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Q4 Chairman's Letter to Shareholders: "A Stock Picker's Market"

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Economy

Generally, the market takes its marching orders from the economy. Lately, the economy has been issuing a wide variety of orders, some in conflict with others. Not surprisingly, the market has been acting confused. It has gone up or down depending on who is issuing what orders.

If we consider only orders issued by the U.S. economy, the news has been uniformly good since my last letter. For example in the last three months, the Citigroup Economic Surprise Index has risen from -50 to over +50 indicating that the U.S. economy has been performing much better than expected.

To illustrate the conflicting orders the market has been hearing: in contrast to the U.S., the same index for China has fallen from +20 to -20 since last quarter. Not only are global economies issuing confusing orders but politicians have also been a study in conflict. For example, U.S. politicians decided to have a big dustup over extending payroll tax cuts, a policy economists uniformly agree is a good idea. However, our political leaders enjoy arguing so much that they delayed agreeing upon this non-controversial item. It appears as though they argue just for the sake of arguing. It’s not a pretty sight for taxpayers who are the ones actually footing the bill for this frivolous behavior.

While China’s economy has been underperforming expectations, at least Chinese leaders aren’t arguing among themselves.

Of course, most of the economic troubles impacting the market are emanating from Europe these days. The European Union really does have a tough problem as its leaders are trying to meld together nations with widely divergent cultures and beliefs about how their economies ought to function. About the only bright ray of hope we see for Europe is the reminder that there was plenty of arguing back in the U.S. during the 1700s as our forefathers were working to form a union from 13 disparate colonies. While we can say “All’s well that ends well,” it is clear that the road ahead for Europe is very rocky. While Europe’s Gross National Product (GNP) is less than that of the U.S., its banking system is nearly four times larger—even though European banks as a whole have less capital than U.S. banks as a whole. Just as excessive leverage proved to be the downfall of companies and homeowners in the U.S. during our mortgage meltdown, excessive bank leverage is a big challenge for Europe. Not only is the future course of Europe dependent on how well its politicians are able to negotiate a mutually acceptable solution, but the future course of the stock market will be affected by the success of these negotiations.

Markets

Economics is often known as the gloomy science so I hope I didn’t overwhelm you with gloom in my introduction. I just wanted to explain why the market seems to be having such a tough time. While the stock market has definitely been volatile, the S&P 500 managed to record a sizable gain of 11.82% for the fourth quarter and a marginal gain of 2.11% for the calendar year ended December 31, 2011.  Considering the headlines the market had to cope with during the past 12 months, in our opinion, this isn’t bad performance. Further, as I noted, the U.S. economy, which is the largest on the globe, gained traction at a decent rate during the past quarter. While it hasn’t been a great market environment, it has actually been a good market for Wasatch. A market without a strong trend is known as a stock picker’s market because, historically, the only way an investor has done well in these periods is by selecting quality stocks at reasonable valuations. This is virtually the definition of what we at Wasatch try to do as investors on behalf of our shareholders.

At Wasatch, we look for high quality companies that we believe can thrive even during difficult times. Many people equate high quality companies with blue chip stocks. However, given our focus on smaller companies, most blue chip stocks are off limits to Wasatch. So we have to search for quality in companies that are not (yet) bellwethers of industry. It might be helpful to explain how we discern quality in a company.

We look for smaller companies with great business models, growth prospects and strong balance sheets. These “light blue” chips may not yet pay a dividend but their ability to do so grows by the day. One example is O’Reilly Automotive, Inc. (ORLY), a long-time holding at Wasatch in several of our funds. While O’Reilly has not yet paid a dividend, it has all of the characteristics we look for in a high quality company: an effective management team that has transformed a tiny company into an industry leader, steady, rising earnings and low debt levels. Once O’Reilly’s investment opportunities diminish as the company grows in size, we fully anticipate that it will begin to pay dividends.

We also like high quality companies that may only be paying small dividends but are committed to increasing their dividends as they grow. Two notable examples owned by Wasatch happen to be technology-related companies: Xilinx, Inc. (XLNX) and Microchip Technology, Inc. (MCHP). Both of these stocks have steadily increased their dividends, which we believe is another indicator of quality beyond the absolute dividend yield of a company’s stock.¹ Past performance cannot guarantee future results.

Wasatch

I continue to believe that our current restrained economic growth environment points to a stock picker’s market for some time to come. The fundamental, company-level analysis we do here at Wasatch has always been central to our investment selection process, whether it’s applied to a broad theme, as in our Wasatch World Innovators Fund (WAGTX), or to a more targeted opportunity, like the Wasatch Emerging Markets Small Cap Fund (WAEMX). No one likes the volatility the market has given us over the past year. But as long-term investors, we see corrections as opportunities to buy stocks at bargain prices. With the valuations of many small companies becoming more attractive, we believe this is a good time to invest and stay invested.

As we enter the new year of 2012, I am pleased to report that over 90% of our equity funds, open three years or more, beat their 3-year Morningstar peer group average*.  Results will vary for other periods.  Past performance cannot guarantee future results. Click here to see performance by fund. 

Thank you for the opportunity to manage your assets this year.

 

 

Sam Stewart

 

The primary investment objective of WAGTX and WAEMX is long-term growth of capital.

Investing in foreign securities, especially in 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.

¹To obtain the most recent list available of top 10 fund holdings please visit www.wasatchfunds.com.  Portfolio holdings are subject to change at any time.  References to specific securities should not be construed as recommendations by the Funds or their Advisor.  Current and future holdings are subject to risk.

The Citigroup Economic Surprise Indices are objective and quantitative measures of economic news. They are defined as weighted historical standard deviations of data surprises (actual releases vs. Bloomberg survey median). A positive reading of the Economic Surprise Index suggests that economic releases have on balance beaten the consensus. The indices are calculated daily in a rolling three-month window.

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 directly in this or any index.

Gross National Product (GNP) is an economic statistic that includes gross domestic product (GDP), plus any income earned by residents from overseas investments, minus income earned within the domestic economy by overseas residents.

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

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. 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.

*Based on cumulative total return, 8 of 15 (53%), 14 of 15, 9 of 13, and 6 of 7 Wasatch equity funds outperformed their Morningstar Category for the 1, 3, 5, and 10 year periods ended 12/31/2011, respectively.  Not all funds outperformed for all periods.  Fund returns have been affected by market volatility and are negative for certain periods.  Past performance is no guarantee of future results. (Source for data: Morningstar, Inc. All rights reserved). The information contained herein (1) is proprietary to Morningstar and/or its content providers; (2) may not be copied or distributed; and (3) is not warranted to be accurate, complete, or timely. Neither Morningstar nor its content providers are responsible for any damages or losses arising from any use of this information.

© 2012 Wasatch Funds. All rights reserved. Wasatch Funds are distributed by ALPS Distributors, Inc.

WAS002583 4/20/2012