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

Investor Class | Institutional Class
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Q4 2017
Investment Conditions Improved for Emerging Markets in 2017
by Roger Edgley, CFA, Andrey Kutuzov, CFA, Scott Thomas, CFA and Kevin Unger, CFA

“Improving economic fundamentals across a number of developing countries resulted in a very strong year for emerging-market equities. Emerging-market currencies appear to have stabilized and are more competitive. Current-account balances have improved for the majority of emerging markets and stock valuations are still below their long-term averages.”

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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 December 31, 2017, the average annual total returns of the Wasatch Emerging Markets Small Cap Fund for the one-, five- and 10-year periods were 38.20%, 3.25%, and 5.45%, and the returns for the MSCI Emerging Markets Small Cap Index were 33.84%, 5.41% and 2.78%.  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 December 31, 2017, the Wasatch Emerging Markets Small Cap Fund—Investor Class gained 7.69% and underperformed its benchmark, the MSCI Emerging Markets Small Cap Index, which returned 9.23%.

Improving economic fundamentals across a number of developing countries helped push emerging-market equity prices solidly higher during the fourth quarter, resulting in a very strong year. While performance was strong across a number of countries in 2017, we observed that the emerging-markets asset class continues to be diverse with a lot of different countries producing a high dispersion of returns. Emerging-market countries can be at very different levels of development, and returns of their equity markets can differ significantly.

Wasatch focuses on bottom-up, fundamental data at the company level. However, we also spend time and effort to understand the environment at the country level in terms of macro risks in order to more fully understand the investment opportunities. In some emerging markets there are structural risks from the political, economic or financial systems that can pose a higher degree of difficulty for investors. Some of these macro risks may affect equity-market returns. At the same time, a country with high political risk, but low financial and economic risk may present opportunities. At Wasatch, we pride ourselves on our intensive due diligence, which includes significant travel and in-country company visits, in order to understand the potential impact these factors could have on prospective and existing investments.

For the fourth quarter, the Fund’s holdings in Korea were the largest source of absolute contribution in a very strong market. However, Korea detracted from performance relative to the benchmark due to an underweight position and the underperformance of our holdings. Similarly, a strong showing by the Fund’s holdings in India was outpaced by the stock performance of the benchmark’s holdings, which while adding to the Fund’s return detracted from relative performance. Taiwan was a top-contributing market for the Fund and the benchmark. The Fund’s stocks in Taiwan outperformed their benchmark counterparts. Weakness among the Fund’s holdings in Mexico detracted from absolute performance for the quarter, and our overweight position in the country detracted from relative performance even though our holdings were down less than those in the benchmark.

Details of the Quarter

The Fund’s gain in Korea was driven by rebounds in several holdings from prior weakness. The improved investment backdrop in Korea included a pickup in third-quarter gross domestic product (GDP) growth and an apparent easing of concerns regarding the country’s deployment of the United States’ Terminal High Altitude Area Defense (THAAD) anti-missile defense system. THAAD has been a source of recent diplomatic and economic friction between Korea and China, which accounts for approximately one-quarter of total Korean exports.

Three of the Fund’s top contributors for the fourth quarter were from Korea. Loen Entertainment, Inc. operates Korea’s largest music streaming platform. The company’s share price continued to rebound from earlier weakness that occurred when the Chinese government blocked videos of Korean music and television dramas from online-streaming services in response to Korea’s deployment of THAAD. That retaliation now appears to have run its course. Korea has one of the highest smartphone-penetration rates in the world, and data plans are relatively inexpensive. Loen has continued to grow its user base even as it has increased prices. In our view, the company is extremely well-managed and continues to increase its dominance in the Korean music-streaming industry.

Koh Young Technology, Inc. designs and manufactures precise 3D measurement and inspection equipment used for testing accuracy and reliability of circuit-board assemblies and semiconductors for information-technology (IT) companies world-wide. The benefit of 3D inspection is that it decreases the failure rate of printed circuit boards and removes the requirement for human inspection. Koh Young is headquartered in Seoul, with offices in Germany, the U.S., Japan, Singapore and China. Our favorable view of the company is supported by recently reported strong earnings growth.

Hanmi Pharm Co. Ltd. is a Korean company that produces pharmaceutical products, including antibiotics, vitamins and tonics. We also like the company for its strong focus on research and development.

Taiwan is the largest country weight in the Fund, at a weighting close to that of the benchmark. The Fund’s holdings in Taiwan outperformed those in the benchmark, adding nicely to relative performance. Stabilization in China and the general cyclical improvement in the U.S. and emerging markets have been positive for Taiwanese companies. For the quarter, the Fund’s strongest contributor and several additional top 10 contributors were from Taiwan.

Chroma ATE, Inc. was the Fund’s strongest contributor for the quarter, with the stock up over 50%. Chroma also contributed for calendar year 2017, as the stock rose over 75%. The company is a world leader in supplying precision test and measurement systems and is a leader in testing technology for electric vehicles as well as 3D lasers. The stock was up based mostly on the improved outlook for electric-vehicle manufacturer Tesla.††

Airtac International Group, headquartered in Taipei City, Taiwan, manufactures and supplies pneumatic equipment and components for factory automation systems. Gourmet Master Co. Ltd. operates coffee shops and sells baked goods wholesale in Taiwan, China and the U.S. These companies were the Fund’s second- and third-best contributors, respectively.

