The Wasatch International Growth Fund returned -1.37% in the fourth quarter of 2014, outperforming the -3.98% decline of the MSCI All Country (AC) World Ex-U.S.A. Small Cap Index. Many of the concerns that plagued global markets during the third quarter escalated as year-end approached. Russia was the poster child with the local index dropping 50% (in U.S. dollar terms) during the fourth quarter. The Fund is not exposed to Russia, though we are also concerned over second-order effects stemming from Russia. Europe’s problems continue, exasperated by Russia and Greece, creating a quagmire for companies doing business there. The fear of deflation casts a cloud on Europe’s recovery, muddled in part by uncertainties around the European Central Bank’s implementation of quantitative easing.†† We believe structural issues in Europe must be addressed before we see a durable and lasting recovery. Our approach to Europe has been 1) maintain an underweight position, 2) focus on companies with predictable and stable businesses, 3) emphasize companies that conduct business outside the region, 4) favor companies with improving fundamentals. While the latter has become increasingly difficult in these turbulent times, we still are uncovering gems.
Patrizia Immobilien AG is one such example and was introduced to the portfolio in the third quarter. Patrizia is transforming itself from a pure residential property owner in Germany to a Pan European real-estate manager. This transition will be mostly complete by 2016, resulting in a business model that is asset-light with largely recurring revenues. This change improves the quality, returns and cash flows of the company’s business. Patrizia is also operating a relatively unique business model, especially among publicly traded companies, and helps solve a problem for pension-fund clients in search of yield.
While continental Europe is cutting interest rates, the United Kingdom (U.K.) is poised to go the other way given that its economy is further along the path to recovery. One event that could weigh on U.K. stocks in 2015 is the general election scheduled for May. Support has been waning for the major political parties and there is increased support for smaller parties. This could create uncertainty with the threat for potential policy changes if the balance of power shifts. On the political front in Japan, Prime Minister Abe was re-elected, which should provide stability and enable Abe to implement his “third arrow” stimulus reforms. In Japan, we have been witnessing a gradual positive shift of corporate culture and we continue to find ample compelling investment opportunities in this market.
Politics played an even bigger role in emerging economies. A close election result in Brazil saw Dilma Rousseff re-elected to a second term as president, which was seen by investors as a market-unfriendly outcome. Brazil, a market in which we hold no investments, sold off -16% during the quarter. On the other side of the coin, we have witnessed the positive implications of elections. Earlier in 2014, India elected a new Prime Minister, Narendra Modi. This should pave the way for reforms and much-needed infrastructure and capital spending. India has been a strong-performing market this year, and our large overweight, nearly 5% for the Fund versus about 2% for the Index, has provided a boost to performance.
Details of the Quarter
With the exception of the energy sector, where the collapse in the price of oil sent energy stocks reeling indiscriminately, it was a good quarter for stock picking. Our top contributors came from a variety of sectors and countries from around the world. Amara Raja Batteries Ltd. is an Indian industrials company; Medy-Tox, Inc. is a South Korean pharmaceutical company; and Domino’s Pizza Group plc is a U.K.-based consumer-staples company. While at first glance these companies may seem very different, the one thing we believe they have in common is that they are high-quality, long-duration growth companies.
Amara Raja Batteries is the second-largest battery company in India with exposure to several vertical markets, such as telecommunications and automobiles. The company has managed to consistently grow by taking market share and by increasing sales to the aftermarket segment as India’s economy develops. Amara Raja has a 15-year relationship with U.S.-based Johnson Controls,‡ which supplies technology support and expertise. This gives Amara Raja Batteries a competitive advantage as it has developed a premium brand, which is especially helpful in the trade channel as it filters down to the consumer level and drives replacement volumes. Aftermarket sales constitute a higher-margin segment, further boosting profitability. The company should get an additional tailwind from the infrastructure and capital spending that we expect to occur in India in coming years.
