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

Investor Class | Institutional Class
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Q1 2018
Fund Performed as Expected in 2018’s Volatile First Quarter
by JB Taylor, Ken Korngiebel, CFA and Ryan Snow

“In our view, the Fund’s outperformance in these choppier markets underscores its bias toward high-quality companies, as evidenced by strong earnings growth, sustainable competitive advantages and experienced management teams.”

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For the period ended March 31, 2018, the average annual total returns of the Wasatch Small Cap Growth Fund for the one-, five- and ten-year periods were 24.63%, 11.04%, and 11.13%, the returns for the Russell 2000 Growth Index were 18.63%, 12.90%, and 10.95%, and the returns for the Russell 2000 Index were 11.79%, 11.47%, and 9.84%.  Expense ratio: Gross 1.27% / Net 1.27%. 

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

During a quarter in which U.S. stock markets turned volatile for the first time in many months, the Wasatch Small Cap Growth Fund—Investor Class logged strong performance in both absolute and relative terms. The Fund gained 7.86% compared to a 2.30% return for its primary benchmark, the Russell 2000 Growth Index. The Fund’s secondary benchmark, the Russell 2000 Index, declined -0.08%.

The Fund’s outperformance of the Russell 2000 Growth Index came primarily as a result of stock selection, which was especially beneficial in the health-care, information-technology, industrials and consumer-discretionary sectors. In fact, with the exception of financials, stock selection was a plus in every sector in which we were invested. Consumer stocks declined in the quarter, but even so, our stocks in the consumer-discretionary and consumer-staples sectors were down far less than those in the benchmark. The Fund’s lack of exposure to the materials, telecommunication-services and utilities sectors also contributed to performance relative to the benchmark.

In our commentary last quarter, we noted having taken steps during 2017 to improve the Fund’s risk profile. We wrote, “We believe our efforts to manage risk will be seen as especially beneficial when markets become more volatile.”

Not long after we wrote those words, volatility reemerged in rather dramatic fashion. In February, U.S. stocks sold off sharply. Robust employment and wage growth combined with rising bond yields and recently enacted tax cuts caused investors to become concerned over the threat of higher inflation and additional interest-rate hikes. Investors feared Federal Reserve officials would act even more aggressively to slow economic growth. The Fed raised interest rates in March and is likely to do so twice more this year. After February’s swoon, stocks partially recovered, only to fall again in the second half of March against a backdrop of somewhat softer economic indicators and turmoil in the tech world.

In our view, the Fund’s outperformance in these choppier markets underscores its bias toward high-quality companies, as evidenced by strong earnings growth, sustainable competitive advantages and experienced management teams. These characteristics are best measured on a company-specific basis—thus our intensive, bottom-up research process. In times of market stress, we generally expect investors to express a preference for sounder companies. We see the Fund’s year-to-date performance relative to its main benchmark as bearing that out.

As we mentioned, the primary adjustment we’ve made to the Fund over recent months—both last year and continuing into 2018—has been to put an even finer point on quality. One way we’ve done that is by trimming positions where we’ve become less confident in management’s ability to deliver growth, either because an industry’s competitive dynamics have shifted or because of one or more factors specific to the individual companies.

One example of a name we’ve sold is Luxoft Holding, Inc. (LXFT), a Swiss information-technology company listed in the U.S. Luxoft provides high-end enterprise software to major banks and other clients. Internal reorganizations and operational struggles ultimately led us to reduce and then eliminate our position. While we believe Luxoft has excellent product characteristics and the management team has created value in the past, there was some tension in the business model—customer concentration risk, for one—that led us to conclude Luxoft was no longer a good fit for the Fund, especially given our increasingly sharp focus on quality and mounting concerns that growth might not materialize as expected. Luxoft detracted from the Fund’s performance for the quarter.

