We are going to recount the quarter and year in fairy tales and nursery rhymes. Nursery rhymes often reflect events in history and parody the economics and politics of the period. In a world in which a rising rate environment has paradoxically led to lower rates, a world in which excess labor supply has led to less expensive and better robots, and a world in which an oversupply of money has only led the world’s central bankers to chop down more trees, what better environment to use our quarterly letter as an ode to the lyrical rhyme. In addition, 2014 was a year in which the S&P 500’s††† longest losing streak was three days. That has never happened in the 90-year history of the S&P 500—a post-crisis fairy tale if we’ve ever heard one. So one, two, buckle your shoe, as we begin another year in stock market Wonderland. For the Fund, 2014 was a good year with an okay finish. The Wasatch International Opportunities Fund was down -3.60% versus its benchmark, the MSCI All Country (AC) World Ex-U.S.A. Small Cap Index, which declined -3.98% in the quarter. This slight outperformance increased the Fund’s lead on the Index for the year to 7.1 percentage points—a reversal of the previous year’s struggles. For the 12-month period ended December 31, 2014, the Fund gained 3.07%, while the Index was down -4.03%. Micro caps had a bad year. The Fund didn’t have a bad year (at least compared to the Index), and we believe it is our process of investing in companies that we consider to be high quality that enabled us to do relatively well—not quite beauty and the beast—but we will take it given all that the world threw at us in 2014. It was a hard year.
Details of the Quarter
Vladimir Putin sat on a wall. Vladimir Putin had a great fall. All the king’s horses and all the king’s men couldn’t put Putin’s oil kleptocracy together again. The oil commodity boom finally came to a close in the quarter, ending an era of windfall profits for Russia’s leadership. What happened? Some believe the United States and Saudi Arabia gave Putin a little push off the wall. Sheikh Zaki Yamani, the Saudi oil minister during the 1970s, brilliantly stated, “The Stone Age did not end for lack of stone, and the Oil Age will end long before the world runs out of oil.” Could the end of the Oil Age predicted by the Saudi oil minister finally be at hand? At present, the world has plenty of oil and falling demand for it. In addition, a monopoly, OPEC,‡ has artificially elevated the price for years. This was easy to do when China had a continual unquenched thirst for the commodity and the U.S. was resting on its laurels in innovation. However, high oil prices over an extended time period, led to technological progress—creative destruction—that might potentially push oil into the Stone Age. In addition, global growth is slowing. This is where we sit today. In a world where there is plenty of oil because growth in demand was assumed to be perpetual, prices stayed too high too long leading to innovation that drove up supply, and OPEC lost control of its monopoly pricing. We think this will ultimately be very good for the world’s consumers—a space in which the Fund is heavily invested.
So it should come as no surprise that the biggest source of outperformance in the quarter came from our underweight position in the energy sector. In addition to having less than a quarter of the benchmark’s weight in the sector, our lone energy holding, Hankook Shell Oil Co. Ltd., saw a reversal of its strong momentum from the previous quarter. Hankook’s stock price fell nearly 30% in the final three months of the year, which actually still beat the energy component of the Index, which was down over 30%.
The industrials sector was the second-biggest contributing sector in the fourth quarter and was the biggest contributor for the year. We outperformed the Index in the industrials sector on the basis of stock selection, but our underweight position (11.4% for the Fund versus 19.7% for the Index) shaved off some relative performance. Outperformance primarily came from two stocks— Indian battery manufacturer Amara Raja Batteries Ltd. and a power-equipment manufacturer from Taiwan called Voltronic Power Technology Corp., a company we met shortly after its initial public offering (IPO)‡‡ earlier in the year. The Fund’s relative performance also benefited from lack of exposure to construction and engineering stocks, which were down
-16.3% in the Index. Fund holding Sarine Technologies Ltd., an Israeli company involved in diamond grading equipment and services primarily in India, saw some expected short-term headwinds and its stock price fell -23.3%, giving back its strong gains from the previous quarter.
The information-technology (IT) sector of the Fund outperformed for the quarter. It was down
-0.6%, and handily beat the benchmark’s -3.2% return. Robust results from IT services companies EOH Holdings Ltd. in South Africa and My E.G. Services Berhad in Malaysia drove performance in what was an otherwise mediocre quarter for the sector.
Although our consumer-staples and consumer-discretionary stocks failed to beat their benchmark counterparts for the quarter, the Fund’s relative performance was helped by a heavy overweight in the consumer-staples sector (34% versus 6.2% for the Index). Looking ahead, we feel the Fund is well-positioned with high-quality consumer names whose margins should benefit from lower input costs over the coming quarters.
The health-care sector was home to one of the Fund’s top contributors—Kimia Farma Persero Tbk, an Indonesian pharmaceutical company, which saw a stock-price gain of 25.3% in the quarter. A significant detractor was also found in the health-care sector—a Russian hospital company, MD Medical Group Investments plc, whose stock was off 32.9% for the three-month period on macroeconomic concerns. MD Medical is also our only direct exposure to Russia.
Having no exposure to metals and mining companies helped the Fund’s performance versus the Index in the materials sector, where that industry lost -11.5%. Unfortunately, we also were not invested in the paper and forest products industry, which had reasonably good performance, and we struggled with stock selection in the chemicals industry.
Financials, the largest sector in the Index, and a sector in which we’ve historically had a difficult time finding high-quality micro-cap names, was our biggest detractor from performance relative to the Index during the quarter, primarily because our stocks significantly lagged those in the Index. We typically have been underweight versus the Index in real-estate investment trusts (REITs) because we have found that REITs generally lack balance-sheet strength. As a result, the Fund sometimes underperforms in the financials sector when the REIT industry does well, as was the case in the fourth quarter. Insurance was another industry in financials in which the Fund underperformed the benchmark. Our exposure to British-American Investments Co. Kenya Ltd. hurt, as its stock pulled back following a strong run.