Medy-Tox sells a product called Innotox, seen as an improved replacement for Botox. The treatment is mainly used for facial wrinkles, but the company is also marketing the product for body treatments and even medicinal purposes (for example, relaxing muscles after a stroke). The company signed a global distribution agreement with Allergan, while Medy-Tox retains distribution rights in Korea and Japan. One reason we like investing in companies in the health-care sector is that it’s very much a stock picker’s sector. South Korea was among the worst-performing markets in the fourth quarter, down nearly -9% according to the Index, yet Medy-Tox rallied strongly with a gain of over 36%. This is another example of a gem we discovered, completed our thorough due diligence, and then introduced to the portfolio in the third quarter.
Last quarter we highlighted Domino’s Pizza in Australia as a top contributor, and this quarter Domino’s Pizza U.K. made it onto the podium. Similar to its Australian counterpart, domestic sales have been strong with double digit like-for-like sales‡‡ growth along with improved efficiency thanks to technological innovation. One key difference between these two Domino’s businesses is that international sales have been weak for Domino’s Pizza U.K. The company owns the master franchise for Germany, which has proven more challenging than expected. The good news is that expectations for a turnaround in the business have been removed from the stock and we continue to believe the long-term opportunity is tremendous.
Not surprisingly, the list of the Fund’s worst performers was stacked with companies exposed to the energy sector. It is of little solace that our energy companies as a group were down less than the energy stocks in the Index. Our focus on quality businesses with solid balance sheets, strong cash flows and emphasis on recurring revenues provides not only a cushion during uncertain times, but also enables such companies to continually invest so they can be the leaders of the future.
ShawCor Ltd. (Canada) was one of the largest detractors during the fourth quarter. The company is the global leader in oil and gas pipe coating solutions (think anti-corrosion, flow protection) with more than 30% global market share in an otherwise fragmented industry. Scale matters in this business and there is a continual need to innovate and fund research and development, which enables ShawCor to win larger and more complex projects. Given the company’s market-leading position, we believe it will emerge from the energy downturn in an even stronger position.
We see Rotork plc as a high-quality industrials company. Rotork provides control automation to pipelines, refineries, power plants, wastewater plants, etc. Less than half of its business is exposed to the oil and gas industry and that is primarily in the form of maintenance revenues, leaving the company less exposed to capital-spending cycles. However, during price meltdowns, the market doesn’t differentiate and Rotork was a detractor for the quarter. Once the dust settles, we believe investors will once again realize that Rotork is a global market leader with a large growth opportunity backed by strong cash flows, high returns, and a conservative and capable management team. (Current and future holdings are subject to risk.)
We continue to be underweight in Europe and overweight in the Asia-Pacific region. The two biggest overweights in Asia are Japan and India. We believe both of these markets have a positive and improving investing environment, and our screening process continues to highlight many intriguing investment opportunities. We increased our weight in both of these markets during the fourth quarter.
As we enter 2015, we are faced with uncertainty and concerns regarding global markets. It will be a challenging year but it’s a challenge we relish. Our focus remains on a deep due diligence research process in an effort to gain a better understanding and provide perspective on our portfolio investments. During 2014, our international investment team traveled to 42 countries and our schedule for the first quarter of 2015 is full of travel.
Thank you for your support.
Roger Edgley and Linda Lasater
**The MSCI AC World Ex-U.S.A. Small Cap Index is an unmanaged index and includes reinvestment of all dividends of issuers located in countries throughout the world representing developed and emerging markets, excluding securities of U.S. issuers. This index is a free float-adjusted market capitalization index designed to measure the performance of small capitalization securities.
†The MSCI World Ex-U.S.A. Small Cap Index is a free float-adjusted market capitalization weighted index designed to measure the equity market performance of developed markets, excluding the United States.
You cannot invest in these or any indices.
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 International Growth 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.
‡As of December 31, 2014, the Wasatch International Growth Fund was not invested in Johnson Controls, Inc..
‡‡Like-for-like sales is a comparison of this year’s sales to last year’s sales for a company, taking into consideration only those activities that were in effect during both time periods. Like-for-like sales is a method of valuation that attempts to exclude any effects of expansion, acquisition or any other event that artificially enlarge a company’s sales.