Finally, the Wasatch World Innovators Fund saw some light at the end of the dark tunnel we traveled through for most of 2014. During the fourth quarter, the Fund generated a 0.32% return—just short of the 0.59% return for the benchmark MSCI All Country World Investable Market Index. Throughout most of the year, we were well behind the benchmark, as reflected by the Fund’s -3.68% loss in contrast to the benchmark’s 3.84% gain. The year’s results have certainly put a blemish on the Fund’s long-run track record of success. Still, the Fund’s five-year performance and 10-year performance remain in the top decile. We assure you that we have made no significant changes to the investment process that helped us do so well for so long for our shareholders. It is our full intention to produce future results that are as beneficial to our shareholders as our historical results have been.
Every year, we tend to have several large winners that more than offset the drag of the few large losers that we own. We tend to have both large winners and losers due to the large position sizes we hold in our relatively concentrated portfolio. In 2013, for example, 13 stocks each contributed one percentage point or more to our results. That year was unique because we didn’t have a single stock that cost us as much as one percentage point in performance. For 2012, the tally was seven winners to offset the single loser. In 2014, we didn’t have a single winner that contributed more than one percentage point to our results, while we had four large losers—each of which cost us more than one percentage point. Our style of holding concentrated weights in only a small number of our favorite companies hurt us in 2014 because we chose several stocks that turned out to be losers.
While not offering an excuse for our weak performance (no one twisted our arm and demanded that we buy the stocks that struggled), we think that a possible explanation of the dearth of winners was the relatively mature stage of the bull market.† In the initial stages of a bull market, nearly every stock is undervalued. No matter what stocks we own, our portfolio is likely to gain in value. As stocks rise in a bull market, their progress is aided by investors ferreting out pockets of value that haven’t yet been fully appreciated. At the conclusion of a bull market, virtually every stock is overvalued. In 2014, we were certainly nearer the end of the bull market—even if the end lies years into the future—than we were in 2012 or 2013. It was harder to find undervalued stocks in 2014, hence the absence of winners.
Further, as the bull market advances and pockets of value become harder and harder to find, the tendency of investors (us included) is to look for value in companies that present a higher degree of difficulty. The business models of these companies are often complex or controversial. Their stocks offer the antithesis of the easy pickings found in the early stages of a bull market. Value should lead to increased stock prices if these “high degree of difficulty” companies can execute well. During 2014, unfortunately, all of our high degree of difficulty companies fell flat on their faces.
For both the quarter and the year, the Fund’s results were dominated by underperformance in relatively large holdings—the high degree of difficulty companies just mentioned. As we discussed last quarter, our relative concentration in a small group of stocks can lead to performance variation from the benchmark. For this reason, we want to hold ourselves accountable for the performance of the companies we own, rather than for the relative performance of the stocks we own. Using the benchmark of company performance, we fell short for both the quarter and the year. Simply put, we made some mistakes that cost us dearly.
That said, we are not going to change our stripes by reducing our position sizes and upping the number of stocks in our portfolio. We remain focused on picking our companies one at a time, while not making calls on sectors, economies or currencies. And right now, we are excited about the portfolio. Versus the previous year, sales growth for our portfolio companies during the quarter was a brisk 19%, compared to 7% for the MSCI All Country World Investable Market Index and compared to the 4% annualized U.S. gross domestic product growth rate. Profitability at our companies is better as well, with an EBITDA (earnings before interest, taxes, depreciation and amortization) growth rate of 17%, which exceeded the 11% registered by benchmark. Last, but not least, the returns on capital of our portfolio followed the same pattern with an average ROA†† of 11%, which was higher than the benchmark average of 7%. We believe that some of our companies will have periods in which sales growth outpaces profit growth due to their investing ahead of future opportunities. We are comfortable with this phenomenon given the consistently higher returns on capital our companies achieve, which suggests they manage to grow faster while at the same time investing capital more effectively than the average company. So in short, we are optimistic about the future for our team of portfolio holdings.
Details of the Quarter and Year
We did have a couple of stocks pay off for us in the quarter and make it into the winners’ column, which for a quarter we define as a contribution of at least half a percentage point (we define our quarterly losers as detractors of half a percentage point or more). Mekonomen AB (Sweden) was our strongest contributor during the quarter. It was nice to see our thesis on Mekonomen finally start to play out, as we have held the company for more than three years while the stock went either sideways or, more recently, down. Mekonomen is a Scandinavian auto-parts producer, distributor and retailer with associated repair shops. In an attempt to consolidate a fragmented market, Mekonomen has acquired several related businesses. In the United States, AutoZone and O’Reilly Automotive have demonstrated the success of the consolidation strategy that Mekonomen is pursuing in Scandinavia.††† As AutoZone and O’Reilly grew, their increased purchasing power led to improved margins and growing earnings, which paid off in substantially higher stock prices. Many investors had given up on Mekonomen as it was slow to cut overlapping costs. During the summer, Mekonomen’s stock got very inexpensive, offering an 8% free cash flow yield with a 5% dividend yield.‡ Finally, Mekonomen’s gross profit margin began to rise consistently as the company’s increased purchasing power led to lower costs, which in turn helped the company sell more private-label products. Mekonomen also improved margins by closing several underperforming stores. Together, these measures helped earnings per share‡‡ to grow, which sparked a rally in Mekonomen’s stock price.
