from a broad variety of industries. The Index is unmanaged and is a commonly used measure of common stock total return performance.

The MSCI Emerging Markets Index captures large and mid cap representation across 24 emerging market countries. With 839 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.

The MSCI World ex USA Index captures large and mid cap representation across 22 of 23 developed market countries—excluding the United States. With 1,020 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country.

Source: MSCI. The MSCI information may only be used for your internal use, may not be reproduced or redisseminated in any form and may not be used as a basis for or a component of any financial instruments or products or indexes. None of the MSCI information is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such. Historical data and analysis should not be taken as an indication or guarantee of any future performance analysis, forecast or prediction. The MSCI information is provided on an “as is” basis and the user of this information assumes the entire risk of any use made of this information. MSCI, each of its affiliates and each other person involved in or related to compiling, computing or creating any MSCI information (collectively, the “MSCI Parties”) expressly disclaims all warranties (including, without limitation, any warranties or originality, accuracy, completeness, timeliness, non-infringement, merchantability and fitness for a particular purpose) with respect to this information. Without limiting any of the foregoing, in no event shall any MSCI Party have any liability for any direct, indirect, special, incidental, punitive, consequential (including, without limitation, lost profits) or any other damages. (www.msci.com)

The Bloomberg Barclays US Aggregate Bond Index is a broad-based flagship benchmark that measures the investment grade, US dollar denominated, fixed-rate taxable bond market. The index includes Treasuries, government-related and corporate securities, mortgage-backed securities (MBS) (agency fixed-rate and hybrid adjustable-rate mortgage [ARM] pass-throughs), asset-backed securities (ABS) and commercial mortgage-backed securities (CMBS) (agency and non-agency).

The Bloomberg Barclays US 20+ Year Treasury Bond Index measures the performance of U.S. Treasury securities that have remaining maturities of 20 or more years.

You cannot invest directly in these or any indexes.