In some cases, however, we’re willing to be patient in waiting to see growth materialize. Two current holdings—one a top contributor for the first quarter and the other the largest detractor—demonstrate the patience that’s sometimes needed. The Fund’s fourth-best contributor was Copart, Inc. (CPRT), which we also highlighted last quarter given its strong contribution then as well. The detractor was Health Services Group, Inc. (HCSG), which we discuss further in the quarterly details below. Health Services Group’s growth prospects reminded us of Copart’s 18 to 24 months ago—we were willing to wait for business changes to be digested because we felt the company had strong potential.

Before commenting further on individual holdings, we return to our discussion of broad economic issues. Following a strong start to the year for both the economy and the stock market, inflation concerns and rising interest rates in February derailed the early advance in equities. Later, political uncertainty and fears of a trade war between the U.S. and China also impacted the financial markets. Economic data, which had initially been coming in stronger than expected, began to weaken as the quarter continued. As of March 29th, the Federal Reserve Bank of Atlanta’s GDPNow model forecasted first-quarter 2018 U.S. gross domestic product (GDP) growth of just 2.4%—down from an earlier estimate of 5.4% on February 1st.

Also during the first quarter, the U.S. government’s newly announced tariffs on aluminum and steel—as well as separate measures directed specifically at China—hung over the market 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 companies currently tend to be valued more attractively than their larger peers, and their domestic focus leaves them well-positioned to benefit from a lower corporate tax rate.

In many instances, tax reform may prove to be another tailwind. For strong companies that are already generating profits, tax reform has the potential to free up additional cash on the order of several percentage points of revenue. As analysts, when we discover such a large potential increase in available cash upon evaluating a company’s prospects, we’re thrilled. Impacts of this size are highly consequential from a fundamental-analysis standpoint. As mentioned above, the additional cash companies get as a result of tax reform may become available for investment in growth, higher employee compensation, buying back shares or returning cash to shareholders in the form of higher dividends.

The Fund has historically had a bias toward more-profitable companies, on average, than those that make up the Russell 2000 Growth Index. Since more-profitable companies will disproportionately benefit from lower taxes, we see the Fund’s holdings as already in good position relative to tax reform. For highly profitable companies that have opportunities to deploy capital effectively to fuel growth, we see tax reform as providing a meaningful boost.

DETAILS OF THE QUARTER

Business-software specialist Zendesk, Inc. (ZEN) was the Fund’s top contributor for the first quarter. The company saw its stock price rise throughout the quarter amid continued investor optimism about the increasing number of large organizations using Zendesk’s platform. The company’s shares got another boost in February after Zendesk reported year-over-year quarterly sales growth of 39%, better-than-expected earnings results and a positive outlook for continued strong growth over the remainder of 2018.

Second-best contributor, Callidus Software, Inc. (CALD), recently announced its acquisition by enterprise-software giant SAP SE.†† Callidus’ sales performance management software helps companies prepare “configure, price and quote” (CPQ) proposals for their products and track sales activity. SAP was willing to pay a premium for the stock because the acquisition should provide immediate and ongoing benefits. For example, the CPQ module fills a void in SAP’s existing lineup and should be well received by its customer base which includes large industrial companies with thousands of products and complicated pricing. Callidus had also successfully transitioned from a front-loaded, implementation heavy structure to a cloud-based subscription model that generates predictable, recurring revenue.  

The Fund’s third-best contributor was HealthEquity, Inc. (HQY), a U.S.-based health-care company that provides an online platform to manage Health Savings Accounts (HSAs), Health Reimbursement Arrangements, Flexible Spending Accounts and other health-related accounts. In HealthEquity’s most-recent quarterly financial release, management reported revenue growth of 31% over the same period a year ago. During February, the company’s shares experienced volatility—with a strong advance early in the month, then a pair of dips from which the price more than recovered to end the quarter with an increase of nearly 30%. We continue to view HealthEquity as well-positioned in the fast-growing HSA market.

Copart (mentioned above) was the Fund’s top contributor last quarter and fourth-best contributor in the first quarter. This U.S. auto salvager has continued to impress us with both its growth and quality metrics. Copart is a company we held for many months before its share price really took off. It’s a prime example of how we’re happy to be patient with companies we see as high-quality with significant growth opportunities even though it may take some time to reap the potential rewards.

