Global equity markets remained volatile during the second quarter of 2015. Our benchmark, the MSCI All Country World Investable Market Index (ACW IMI), hit an all-time high in May, only to finish the year ended June 30 with a relatively flat return of 0.81%. While the market repeatedly bumped into a ceiling over that time frame, likely caused by historically rich valuations,† the Wasatch World Innovators Fund was able to stage somewhat of a comeback thanks to good stock-selection. The Fund finished the year with a 2.30% return, slightly outpacing the benchmark.
During the second quarter, the Fund was up 3.28%, which was a strong return relative to the benchmark’s 0.54%. Our Fund has beaten the benchmark for two quarters in a row, and we feel like it’s finally safe to say (with fingers crossed and wood knocked) that we’re back on track. The World Innovators strategy of building a relatively concentrated portfolio of companies we consider to be high-quality that are consistently taking market share has now delivered an average annual total return over the past five years of 16.17%, four percentage points better per year than the benchmark (the ACWI IMI was up 12.17% on an average annual basis).
Details of the Quarter
The simple key metrics we track at the portfolio level to ensure we stick to our mission of finding long-run, sustainable market-share winners at reasonable prices are mostly right where we want them. The glaring exception is the Fund’s price-to-earnings (P/E) ratio.†† At quarter-end, our stocks traded at 27 times trailing earnings versus the stocks in the benchmark at 23 times. To be clear, we don’t mind paying a premium relative to the benchmark’s average. In fact, we like to think that we own outstanding companies that will durably grow earnings faster than their peers, so they deserve premium multiples. As a result, the difference versus the benchmark is not the problem. Instead, we’re concerned about the absolute levels of valuation metrics at this point. It’s a small consolation, but both the Fund and the benchmark had slightly richer P/E ratios last quarter. And with the market’s sideways trajectory, this means earnings have at least started to catch up with prices.
As for our other key metrics, our portfolio companies grew sales 12% over the past year versus 7% for the benchmark. Our EBITDA (earnings before interest, taxes, depreciation and amortization) grew 5% versus 6%. And our return on assets (ROA)††† was 10% versus 7%. We’d prefer our EBITDA growth to outpace the benchmark, and when it doesn’t we have to be concerned that our market-share gainers are growing unsustainably. However, in this case, we think it comes down to a handful of portfolio companies facing tough comparisons from prior periods. In particular, the Japanese consumption-tax hike of April 2014 led to a spending binge that’s making year-on-year growth a lot tougher for our Japanese holdings. In the cases of Herbalife Ltd. and Nu Skin Enterprises, Inc., regulatory actions have caused what we see as a temporary decline in profits. Most importantly, we like the valuations of these companies, both of which we believe are at low risk of having insufficient capital to fund the maintenance and growth of their businesses.
At the company level, we had a decent quarter with one significant contributor and no significant detractors, a result we’ll gladly take. The one big contributor was Abcam plc (United Kingdom), a stock we’ve held since we began managing the Fund. The stock continued to rise and recover from its sell-off last year. Abcam is like the Amazon.com‡ for antibodies and other consumables used by life science research labs around the world. Abcam has consistently grown sales at double-digit rates. In 2014, however, after a year of British pound strengthening, the company—which is based in Cambridge, England—reported the first single-digit annual sales growth in its history, mostly due to currency-translation effects. As other investors sold on disappointment over growth that was down from double digits, we rightly chose to add to our position, focusing on the business quality and ability to gain market share over the long run. (Current and future holdings are subject to risk.)
We’ve just seen a year of market volatility leading to a round trip in index prices. The simple conclusion to draw is that after approximately five years of bull-market‡‡ conditions, we’ve now entered a new territory—to give it a simple name, we’re in “risk-off”‡‡‡ territory. For stock-pickers running a relatively concentrated portfolio, this is nothing to fear because despite elevated P/E ratios, there are still inefficiently priced one-off opportunities for investors to exploit. Nonetheless, we take note of choppy markets, we gauge if market appetites have changed, and we look for ways to take advantage of the times.
We’re currently less interested in owning the fastest-growing companies and merger and acquisition (M&A) stories that are not self-funding their growth, even though there are some clear innovators to be found in that category. We believe the wisest opportunities in which to invest right now are the steady-eddy market-share gainers, the great brands and products that are chipping away at weaker competitors. In particular, we like companies with strong free cash flow to fund investments and impeccable balance sheets to weather rainy days. In fact, the majority of our companies have net cash balance sheets. And the Fund’s average net debt as a percentage of equity is 15% versus the benchmark’s 60%. We think these are businesses built to last!
Finally, we’re thankful for the opportunity to manage your savings and will do our best to protect and grow 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)
CFA® is a trademark owned by CFA Institute.
The Wasatch World Innovators 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 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.
†††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.
‡As of March 31, 2015, the Wasatch World Innovators Fund has 1.0% of its net assets invested in Amazon.com.
‡‡A bull market is defined as a prolonged period in which investment prices rise faster than their historical average. Bull markets can happen as the result of an economic recovery, an economic boom, or investor psychology.
‡‡‡“Risk-off” is when investors become more cautious and take money out of the market, not being willing to risk it, thus risk off.