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

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4Q18
Fund Held Up Better Than Its Benchmark Amid Fourth-Quarter Volatility
by JB Taylor, Ken Korngiebel, CFA and Ryan Snow

“In the current environment, we’ve been sifting through beaten-down stocks in search of those we think have been unfairly punished. By examining our current holdings and watch-list prospects on a case-by-case basis, our goal is to take appropriate position sizes in the ones we believe have the greatest potential for long-term appreciation.”

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For the period ended December 31, 2018, the average annual total returns of the Wasatch Small Cap Growth Fund for the one-, five- and ten-year periods were 3.50%, 6.15%, and 14.76%, the returns for the Russell 2000 Growth Index were -9.31%, 5.13%, and 13.52%, and the returns for the Russell 2000 Index were -11.01%, 4.41%, and 11.98%.  Expense ratio: Gross 1.20%. 

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

U.S. equity prices fell sharply during the final three months of the year, as uncertainty about global economic growth, international trade and U.S. monetary policy created an unfavorable environment for stocks. The Wasatch Small Cap Growth Fund—Investor Class fell -18.85% during the quarter. The Fund’s primary benchmark, the Russell 2000 Growth Index, declined -21.65%. And the Fund’s secondary benchmark, the Russell 2000 Index retreated 20.20%.

For 2018 as a whole, the Fund posted a gain of 3.50%, which compared favorably to the Russell 2000 Growth’s full-year decline of -9.31%. As of December 31st, the Fund had also outperformed its benchmark over the preceding three-, five- and 10-year periods.

Despite drama in the financial markets, we haven’t seen deterioration in company-specific fundamentals. In general, revenue and earnings growth rates still look strong among the companies held in the Fund. Moreover, we continue to receive positive feedback from management teams regarding their businesses and industries.

We don’t know where the stock market will go from here, whether there are more highly volatile days ahead or whether there will be an imminent and sustainable rebound off the bottom. What we do know is that the Fund’s holdings are, in our view, as high quality as they’ve ever been. And that’s exactly the positioning we want to have for whatever comes next.

As always, our focus is on selecting outstanding businesses with growth potential that we believe can be maintained over multiple years. Our focus isn’t on companies that might benefit from some sort of macro condition—such as the shape of the yield curve, the status of trade negotiations or the tone in politics.

That said, in an environment like the one we experienced during the fourth quarter, macro events do affect the Fund’s holdings along with the rest of the stock market. So it’s not that we put our heads in the sand over macro conditions, it’s just that we focus where we think we have competitive advantages—in the realm of analyzing company-specific fundamentals.

ECONOMY AND MARKETS

For most of the quarter, worries about U.S. monetary policy dogged the financial markets. Economic-growth concerns moved to the forefront as seemingly contradictory messages from the Federal Reserve (Fed) stoked fears that the U.S. economy may be losing steam.

The U.S. Bureau of Economic Analysis reported that real gross domestic product increased at an annual rate of 3.4% during the third quarter—revised down from the previous estimate of 3.5% and significantly weaker than the 4.2% pace logged during the second quarter of the year. As the immediate stimulus of the Tax Cuts and Jobs Act of 2017 continued to fade, investors fretted that a policy mistake by the Fed might bring on a recession in 2019.

Stocks were weak from the outset of the quarter as the trade dispute between the U.S. and China captured headlines and the yield on the 10-year Treasury bond surged above 3%. The market selloff accelerated on October 4th after Federal Reserve Chairman Jerome Powell said in an interview that the Fed’s policy interest rate was “a long way from neutral.” Because the federal-funds rate is closely tied to rates on most forms of consumer debt, investors worried that an extended series of Fed rate hikes might crimp household spending and slow economic growth.

Worries eased somewhat in late November when Mr. Powell attempted to walk back his previous remarks, saying in a speech that interest rates “remain just below the broad range of estimates of the level that would be neutral for the economy.” On December 19th, while the Fed raised its benchmark interest rate for the fourth time in 2018 to a range of 2.25% to 2.5%, Fed officials signaled that this could be the last rate hike for a while as their projections for economic growth and inflation in 2019 removed the urgency of repeated rate hikes.