Another strong performer in the fourth quarter was Abcam plc (United Kingdom). Unlike Mekonomen, Abcam’s business has maintained a positive trajectory. However, when Abcam announced earlier in 2014 that its founder was retiring, investors became concerned about the transition to a new management team given how successful the founder had been in growing the company. After performing substantial due diligence, including background checks on the new management, we grew comfortable enough to increase our position. As other investors reached a similar conclusion, the stock price rose steadily.
Foremost among our mistakes in 2014 was our response to news regarding Ocwen Financial Corp. (OCN), which had been a significant Fund holding. In February, Benjamin Lawsky, New York State’s Superintendent of Financial Services, halted the sale of home-loan servicing from Wells Fargo to Ocwen. As Lawsky had already acquired the reputation of a “hanging judge,” the prudent move would have been to trim our Ocwen position, possibly even selling it entirely. However, at that time, we made the assessment that the one-third decline in Ocwen’s price fully reflected the impact of the potential remedy Lawsky would impose. So instead of trimming, we added to our position. We did this as we believed that the halt of the Wells Fargo/Ocwen transaction would be temporary and that banks would continue to sell their servicing of problematic loans to specialty operators like Ocwen who were better-positioned to deal with such loans.
When Lawsky finally announced the draconian penalty he was imposing on Ocwen, the announcement drove the stock down to the $15 level, a more than 50% additional decline from its February level. While it may turn out to be that we slammed the door after the horse was already out of the barn, we finally sold our Ocwen position because we were concerned that the penalty could ultimately put Ocwen out of business.
During the quarter, in addition to Ocwen being a significant detractor, we suffered an even bigger impact from the decline in the stock price of Altisource Portfolio Solutions S.A. (ASPS), a sister company to Ocwen. When a homeowner is unable or unwilling to make mortgage payments, Ocwen outsources much of the work required to deal with the situation. Altisource provides all of the services needed to repossess a home and then to repair and maintain the home until a buyer is found. Investors fear that impairment in Ocwen’s business will lead to a diminishing supply of work for Altisource. While that is likely true, we continue to hold Altisource as we believe that to the extent banks are forced to deal with their problematic loans rather than sell them, the banks will look to outsource much of the heavy lifting these loans require to firms like Altisource.
In the absence of the loss from Altisource, we would have enjoyed more than a 2% return for the quarter, which would have handily beaten the benchmark. Similarly, we would have enjoyed a positive year slightly ahead of the benchmark without the combined losses of Ocwen, Altisource, ASOS plc (United Kingdom) and Herbalife Ltd. (HLF). The primary lesson of 2014 has been to be even more wary of high degree of difficulty stocks that have complex or controversial business models. (Current and future holdings are subject to risk.)
Based on strong recent reports, we are somewhat more comfortable with the economic outlook for the U.S. We continue to be cautious about the global economy, given continuing problems in Europe and Japan and slowing growth in China. We do think that, on balance, lower oil prices will provide a boost for the global economy. As our allocation to the U.S. was about 60% of Fund assets as of December 31, 2014, we are somewhat cautious about the multi-year run in U.S. stocks, which has stretched valuations.‡‡‡ That said, we remain stock-pickers in search of innovative companies that are not fully appreciated by the market.
As always, we appreciate the trust you have placed in us by allowing us to manage a portion of your assets. We promise you that we will treat your money as though it were our money. And you should know that we do have significant amounts of our own assets invested alongside yours.
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.
†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.
††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 December 31, 2014, the Wasatch World Innovators Fund was not invested in AutoZone, Inc. or O’Reilly Automotive, Inc.
‡Dividend yield is a company’s annual dividend payments divided by its market capitalization, or the dividend per share divided by the price per share. For example, a company whose stock sells for $30 per share that pays an annual dividend of $3 per share has a dividend yield of 10%.
‡‡Earnings per share or EPS is the portion of a company’s profit allocated to each outstanding share of common stock. EPS growth rates help investors identify companies that are increasing or decreasing in profitability.
‡‡‡Valuation is the process of determining the current worth of an asset or company.