The Wasatch World Innovators Fund returned 6.96% in the fourth quarter. The Fund’s benchmark, the MSCI All Country World Investable Market Index, was up a bit more at 7.25%. For the quarter, the Fund’s return was good but not remarkable. For the year, however, the Fund’s 33.70% gain surpassed the benchmark’s 23.55% gain by over 10 percentage points, which is outperformance fit for the record books.
We cannot help but be pleased with the results—and a little anxious about what lies ahead. Any time the “record books” are mentioned, it is wise to look out below. On the bright side, it is our opinion that the stock-price increases thus far have been justified to a significant extent. Global economic fundamentals provide more clarity and room for optimism today than they have in half a decade. The biggest difference is that all of the major global economies are finally seeing slow, but accelerating, growth. While growth rates are admittedly still on the low side, we think the rising trend is more important. Risks haven’t disappeared, of course. But again, we think “the trend is our friend.”
The central concern today is that excessive quantitative easing (QE)† is setting us up for the next disastrous bubble. The Fed, however, just announced the start of QE reduction. Moving on to the topic of valuation†† (which we believe is the most significant determinant of risk), we think there is understandably a general consensus that stocks are somewhat expensive. We agree that valuation multiples are a little high right now, just above long-term averages for most indices. However, as stock pickers—rather than as indexers—we still see ways to make money. Thankfully, our mandate to be global investors gives us a broad opportunity set to choose from. So while S&P 500††† valuation levels are somewhat above their long-term averages and Russell 2000‡ levels are well above theirs (excluding the era of the Internet bubble), French small caps, for example, are actually trading at healthy discounts to their long-term averages.
Details of the Quarter
Let’s start our look at the quarter with a few key metrics for the Fund versus its benchmark. Trailing 12-month median sales growth, earnings-per-share (EPS)‡‡ growth and return on assets (ROA)‡‡‡ for our companies were 14%, 16% and 9%, respectively. These compare to 6%, 6% and 5%, respectively, for the benchmark. While the Fund’s metrics were above those for the benchmark, the Fund’s metrics were below our three-year averages, which had been in the high teens. We believe this is a function of seeking out better valuations as some sub-sectors of U.S. stocks had a bout of irrational exuberance in 2013. For example, fast-growing Internet companies such as Zillow, LinkedIn and Facebook§—names owned by the Fund in the past—are all clearly overpriced today in our opinion. Many of the better-valued replacements we found are in slower-growth industries. What has not changed is that we are still buying “world innovators,” which we define as companies taking significant market share from the competition over long periods of time. This is why the Fund’s growth metrics are more than two times the benchmark’s and the Fund’s ROA is almost double.
We are systematically overweight in both information-technology and health-care companies, as both sectors abound with innovative companies. Further, most information-technology companies and a great many health-care companies sell into the global marketplace. This gives us the opportunity for the multiple eyes vetting that helps us find innovators that are likely to maintain and grow their market shares. Our information-technology and health-care companies recorded positive returns for the quarter. Relative to similar companies held by the MSCI benchmark, our information-technology companies outperformed and our health-care companies underperformed. Financials was another sector that made a positive contribution for the quarter. The financials sector is a useful counterweight in the Fund because—barring an overall market event—returns from financials are often relatively uncorrelated with the returns from both information technology and health care.
Sector results were broadly similar for the year, with major contributions from the Fund’s overweighted information-technology and health-care holdings. It is worth noting that the consumer discretionary sector was also a strong contributor for the year based on the strength of two Internet retailers. ASOS plc is based in the United Kingdom, but has penetrated markets in the U.S. and Europe, and is heading to China. Start Today Co. Ltd. is based in Japan, the home of a great deal of trendy fashion. Both of these retailers target youth markets, where fashion tastes change quickly. Among our consumer-staples holdings, the largest annual return came from Herbalife Ltd., which benefited from the counter evidence that cast doubt on the charges made against the company by short-seller Bill Ackman.
The Fund’s strong performance for the fourth quarter was mostly an across-the-board phenomenon benefiting from the strength of the market. The biggest contributors to performance for the quarter were Google, Inc., Amazon.com, Inc. and Apple, Inc., all large weights that were up more than the market without any significant news to report. We have modestly trimmed our positions in these companies, but overall we continue to like this group of tech “oldies but goodies.” We think their super-strong brands will enable higher growth rates for longer than most investors expect, thus justifying higher stock prices.
Our worst investment for the fourth quarter was InnerWorkings, Inc. The company reported another weak quarter and achieved the dubious honor of being our first company to downgrade earnings guidance three times in a single year. InnerWorkings has been a controversial stock at Wasatch and in the markets. Management tells a very interesting story of transforming the print industry using technology. Sales have grown, so it looks like the company is making rapid market-share gains. However, InnerWorkings has been in business long enough that, if the operating model were truly effective, the company should be reporting profits and cash flow by now. With the company’s status as a “world innovator” in serious question, we decided to take our loss and move on.
We also suffered a loss in our investment in Bio-Reference Laboratories, Inc. Contrary to InnerWorkings, we don’t doubt the strength of Bio-Reference Laboratories’ operating model and the company continues to execute and take market share admirably. However, uncertainties caused by the implementation of the Affordable Care Act (ObamaCare)§§ seem to be slowing expenditures on health care in the U.S. We reduced our weight in Bio-Reference Laboratories because we think uncertainty could persist for a while longer. However, it is possible that we will revisit the company in the future.
Given the exceptionally strong stock-market advances we’ve seen over the past five years, our outlook is incrementally more cautious. Although improving global economies may provide a boost for companies in the years ahead, some of the stock-market gains that have already occurred have been driven by expansion in price-to-earnings multiples.§§§ In other words, investors have been willing to pay more for a stream of earnings. We believe this could set the stage for increased volatility in stock prices—a divergence from the steady gains the market has delivered in recent years.
Our response to higher risks is to do what we have always done: invest in solid, innovative companies that we think have significant long-term growth potential. In this sense, we welcome increased volatility if it allows us to buy shares of such companies at more attractive prices. We believe this steady approach should continue to support Fund performance over time, even if the broader market environment becomes less favorable.
Thank you for the opportunity to manage your assets.
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.
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The Wasatch World Innovators Fund’s investment objective is long-term growth of capital.
†Quantitative easing is a government monetary policy used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity.
††Valuation is the process of determining the current worth of an asset or company.
†††The S&P 500 Index includes 500 of the United States’ largest stocks from a broad variety of industries. The Index is unmanaged but is a commonly used measure of common stock total return performance.
‡The Russell 2000 Index is an unmanaged total return index of the smallest 2,000 companies in the Russell 3000 Index, as ranked by total market capitalization. The Russell 2000 is widely used in the industry to measure the performance of small company stocks.
‡‡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.
‡‡‡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, 2013, the Wasatch World Innovators Fund was not invested in Zillow, Inc., LinkedIn Corp. or Facebook, Inc.
§§The Patient Protection and Affordable Care Act (PPACA), commonly called the Affordable Care Act (ACA) or “ObamaCare,” is a United States federal statute signed into law by President Barack Obama on March 23, 2010.
§§§The price-to-earnings or P/E ratio is the price of a stock divided by its earnings per share.