Wasatch Ultra Growth Fund® (WAMCX)  Invest in this Fund 

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3Q18
The Next Five Years May Look Different Than the Last Five Years
by John Malooly, CFA

“Increased valuations throughout the small-cap equity universe suggest investment returns over the coming five-year period will be significantly lower than during the previous five years.”

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For the period ended September 30, 2018, the average annual total returns of the Wasatch Ultra Growth Fund for the one-, five- and ten-year periods were 41.97%, 17.33% and 15.56%, the returns for the Russell 2000 Growth Index were 21.06%, 12.14% and 12.65%.  Total Expense Ratio: Gross 1.35%.

 

Data shows past performance, which is not indicative of future performance. Current performance may be lower or higher than the data quoted. To obtain the most recent month-end performance data available, please click on the “Performance” tab of the individual fund under the “Our Funds” section. The Advisor may absorb certain Fund expenses, without which total return would have been lower. Investment returns and principal value will fluctuate and shares, when redeemed, may be worth more or less than their original cost.

Wasatch Funds will deduct a 2.00% redemption proceeds fee on Fund shares held 60 days or less. Performance data does not reflect the deduction of fees, including sales charges, or the taxes you would pay on fund distributions or the redemption of fund shares. Fees and taxes, if reflected, would reduce the performance quoted. Wasatch does not charge any sales fees. For more complete information including charges, risks and expenses, read the prospectus carefully.

Wasatch Funds are subject to risks, including loss of principal.

Overview

Equities of small companies continued their impressive run during the third quarter of the year, as the benchmark Russell 2000 Growth Index logged its tenth consecutive quarter of positive returns. The Wasatch Ultra Growth Fund’s return of 10.37% surpassed the benchmark’s 5.52% gain for the quarter. While the fundamentals of our companies continued to improve, their stock prices rose at an even faster pace. Increased valuations throughout the small-cap equity universe suggest investment returns over the coming five-year period will be significantly lower than during the previous five years.

With growth stocks outgaining value stocks during the quarter, the small-cap growth investment style was a tailwind for the Fund. Health care was the largest source of strength against the benchmark, as a series of favorable developments at the company level propelled our holdings to outsized gains. When investing in health care, we look for companies using new technologies to do things “better, faster, cheaper.” By focusing on companies creating significant value, our goal is to identify businesses whose long-term growth is not closely tied to macroeconomic or political developments.

Software stocks also did well. Improvements in software technology are expanding its application to an ever-widening range of human activities. Software stocks tend to shine late in an economic cycle, when businesses are more likely to favor technology investments over human capital.

Laggards during the third quarter included cyclicals and other stocks in what are traditionally considered value areas of the market. Energy, materials and financials in particular were the worst-performing sectors of the Index. Even so, our energy and materials stocks generated solid returns and were a source of outperformance relative to the benchmark. Financial stocks were the poorest performers in the Fund and the financials sector was the greatest source of weakness versus the benchmark. Rising short-term interest rates threatened to raise the funding costs of banks and other lenders, weighing on their stock prices.

We attribute the strong performance of the Fund during the quarter to the solid fundamentals of the companies we own. In an environment of rich valuations, we believe the experienced management teams, strong balance sheets and other favorable characteristics of our companies became increasingly attractive to investors. As equity prices rose, we sought to control risk by trimming positions in stocks that had moved up significantly in price and reinvesting the proceeds in more-reasonably valued issues.

Details of the Quarter

The strongest contributor to Fund performance for the quarter was Tandem Diabetes Care, Inc. (TNDM). The company offers insulin-delivery systems for people with diabetes. In August, Tandem launched its t:slim X2™ Insulin Pump with Basal-IQ™ Technology, a predictive feature designed to reduce the frequency and duration of low-glucose events (hypoglycemia). The new system requires no finger sticks for calibration or diabetes-treatment decisions. Encouraging financial results and improved forward guidance also helped to drive Tandem’s stock price higher during the quarter.

Paylocity Holding Corp. (PCTY) was another top contributor. The company provides software for payroll and human-capital management (HCM) using the SaaS (Software-as-a-Service) business model. Revenues grew 27% year-over-year in Paylocity’s most-recently reported quarter, topping Wall Street forecasts. The company benefited from broker referrals and a growing sales force, which expanded 21% in the most-recent fiscal year. Paylocity’s newly launched integration marketplace allows its customers to review more than 300 integration partners and capabilities across a number of HCM functions.

Freshpet, Inc. (FRPT) continued to move higher in the quarter. The company sells fresh, refrigerated meals and treats for dogs and cats in the U.S., Canada and the United Kingdom. Shares of Freshpet rose sharply in early August after the company reported better-than-expected net sales, which jumped 23% compared to the same quarter a year ago. Management raised its full-year guidance for 2018 as Freshpet’s core dog household penetration increased at its fastest rate in more than three years. The company announced plans to expand its manufacturing facility in Pennsylvania to meet the growing demand for its products.