The market headed lower in December on renewed uneasiness about the ability of the U.S. to come to a long-term trade agreement with China. Mixed economic data from both countries fanned concerns about weaker global growth. As key measures such as single-family housing starts and new orders for manufactured goods came in below expectations, investors became increasingly concerned about the direction of the U.S. economy.

Stocks of smaller companies fared worse than large-cap issues during the fourth quarter as investors sought to reduce risk in their portfolios. All sectors within the benchmark Russell 2000 Growth Index except the utilities sector lost ground for the quarter.

Energy was the worst-performing sector of the Index as U.S. crude briefly plunged below $43 a barrel. Rising output from the U.S., Saudi Arabia and Russia weighed on oil prices, while slowing demand growth and U.S. waivers on Iran oil sanctions also contributed to weakness in crude prices. Oil finished the quarter at $45.41 a barrel—down nearly -41% from a multi-year high of $76.90 reached on October 3rd.

The Fund held up better than the benchmark during the volatile fourth quarter as our stocks were not down as much as their benchmark counterparts. Our health-care holdings contributed the most to performance relative to the benchmark led by Ensign Group, Inc. (ENSG). Although the Fund’s information-technology holdings were the largest source of weakness against the benchmark, the sector was home to Five9, Inc. (FIVN), one of the Fund’s top overall contributors. The financials sector, including Metro Bank plc, was another area of weakness against the benchmark. We discuss all three companies in the DETAILS OF THE QUARTER section below.

ADHERING TO OUR INVESTMENT DISCIPLINE

Before getting into what worked and what didn’t for the quarter, we’d like to draw attention to two examples of how we adhere to our long-term investment discipline even during sharp corrections—including corrections in specific stocks and corrections in the market as a whole. These examples illustrate our commitment to focusing on high-quality companies with strong underlying fundamentals and sticking with our investments even in the face of downward pressure on stock prices.

As we wrote last quarter prior to the ensuing correction, “Rather than paying too much attention to market cycles, we focus on finding high-quality growth companies that we believe will help us take advantage of favorable conditions, and hopefully help us navigate more-difficult environments too.” The following two examples give more details regarding what we meant by that statement.

First up is one of the fourth quarter’s largest detractors, Ollie’s Bargain Outlet Holdings, Inc. (OLLI). You may recall that Ollie’s had been among the third quarter’s top contributors. And, indeed, the stock experienced a tremendous positive run with a gain of over 20% for the year ended December 31, 2018. Well before the market had rewarded the stock price, our research indicated that Ollie’s “treasure hunt” shopping experience would be difficult for online competitors to replicate. This and other competitive advantages led us to believe Ollie’s could double the number of its stores to more than 500 in the coming years.

When we uncover a company with the potential to double in size over the next three to five years, our senses perk up and our pencils come out. In our experience, with that type of growth story, the important thing is to buy and own shares in the company—not to time the purchase precisely. Because we’re investing for the long term, we purchased Ollie’s with a reasonable attention to price but with an even greater attention to the company’s ability to expand without significant threats from online retailers. While we were pleased to see Ollie’s share price soar (until the fourth quarter of 2018), we always recognized the risk that the price might fluctuate significantly in short term.

As we said, in addition to long-term growth, we also pay attention to price in our investment decisions. For instance, we took some profits on Ollie’s during the third quarter to mitigate near-term risks. Then, as the stock sold off in more-recent months, we added back to our position in Ollie’s. We did so because we believe in the company just as much now as we did several months ago.

Of course, Ollie’s—like many other companies in the Fund—isn’t immune to lower consumer demand, such as occurs during a recession. But with fast-growing, high-quality companies, we believe that even the downward portion of an economic cycle can eventually be beneficial. That’s because when all companies are struggling, the best ones are often able to increase market share and come out of a difficult period with an even better competitive position.

Again, although we’re aware of the macro picture, our focus is always on the fundamentals of individual companies. If we believe we’ve identified a potential multi-year winner such as Ollie’s, we don’t let a temporary downturn change our thesis unless that downturn affects the company’s long-term fundamentals.

