The Wasatch International Opportunities Fund gained 4.31% in the fourth quarter and slightly underperformed its benchmark, the MSCI AC World Ex-U.S.A. Small Cap Index, which gained 4.63%.
It felt like an awful year for the micro cap asset class. We faced several headwinds that in the past we’ve been able to ward off by stock selection. This year we were not able to overcome those macro forces. Micro caps had a tough year in the international arena while in the U.S., micro caps enjoyed strong tailwinds as investors seeking higher returns jumped into the stocks of the smallest companies. In addition, the Fund has traditionally been overweight in emerging markets, which struggled this year. In the fourth quarter, the continuation of these market trends—the underperformance of micro caps and emerging markets—had the biggest impact on the Fund’s performance relative to the Index.
The Fund ended the year up nicely with a positive return of 19.33%, but trailed the Index, which was up 19.73%. We had spectacular stock selection this year, but our underweight in developed markets hurt relative performance. If you slice the world into developed and emerging markets, our developed market picks (up 40.4%) outperformed their Index peers (up 25.4%) and our emerging market stocks returned 9.4% compared to a 1.1% return for emerging market stocks in the Index. However, our big underweight in developed markets (44% versus 79%) cost us close to two percentage points of relative performance, while our overweight in emerging markets (52% versus 20%) cost us roughly 5.5%. We think our stock picking was very good. Our allocation hurt.
Details of the Quarter
Portfolio management is a lot like F. Scott Fitzgerald’s short story “The Curious Case of Benjamin Button.” We start each year feeling old and wizened—a kind of rebirth with the lessons acquired from the previous year. The year ticks down, and whatever knowledge and maturity we started the year with is quickly unraveled by the peculiarities of each tick of the market. We are left at the end of the year recounting the year from end to beginning—backward—and wondering what we would have done differently—wishing at times we could freeze the hands of the clock. Then, a new year starts, giving us another shot at improving on the past.
So we ask ourselves: What would we change now or could have changed last year? The answer depends on whether we’re thinking about the past year or about the long-term returns of the Fund. Markets were up a lot last year. The Fund kept up but didn’t outperform. This tended to be a common thread across many Wasatch funds in 2013. Our focus on quality and stability tends to lead our portfolios to outperform in down markets and underperform in up markets. This was tested during the second quarter when markets contracted, and we had a very good quarter relative to our benchmark. Wasatch Advisors’ Chairman Sam Stewart has some concerns about valuations††† in the U.S. While he thinks that U.S. economic growth looks promising, the domestic equity markets might be ahead of themselves. While valuations are not stretched in the international arena, our markets historically have not escaped when the U.S. markets experience a correction. We deliberately structure the Fund to try to mitigate the detrimental impact of a correction, while still delivering a portfolio with great long-term growth prospects at a reasonable valuation.
Looking at the past year—we would have benefited from a tilt away from the emerging world. However, when looking at global demographics, potential productivity gains, and growth, and marrying that with valuation, the emerging world still looks very good to us as long-term investors. And our stock picks tend to be somewhat agnostic to the moods of the economic landscape—we focus on stable growers, examples of which include a Polish chocolate company, a Japanese baby bottle maker (talk about a headwind) with exposure to China, a Taiwanese cosmetics company, a Middle Eastern hospital provider, and an Australian pizza company. So in sum, we think the portfolio still looks well positioned. The quality of our companies, as reflected in high return on equity (ROE),‡ return on assets (ROA),‡‡ and low debt, looks good. The Fund has demonstrated its ability to soften the impact of corrections, and it has been participating in up markets. We are not chasing some of the lower quality value names that are participating in the strong bull market‡‡‡ countries either.
From a sector standpoint, the weakest performer in the quarter was consumer staples, a sector that has historically added a lot of outperformance for the Fund, and one in which it continues to be heavily overweighted (37.8% versus 5.9% for the Index). Our performance of 0.4% failed to match the 2.0% return of the benchmark in the quarter, largely due to the recent emerging market headwinds. For example, some of the biggest detractors during the quarter were Singapore companies Super Group Ltd. and Del Monte Pacific Ltd., along with Pepsi-Cola Products Philippines, Inc., all of which produce and distribute food products in Asia. From a long-term perspective, we are excited about the exposure these companies provide to these growing markets. The consumer staples sector boasted several strong performers during the quarter as well, including Wawel S.A. (Poland), Vitasoy International Holdings Ltd. (Hong Kong), and Hup Seng Industries Berhad (Malaysia).
Consumer discretionary was a sector in which we continued to struggle against the Index. While some of the developed country stocks like Japanese restaurant-company The Monogatari Corp. and online travel companies Ikyu Corp. (Japan) and Webjet Ltd. (Australia) struggled during the quarter, two of the biggest detractors from the sector’s performance were large positions in emerging country stocks Famous Brands Ltd. and Spur Corp. Ltd., which manage food franchises in South Africa. Despite the generally poor showing by food and travel stocks, there were strong exceptions that offset a lot of underperformance in the sector, including retailers like Poya Co. Ltd. (Taiwan) and Seria Co. Ltd. (Japan); clothing and footwear companies Ted Baker plc (United Kingdom), Delta-Galil Industries Ltd. (Israel), and Bata India Ltd.; and Indian auto component producers WABCO India Ltd. and Goodyear India Ltd.