One of the greatest detractors from Fund performance for the quarter was Eagle Bancorp, Inc. (EGBN), the holding company for EagleBank, which operates banking offices in the Washington, D.C. area. Eagle saw its stock price slide on concerns that, as interest rates rise, the bank may not be able to maintain what have been highly attractive differences between what it pays depositors and its income from lending. We think investors have overreacted because Eagle’s earnings yield also rises as rates increase due to variable-rate loans. We added to our position in the stock.

nLIGHT, Inc. (LASR) also detracted from performance. The company makes high-performance lasers for industrial, aerospace and defense applications. Shares of nLIGHT declined amid concerns that higher tariffs and a slowdown in China’s economy may impact Chinese demand for the company’s products. While we think these concerns are valid, we believe nLIGHT’s long-term prospects remain attractive. The company’s lasers are rapidly replacing older, carbon-dioxide lasers for industrial cutting and welding, particularly in the production of automobiles.

PDF Solutions, Inc. (PDFS) was another detractor. The company provides technologies for optimizing the design and manufacture of integrated-circuit chips. We liquidated our position in PDF following a key management change and deterioration in the company’s growth prospects. With a main customer exiting the space and little indication that PDF’s management team will be able to execute on the opportunities available, we decided to move on. (Current and future holdings are subject to risk.)

Outlook

As company-focused, fundamental investors, we believe earnings drive stock prices between upper and lower extremes of severe undervaluation and severe overvaluation. While these extremes do not represent impermeable boundaries, valuations historically have shown a strong tendency to revert toward their long-term mean. Even under the optimistic assumption that price/earnings multiples will remain static at currently elevated levels indefinitely, annualized stock returns (net of dividends) would be expected to approximate annual rates of earnings growth.

Looking forward, we are pleased with the makeup of the Fund. We believe the fundamentals of our companies are solid, and that we own high-quality companies with strong management teams. However, it also feels like the strong results this year have pulled in forward returns. Over the last 20 years, the Russell Growth Index has returned 8.59% on average each year. In some five-year periods performance was higher than the average and in other periods the market generated low returns. Return profiles are often better after extended periods of low or negative returns.

We typically expect to generate a 12% to 15% annualized return when we buy a company. Because not all companies hit their targets, however, we would consider annualized returns of 10% to 12% over a five-year period to represent good investment results, results that likely would exceed those of our market benchmark. Given that the Fund has returned 17.33% annually for the five years ended September 30, 2018, we expect performance to moderate significantly in the years to come.

Thank you for the opportunity to manage your assets.

Sincerely,

John Malooly

 

 

 

**The Russell 2000 Growth Index measures the performance of those Russell 2000 Index companies with higher price-to-book ratios and higher forecasted growth values. The Russell 2000 Index is an unmanaged total return index of the smallest 2,000 companies in the Russell 3000 Index. The Russell 2000 is widely used in the industry to measure the performance of small company stocks.

You cannot invest directly in these or any indexes.

The Wasatch Ultra Growth Fund has been developed solely by Wasatch Advisors, Inc. The Wasatch Ultra Growth Fund is not in any way connected to or sponsored, endorsed, sold or promoted by the London Stock Exchange Group plc and its group undertakings (collectively, the “LSE Group”). FTSE Russell is a trading name of certain of the LSE Group companies.

 All rights in the Russell 2000 Growth Index vest in the relevant LSE Group company, which owns the Index. Russell ® is a trademark of the relevant LSE Group company and is used by any other LSE Group company under license.

 The Index is calculated by or on behalf of FTSE International Limited or its affiliate, agent or partner. The LSE Group does not accept any liability whatsoever to any person arising out of (a) the use of, reliance on or any error in the Index or (b) investment in or operation of the Wasatch Ultra Growth Fund or the suitability of the Index for the purpose to which it is being put by Wasatch Advisors, Inc.

CFA® is a trademark owned by CFA Institute.

The Wasatch Ultra Growth Fund’s primary investment objective is long-term growth of capital. Income is a secondary objective, but only when consistent with long-term growth of capital.

Earnings growth is a measure of growth in a company’s net income over a specific period, often one year.

The price/earnings (P/E) ratio, also known as the P/E multiple, is the price of a stock divided by its earnings per share.

Valuation is the process of determining the current worth of an asset or company.

The Russell 2000 Growth Index measures the performance of the Russell 2000 companies with higher price-to-book ratios and higher forecasted growth values.   Russell Investment Group is the source and owner of the trademarks, service marks and copyrights related to the Russell Indexes. Russell® is a trademark of Russell Investment Group. 

You cannot invest directly in indexes.

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CFA® is a trademark owned by CFA Institute.