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

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Q1 2014
Geopolitical Turmoil in Ukraine Weighs on Fund’s Russian Holdings
by Roger Edgley, CFA, Laura Geritz, CFA and Andrey Kutuzov, CFA

“Overall, conditions for the companies held by the Fund remain benign.”

Emerging Markets Small Cap
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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 unstable currencies, highly volatile securities markets and political and social instability, which are described in more detail in the prospectus.

For the period ended March 31, 2014, the average annual total returns of the Wasatch Emerging Markets Small Cap Fund for the one-, five- and since inception periods were -10.64%, 26.47%, and 4.50%, and the returns for the MSCI Emerging Markets Small Cap Index were 0.40%, 19.70%, and 0.65%.  Expense ratio: Gross 2.13% / Net 1.95%.

Recent stock market performance has caused atypical short-term returns for some asset classes,which may not continue in the future. Fund performance may be subject to substantial short-term changes due to market volatility.

 

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 or taxes, which if reflected, would reduce the performance quoted. 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 Emerging Markets Small Cap Fund returned -3.02% for the first quarter and underperformed the MSCI Emerging Markets Small Cap Index, which returned 3.54%. Performance in emerging market equities was volatile during the quarter, with a sharp decline in January followed by a bounce back in February and choppy trading during March. The negative sentiment surrounding emerging markets seems to be settling, but we may see volatility continue for some months given continued perceptual risk, especially when there are flare-ups like the geopolitical turmoil in Ukraine. The flow of U.S. economic data in key areas such as retail sales and housing was disappointing for much of the period, although some of the weakness was attributed to extreme weather conditions. In late January into the first part of February, stocks slid as weak U.S. data raised concerns over the ability of emerging market economies to withstand higher U.S. interest rates on top of softer demand from China. However, stocks spent most of February climbing back. The rebound occurred as some key indicators stabilized and investors began to feel comfortable that U.S. Federal Reserve policy support would be removed gradually and with regard for incoming data. Entering March, geopolitics moved to the forefront, as tensions between Russia and Ukraine rose sharply, culminating in Russia’s annexation of Crimea. Stocks were volatile but mostly traded within a band throughout March, as investors kept a wary eye on the Ukraine crisis while waiting to see if spring would indeed bring an improvement in economic releases.

Details of the Quarter

The Fund’s investments in Russia detracted from absolute and relative performance. Russia’s actions in response to the crisis in Ukraine have had severe short-term negative impact on the Russian stock market and Russia’s currency, the ruble. We believe much of this could normalize over the medium term. However, the long-term effects are likely to compound the structural problems in the Russian economy thus leading to continuing deceleration in economic growth and structural currency weakness. The performance of the Fund’s Russian holdings reflected the challenging macro environment. TCS Group Holding plc, Russia’s leading provider of online retail financial services, M Video OJSC, Russia’s largest electronic retail chain, O’Key Group S.A., a fast growing food retailer, MD Medical Group Investments plc, the leading provider of pre-natal health care, and Global Ports Investments plc, a leading regional container port operator, were all down in March and detracted from performance for the quarter.

While hopes of stimulus measures to support China’s economy emerged toward the end of the quarter, the Fund’s Chinese stocks were generally down. The Fund continues to be structurally underweight in China and we continue to be highly selective of Chinese companies, as we believe there are real long-term issues that will be difficult to address. We are positioned defensively here. Sino Biopharmaceutical Ltd. was up over 17% last quarter and was one of the Fund’s top 10 contributors, but gave back some of that performance in the first quarter. Biostime International Holdings Ltd., a pediatric nutrition and baby care products provider, and Sa Sa International Holdings Ltd., the largest specialty cosmetics retailer in Hong Kong with a strong regional presence (Hong Kong, China, Macau, Taiwan, Malaysia), were among the Fund’s largest detractors from performance in the first quarter. A sizable driver of Sa Sa’s sales is Chinese tourists visiting Hong Kong. Chinese tourism to Hong Kong decelerated driven by changes to a tourism law in China. (These kinds of one-off disruptions to the market are common in China.) This deceleration resulted in slower top-line growth and margin pressure for Sa Sa. However, we believe that Sa Sa has a strong brand and that Chinese consumer spending on cosmetics is on a long-term growth trajectory so we believe the company’s performance will normalize.

Student protests in Taiwan continued to delay the passing of a trade pact with China and our Taiwanese stocks were generally weak. The Fund is structurally underweight versus the benchmark in Taiwan at nearly 16% versus the benchmark at approximately 21%. Several of the Fund’s holdings provided solid performance during the quarter, including Airtac International Group, a pneumatic equipment company with substantial business in China. Other stocks were down, including St. Shine Optical Co. Ltd., a contact lens manufacturer.

The Fund’s holdings in India also detracted from absolute and relative performance. The Fund is structurally overweight in India as we are constructive on the Indian market in general and on our holdings in particular. In India, we have been able to find what we believe are high quality companies with strong corporate governance that fit our investment profile broadly across sectors. Many of our holdings performed well in the first quarter, including Pidilite Industries Ltd., an adhesive manufacturer, and Bata India Ltd., the largest formal shoe retailer in the country. On the downside, Jubilant Foodworks Ltd., Bayer CropScience Ltd., and Mahindra & Mahindra Financial Services Ltd. detracted from performance. Mahindra is a vehicle financier focused on the rural economy of India. The stock outperformed significantly in 2013 relative to other financials in India as the ability to pass on a spike in funding costs and continue to grow in rural areas supported results. We trimmed our weight due to rich valuation†† levels several months ago, however, the stock has been weak as there were questions surrounding the asset quality in some of the Southern Indian states. Some of these concerns appear to be a matter of timing (collection of payments) and we continue to be constructive on the company’s long-term growth prospects. Valuation is also now at more reasonable levels.

