Wasatch Small Cap Growth Fund® (WAAEX)  Invest in this Fund 

Investor Class | Institutional Class
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Q3 2017
Positioned for Continued Macroeconomic Growth
by JB Taylor, Ken Korngiebel, CFA and Ryan Snow

“In the Fund, we’re especially focused at present on companies that seem poised to deliver long-term growth by benefiting from world-wide economic strength, industrial-production trends and increased capital expenditure by businesses.”

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For the period ended September 30, 2017, the average annual total returns of the Wasatch Small Cap Growth Fund for the one-, five- and ten-year periods were 14.92%, 10.22%, and 7.71%, the returns for the Russell 2000 Growth Index were 20.98%, 14.28%, and 8.47%, and the returns for the Russell 2000 Index were 20.74%, 13.79%, and 7.85%.  Expense ratio: Gross 1.30% / Net 1.30%. 

Data shows past performance, which is not indicative of future performance. Current performance may be lower or higher than the data quoted. To obtain the most recent month-end performance data available, please click on the “Performance” tab of the individual fund under the “Our Funds” section. The Advisor may absorb certain Fund expenses, without which total return would have been lower. Investment returns and principal value will fluctuate and shares, when redeemed, may be worth more or less than their original cost.

Wasatch Funds will deduct a 2.00% redemption proceeds fee on Fund shares held 60 days or less. Performance data does not reflect the deduction of fees, including sales charges, or the taxes you would pay on fund distributions or the redemption of fund shares. Fees and taxes, if reflected, would reduce the performance quoted. Wasatch does not charge any sales fees. For more complete information including charges, risks and expenses, read the prospectus carefully.

Wasatch Funds are subject to risks, including loss of principal.

Overview

The Wasatch Small Cap Growth Fund—Investor Class returned 4.65% during the third quarter of 2017, performing well on an absolute basis but trailing both its primary benchmark, the Russell 2000 Growth Index, which gained 6.22%, and the Russell 2000 Index, which gained 5.67%.

The health-care and industrials sectors were two broad areas responsible for the Fund’s solid gain in the third quarter. In the health-care sector, despite a significant underweight relative to the benchmark, the Fund’s holdings produced a strong return and outperformed their benchmark counterparts.

In the industrials sector, the Fund’s relative performance was aided by our large overweight compared to the benchmark’s sector. We’d like to use this quarter’s commentary as an opportunity to share our optimistic view about the Fund’s holdings, beginning with the macro picture and then transitioning to market dynamics and the opportunities we’re seeing.

First, the macro view: we’re still cautiously optimistic. As Wasatch Funds’ President Sam Stewart writes in his third-quarter “Message to Shareholders,” the incredible duration of the current economic expansion—now the third-longest run since 1854—isn’t in and of itself a reason to expect a downturn. In fact, recent economic indicators appear increasingly favorable for continued economic growth despite a quarter in which natural disasters, political strife and geopolitical tensions dominated headlines.

One broad-based view on economic expansion is provided by a recent report from the Organization for Economic Cooperation and Development (OECD), which describes a world economy that has “picked up momentum, as expanding investment, employment and trade support synchronized growth across most countries.” More universal economic expansion, such as the OECD reported, is clearly positive for growth-oriented companies and underscores our optimism about their ability to continue to achieve solid earnings improvement.

Specific to the U.S., economic markers are generally favorable as well. In fact, one broad measure of economic health suggests plenty of headroom for further market advances. See the chart below, which plots a collective measure of a basket of U.S. economic indicators. As shown, this index has only recently recovered to the level of its high prior to the global financial crisis. At the three prior points of recovery following previous highs, economic expansion continued for seven, eight and four years, respectively. The implication is that the current moderate-growth expansion may have plenty of room to run.

Having established the potential for a “Goldilocks-style” (not too hot, not too cold) expansion to continue, the obvious next question is: What does that imply for the U.S. stock market as a whole and for small caps in particular? In our view, one of the key dynamics to consider is the relationship between a company’s growth and its stock valuation.

Consider the following chart, which presents Russell 3000® Index data on sales growth and valuations from the end of 1999 through September 30, 2017. As shown, valuations dipped precipitously during the 2000 – 2001 correction, while sales only barely turned downward. Then, valuations recovered as both figures rose in tandem until the global financial crisis. After the crisis, valuations resumed an upward march—and in 2013 passed their prior high—but sales growth has been notably more restrained, to the point of being nearly flat over the past few years. The last two years demonstrate an especially striking mismatch where valuations increased even though underlying sales growth was flat.

