The third quarter saw high volatility across the globe’s financial markets, with the MSCI All Country (AC) World Ex-U.S.A. Small Cap Index down -10.02% for the three months ended September 30, 2015. The Wasatch International Opportunities Fund did not escape the tumult. The Fund declined -5.84%, yet managed to outperform the Index over the same timeframe. Given the weak performance of global stocks in the third quarter, the Fund had returned just 2.24% since the beginning of the year through September 30, 2015, while the Index was down -2.54%.
Details of the Quarter
Just as concerns over Greece began to subside, and developed markets began to take comfort in improving economic data from Europe, China’s muddled handling of its currency and stock markets left global investors disconcerted about the country’s future prospects, its policy responses, and its impact on world economics. The U.S. Federal Reserve’s decision to leave interest rates unchanged, despite reasonably strong domestic economic indicators, further upset global markets and revived debate on the timing of U.S. rate increases going forward. Emerging markets bore the brunt of these concerns, as global investors are estimated to have sold $19 billion worth of emerging-market equities in the third quarter, the worst sell-off since 2008. As a result, developed-country stocks in the Index held up much better over the quarter than emerging-market stocks, but lagged the more insulated frontier stocks. The Fund followed those same trends, though our holdings outperformed relative to the Index in each area by four to six percentage points.
Given recent increases to our company weights in Japan, the Fund ended the quarter with nearly half of its invested assets in developed markets, which is still well under the Index weight of over 78%. As we’ve continued to find and add what we consider to be high-quality, undiscovered micro-cap companies with strong market positions in less-traveled parts of the globe, the portion of the Fund invested in frontier markets has crept up to 10%. The remainder of the Fund is invested in strong, growing companies in the emerging world that we believe have the potential to outperform over time.
It is worth noting that currency proved to be a difficult headwind in several emerging countries, particularly South Africa, Malaysia and Turkey, where local currencies depreciated relative to the U.S. dollar during the quarter and cost the Fund 0.89 of a percentage point of performance.
The biggest contributor from a country perspective (contributing almost half of the Fund’s outperformance of the Index) was Japan. Not only did our Japanese holdings outperform the Index as a whole, but Japan is a country in which the Fund is overweight relative to the benchmark. Most importantly, however, was that our stocks in Japan did significantly better than those in the Index. Several members of the international team spent time in Japan again this last quarter. As a result, we ended up increasing our exposure to Japan, including adding to some companies that we believe are high-quality innovators like Next Co. Ltd., a top online real estate company taking share in a resurgent Japanese market, and SMS Co Ltd., a website operator for senior-care recruitment that also has the potential to disrupt the enterprise resource planning (ERP) systems for nursing facilities in the country.
Our decision to remain underweight in China, something we discussed in our last quarterly commentary, proved beneficial, as our under-allocation to the country (3.4% weight for the Fund versus 6.6% for the Index when combining China and Hong Kong) was our second-biggest source of country outperformance. With Hong Kong and China stocks in free-fall, we benefited from our smaller weight in a few select companies.
The Fund’s lack of exposure to Canada was a similarly strong factor, as over a third of the Index’s weight in Canada is in the energy and materials sectors, where prices have been hit on concerns of lower demand from China coupled with excess supply.
Finally, our stocks in Australia, Poland, India and Taiwan contributed strongly to the Fund’s outperformance. Not only were each of these countries more heavily weighted in the Fund than in the Index, but again, our stock-picking was better in each geography.
The biggest detriment to performance was our underweight of Western European companies, which make up over 41% of the Index (versus the Fund at 8%). Companies in the Index from these countries were down less than half of the overall benchmark’s return during the quarter, meaning that our underweight detracted from relative performance. Thankfully, solid stock selection again made up much of that deficit. Team members also spent time in Europe during the quarter to make sure we are comfortable with our underweight there. As a result of their visit, we added some new names and increased our weight in others we already owned. These are companies that we feel fit our long-term investment horizon, and some of their stocks had pulled back like Capio AB, the market leader in the Swedish private health-care sector that is growing throughout Europe.
The consumer-discretionary sector contributed the most to the Fund’s performance relative to the Index. Besides Japanese company Next, which we already mentioned, we also saw strong performance again from Australian Internet travel site Webjet Ltd. on the back of increasing travel momentum, and aided by a weaker Australian dollar.
Industrials also contributed favorably to the Fund’s relative performance over the last three months. Electrical-equipment providers Amara Raja Batteries Ltd., a battery producer in India, and Voltronic Power Technology Corp., a Taiwanese power-product manufacturer, were two of the Fund’s top contributors.
Materials and energy were the other large sector contributors, primarily due to the lack of any exposure to the metals and mining or energy equipment and services industries. Each sector was down -25% in the Index.
Consumer staples also made a solid contribution to performance versus the Index, as most of the Fund’s holdings added to the outperformance. However, a few consumer-staples holdings were among the Fund’s largest detractors including Warabeya Nichiyo Co. Ltd., a prepared-food supplier to Japan’s Seven-Eleven stores that has been hit with higher-priced input costs, Pepsi Cola Products Philippines, Inc. and Philippine Seven Corp. A recent call with the management team of Warabeya Nichiyo and our deep analysis of our consumer staples companies in the Philippines gives us confidence that these are still high-quality companies with the potential to add long-term value to the Fund.
The health-care sector detracted from the Fund’s relative performance. A few Asian pharmaceutical companies including PT Kimia Farma Persero Tbk (Indonesia) and Lee’s Pharmaceutical Holdings Ltd. (China) weighed on results in the sector. Nevertheless, we are excited about our positions in these companies over the coming years.
Finally, because the financials sector within the Index outperformed the Index in general, our heavy underweight of financial stocks (3.8% versus 21.6% for the Index) and the greater decline in our holdings meant that the sector detracted from Fund’s absolute and relative performance in the quarter. (Current and future holdings are subject to risk.)
From a valuation††† perspective, the Fund is now near the most attractive levels on price-to-book‡ and price-to-sales‡‡ basis we’ve seen in the last three or four years. On a price-to-earnings‡‡‡ basis (using both current earnings and forward estimates) the Fund is trading at levels similar to the past couple of years. We are cognizant of equity valuations and expect to trim positions as prices rise and reduce our return calculations. We also expect to add to positions when we see our favorite long-term holdings pull back.
While we can’t know what surprises the global markets have in store for us, we do have confidence that our investment process will continue to point us to companies that have the potential to thrive over time. We are optimistic about the positioning of the Fund, and excited about the great opportunities we continued to uncover as we traveled the globe in search of emerging World’s Best Growth Companies.§
Thank you for the privilege of managing your money.
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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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.
‡The price-to-book ratio is used to compare a company’s book value to its current market price.
‡‡The price-to-sales ratio is a stock’s capitalization divided by the company’s sales over the trailing 12 months. The value is the same whether the calculation is done for the whole company or on a per-share basis.
‡‡‡The price-to-earnings (P/E) multiple, also known as the P/E ratio, is the price of a stock divided by its earnings per share.
§World’s Best Growth Companies (WBGCs) are defined by Wasatch as companies that we believe possess an identifiable, sustainable competitive advantage, are well managed, underfollowed, undervalued and are producing above average earnings growth relative to their industry and country of origin.