’Twas the night before Christmas, when in the Fed’s house, Janet Yellen was stirring. And in Russia there was a kleptocratic louse. Wall Street’s stockings were hung by the chimney with care, in hopes that Christmas bonuses still would be there. In 2014, however, there was a large discrepancy between the naughty and the nice for stock-market performance around the world. For the first time in 25 years, the U.S. dollar gained against most major currencies. This was driven by the United States’ new-found leadership as the world’s dominant oil-producing country. While many argue that the U.S. has not benefited from quantitative easing,‡‡‡ printing money to drive up prices, years of liberal monetary policy likely had an influence on oil prices—the Fed’s stimulus helped propel them higher. China’s demand helped too, and the U.S. countered high oil prices by creating new industries that unraveled the world oil order. We aren’t going to suggest that the Fund’s underweight position in energy was due to our ability to predict the demise of the OPEC monopoly, but our process aimed at finding high-quality companies and our belief that the cycle was a little long in the tooth provided a big benefit to the Fund for the quarter and the year. Generally speaking, if you were an oil-importing country and benefited from falling oil prices, you did well for the year, and if you were an exporter, you didn’t. The Fund had an overweight position in oil-importing nations.
From a geographic perspective, a big source of outperformance during the quarter (again, no surprise) was our underweight position in Canada. In the benchmark, Canadian securities were down 11.4% (largely a result of the heavy exposure to energy and materials stocks). India and South Africa were also strong contributors for the Fund, primarily due to the performance of the handful of stocks mentioned previously, and to the performance of Famous Brands Ltd. (South Africa), one of Africa’s most promising restaurant companies. The Fund struggled in Israel, where we are overweight (3.9% versus the Index at 0.7%), and had weak performance due to our position in Sarine Technologies, already mentioned, as well as supermarket chain Rami Levi Chain Stores Hashikma Marketing 2006 Ltd. The United Kingdom (U.K.) was also a big detractor. Our lone stock in the U.K., health care IT company EMIS Group plc did well, but being drastically underweight in a country that performed better than most hurt the Fund’s relative performance for the quarter. For 2014, the country story was really about the strong contribution from our investments in India. The Fund outperformed the Index in India with a gain of 74.3% compared to 57.1% for the Index and with a weight over five times that of the Index. (Current and future holdings are subject to risk.)
Despite a reprieve earlier in the year, the Fund’s heavy weighting in emerging-market and frontier-country (EM/Frontier) stocks (60% of the Fund versus 22% for the benchmark) again detracted from performance in the fourth quarter. Our EM/Frontier holdings were down -3.0% over the last three months, while our developed-country stocks were down -1.8%. For the year, our EM/Frontier stocks were up 8.9% versus the stocks in the Index, which were down -3.9%. The Fund’s developed-market stocks returned 0.6%, which handily beat the -5.1% return of developed-market stocks in the benchmark. We continue to see developed-world economies as the Mad Hatter’s Tea Party, the U.S. eases, then Japan eases, then Europe eases, and maybe next China, in an attempt to export their way to a fresh economy—to move to a seat with a clean tea cup. Most everyone is prognosticating that Japan will get the spot of the March Hare, who spilled his milk. However, it’s only a matter of time before someone else at the table dirties their cup as well—the price of combative currency policies. If you want to drink tea, all the cups get dirty, and there is nowhere to shift. The global tea party is a zero-sum game.
As a micro-cap focused strategy, the Fund is still experiencing market-cap headwinds. In the fourth quarter, for example, our lack of exposure to larger-cap names (companies with market capitalizations of greater than $2.2 billion) and our heavier weighting of smaller-cap names (companies with market capitalizations of less than $238 million) relative to the Index cost nearly four percentage points of performance, which we again made up for with our focus on picking stocks that we deem to be high quality.
We’ve been calling for deflation for a long time, and we believe the Fund is positioned should this occur. We see no reason why, with oil prices down, that the Fund should not continue to benefit from this positioning (at least relative to the Index) as we enter the New Year. Global consumers will benefit from falling prices at the pump and hence will have more money to spend. The Fund is overweight in what we see as high-quality consumer companies that have long-duration growth stories. However, paradoxically, weakness in the global economy has continued to allow the markets to broadly do better than we ever imagined, as investors continue to seek returns they can’t get from their minimal interest bank accounts. Valuations§ are neither too hot nor too cold, but the magic the world’s central bankers have used to create what we believe is a tepid and confusing investment environment is nothing short of a fairy tale.
So once upon a time, Russia, Nigeria, Saudi Arabia and Venezuela were fabled oil economies. We do not know what 2015 will bring, but we do know that our process has led us to what we regard as high-quality companies with reasonable valuations that we believe will do relatively well even in trying times. We will invest independently through deep due diligence, striving to pick good companies, and not relying on a perplexing macro backdrop. We will do our best not to blindly follow the Pied Piper. The end.
Roger Edgley, Laura Geritz and Jared Whatcott
†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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The Wasatch International Opportunities Fund’s investment objective is long-term growth of capital.
†††The S&P 500 Index includes 500 of the United States’ largest stocks from a broad variety of industries. The Index is unmanaged and is a commonly used measure of common stock total return performance.
‡OPEC is an acronym for the Organization of Petroleum Exporting Countries. OPEC was founded in 1960. It is a collective of countries that export large amounts of petroleum and was formed to establish oil-exporting policies and set prices.
‡‡An initial public offering (IPO) is a company’s first sale of stock to the public.
‡‡‡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.