At present, there’s no doubt that valuations are on the high side, but again the economic picture gives plenty of reason to think they may advance even further. We do think the relationship between valuations and sales is likely to begin to normalize—and that may well come in the form of stronger sales growth rather than lower valuations across a broad index such as the Russell 3000.

To the extent that proves to be the case, we expect companies with stronger growth prospects to benefit—and, in particular, companies with relatively depressed valuations despite their promising growth prospects.

This thesis now brings us to the industrials sector, which as we mentioned was a positive performance driver during the third quarter. In our analysis at the individual-company level, we like what we see. More broadly, our optimism isn’t based on some new wave of the “reflation trade” (or “Trump trade”) of the kind we avoided late last year. Rather, we recognize that the slow-growth economy is chugging along well enough to favor a positive turn for the sector. The following chart shows trailing 12-month capital expenditures expressed as a percentage of year-over-year growth. After dropping during and immediately after the last recession, capital expenditures leapt upward as the economy normalized. But since 2012, growth in capital expenditures has trended down. We think an upturn may be at hand.

When applying this cyclical framework to certain industrial names that we view as attractive, we see the potential for meaningful improvements in profitability and earnings. One example is Fund holding RBC Bearings, Inc. (ROLL), a manufacturer of precision bearings for aerospace, defense and industrial customers. It’s this last segment that’s especially relevant to the company’s growth prospects at present. As capital expenditures within the industrials sector increase generally, we believe the company stands to benefit with higher sales growth rates and, given strong free cash flow conversion rates, stronger earnings as well.

To the extent this positive view is borne out, we believe RBC Bearings has the potential to reach a 15% compound annual growth rate (CAGR), which for years has been our yardstick at Wasatch. That would stand in contrast to the approximately 10% CAGR the company logged over the past 20 years.

In summary, we’re drawn to attractive industrial companies like RBC Bearings because we see them as likely beneficiaries from (1) improving world-wide economic growth, (2) greater capital spending by corporations, and (3) normalization of the relationship between sales growth and valuations. For these and a variety of company-specific reasons, we anticipate maintaining our overweight position in the industrials sector for the foreseeable future.

Details of the Quarter

The Fund’s top contributor to performance for the third quarter was health-care holding Sangamo Therapeutics, Inc. (SGMO). One of Sangamo’s peers in cell therapy announced an acquisition that sent its stock price soaring and lifted the stocks of related biotech companies. We believe a return of mergers-and-acquisitions activity among specialty pharmaceutical firms bodes well for Sangamo, as does cell therapy being increasingly seen as an established and accepted form of treatment.

ICON plc (ICLR), a global contract research organization providing drug development and other services to the pharmaceutical, biotechnology and medical-device industries, was also a top contributor. ICON’s financial results for the most-recent quarter were reported in July and showed an increase in net income of 10.7% and a rise in earnings per share of 14.9% compared to the same quarter a year ago. Given the company’s strong backlog of business, we believe ICON can continue to do well.

Monro, Inc. (MNRO) (formerly Monro Muffler Brake, Inc.) was a leading detractor during the second quarter but bounced back to end the third quarter among the Fund’s top contributors. Our thesis remains that Monro is well-positioned to strengthen its competitive advantages due to direct-sourcing of parts, industry consolidation trends, and an aging economic cycle that means more car owners are reaching their likely “post-dealer” years of auto maintenance. Monro’s share price fell during the second quarter on news of management changes. Investors have since gotten more comfortable with those changes. We met with the new CEO during the last week of the quarter and came away with renewed confidence in the company and its leadership.

The Fund’s largest detractor in the third quarter was Spirit Airlines, Inc. (SAVE). Spirit’s stock price tumbled near the end of July when the company’s latest financial results disappointed investors. Ongoing contract negotiations with its pilots also weighed on the stock. Given consumer demand for low-fare air service, we see strong growth potential for Spirit so long as its costs remain structurally low relative to the industry’s large players. We’re closely watching both industry dynamics and Spirit’s company-specific factors.

Lastly, a couple of information-technology firms were among the holdings that weighed on the Fund’s return for the quarter. Ultimate Software Group, Inc. (ULTI), a human-capital software company, reported lower-than-expected earnings. Management reduced current-year guidance due to implementation delays at some of the company’s largest customers. However, Ultimate Software’s progression into serving larger clients—“enterprise” scale—appears intact. We remain confident in the management team and look for solid growth ahead, if slightly delayed.

