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

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Q2 2018
Software Companies Continued to Drive Performance in IT
by John Malooly, CFA

“Software stocks tend to perform well late in an economic cycle, when businesses are more likely to favor technology investments over human capital.”

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For the period ended June 30, 2018, the average annual total returns of the Wasatch Ultra Growth Fund for the one-, five- and ten-year periods were 37.08%, 17.02% and 12.02%, the returns for the Russell 2000 Growth Index were 21.86%, 13.65% and 11.24%.  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

The Wasatch Ultra Growth Fund gained 14.57% during the second quarter. The Fund significantly surpassed its benchmark, the Russell 2000 Growth Index, which rose 7.23%. For the quarter ended June 30, 2018, the Ultra Growth Fund had outperformed the Index over the one-, three-, five- and 10-year periods.

Stocks of small companies outperformed large-cap issues during the quarter as global-trade concerns weighed more heavily on large companies with direct exposure to international markets. The Fund also benefited from the continued strong performance of growth stocks. For the past several years, strength in growth stocks has been driven largely by innovative companies using new technologies to disrupt their industries and take market share from competitors.

Health care and information technology, respectively, were the greatest sources of outperformance relative to the benchmark. In both areas, our stocks significantly outgained their counterparts in the Index and made large contributions to the Fund’s return. Medical-device companies were key contributors in health care, while software stocks drove Fund performance in the information-technology sector. Software stocks tend to perform well late in an economic cycle, when businesses are more likely to favor technology investments over human capital.

The only significant source of weakness against the benchmark was the financials sector. The Fund held most of its financials weight in a collection of small-bank stocks, which underperformed the financials component of the Index. Even so, we think the small banks owned in the Fund are well-positioned for the current environment. For the most part, our banks tend to be attractively valued on our metrics and typically stand to benefit from higher long-term interest rates.

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. Tandem’s shares extended the surge they began in February after the company’s capital raise strengthened its balance sheet and removed a major source of investor uncertainty. The stock got an additional boost in June on news that the Food and Drug Administration (FDA) had approved the latest upgrade to Tandem’s insulin pumps. The new devices use an algorithm to suspend insulin delivery when low blood glucose is predicted, then automatically resume insulin delivery once glucose levels begin to rise. We trimmed our weight in Tandem but continue to hold a meaningful position in the Fund.

Exact Sciences Corp. (EXAS), a molecular-diagnostics company with an innovative test for colon cancer, was also a top contributor. Named Cologuard,® the test avoids the high cost and invasiveness of a colonoscopy by screening a stool sample for cancerous and precancerous cells. Exact Sciences saw its stock price jump in May after the American Cancer Society recommended screening for colon cancers starting five years earlier, at age 45. Although a separate clinical trial would be required, the company affirmed its commitment to seek FDA approval for making Cologuard available to the lower age group. Optimism about a new test for liver cancer currently under development at Exact Sciences also helped lift the stock.

Another strong contributor in the Fund was nLight, Inc. (LASR), a holding added during its initial public offering (IPO) in April. The company makes high-performance lasers for industrial, aerospace and defense applications. In its first earnings release as a public company, nLight reported a better-than-expected 40% increase in quarterly revenue. Management cited accelerating demand across all business segments, led by growth in the industrial end market. The company’s lasers are rapidly replacing older, carbon-dioxide lasers for industrial cutting and welding, particularly in the production of automobiles.

One of the greatest detractors from performance for the quarter was Esperion Therapeutics, Inc. (ESPR). The company develops oral therapies for people with elevated low-density lipoprotein cholesterol (LDL-C, or “bad cholesterol”). Esperion’s lead drug candidate, bempedoic acid, is intended for high-risk patients who have not responded well enough to cholesterol-lowering drugs such as statins. Bempedoic acid can be taken alongside statin drugs to increase their effectiveness. Shares of Esperion tumbled in early May after a Phase 3 readout for bempedoic acid revealed 13 deaths in the treatment group compared to two for the placebo. Although an independent safety-monitoring committee concluded the deaths were unrelated to the study, spooked investors sold the stock in what we view as an unwarranted reaction. In our analysis, the study data showed bempedoic acid is safe and effective. We used Esperion’s lower, more-attractive stock price as an opportunity to add to the Fund’s position.

LGI Homes, Inc. (LGIH) was another significant detractor. The company designs and builds entry-level homes in Texas, Arizona, Florida and other U.S. locations. Earnings per share soared 111% in LGI’s most-recent quarter on 71% revenue growth, exceeding Wall Street expectations. The stock sold off despite these good results, however, as investors feared rising mortgage rates would make homes less affordable for potential buyers. Sharing these concerns, we had cut back the Fund’s position in LGI in January of this year. However, we believe the company’s shares remain a worthwhile holding and we modestly increased our weight toward the end of the quarter. With housing supplies tight and demographics favorable in the markets LGI serves, we think the company still has room to grow.

Another of the Fund’s large detractors was AAON, Inc. (AAON). The company sells air-conditioning and heating equipment in the U.S. and Canada. Although AAON reported record revenue in its most-recent quarter, earnings per share fell 58% versus the year-ago period. The company’s decision to maintain a larger-than-necessary workforce during a typically slower quarter had a significant impact on profitability. Management also cited a less-profitable product mix and double-digit increases in the cost of copper and galvanized steel—as well as a one-time bonus of $1,000 per employee paid as a result of the Tax Cuts and Jobs act of 2017. We view these developments as temporary and expect gross profit to recover as AAON ramps up production heading into its peak season. The company is already seeing a shift in demand to its more-profitable product lines, and it expects its recent price increase to offset higher raw-material costs. In the meantime, we remain patient. (Current and future holdings are subject to risk.)

Outlook

The increased availability of private funding has allowed small companies to stay private longer and to go public at higher market capitalizations. The result has been a slowing in the pace of IPOs and fewer opportunities for small-cap investors. Although IPOs are not an essential part of our investment strategy, from a long-term standpoint, a healthy IPO market is necessary to replenish the investable pool of small companies. We are pleased with the quality of recent public offerings and we’ve been selectively participating in offerings that we think represent attractive additions to the Fund.

Recent trends in secondary offerings have been less encouraging. The window for companies to come public is wide open, and biotechnology companies in particular have been very aggressive at using good news as opportunities to raise additional capital. Investors, in turn, have become conditioned to expect positive news to be rapidly followed by the dilutive effect of an increase in the number of shares outstanding. Price discovery in biotech stocks has become less efficient, as investors must discount not only company developments, but also the capital raises that follow in their wake.

Strong gains in stock prices over the past 12 months have significantly pushed up equity valuations in the broader market and in the Fund. Although company fundamentals also have improved in many cases, stock prices have risen faster. With our return outlook less optimistic than it was a year ago, we think the lofty returns of the previous 12 months are unlikely to be repeated in the 12 months 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 per share or EPS is the portion of a company’s profit allocated to each outstanding share of common stock. EPS growth rates help investors identify companies that are increasing or decreasing in profitability.

An initial public offering (IPO) is a company’s first sale of stock to the public.

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.