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Q2 Chairman's Letter to Shareholders: "A Trendless Stock Market"

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Economy

A common theme affecting economies around the world is that the bill for our debt binge is finally coming due. While the European drama has captured the attention of headline writers, the less glamorous but larger problem at hand is how the world will cope with the lethargic growth we face due to the debt overhang. My conclusion is that there are no quick solutions. We are in for a long slog.

The U.S. economy continues to move ahead with a sluggish but positive growth rate as reflected in last quarter’s 2.2% GDP growth. The largest part of the U.S. economy—consumer spending—also continues to grow at an even greater rate than personal income. The result is a decrease in the national savings rate, which only serves to increase the debt overhang. Stubbornly high unemployment prevents many families from dealing with their debt load.

The second quarter’s generally negative stock market performance was not surprising given the sharp run up in stock prices that we saw in the two prior quarters. Despite a big positive day on the last day of the quarter, the S&P 500 ended the period down 2.75%. The loose correlation I pointed out between worrisome economic headlines and negative stock performance certainly came back into play, as Greece’s elections and on-going negotiations with the rest of the European Union (EU) returned to the front pages. But the news isn’t all bad and I do think Europe’s problems are solvable, though they will take time to resolve. Indeed, on June 29th, European leaders reached an agreement that alleviated some of the concerns surrounding the debt crisis, which helped the euro to appreciate and drove up stock prices globally.

There continue to be some decent background elements to the global economy, including longer-term trends like favorable demographics and higher GDP growth in emerging economies and excess liquidity supplied by the world’s central banks. I anticipate that central bank actions around the world will continue in an attempt to prop up business conditions and stock markets (though these actions are certainly at the expense of conservative savers who are seeing record low interest rates on bank deposits).

With continued sub-par economic growth and job creation, the U.S. Federal Reserve has certainly not seen any need to tap on the brakes. Long-term interest rates hit record lows during the quarter with the 10-year U.S. Treasury bond yielding just 1.67% as of June 29, 2012. All of this boils down to what looks to be an extended weak uptrend for the U.S. and most of the global economy.

Markets

Economic uncertainties and sluggish global growth point to a trendless stock market environment for some time to come. A trendless market is a stock picker’s market. I believe quality companies with defensible business models purchased at reasonable valuations will outperform.

The question many investors are asking is what happens if Greece exits the EU. First off, in the same way bankers have had the habit of employing a “pretend and extend” approach to addressing bad loans, I think politicians will be even less inclined to take dramatic steps to force this outcome in Europe. Still investors should be prepared for the possibility that Greece may default on its debt and/or exit the EU and its currency.

Being prepared during uncertain times doesn’t necessarily mean putting all of your cash under your mattress, but saving a little dry powder for market pullbacks and future opportunities is often a good idea.

Wasatch

I believe a stock picker’s market plays to Wasatch’s strengths. Classic Wasatch investing is about trying to find high-quality growth companies with defensible and sustainable business models capable of producing earnings growth in almost any market environment. This is an investment process we have honed now for more than 35 years and we remain dedicated to long-term investing with this approach, even in the face of so much general economic uncertainty.

Many have commented on the highly publicized Facebook (FB) initial public offering (IPO) that occurred this quarter and—while bigger than most companies we research—Facebook doesn’t appear to have the characteristics of a company we would invest in. Our analysts look for companies with sustained revenue and earnings growth, strong financials, a sustainable competitive advantage, a proven management team and reasonable valuation. While we do carefully and selectively invest in some IPOs, Facebook was not one we at Wasatch would have participated in.

Because finding the “World’s Best Growth Companies” is what we seek to excel in at Wasatch, you might want to see firsthand how far some of our managers and analysts go in their search and take a look at a short video of the Wasatch Research Team on a recent eight-country tour of Southeast and South Asia. Visit our website for the link, or go directly to our YouTube channel www.youtube.com/wasatchfundstv).

With sincere thanks for your continued investment,

Sam Stewart

 

RISKS:

Investing in foreign securities, especially in frontier and emerging markets, entails special risks, such as currency fluctuations and political uncertainties, which are described in more detail in the prospectus. Investing in small cap funds will be more volatile and loss of principal could be greater than investing in large cap or more diversified funds.

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 it carefully before investing.

GDP or gross domestic product 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.

The S&P 500 Index includes 500 of the United States’ largest stocks from a broad variety of industries. The Index is unmanaged but is a commonly used measure of common stock total return performance. You cannot invest in this or any index.

An initial public offering (IPO) is a company’s first sale of stock to the public.

World’s Best Growth Companies (WBGCs) are defined by Wasatch as companies outside the United States that we believe possess an identifiable, sustainable competitive advantage, are well managed, undervalued and are producing above average earnings growth relative to their industry and country of origin.

Information in this report regarding market or economic trends or the factors influencing historical or future performance reflects the opinions of management as of the date of this report. There is no assurance that the process discussed will consistently lead to successful investing. 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.

© 2012 Wasatch Funds. All rights reserved. Wasatch Funds are distributed by ALPS Distributors, Inc. WAS002840  9/20/2012