Last quarter, the Wasatch World Innovators Fund saw light at the end of the tunnel after what was mostly a disappointing 2014. We are happy to report that the Fund emerged from the long, dark tunnel and beat its benchmark during the quarter ended March 31, 2015. The return provided by the Fund in the March quarter was 2.93% versus a 2.58% return for the MSCI All Country World Investable Market Index (ACW IMI). We’d like to think this is the first step back onto the path of consistently beating the market with a concentrated portfolio of investments in high-quality companies that are taking market share in their industries. This strategy, which in spite of a couple of bad quarters in 2014, built the Fund’s average annual total return over the past five-year period of 13.84%, besting the benchmark by almost five percentage points per year (the ACW IMI was up 9.25% over that period). We often go out of our way in our quarterly Fund commentaries to call attention to longer-horizon results because we think our investors should look at how the Fund has done over the long run, instead of focusing on how much it beat the benchmark by this quarter or its slight underperformance last quarter. Admittedly, we do it for ourselves too, because it helps keep us grounded, especially after short runs of exceptionally good or bad performance.
Details of the Quarter
The key metrics we quote each quarter continue to suggest that the Fund is populated with companies that fit the World Innovators’ mission to find sustainable market-share winners with outstanding business models. At the end of the quarter, the Fund’s weighted-average sales and EBITDA (earnings before interest, taxes, depreciation and amortization) growth were 15% and 12%, respectively, versus the benchmark’s figures of 8% and 8%, respectively, and in a global economy growing closer to 2%. We interpret the higher growth rates that our companies have achieved to mean the companies are taking market share from competitors. Next, we track the return on assets (ROA)† of the portfolio, which in the first quarter came in at 12%, well above the benchmark average of 7%. We think better returns on investment suggest that our companies have above-average management teams and business models that place them in a virtuous circle: higher returns generated per dollar (or euro or yen) invested means more dollars to invest in growth initiatives; investments lead to faster sales growth and market-share gains at the expense of the competition, or in other words a bigger “piece of the pie” each year; the larger “piece of the pie” brings scale benefits such as purchasing power and better operational leverage on assets and overhead with the outcome being even higher returns on capital†† and more dollars to invest each and every year.
The final key metric we track, and the one we are currently the least pleased with, is the price-to-earnings (P/E) ratio.‡ As of quarter end, our portfolio traded at 28 times trailing 12-month earnings compared to 24 times for the benchmark. We think the premium we pay for the stocks we hold is normal given their higher growth rates and ROA, so that’s not the concern. What we don’t like is that one year ago the respective P/E ratios for the Fund and benchmark were 26 times and 21 times. Stock prices were above average compared to history last year and this year they are more above average. For this reason, we have nudged the portfolio in a more conservative direction, selling some fast-growing tech stocks like Twitter, Inc. (TWTR) and Ocado Group plc (United Kingdom) with market-darling price tags, and adding some of our favorite defensive growth companies that we believe are reasonably priced, a list we’ve been building up one stock at a time for decades. For example, during the quarter we added names like Computer Programs and Systems, Inc. (CPSI), a software developer for small hospitals; PriceSmart, Inc. (PSMT), the “Costco” of the Caribbean and Central America; and, yes, our old friend Apple, Inc. (AAPL). All of these companies are innovators and leaders taking market share from the competition, with far more cash stored up than debts owed on their books, and consistently high returns on capital invested.
Our largest positive contributor to performance for the quarter was Valeant Pharmaceuticals International, Inc. (VRX). The therapeutic drug developer is in the process of acquiring Salix Pharmaceuticals‡‡ and investors are excited about the deal given Valeant’s track record of adding new companies and products to its world-class distribution platform that have yielded consistently positive returns on prices paid for acquisitions.
We did have one big loser—Kroton Educacional S.A. The company was impacted by a change in government policy, which made government-financed education in Brazil less profitable. Unlike the U.S., Brazil relies on private education to fill the gaps in public education. However, the government is still the government and can change the rules at any time. (Current and future holdings are subject to risk.)
To paraphrase Herb Stein, “these high levels of returns can’t continue.” We don’t see an immediate cause for their non-continuation other than valuation.§ Stocks simply can’t keep going up and up without hitting some sort of rational limit. No matter how good a company is, it is only worth so much. However, history suggests that corrections don’t happen just because stocks are richly valued. It usually takes some sort of economic or political crisis to precipitate a market correction.
While the U.S. economy seems to be doing well, the strong dollar is apt to take a toll sooner or later. Europe is currently struggling as is Brazil and some parts of Asia. So while a specific economic crisis doesn’t appear at hand, one certainly can’t be ruled out.
On the political front, we have plenty of cause for concern. Greece is still an issue. Russia is still being aggressive. The Middle East and Africa are suffering various forms of chaos. Any of these conflicts could coalesce into a full-blown crisis.
Please don’t read this and walk away feeling gloomy. That’s certainly not the way we feel, especially because we believe in the growth potential of our innovative companies. But when stock prices are high, we are on heightened alert and strive to invest cautiously and we hope wisely.
As always, we appreciate the confidence you have shown in us and in Wasatch by allowing us to manage your hard-earned money.
Sam Stewart and Josh Stewart
**The MSCI AC World IMI (All Country World Investable Market Index) is a free float-adjusted market capitalization weighted index designed to measure the equity market performance of large, mid, and small cap companies across developed and emerging markets throughout the world. You cannot invest directly in this or any index.
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)
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The Wasatch World Innovators Fund’s investment objective is long-term growth of capital.
†Return on assets (ROA) measures a company’s profitability by showing how many dollars of earnings a company derives from each dollar of assets it controls.
††Return on capital is a measure of how effectively a company uses the money, owned or borrowed, that has been invested in its operations.
‡The price-to-earnings (P/E) ratio, also known as the P/E multiple, is the price of a stock divided by its earnings per share.
‡‡As of March 31, 2015, the Wasatch World Innovators Fund was not invested in Salix Pharmaceuticals, Ltd.
§Valuation is the process of determining the current worth of an asset or company.