The Wasatch International Opportunities Fund gained 2.77% in the first quarter of 2014, underperforming its benchmark, the MSCI All Country (AC) World Ex-U.S.A. Small Cap Index, which gained 3.47%.
Global markets stumbled out of the gates in the latter half of January as concerns over Chinese economic growth added to persistent worries about the impact of tapering of U.S. quantitative easing on vulnerable emerging economies. By March, however, emerging markets had bounced back, at least partly due to the easing geopolitical situation with Russia, improving economic data from Europe, and some cautious optimism with regard to China and Japan.
As those familiar with our style of investing know, this Fund has gravitated toward higher exposure to emerging markets given the appeal of companies that benefit from potent trends in demographics, potential productivity gains, and growth headroom. In the recent past, this heavier exposure to emerging markets has made it more difficult to outperform the developed-heavy benchmark. Fortunately, these trends reversed in March due to the rebound in emerging markets, and for the quarter, the performance of emerging and developed economy stocks was roughly equal.
The strong correlation between performance and market cap that we’ve seen over the last few quarters, however, continued unabated into 2014’s first quarter, again creating a powerful headwind for a fund oriented toward micro-cap names. In fact, the benchmark’s largest decile stocks outperformed the smallest decile by over 12 percentage points in the three-month period ended March 31.
Details of the Quarter
Our heavy consumer exposure (the consumer staples and consumer discretionary sectors), which is over 50% of the Fund, ended up being a bit of a drag on performance this quarter, as these sectors underperformed the Index as a whole. The strong performance of a few developed-market consumer stocks like Australia’s Domino’s Pizza Enterprises Ltd. (+29%), Danish brewery Royal UNIBREW A/S (+22%) and Nordic chocolate manufacturer Cloetta AB (+20%) failed to make up for the generally lackluster performance of consumer companies across the rest of the globe.
Industrials was essentially the only sector offering outperformance during the quarter, returning just over 15% relative to about 3% for the industrials component of the Index. Companies like Sarine Technologies Ltd. (+34%), Eicher Motors Ltd. (+24%), and Amara Raja Batteries Ltd. (+21%), all of which we visited in India during the quarter, had very few underperforming peers pulling down the sector. Unfortunately, our low weight of about 11.5% relative to the Index’s weight of over 20% did cost us a bit.
In the information technology sector, GMO Payment Gateway, Inc. (+37%) of Japan and XING AG (+40%), Germany’s version of LinkedIn, displayed impressive first quarter performance, but the sector was pretty lackluster besides, underperforming the benchmark by around two percentage points.
The materials sector boasted a few stocks that did well in the first three months of the year. Despite not being large positions, Canadian packaging manufacturer Winpak Ltd. (+23%), Indonesian cement producer PT Semen Baturaja Persero Tbk. (+40%), and Supreme Industries Ltd. (+21%), an Indian plastics good manufacturer, were the largest contributors to performance in the sector, which also had a number of underperformers including Tikkurila Oyj (-11%), a Finnish paint manufacturer, and Nigeria’s Chemical & Allied Products plc (-23%).
The lackluster performance of St. Shine Optical Co. Ltd. (-22%), a Taiwanese contact lens manufacturer, and Abcam plc (-20%), a United Kingdom company we’ve owned since 2005, resulted in underperformance of the health care sector.
Financials, at only 3% of the portfolio, was drastically less than the 19% weight of the Index during the quarter. Despite financials being a sector in which it is difficult to find what we consider to be high-quality micro-cap companies, the stocks we do own, like Kenya’s British-American Investments Co. (+23%), EastWest Banking Corp. (+16%) in the Philippines, and South Africa’s Peregrine Holdings Ltd. (+11%), soundly beat the 4% benchmark return.
The biggest contributors to performance from a country perspective were Japan, where our 1% portfolio return was enough to dominate the -2.3% return of the Index, and India, which had an 11% portfolio return that was in-line with the Indian portion of the Index.
Not surprisingly, the quarter was a tough one for South Africa and Turkey. Our heavier country weights relative to their benchmark counterparts contributed to the underperformance of already weak markets.
Finally, it is worth discussing our exposure to Russia and Eastern Europe, given the recent geopolitical developments with Ukraine. Our lone investment in Russia, MD Medical Group Investments plc (-24%) was a small position, and therefore wasn’t a big detractor from performance. And while following our disciplined bottom-up process fortunately had limited our exposure to Russia to only 0.37% of the portfolio, we saw two of our Finnish companies, a total weight of about 3%, suffer more than 10% declines. Tikkurila, a paint manufacturer, and Olvi Oyj, a beverage producer, both have significant revenue exposure to former Soviet republics. We believe both of these companies are well positioned with even better valuations now. Apranga PVA, a clothing retailer in Lithuania, on the other hand, was actually up over 3% during the quarter. (Current and future holdings are subject to risk.)
As our own Dr. Sam Stewart points out in his most recent Message to Shareholders with regard to the current U.S. economic environment, “We’ve never been down this road before…” This is true internationally as well, as there are a lot of question marks regarding the robustness of a global economic recovery, valuations remain stretched in some markets (including the U.S.), and the specter of geopolitical risk still looms.
While this might create the potential for added volatility in global equity markets, our goal is to structure the Fund in a way that will mitigate the adverse impact of short-term corrections while providing the potential to deliver portfolio returns commensurate with the great long-term growth prospects of the underlying companies. Because our process is focused on owning high-quality, undiscovered companies with long time horizons, we are occasionally exposed to market movements (such as strong performance of developed markets, large-cap stocks, or lower quality names) that make it more difficult to outperform the benchmark in the short-term. This is when we rely on our deep, disciplined stock-picking to keep the Fund well-positioned while we wait for the short-term headwinds to abate.
Besides the attractive structural drivers for the stocks of emerging market and micro-cap companies that we’ve outlined previously, when coupled with the relative attractiveness of stock valuations (which are generally more favorable for lower market capitalization and emerging market stocks), we are content with the Fund’s exposure to emerging market companies that we believe are high-quality, and we feel confident in the positioning of our micro-cap mandate.
Thank you for the opportunity to invest your assets.
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.
‡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.
‡‡Correlation, in the financial world, is a statistical measure of how asset classes, securities, markets, or countries move in relation to each other.
§As of March 31, 2014, the Wasatch International Opportunities Fund was not invested in LinkedIn Corp.
§§ Valuation is the process of determining the current worth of an asset or company.