Wasatch Emerging Markets Small Cap Fund® (WAEMX)  Invest in this Fund 

Investor Class | Institutional Class
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3Q18
Despite Recent Headwinds, Emerging Markets Hold Opportunities for Long-Term Investors
by Roger Edgley, CFA, Andrey Kutuzov, CFA, Scott Thomas, CFA and Kevin Unger, CFA

“Experience has taught us that while macro-related events may feature prominently in news headlines, they usually have minimal impact on the long term underlying value of the businesses in which we invest.”

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Investing in small or micro cap funds will be more volatile and loss of principal could be greater than investing in large cap or more diversified funds.
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.

For the period ended September 30, 2018, the average annual total returns of the Wasatch Emerging Markets Small Cap Fund for the one-, five- and 10-year periods were -7.02%, 1.29%, and 8.78%, and the returns for the MSCI Emerging Markets Small Cap Index were -4.20%, 2.72% and 7.43%.  Expense ratio: Gross 2.02% / Net 1.96%.

 

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

For the quarter ended September 30, 2018, the Wasatch Emerging Markets Small Cap Fund—Investor Class declined -7.33% and underperformed its benchmark, the MSCI Emerging Markets Small Cap Index, which lost -4.21%.

There is no shortage of events around the world that have the potential to impact financial markets. The Trump administration’s tough talk on trade and the imposition of U.S. sanctions have left countries and companies uncertain about what they can export and import and with whom. In addition, the budding trade war between the U.S. and China dampened enthusiasm for emerging-market assets and unsettled global markets. Pressure from rising U.S. interest rates, a stronger dollar, and political uncertainty also contributed to a general sense of cautiousness on the part of investors.

Experience has taught us that while macro-related events may feature prominently in news headlines, they usually have minimal impact on the long term underlying value of the businesses in which we invest. Rather than paying too much attention to the headlines, we seek to identify changes at the company level such as new competitive challenges or deteriorating fundamentals. We also look at broader themes that can specifically affect businesses such as the disruptive nature of technology, for example. The constant in our investment process is our unrelenting focus on identifying and thoroughly researching companies that we see as high quality with outstanding potential for long-duration growth.

While we believe the backdrop for international small-cap equities remains constructive, there is turmoil in some emerging-market countries, and emerging-market stocks were among the worst performers in the third quarter. Some developing countries do have issues and their markets and currencies have been severely affected. Currency crises in Turkey, Brazil and Argentina and a sharp selloff in Chinese equities weighed on investor sentiment toward emerging markets during the third quarter.

However, we believe the perception of contagion, which led to the broad selloff in emerging markets, is greater than the reality. Many developing countries are in a better position compared to the “Taper Tantrum” of 2013 when the emerging-market countries deemed to be most at risk from the U.S. Federal Reserve’s planned tapering of asset purchases were dubbed “The Fragile 5.” Today, currencies of developing countries such as India appear to have stabilized and are more competitive. Current-account balances have improved and stock valuations are still below long-term averages. We like the strength we have been seeing as companies have been producing the earnings growth we expect. We have been adding to our positions in companies that we feel have been unfairly sold off.

On a country basis, Thailand, Mexico and Malaysia added to the Fund’s return and our holdings outperformed their benchmark counterparts. However, this was not sufficient to offset negative performance in the Fund’s most heavily weighted countries—Taiwan, India, China and Korea. Relative to the benchmark, our holdings in Taiwan, China and Korea underperformed, while our holdings in India, though down, outperformed their benchmark peers.

DETAILS OF THE QUARTER

Thailand added the most to the Fund’s return for the quarter. The macro backdrop for the country looks quite good with a current-account surplus, a manageable fiscal deficit and solid gross domestic product (GDP) growth. Trade data is starting to inflect positively after multiple years of compression. Infrastructure spending is starting to materialize. Thailand has been working with its neighbors, Cambodia, Laos, Myanmar and Vietnam, so that this group of countries may benefit from coordinated economic development and growth in the region. Some of the Fund’s holdings benefit from this dynamic. Three of the Fund’s top contributors for the quarter were from Thailand.

