The Wasatch World Innovators Fund returned 0.64% in the first quarter. The Fund’s benchmark, the MSCI All Country World Investable Market Index, was up somewhat more at 1.33%. Given the volatility in the markets, this short-term underperformance is not very meaningful. Over the longer term, the Fund has outperformed the benchmark for one year, three years, five years, 10 years and since the Fund’s inception.
As portfolio managers, we seek out market inefficiencies—situations in which we perceive that a company’s price tag offers a discount to its true value. We don’t get every investment right, but we think we have a decent batting average, which is reflected in our track record. That said, the stock market is volatile and can misprice a company for weeks, months or even years. As a result, we don’t expect to time our investments perfectly or beat the market every quarter.
Because the market is so noisy in the short term, we look beyond stock prices to see how our companies are performing on a fundamental basis. The weighted-average sales growth of our companies was 20% this quarter, a slight increase from the 19% recorded last quarter, and well above the 5% or so growth of the average company. This means that, as a group, our companies are continuing to reflect their innovator status by rapidly taking market share. Our companies’ weighted-average return on assets (ROA)† and return on equity (ROE)†† were 10% and 23%, respectively. These metrics are meaningfully ahead of those for the benchmark, and are clear manifestations of outstanding business models. Profitability growth this quarter was strong as well; our companies registered weighted-average EBITDA (earnings before interest, taxes, depreciation and amortization) growth of 16%, just off the 17% pace from last quarter.
In general we’d like to see our companies grow profits faster than sales, and in the long run that’s what a more mature innovator does. However, we have a portfolio comprised of both mature innovators and emerging innovators. The latter group tends to include companies early in their life cycles. These emerging innovators prioritize long-term leadership in a category over short-term profits. In some cases, the stock market has a hard time putting the correct price tag on companies investing for the long term, giving active investors like us the chance to buy these businesses at attractive prices.
The best way to understand our investment strategy is to look at the many examples of mature innovators that we currently own. These mature innovators include the Priceline Group, Inc. (PCLN), Amazon.com, Inc. (AMZN) and Google, Inc. (GOOG), with respective market caps of $60 billion, $150 billion and $370 billion. All three of these companies went through phases in which long-term growth and leadership were prioritized over short-term profits. To put it bluntly, these companies lost piles of money during large portions of their history. But in the long run, a great deal of value has been created. We hope that some of our smaller emerging innovators will go on to become leaders that revolutionize their industries and create billions of dollars in shareholder wealth.
Details of the Quarter
Myriad Genetics, Inc. (MYGN) was our largest contributor to performance for the first quarter. The company bounced back from overdone concerns regarding a lower reimbursement rate for the company’s BRCA breast-cancer test. We took advantage of the strong stock-price increase and sold our position. We’ll reevaluate the company once the dust settles.
An additional contributor to performance was Groupe FNAC, which is a French company that sells a wide range of books, music, consumer electronics, appliances and travel services. The company’s stock was up over 50% during the quarter, largely based on a dramatic improvement in operating income, net income and free cash flow. With the stock’s price increase, we took the opportunity to trim our position in Groupe FNAC, which we now consider to be less attractively valued.
On the other side of the ledger, Herbalife Ltd. (HLF) was our largest detractor from performance due to Bill Ackman’s continuing efforts to bring the company down. He did succeed in creating some political pressure on the Federal Trade Commission (FTC) to open an inquiry. On price weakness, we added to our Herbalife position as we believe the FTC inquiry will not uncover any wrongdoing because Herbalife operates under long-established safe-harbor rules for multilevel-marketing companies.
Abcam plc (United Kingdom) also suffered a meaningful decline and hurt our performance for the quarter. While we were unable to pinpoint the cause, we have sufficient confidence in the company and its business model that we added to our position.
A few other stocks had similar-size negative impact on performance for the quarter: The decline of SodaStream International Ltd. (Israel) was driven by a hiccup in the supply chain of this rapidly growing soft-drink company. The hiccup led to weak earnings and a weak outlook. The drop in Ocwen Financial Corp. (OCN) was the result of an unexpected delay in the receipt of mortgage-servicing contracts due to the inquiry of a politician looking to make a name for himself. The reality is that Ocwen Financial has a much more consumer-friendly servicing policy than the bank that was transferring the contracts. Finally, our position in no-frills Mexican air carrier Volaris Aviation Holding Co. (VLRS) suffered from the effects of a price war. (Current and future holdings are subject to risk.)
Now we come to the subject of stock valuations.‡ Clearly, world stock markets have been in a bull‡‡ mode for a long time now, about five years since the depths of the global financial crisis. The simplest, albeit imperfect, metric that reflects valuations is the price-to-earnings (P/E) ratio.§ For the Wasatch World Innovators Fund, the weighted-average P/E ratio is 26 based on 12-month trailing earnings. This compares to a weighted-average P/E ratio of 21 for the benchmark. Relative to historical levels, both of these P/E ratios are on the high side and give us reasons to be wary.
One important factor regarding the current bull market is that the range of P/E ratios investors are willing to pay seems to have broadened significantly. And certain segments of the market have extremely high P/E ratios. In many cases, investors are ignoring profits completely and have started to value companies based on sales. Some segments of the market are still valued at close to reasonable prices, which we often define as a PEG ratio of around 1.0. (The PEG ratio is computed by dividing a company’s P/E ratio by that company’s annual earnings-growth§§ rate. A lower PEG ratio often indicates a more reasonable valuation.) Other segments of the market—biotech, Software-as-a-Service (SaaS) and social networking, for example—are likely in bubble territory.
As of this writing, global markets have started to make some adjustments and many of the extremely expensive stocks have seen sharp price declines. Our game plan, as always, is to use common sense when it comes to the prices we are willing to pay for stocks, and so far most of our holdings have avoided the sharp declines.
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.
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 equity (ROE) measures a company’s efficiency at generating profits from shareholders’ equity.
‡Valuation is the process of determining the current worth of an asset or company.
‡‡Someone who is “bullish” or “a bull” is optimistic with regard to the stock market’s prospects. 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.
§The price-to-earnings (P/E) ratio is the price of a stock divided by its earnings per share.
§§Earnings growth is a measure of growth in a company’s net income over a specific period, often one year.