The Fund’s holdings in India were a significant source of contribution for the quarter, and the most significant source of contribution to the Fund’s return for the year. In preparing for the Wasatch investment team’s most recent research trip to India, our screening process produced over 200 interesting companies to visit while there—companies with high-quality, long-duration growth profiles—and showed that the breadth of interesting investment opportunities in India continues to be vast. Three members of the Wasatch team traveled to Delhi, Mumbai, Chennai, Pune, Bangalore and Jaipur during the fourth quarter to get a closer look at these companies.

Following the reforms of Prime Minister Narendra Modi’s government over the past 13 months, most notably demonetization and the implementation of a goods-and-services tax (GST), Indian companies appear to be adjusting to the new reality. The overall economy slowed mid-year as disruptions from the recently enacted GST proved more severe than anticipated. In an attempt to ease burdens on businesses and reduce inflationary pressures, the government relaxed filing standards and lowered GST rates on about 200 items. This resulted in some pent-up demand, and in the fourth quarter we started to see spending accelerate. We believe that the recent reforms will be good for the overall Indian economy over the long term.

Recognizing that stock valuations of Indian companies have risen substantially in recent years, we’re continuing to thoroughly review the risks and opportunities of the portfolio’s Indian investments.

Though the potential long-term benefits of India’s goods-and-services tax (GST) are enormous, preliminary evidence gathered during our research trip suggests the new tax regime may be falling short of its stated goals.

Similarly, the likely repercussions of the government’s recapitalization of India’s public-sector undertakings (commonly referred to as “PSU banks”) must be examined closely. Investing in India—and in Indian financial-services companies in particular—have been rewarding themes for Wasatch. Now, however, we’re reevaluating the Fund’s positions in Indian financial-services companies in light of the sector’s shifting business environment and competitive landscape. PNB Housing Finance Ltd. detracted from performance for the quarter. PNB makes housing loans to individuals and corporate developers. Concerns about increased government borrowing and rising interest rates in India weighed modestly on shares of PNB and other lenders that obtain significant funding in the country’s wholesale market.

The Fund continues to be structurally underweight in China, although we are becoming cautiously constructive and increased our weight throughout 2017. Historically, our significant due-diligence efforts and visits to China have yielded relatively few companies meeting our investment criteria. We believe China’s unique challenges require a higher return threshold.

While we remain conscious of the many risks, our assessment of the investment backdrop in China has moved from negative to more neutral. We see signs of stabilization in the market and the currency, and the fundamentals of the companies we’ve visited appear to be improving. Manufacturing activity has picked up, as have exports. In our estimation, Chinese companies have been allocating capital better with lower capital expenditures and higher returns on equity. We’ve been finding more interesting companies that meet our quality standards and have long-duration growth potential in manufacturing, information technology and industrials, for example, where growth is less dependent upon the macro environment.

China is an increasingly significant component of emerging markets. China is not only home to approximately one-quarter of the emerging-market universe, but it also serves as an engine of growth through its purchases of raw materials and finished goods from other emerging markets. The Wasatch team has deep experience in mainland China and visits on a regular basis to meet with government representatives and prospective companies.

Alsea S.A.B. de C.V. was one of the Fund’s largest detractors for the quarter. Alsea operates franchises of international restaurant brands such as Dominos, Starbucks and Burger King as well as other well-known brands in Mexico, South America and Spain. Our research showed Alsea’s expected growth rate shrinking. The company has grown larger and has a relatively low cash position, which means large acquisitions would require adding debt to the balance sheet. In addition, it has become increasingly difficult for Alsea to reap economies of scale in the restaurant business model, which could make future growth less profitable. As a result of these factors, we elected to sell the position. (Current and future holdings are subject to risk.)

Outlook

In reviewing 2017 and considering the question of where the emerging-markets small-cap asset class is headed, it is worth going over the past seven years or so. Looking back at the five years ended December 31, 2017, emerging-market investors have faced a difficult environment and investment returns, including those for the Emerging Markets Index and the Wasatch Emerging Markets Small Cap Fund, have not yet compensated investors for the risk they have taken. For the five-year period ended December 31, 2017, the Emerging Markets Index had an average annual total return of just 4.35%, while the average annual return for the MSCI World Index was 11.64%. As the chart below shows, the Emerging Markets Index has essentially traded sideways, underperforming the MSCI World Index by over seven percentage points since 2012.

EM

Over the past five years, the 24 countries represented in the MSCI Emerging Markets Index have experienced massive political and economic changes, much more so than say the U.S. or Europe. The population set in emerging markets is enormous and includes China and India with populations of over 1.3 billion each.