Srisawad Corp. Public Co. Ltd., a finance company in Thailand, was a significant contributor to performance. Srisawad’s stock began to recover after a quarterly earnings report included reference to loan-portfolio details that may have given investors pause. We spoke with the management team to gain a better understanding of a surprising nonperforming-loan statistic and, more generally, evidence of margin contraction. We came away satisfied with management’s response, and we maintained our optimism about Srisawad’s growth prospects as the company has been aggressively adding branches.

Muangthai Capital Public Co. Ltd. provides various lending services in Thailand as well as insurance brokerage services. The management team has been developing and refining the business and processes for the past 30 years. Given the flexibility of Muangthai’s business model, we believe the company will be able to continue to scale it across the country where we believe there is significant opportunity for sustainable growth.

Minor International Public Co. Ltd. is the leading hospitality and restaurant operator in the Asia-Pacific region. The company is one of the largest hotel companies in the world, but we believe it can become significantly larger given its growth and restaurant expansion plans. We believe the company’s management team is world-class and it has a long history of success. Management has done well to acquire brands and is committed to offering unique experiences and services. Further, Minor has done well by diversifying away from Thailand, which has made the company’s financials more stable and has resulted in international recognition for the company’s portfolio of brands. Given the management team’s ability to roll out and execute new concepts, we believe the runway for growth is long. The company recently reported strong revenue growth driven by its core hotel business.

In August, Mexican stocks rallied and the peso firmed on news that the U.S. and Mexico had reached a deal to replace the North American Free Trade Agreement (NAFTA). The Fund’s top contributor to performance for the quarter was Grupo Aeroportuario del Centro Norte S.A.B. de C.V., which operates a group of airports in Northern Mexico under a concession regime. The main airport in the group is in Monterrey, which is the third largest city in Mexico and is a manufacturing hub. The rest of the business is spread around numerous small airports. Revenues are mainly driven by domestic travel. Tourist airports are inconsequential for this area. Mexican air travel is heavily under-penetrated even relative to other emerging markets with similar GDP-per-capita. The majority of Mexicans travel by luxury bus rather than by air. The company has seen passenger growth accelerating, and a new CFO is making a concerted cost-reduction push that should continue to benefit the company over time.

Taiwan, one of the Fund’s largest market weightings, was the greatest detractor from performance for the quarter. As a country, Taiwan has a stable currency, a large current-account surplus, and a slightly negative fiscal balance. Returns on equity for Taiwanese companies have been trending up for the last few years. Taiwan’s companies compete globally, with a world-class manufacturing and engineering base that makes Taiwan a key part of the global information-technology (IT) supply chain.

This year, however, Taiwan has been increasingly affected by trade-war issues between the U.S. and China, and by changes in investor sentiment and expected growth for the IT sector in general and the semiconductor industry in particular. In addition, there is some evidence that IT supply chains are getting disrupted. These issues have led to concern for IT growth stocks in Taiwan. We continue to monitor our positions in Taiwan and at present are slightly underweight versus the benchmark in the country.

While Taiwanese stocks in both the Fund and the benchmark were down during the quarter, the Fund’s holdings were down significantly more. Several of the Fund’s largest detractors were from Taiwan.

Taiwan’s Silergy Corp. manufactures high-performance mixed-signal and analog integrated circuits. Silergy saw its stock price decline as a global shortage of passive electronic components impacted production of its products. We believe the shortage will be temporary and expect the company to ramp up production when components become more-readily available.

Ennoconn Corp. is involved in the design and development of industrial motherboards primarily in Taiwan. The company provides hardware system solutions for various market applications, including point-of-sale (POS) locations, banking automation, kiosk, lottery and industrial automation. The stock corrected during the third quarter, but again, we have no fundamental concerns with the company. We continue to monitor the integration of Kontron/S&T, which we believe will drive earnings for the coming years. We see Ennoconn as having massive headroom for growth as it continues to gain market share in the industrial personal computer (PC) space, and develops more value-added services for its platform.

ASPEED Technology, Inc. is a fabless integrated-circuit design house based in Taiwan that specializes in server management, personal computer audio/video extension solutions, desktop virtualization and security enhancement. The company’s products range from silicon chips and silicon IPs (the company licenses its technology to customers as intellectual property) to software products that enable sophisticated SoC (System-on-a-Chip)-centric multimedia, graphics and network applications. The stock was down during the third quarter but we do not believe there are any fundamental concerns. Capital expenditures on cloud-computing solutions remain strong across the world and ASPEED’s revenue growth year-over-year for the company’s most-recent quarter was over 20%. There were some shipping disturbances and restrictions on sales in June that affected revenue, but the situation was reversed by July.