U.S. auto-repair chain Monro, Inc. (MNRO) is our second example in which we adhered to our long-term investment discipline. Monro detracted slightly from the Fund’s performance for the quarter but has been a winner over the longer term. Like Ollie’s, we saw Monro as having outstanding growth potential and we took note of the progress the company was making in turning its business around. When Monro announced a new management team in 2017, we made an onsite visit to meet the company’s new CEO to ensure we continued to feel comfortable with the company’s direction. After our visit, we added to the Fund’s position in Monro—only to see the stock price tread water for several months.

However, regardless of the price movement, our research indicated that our reasons for investing in Monro were still valid. We held the position and even added to it over the following months. As Monro’s quarterly financials reflected the company’s progress, the stock price responded.

Despite a very small decline in the fourth quarter, Monro was a significant contributor for 2018 as a whole. Like Ollie’s, we continue to hold Monro because our investment thesis is unchanged and we still believe in the management team.

Of course, sometimes our views do change. For each position in the Fund, we test our investment thesis again and again, periodically bringing on a fresh set of eyes. When our ongoing research suggests that a company’s direction may not support our thesis as strongly as in the past, we trim our position or eliminate it entirely. But often, especially in the face of sharp downturns, we take advantage of lower prices to add to positions in companies that we believe continue to warrant our confidence.

DETAILS OF THE QUARTER

As noted above, one of the Fund’s leading contributors for the fourth quarter was Five9, an information-technology company with a software solution that enables its clients to better manage their customer interactions across various channels including voice, chat, email, web and social media. Five9 also provides a set of management applications including workforce management, quality management and supervisor tools. After meeting onsite with the company’s management team, we came away impressed and believe they have the right strategic vision for the firm. We believe the company’s focus on artificial intelligence and increasing the number of interactions that can be automated provides a significant opportunity given that traditional contact centers are extremely labor-intensive. From a competitive perspective, we think Five9 is well-positioned in its industry since there are many smaller regional players but not the big fish we think Five9 has the potential to become. The company has strong gross margins and recurring revenue via software licensing.

U.S. health-care holding Ensign Group, mentioned earlier in the commentary, was also a top contributor. The company provides nursing and rehabilitative-care services. Adjusted operating earnings in Ensign’s most-recent quarter rose 27.8% versus the same quarter a year ago on 8.9% revenue growth. Management said the results, which surpassed Wall Street expectations, were driven by favorable acquisition decisions and improving transitions at the company’s facilities. Ensign pleased investors further by raising its full-year guidance for 2019.

Ensign was a turnaround story—a classic example of a holding that we believed had the potential to grow steadily over a three-to-five-year time period. We saw Ensign experience some bumps along the road of a strategic expansion but maintained confidence in the management team’s ability to work through the setbacks. In November, other investors came to share our enthusiasm, sending the stock price up sharply. In December, the price fell back along with the market as a whole. But Ensign ended the quarter with a single-digit positive return—and therefore was far ahead of most stocks in both the Fund and the benchmark.

On the negative side of the ledger, the largest detractor for the fourth quarter was the United Kingdom’s Metro Bank (noted above), a holding that was also among the third quarter’s biggest detractors. As we wrote previously, this retail bank’s competitive advantage is a disruptive, customer-first business model offering unparalleled levels of service. Metro Bank’s management team is highly experienced with the potential, in our opinion, to take significant market share from competitors over 10 years or more. Weighing against Metro Bank’s attractive growth potential were concerns about financial conditions in the U.K., including Brexit-related uncertainties and falling property prices.

Several U.S. industrial holdings were also among the Fund’s major detractors—with the most significant being Barnes Group, Inc. (B). Barnes is a global provider of engineered products, industrial technologies and solutions used in aerospace, transportation, manufacturing, health care and packaging. Investors grew concerned about the company’s expansion potential in a lower-growth economy. While Barnes isn’t immune to a slowdown in demand, we like its cash-flow-rich business model and potential to gain share from competitors throughout the business cycle.