At Wasatch, we are primarily bottom-up investors, but we take note of bigger-picture changes and trends. While understanding conditions in the macro environment comes second to understanding the investment potential of individual companies, we have found knowledge of the macro environment helpful in understanding the risks—in U.S. dollar terms—posed by domestically oriented emerging-market stocks.

Some of the notable emerging-market changes and trends we have seen over the past five years include the following:

The BRICS (Brazil, Russia, India, China and South Africa) are no longer at the forefront of discussion involving emerging markets as Brazil, Russia and South Africa have all diminished. The weight of these three countries in the MSCI Emerging Markets Index was approximately 17% as of December 31, 2017, and they have all underperformed the Index for the past five years. India and North Asia are currently more dominant. As of December 31, 2017, China was nearly 30% of the MSCI Emerging Markets Index. In June 2017, MSCI said that it would gradually add 222 China A-shares to the Emerging Markets Index.

Information technology (IT) has become the largest sector within the MSCI Emerging Markets Index with a weight of nearly 28% as of December 31, 2017. The IT sector has driven a large part of the Index’s returns over the past two years (approximately 37% of return has come from IT).

In parallel with IT becoming a significant part of the Index (28% compared to 24% for IT in the S&P 500® Index), natural resources have become a much less important part of the Emerging Markets Index. In fact, the Index’s IT weight has doubled since 2012, and the weight of natural resources has halved.

The rise of China’s internet names has been staggering. In U.S. dollar terms, Tencent now has a market capitalization of $493 billion, Alibaba’s market cap is $441 billion, and Baidu’s market cap is $64.5 billion.†† Two significant hardware underlay providers—Taiwan Semiconductor and Samsung—have market caps of $220 billion and $267 billion, in U.S. dollar terms, respectively.†† Alibaba was listed at the end of 2014, so it has only been a public company for three years.

We have mentioned trends above, so what has driven the turbulence in emerging-market stocks? If we characterize emerging markets over the past five years as moving sideways, then we see countries’ returns canceling each other out. Emerging markets have been like a multi-cylinder engine where only half the cylinders have been firing, although more recently this has improved. The markets of more commodity-linked countries such as Russia, Brazil and South Africa have not worked well. A lot of that can be attributed to an unfavorable political environment and poor financial conditions.

For countries like Turkey, returns in U.S. dollar terms have been poor and it is hard to see it quickly becoming structurally attractive. Since the coup attempt in 2016, Turkey’s market has underperformed the MSCI Emerging Markets Index by nearly 33 percentage points in U.S. dollar terms.

We see a transition occurring where investing in emerging markets is becoming more and more about stock and industry picking and less about GDP growth and less about which country. The economic environment for emerging markets is much more benign than it has been, as cyclical growth has been kicking in strongly from areas like industrial automation to banking.

So what’s next for emerging markets? The emerging-markets asset class, as measured by the MSCI SMID Cap Index in the chart below, has essentially been flat since 2011 and has really been in a trading range. The Index’s upward move since 2016 has been big and has taken it back to slightly above-average levels, but it still has not surpassed 2011 levels. In other words, as we mentioned earlier, investors have not been compensated for the risk they have taken. In considering what’s next and the fundamentals supporting the last two years, we see a likely continuation of the present trends (i.e., we expect the emerging-markets asset class to keep working. The asset class has lagged the performance of developed-market indexes, and so we believe it has room to push up further. In terms of listed companies, the emerging-markets asset class has continued to grow and broaden. We see this as a structural positive.

EM SMID

The global-growth outlook appears even stronger this month than last as the widespread cyclical recovery continues to gather steam.

Emerging markets continued to perform well based on optimism over growth and returning investment. From our vantage point as bottom-up investors, we like the strength we have been seeing as companies generally have been producing the earnings growth we expect. Emerging-market currencies appear to have stabilized and are more competitive. Current-account balances have improved for the majority of emerging markets, and stock valuations are still below their long-term averages.

Tighter global monetary policy could increase volatility, but overall, we’re excited about the future of emerging markets and have a positive view of their expanding role in the global economy.

We have had a busy travel schedule in the past year. We firmly believe that our in-depth, in-country due diligence is an important focus for helping you achieve your investment objectives. We have another busy travel year planned for 2018.

Thank you for the opportunity to manage your assets.

Sincerely,

Roger Edgley, Andrey Kutuzov and Scott Thomas

 

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 December 31, 2017, the Wasatch Emerging Markets Small Cap Fund was not invested in Tesla, Inc., Tencent Holdings Ltd., Alibaba Group Holding Ltd., Baidu, Inc., Taiwan Semiconductor Manufacturing Co. Ltd. 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.

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 MSCI Emerging Markets SMID Cap Index captures mid and small cap representation across 24 emerging market countries. With 2,210 constituents, the index covers approximately 29% of the free float-adjusted market capitalization in each country. You cannot invest directly in this or any index.

The MSCI World Index captures large and mid cap representation across 23 developed market countries. With 1,653 constituents, the index covers approximately 85% of the free float-adjusted market capitalization in each country. You cannot invest directly 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 directly in this or any index.

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.

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

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CFA® is a trademark owned by CFA Institute.