In India, the Fund is overweight relative to the benchmark and our Indian stocks declined less than those in the benchmark during the third quarter. Indian stocks have been under pressure during 2018 due to what some portray as a deteriorating macro environment from a weakening local currency against the U.S. dollar and rising oil prices that can widen the current-account deficit as India imports roughly 80% of its oil. A general election in 2019 is also creating some market volatility. However, Prime Minister Narendra Modi is still in a position of strength. The Indian economy has historically been largely resilient to external pressures and is still expected to grow more quickly than most other economies. Further, at the more microeconomic level, we see reasons to be encouraged. Domestic consumer demand that retreated following the goods-and-services tax implementation is coming back—demand that is being driven by India’s growing middle class, increasing urbanization and rapid household formation.

India is currently in a growth phase that we expect will continue for the next 20 to 30 years. It is one of the fastest-growing major economies in the world. Despite bumps encountered along the way, the governmental reforms enacted over the past several years have been transforming India’s economy and business conditions and will enable further structural improvements. At the company level, we see accelerating growth in the earnings of our portfolio companies. Further, we continue to find India an excellent source of high-quality companies, with a pool that is broadening due to a high level of initial public offering (IPO) activity with quality companies coming public where management expertise, financial controls, corporate governance and transparency are remarkably good. We are optimistic regarding India’s political, economic and financial-market conditions in the years ahead.

Kajaria Ceramics Ltd., the leading manufacturer of ceramic tiles in India, was a detractor for the quarter. We believe Kajaria Ceramics has a strong competitive advantage due to its brand, distribution capabilities and manufacturing scale. Indian tile purchases are very low even by emerging-market standards so there is significant room for growth. The company is family owned and operated with what we see as an excellent management team. Industry conditions have been challenging, but we believe Kajaria is clearly stronger coming out of the tumult as the company has shed some debt over the past two years and gained market share from competitors.

China’s $12 trillion economy faced fresh challenges as both sides announced new tariffs in the country’s trade dispute with the United States. Manufacturing surveys from China remained weak, suggesting U.S. tariffs may be beginning to affect the Chinese economy. In July, the Chinese government announced a series of stimulus measures—which included special infrastructure bonds and a tax cut—designed to increase domestic demand and ward off an economic slowdown. A key importer of raw materials, components and finished goods from other countries, China functions as a locomotive of growth for other emerging markets.

Despite recent economic headwinds, we believe that China has become a more attractive environment in which to invest. Our research indicates that the risks have become lower and companies’ growth prospects have been getting better. We also have seen improvements in the fundamental strength among smaller and mid-cap companies here. The high levels of speculation and volatility in China’s equity and foreign exchange markets seen in 2015 have subsided. Chinese companies have been allocating capital better with lower capital expenditures and higher returns on equity. We have been finding opportunities in areas where there has been industry consolidation. While we recognize that the challenges unique to the Chinese market remain and require companies to demonstrate a higher return threshold in order to be included in the Fund, we see opportunities here as well.

51job, Inc. Sponsored ADR was the Fund’s largest detractor for the quarter. The company provides online recruitment and other human-resources services in China. Although 51job reported strong quarterly revenues and earnings, the company issued forward guidance that disappointed investors. Also weighing on the depositary receipts of 51job was an unexpected narrowing of margins, which we think may be related to front-loading of sales commissions. Our research is ongoing as we review our assessment of the company’s long-term prospects.

The Fund’s holdings in Korea also detracted from its return. However, we remain positive on the quality of the companies we have been finding in Korea. Many companies have made new technological advances and also have strong returns on capital to help drive their research and the growth of their businesses. Korea’s strong base of an educated population and the manufacturing know-how of global giants like LG and Samsung†† drives a world-class ecosystem for small companies where being an entrepreneurial company is no longer a disadvantage. Like Japan, we see an exciting band of what we call “new generation” publicly listed companies in Korea.

Medytox, Inc. was another of the Fund’s largest detractors for the quarter. Medytox’s stock price may have slipped as part of broad-based volatility in several emerging-market economies. Further, the stock has corrected from an all-time high. We do not believe there are any fundamental concerns and remain confident in the company’s business model and growth prospects. (Current and future holdings are subject to risk.)