Another weak stock in the Fund was Sun Hydraulics Corp. (SNHY). The company, which has changed its name to Helios Technologies, is a manufacturer of high-performance compact hydraulics for a broad set of industrial end markets. In addition, it manufactures electronic controls and display and instrumentation solutions for vehicles, including marine and recreational vehicles.

We like the company’s potential for strong sales growth driven by demand for its products, as indicated by a backlog of orders. We also like its strategic approach to making acquisitions, including two deals that were recently closed, and its planned new-product launches. Although the shares were severely depressed as the industrials sector lost ground, we believe Sun/Helios has good pricing power—including the ability to pass on higher materials costs to customers. (Current and future holdings are subject to risk.)

OUTLOOK

Although we haven’t found it beneficial to incorporate macro events to a significant degree in our investment process, there are short-term periods in which the macro environment overwhelms almost all other factors in determining stock prices. The fourth quarter was certainly one such period.

Beyond that, for what it’s worth, we think the Fed’s rhetoric and interest-rate hikes were the dominant macro themes during the quarter. The market seemed somewhat more resilient to political tensions and trade disputes—which can quickly take a turn for the better, as in the case of the renegotiation of the North American Free Trade Agreement. We can only hope for a similar face-saving deal between the U.S. and China.

Regarding portfolio management, we believe—especially among smaller companies—it pays to be active investors rather than to passively invest in indexes, which are often structured with disproportionate exposures to certain companies and business themes. Our approach, by comparison, is to invest in what we consider high-quality companies with the potential for sustainable growth regardless of where that growth may come from.

Another advantage afforded to us as active investors is the opportunity to adapt to market dislocations in an attempt to benefit the Fund. In the current environment, we’ve been sifting through beaten-down stocks in search of those we think have been unfairly punished. By examining our current holdings and watch-list prospects on a case-by-case basis, our goal is to take appropriate position sizes in the ones we believe have the greatest potential for long-term appreciation.

Thank you for the opportunity to manage your assets.

Sincerely,

JB Taylor, 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.

The Wasatch Small Cap Growth Fund has been developed solely by Wasatch Advisors, Inc. The Wasatch Small Cap Growth Fund is not in any way connected to or sponsored, endorsed, sold or promoted by the London Stock Exchange Group plc and its group undertakings (collectively, the “LSE Group”). FTSE Russell is a trading name of certain of the LSE Group companies.

All rights in the Russell 2000 Growth and Russell 2000 indexes vest in the relevant LSE Group company, which owns these indexes. Russell ® is a trademark of the relevant LSE Group company and is used by any other LSE Group company under license.

These indexes are calculated by or on behalf of FTSE International Limited or its affiliate, agent or partner. The LSE Group does not accept any liability whatsoever to any person arising out of (a) the use of, reliance on or any error in these indexes or (b) investment in or operation of the Wasatch Small Cap Growth Fund or the suitability of these indexes for the purpose to which they are being put by Wasatch Advisors, Inc.

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.

The Bureau of Economic Analysis (BEA) is an agency in the United States Department of Commerce that provides important economic statistics including the gross domestic product of the United States. BEA is a principal agency of the U.S. Federal Statistical System.

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

The federal-funds rate is the interest rate at which private depository institutions (mostly banks) lend balances (federal funds) at the Federal Reserve to other depository institutions, usually overnight. It is the interest rate banks charge each other for loans.

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.

The North American Free Trade Agreement (NAFTA) is a treaty entered into by the United States, Canada and Mexico. In accordance with the terms of the agreement, the three nations phased out numerous tariffs between January 1, 1994 and January 1, 2008. NAFTA’s purpose is to encourage economic activity between the United States, Canada and Mexico.

“Risk-off” is when investors become more cautious and take money out of the market, not being willing to risk it, thus risk off.

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

The yield curve is a line on a graph that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. The most frequently reported yield curve compares three-month, two-year, five-year and 30-year U.S. Treasury securities. This yield curve is used as a benchmark for other interest rates, such as mortgage rates or bank lending rates. The curve is also used to predict changes in economic output and growth.

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.

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CFA® is a trademark owned by CFA Institute.