Luxoft Holding, Inc. (LXFT) missed earnings estimates. The company develops high-value-added custom software for global clients that include large multinational corporations. Luxoft’s stock price declined on concerns about the company’s high customer concentration in some European banks that are under stress. We’re optimistic, however, about the company’s ability to bring its high-value software solutions to a wider set of clients. (Current and future holdings are subject to risk.)

Outlook

As we wrote earlier in this commentary, the Goldilocks economic scenario appears to be continuing in the U.S. with regard to sustained moderate growth, low inflation and rising asset prices.

Looking forward, we don’t expect valuation tailwinds to continue. Company fundamentals will have to matter more to investors at some point, which we believe would bode well for the Fund. We believe we have a great team that learns from mistakes and the best culture for applying a disciplined investment approach. As valuations right-size to growth rates, we believe our discipline will shine.

Fundamentals are certainly of more central importance to investors now than in the period after last year’s presidential election, but factors such as passive investing and extraordinary monetary accommodation by the Federal Reserve (Fed) continue to be distractions. Recently, the Fed announced its intention to start reducing bond holdings acquired during its quantitative-easing program. While it’s not exactly clear how quickly that will unfold, the announcement itself represents a step toward normalcy. The passive-investing trend may prove to be somewhat cyclical in nature, or market volatility may challenge investors’ faith in index-based investing. In any case, some reversion to the mean seems likely, such as in the relationship between valuations and sales growth as illustrated in one of the preceding charts.

In the Fund, we’re especially focused at present on companies that seem poised to deliver long-term growth by benefiting from world-wide economic strength, industrial-production trends and increased capital expenditure by businesses. We also keep close attention on what we’ve described in the past as the “Amazon effect,” which applies not only to retailers but also to distributors, service providers and others. The Amazon effect comes up in our research meetings relating to a wide range of industries, because nearly anywhere there’s attractive growth, there’s also the potential for Amazon to move in. Since 2002, Amazon has achieved a compound annual growth rate of 34%, in contrast to 4% for other retailers in the Russell 1000® Index. Its valuation is now larger than all other Russell 1000 retailers combined, excluding Wal-Mart.

Our disciplined approach continues to turn up attractive prospects, such as with the industrials theme discussed above. Elsewhere, too, we’re finding what we consider to be high-quality companies with outstanding long-term growth prospects. As we wrote last quarter, there’s no shortage of opportunities for the Fund’s investment style, although we always have to remain vigilant regarding valuations.

Thank you for the opportunity to manage your assets.

Sincerely,

JB Taylor, Jeff Cardon, Ken Korngiebel and Ryan Snow


**The Russell 2000 Growth Index measures the performance of Russell 2000 Index companies with higher price-to-book ratios and higher forecasted growth values.

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.

You cannot invest directly in these indexes.

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.

CFA® is a trademark owned by CFA Institute.

The Small Cap Growth Fund’s primary investment objective is long-term growth of capital. Income is a secondary objective, but only when consistent with long-term growth of capital.

††As of September 30, 2017, the Wasatch Small Cap Growth Fund was not invested in Amazon.com, Inc. or Wal-Mart Stores, Inc.

Earnings per share or EPS is the portion of a company’s profit allocated to each outstanding share of common stock. EPS growth rates help investors identify companies that are increasing or decreasing in profitability.

The global financial crisis, also known as the financial crisis of 2007-09 and 2008 financial crisis, is considered by many economists to have been the worst financial crisis since the Great Depression of the 1930s.

The Organization for Economic Cooperation and Development (OECD) is a forum where the governments of 34 democracies with market economies work with each other, as well as with more than 70 non-member economies to promote economic growth, prosperity and sustainable development.

Quantitative easing is a government monetary policy used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity.

Return on assets (ROA) measures a company’s profitability by showing how many dollars of earnings a company derives from each dollar of assets it controls.

The Russell 1000 Index is a market-capitalization weighted index designed to measure the performance of the largest 1,000 companies in the Russell 3000 Index. You cannot invest in this or any index.

The Russell 3000 Index is an unmanaged total return index of the largest 3,000 U.S. companies based on total market capitalization. You cannot invest in this or any index.

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. You cannot invest in this or any index.

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

The Russell 2000 Index measures the performance of the 2,000 smallest companies in the Russell 3000® Index, which represents approximately 8% of the total market capitalization of the Russell 3000 Index.   The Russell 2000 Growth Index measures the performance of the Russell 2000 companies with higher price-to-book ratios and higher forecasted growth values.   Russell Investment Group is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Russell Investment Group. 

You cannot invest directly in indexes.

View the Small Cap Growth Fund’s most current Top 10 Holdings

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.

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CFA® is a trademark owned by CFA Institute.