The Fund’s weight in industrials at 10.6% was about half the benchmark’s weight of 19.8% over the course of the quarter, and we slightly underperformed the Index’s return (5.2% versus 5.6%). Indian industrial manufacturers like Eicher Motors Ltd. (up 43.9%), Kajara Ceramics Ltd. (up 29.5%), and Amara Raja Batteries Ltd. (up 17.6%) were solid contributors, but their performance was more than offset by the negative returns of research and consulting services provider Nihon M&A Center, Inc. (Japan) and office supplies manufacturer Adel Kalemcilik Ticaret ve Sanayi A.S. (Turkey).
Information technology (IT) was the top-contributing sector to performance for the quarter. From providers of data processing and outsourced services like My EG Services Berhad (Malaysia) and GMO Payment Gateway, Inc. (Japan) to Internet software and services names like Japan’s Infomart Corp. and Macromill, Inc., and Brazil’s Linx S.A., our stock-picking handily beat the benchmark.
Our materials stocks underperformed those in the Index, though avoiding metals and mining stocks helped relative performance.
Our health care stocks gained 8.9% and beat the benchmark’s 4.9% return in the sector. Most of the outperformance came from NMC Health plc, a health care company in the United Arab Emirates.
For the quarter, the Fund’s 1.9% average weight in the financials sector was significantly under the benchmark’s 19.5% weight, primarily due to the difficulty of finding micro cap financials that we consider to be high quality. The Fund’s financial stocks outperformed those in the Index largely due to our position in Kenya’s British-American Investments Co. (up 50.9%), one of the strongest performing stocks in the portfolio during the quarter.
Our lone position in energy, Korea’s Hankook Shell Oil Co. Ltd. (up 15.5%), handily beat the energy component of the Index (up 1.2%).
As has been the case for the past year, developed markets in general outperformed emerging markets in the fourth quarter. In the Fund, however, our heavy overweight in emerging market stocks actually beat our underperforming developed market picks—our emerging market stocks were up 5% compared to our developed market stocks, which were up 4.1%. And while both developed and emerging markets have seen expansion in price-to-earnings multiples§ over the last quarter, developed market stocks have maintained their valuation spread relative to the less expensive emerging market securities.
India (up 17%) was our biggest contributor to performance from a country perspective, despite failing to meet the benchmark’s return of about 23%. This was primarily due to the Fund’s heavy weight in India (7.7%) compared to the Index weight of about 1%.
Japan was a strong contributor with a return of 2.4%. The Fund not only beat the benchmark’s return of -0.3%, but the Fund’s underweight position in a relatively weak performing country helped performance relative to the Index.
The United Kingdom was up nearly 9%, but was actually the largest detractor from performance on a country basis because the Fund was substantially underweight with a position of 2.1% compared to a weight of 16% for the Index. United Kingdom stocks in the benchmark returned 10.9% during the quarter.
Other weak countries in the quarter included Turkey (down 10.2%), Singapore (down 11.1%) and the Philippines (down 2.0%). (Current and future holdings are subject to risk.)
So here we are at the end of the year, recounting the beginning from the end, and starting the year anew, aged and hopefully armed with new lessons to improve our management skills and provide the potential for better returns for shareholders.
The market cap headwind has continued for international micro-cap stocks. In fact, benchmark returns over the past quarter were closely correlated with market cap size. In the fourth quarter, the return for the largest decile stocks in the Index was 8.6% compared to a 2.2% decline for the smallest decile. It is worth noting, however, that valuation measures such as price-to-earnings, price-to-book§§ and dividend yield§§§ are generally more favorable for lower market cap stocks. While being invested in some of the market’s smallest companies has hurt us in the short run, we have done the best we can in the face of this headwind. We have focused on our process of picking companies that we believe are high quality and have avoided chasing returns in lower quality pockets of the market.
Eventually, enticing valuations in international micro caps will pull investors back to the asset class, and we believe the Fund is well positioned for this event. More importantly, with a focus on high-quality, long duration growth companies, we believe we are better positioned for a market correction than we have been in the past. We’re not saying a correction is inevitable, but we have heeded the wisdom of our Chairman, who has spent many years reflecting on the past. He believes economic growth in the U.S. holds promise but is concerned about stock valuations. Generally, when the U.S. sneezes, our markets catch cold. We hope it doesn’t happen. We hope correlations# are improving, but we prepare for many scenarios. When we look at our portfolio, we think it looks healthy with reasonable valuations, good growth, high ROEs and ROAs, and low levels of debt. Hence, we’re hopeful that 2014 will deliver good results for our shareholders. Still, we will heed the lessons of our more experienced leaders and continue to start the year at the beginning with the lessons from the end…a curious case of portfolio evaluation and management.
Thank you for the opportunity to invest your assets.
Roger Edgley and Laura Geritz
†The MSCI All Country (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.
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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 International Opportunities Fund’s investment objective is long-term growth of capital.
†††Valuation is the process of determining the current worth of an asset or company.
‡Return on equity (ROE) measures a company’s efficiency at generating profits from shareholders’ equity.
‡‡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.
‡‡‡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) multiple is the price of a stock divided by its earnings per share.
§§The price-to-book ratio is used to compare a company’s book value to its current market price.
§§§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%.
#Correlation, in the financial world, is a statistical measure of how asset classes, securities, markets, or countries move in relation to each other.