As mentioned earlier, Healthcare Services Group was the first quarter’s largest detractor. The company provides housekeeping, food and other services to the health-care facilities industry and is classified in the industrials sector. The company’s quarterly reporting in February included notice of a one-time effect on net income as a result of tax reform. In addition, the process of bringing customers onboard has been more costly than previously anticipated. More broadly, though, the company has experienced growth in both the number of customers and the average number of services provided to customers.

Second-largest detractor Exact Sciences Corp. (EXAS) is a molecular-diagnostics company with an innovative test for colon cancer. Named Cologuard,® the test avoids the high cost and invasiveness of a colonoscopy by screening a stool sample for cancerous and precancerous cells. Shares of Exact Sciences tumbled in March after the company’s selection of celebrity endorsers disappointed investors who had been expecting a higher-profile figure. Concerns about a new blood test that might provide future competition for Cologuard also appear to have tempered the enthusiasm of some investors.

The third-largest detractor was National Vision Holdings, Inc. (EYE), a discount optical retailer and eye care provider. Although National Vision’s most recently reported financial performance showed a record year for revenues and profitability, investors had been expecting even better results. We believe the company continues to have outstanding long-term growth prospects and we bought more shares during the quarter. (Current and future holdings are subject to risk.)

OUTLOOK

Although some economic indicators have been softening and the financial markets have been expressing investors’ nervousness, the environment is still positive overall. Having said that, the current situation does require increasing care to maneuver—as we noted, for example, in our comments above about focusing on quality first and foremost. Another area that bears watching is the Fed’s action with regard to interest rates. While we have not positioned the Fund with any particular view on interest-rate policy, we’re cognizant of potential effects of rising rates.

Rising rates could have an impact on acquisitions. In recent years, many companies have gotten away with mergers and acquisitions that looked accretive to net earnings but they’ve relied heavily on low-interest borrowing to achieve this. Additional results of rising interest rates are likely to be business-model strains on companies without a defensible strategy and adequate pricing power in the face of higher input prices. Yet another important factor we see in the rising-rates equation is the quality of the management team because it’s simply harder for a company to succeed when the cost of capital is higher.

We’ve heard anecdotally that some less-experienced management teams have even started considering the cost of debt—unusually low at present—to be the cost of capital. Such a presumption essentially assumes that debt capital will be available on attractive terms indefinitely. We, on the other hand, believe those days of easy money are sure to end.

While we remain attentive to interest-rate risks—best seen as a tug of war between positive economic news and the Fed’s efforts to keep the economy from overheating—it’s not likely we’ll see a recession this year. Assuming long-term rates stay relatively low, it would take at least four Fed hikes to flatten the U.S. Treasury yield curve to the point where it flirts with inversion. (An inverted curve typically precedes a recession.)

In any case, as always, our focus remains on identifying companies with strong growth prospects. Many companies in the Fund are now experiencing sales growth of 20% or more—outpacing the mid-teens growth achieved in recent quarters. On average, Russell 2000 companies are also growing sales faster than before, with the average now in the high single digits compared to mid-single-digits a year or so ago.

This level of growth continues to reflect a synchronized global economic expansion. How long it will last isn’t a call we make, but we do believe the Fund is positioned with the potential to do well whether the economy keeps humming along or the Fed puts on the brakes.

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.

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 March 31, 2018, the Wasatch Small Cap Growth Fund was not invested in SAP SE.

The “cloud” is the internet. Cloud-computing is a model for delivering information-technology services in which resources are retrieved from the internet through web-based tools and applications, rather than from a direct connection to a server.

Cost of capital is the return required to make a company’s expenditures on a project, such as building a new manufacturing facility, worthwhile. Cost of capital includes the cost of debt and the cost of equity. Another description of cost of capital is the cost of funds used for financing a business. From an investment perspective, it is the return expected by those who provide capital for the business such as stock or bondholders or entities that issue loans to the company.

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.

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.