The Fund’s holdings in Korea significantly outperformed, up approximately 15% versus the benchmark, which was up about 5%. The Fund is underweight in Korea but given the outperformance still contributed nicely to relative performance. We see real opportunities in small cap companies in Korea and have been adding to the Fund’s weight. Some of the attractive main themes we see are in tourism, the Internet and technology companies. We are also seeing the emergence of entrepreneurial, founder-owned, non-chaebol, next-generation companies that have know-how and technology. Korea has a highly educated population and we are seeing companies with returning PhD founders. Hotel Shilla Co. Ltd., a hotel and leisure company, was the portfolio’s top contributor, as the stock rose over 27% during the quarter. Paradise Co. Ltd., a gaming company, and Hanssem Co. Ltd., a manufacturer of kitchen and bath cabinetry, were also among the Fund’s top 10 contributors for the quarter.

Brazil was another market where the Fund’s companies outperformed nicely. CETIP S.A., a securities clearinghouse, and Qualicorp S.A., a Brazilian health care provider, both generated positive performance during the quarter. (Current and future holdings are subject to risk.)

Outlook

One of the trends we are seeing unfold is increasing geopolitical risk globally. The impact is going to be felt throughout the world, whether in developed, emerging or frontier markets as rising geopolitical agitation tends to lead to slowing economic growth and rising risk premiums across the globe. While we are not, nor do we claim to be, experts on geopolitics, we are certainly cognizant of the impact conflict, real or perceived, could have on our companies. We are usually very careful about where we invest and the geopolitical flare-up between Russia and Ukraine caught us by surprise.

Our aforementioned investments in Russia illustrate this point. Using our bottom-up screening process, we have found what we believe are strong companies that are generating excellent returns on capital‡‡ through innovative approaches to their markets, paying generous dividends and looking confidently into the future. These are the kinds of companies we have a history of investing in. However, at some point even the best companies can become difficult investments when they must contend with a consistently depreciating currency on the back of a slowing macroeconomic environment. When the Russian economy slowed to near-zero growth in 2013, we began to see diminishing pricing power among our companies as they struggled to offset cost inflation—a typical sign of an economy beginning to face challenges. We have adjusted our positions accordingly, reducing our weight in these Russian names as we see an increasingly hard road ahead for even world-class companies in such a challenging macro environment.

The other important differentiation we are starting to see in the context of heightening geopolitical awareness is the depth of individual stock markets, defined as the percentage of the local market owned by local investors. This is important because local investors—comprised of local pension funds, mutual funds and individual investors—are the logical “owners of last resort” for home country equities when foreign capital starts running out of the door. When foreigners sell, we want to see local pension funds with long-term horizons step in. We are cognizant of markets with strong local pension fund communities as these markets tend to have lower beta,§ which has been quite helpful in eras of global turbulence. Some great examples are Poland, Malaysia and Chile where strong pension laws have led to high local ownership of equities. Russia unfortunately has not developed such a structure, and since trading shares on the Russian stock exchange became operational just under 20 years ago, foreign investors still dominate ownership of Russian shares. This drives excessive volatility, and as we observed during the first quarter, headline-driven foreign selling did not meet local strategic buyers, thus creating a lot of downside because there is no natural offset to selling pressures. So while we pick what we think are world’s best companies, the issues surrounding these companies from the economic environment to the market composition can have a strong impact on how our investments perform.

Overall, conditions for the companies held by the Fund remain benign. While emerging world growth is slowing, compounded by increasing cost of capital as central banks in emerging markets hike interest rates to offset currency weakness, our companies generally have been able to maintain rock-solid balance sheets and industry-leading margins. It has been during difficult times that we have seen our companies really solidify their lead over their competition. While in good times the rising tide lifts all boats, in times like these our companies have been able to gain market share and continue to invest in products and innovation, even as the competition pulls back—thereby laying the foundation for the next up-cycle. At some point interest rates in the emerging world will peak, China’s economy will stop slowing, election cycles will come to pass, and growth will re-accelerate once again. We look forward to that time, believing that our companies will be well-positioned to take advantage of the new up-cycle in stronger form.

Thank you for your trust and the opportunity to manage your assets.

Sincerely,

Roger Edgley, Laura Geritz and Andrey Kutuzov

 

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

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 indices. 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.

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

The word “chaebol” means “business family” or “monopoly” in Korean. The chaebol structure can encompass a single large company or several groups of companies. Each chaebol is owned, controlled or managed by the same family dynasty, generally that of the group’s founder.

‡‡Return on capital is a measure of how effectively a company uses the money, owned or borrowed, that has been invested in its operations.

§Beta is a quantitative measure of the volatility of a given stock relative to the overall market. A beta above one is more volatile than the overall market, while a beta below one is less volatile.

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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