OUTLOOK

The prospect of shrinking exports to China confronted emerging markets at a time when contagion fears following routs in the currencies of Argentina and Turkey placed countries with current-account deficits under mounting scrutiny from investors. Although Argentina and Turkey comprise only a small part of the emerging-market equity universe, bouts of weakness in the currencies of Brazil, South Africa, India and other countries appeared at times to spook international investors.

Recent data indicate China’s economic momentum has slowed as the government curbs risky lending and as tariffs on Chinese exports to the U.S. begin to bite. As policy makers now shift into a stimulative mode, their ability to provide the appropriate economic medicine will be a key determinant of China’s near-term economic health. Although the stakes are high and the risks are significant, similar periods in the past suggest a reasonable likelihood of success. The Chinese government has an abundance of policy levers at its disposal and has demonstrated an uncanny ability to pull just the right ones at just the right time.

With recent declines in Chinese stocks having brought valuations to more-attractive levels, our research has identified approximately 200 Chinese companies that we think merit further evaluation. Toward that end, analysts from the Wasatch international team recently returned from a trip to China that included visits to 65 companies. This was the first of a series of trips designed to cover our list of candidates for investment in China. The targeted securities span China’s A-share market as well as the H-shares.

Notwithstanding continued uncertainty surrounding tariffs and global trade, the investment environment in emerging markets remains generally favorable in our view. We’re pleased that, for the most part, the companies we own have delivered strong earnings growth despite the recent underperformance of their stocks. As fundamental, bottom-up investors, we believe—over the longer term—earnings-driven market environments will provide beneficial conditions for our investment approach to outperform.

Thank you for the opportunity to manage your assets.

Sincerely,

Roger Edgley, Andrey Kutuzov, Scott Thomas and Kevin Unger

 

The MSCI Emerging Markets and Emerging Markets Small Cap Indexes are free float-adjusted market capitalization indexes designed to measure the equity market performance of emerging markets. You cannot invest in these or any indexes.

Source: MSCI. The MSCI information may only be used for your internal use, may not be reproduced or redisseminated in any form and may not be used as a basis for or a component of any financial instruments or products or indexes. None of the MSCI information is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such. Historical data and analysis should not be taken as an indication or guarantee of any future performance analysis, forecast or prediction. The MSCI information is provided on an “as is” basis and the user of this information assumes the entire risk of any use made of this information. MSCI, each of its affiliates and each other person involved in or related to compiling, computing or creating any MSCI information (collectively, the “MSCI Parties”) expressly disclaims all warranties (including, without limitation, any warranties or originality, accuracy, completeness, timeliness, non-infringement, merchantability and fitness for a particular purpose) with respect to this information. Without limiting any of the foregoing, in no event shall any MSCI Party have any liability for any direct, indirect, special, incidental, punitive, consequential (including, without limitation, lost profits) or any other damages. (www.msci.com)

CFA® is a trademark owned by CFA Institute.

The Wasatch Emerging Markets Small Cap Fund’s investment objective is long-term growth of capital.

††As of September 30, 2018, the Wasatch Emerging Markets Small Cap Fund was not invested in LG Corp. or Samsung Electronics Co. Ltd.

China A-shares, along with B-shares, are sold on mainland China’s two stock exchanges, which are in Shanghai and Shenzhen. The key difference between A-shares and B-shares is that A-shares are denominated in mainland China’s currency, the renminbi, and B-shares are denominated in foreign currency (U.S. dollars in Shanghai and Hong Kong dollars in Shenzhen).

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

H-shares refer to the shares of companies incorporated in mainland China that are traded on the Hong Kong Stock Exchange. Many companies float their shares simultaneously on the Hong Kong market and one of the two mainland Chinese stock exchanges in Shanghai or Shenzhen. Such companies are known as A+H companies.

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

Return on equity (ROE) measures a company’s efficiency at generating profits from shareholders’ equity.

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

The MSCI Emerging Markets and Small-Mid Cap Indexes are free float-adjusted market capitalization indexes that are designed to measure equity market performance in the global emerging markets.  

You cannot invest directly in indexes.

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CFA® is a trademark owned by CFA Institute.