Wasatch Micro Cap Value Fund® (WAMVX)  Invest in this Fund 

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1Q19
Investors’ Appetite for Growth Appears Enormous for Now
by Brian Bythrow, CFA

“With the U.S. economy still on solid footing, one would normally expect economically cyclical, value-oriented names to be more in favor. Yet investors seem as willing as ever to pay high premiums for growth—even when companies are unprofitable.”

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Investing in small or micro cap funds will be more volatile and loss of principal could be greater than investing in large cap or more diversified funds.
Investments in value stocks can perform differently from other types of stocks and from the market as a whole and can continue to be undervalued by the market for long periods of time. Loss of principal is a risk of investing.
Investing in foreign securities, especially in emerging markets, entails special risks, such as currency fluctuations and political uncertainties, which are described in more detail in the prospectus.

For the period ended March 31, 2019 the average annual total returns of the Wasatch Micro Cap Value Fund for the one-, five- and ten-year periods were 5.83%, 9.33% and 18.20%, the returns for the Russell Microcap Index were -2.36%, 5.03%, and 14.97%.  Expense ratio: Gross 1.74%.

 

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

U.S. equity markets rebounded sharply in the first quarter of 2019, with some swaths of the market—high-growth stocks, in particular—now more expensive than they were prior to the fourth quarter’s sharp selloff. The Wasatch Micro Cap Value Fund gained 13.82%, approximately in line with the benchmark Russell Microcap Index, which advanced 13.10%.

Dovish commentary from U.S. Federal Reserve (Fed) officials kicked off the rebound early in the quarter. In our view, U.S. equities were due for a recovery. We believed the selloff during the fourth quarter was overdone, exacerbated in part by program trading. And as we expressed in previous commentaries, we expected the Fed to strike a more moderate stance on interest rates because inflation has remained tame and there haven’t been many signs of excessive risk-taking among businesses and consumers. Other positives during the quarter included the end of the partial government shutdown and de-escalation of trade-war rhetoric between the U.S. and China.

As for absolute stock-price gains during the market’s strong first-quarter upswing, the Fund’s more “growthy” names led the way. We trimmed some of them, such as microchip makers Inphi Corp. (IPHI) and MaxLinear, Inc. (MXL), as stock-price performance increased their weights in the Fund to be larger than we desired. Reducing the size of a position to keep it in line with our ongoing assessment of the company’s growth prospects and valuation level is an important aspect of our risk-management process.

That said, investors’ appetite for growth appears enormous for now. With the U.S. economy still on solid footing, one would normally expect economically cyclical, value-oriented names to be more in favor. Yet investors seem as willing as ever to pay high premiums for growth—even when companies are unprofitable. Approximately one-fourth of Russell 2000® Index constituents are currently losing money.

Investors’ seemingly high tolerance for companies with low or lacking profitability is a characteristic that sets the U.S. market apart at present. Elsewhere in world markets, investors have continued to prefer more-stable companies that generate cash. Historically, both in the U.S. and overseas, if a company slashed its announced earnings expectations, it’s highly likely that its stock price would be punished—and would stay at a lower level until the company could work its way back to growing earnings.

Currently in the U.S., however, we’ve seen the historical preferences for stable growth and cash flows sidelined to such an extent that even raising new capital in the equity markets doesn’t necessarily mean a company’s share price will fall. On the contrary, there are examples of companies raising capital—to fund more sales and marketing efforts—and being rewarded with higher stock prices.

One reason behind investors’ intense focus on growth may simply be a lack of alternatives. Despite some points of concern, such as a lackluster February employment report, the U.S. economy remains strong with no hint of a recession in the near term. With gross domestic product (GDP) growth coming in at 2.9% for 2018, compared to 2.2% for 2017, investors have perceived the U.S. as the best option compared to other world markets.

Details of the Quarter

The stock of Freshpet, Inc. (FRPT), one of the first quarter’s top contributors, rose sharply as investors flocked back to companies with strong growth opportunities—in this case, the potential to redefine a product category with its refrigerated pet food. Freshpet’s stock benefited from the announcement of double-digit revenue and earnings growth for the company’s most-recently reported quarter.

Other top contributors included the two semiconductor firms, Inphi and MaxLinear, mentioned above. These companies are leaders in the “connected home” space, which refers to the increasing need for fast data connections. A new international cable modem standard—DOCSIS 3.1—enables full-duplex connections over cable modems. In our view, Inphi and MaxLinear are poised to benefit as this standard becomes more widely adopted. Both companies also stand to benefit as more new 5G wireless infrastructure is built. 5G equipment involves a greater number of antennas—and therefore chips—than earlier generations of cellular mobile communication technology. We had originally purchased Inphi and MaxLinear as beaten-up technology names. Their stocks had fallen back in the fourth quarter of 2018 along with tech stocks in general, but have bounced back sharply so far in 2019.

Industrial firm Construction Partners, Inc. (ROAD), an asphalt-paving firm operating in five southeastern states, was also among the top contributors for the quarter. Our take is that Construction Partners’ stock price was pulled down in 2018 along with other names in its industry as investors fretted about the impact from inflation in road-aggregate asphalt prices. We recognized that Construction Partners’ business was actually somewhat insulated from those price increases and added to our position. When the company announced its most-recent quarterly results, we think investors came to understand that materials pricing really wasn’t an issue, and the stock snapped back in the first quarter.

Among the Fund’s detractors in the first quarter, the two largest were medical-technology companies Neuronetics, Inc. (STIM) and Ra Medical Systems, Inc. (RMED). Neuronetics focuses on developing devices to treat psychiatric disorders. The company’s organic growth remains high, at around 20%. The stock’s decline may have been a reflection of investors’ wariness about a new competitor in Neuronetics’ space, but so far we haven’t seen competitive forces impacting the business.

Ra Medical Systems is a newly public company that missed its sales forecast right out of the chute. The company designs and markets lasers and catheters used to treat skin and cardiovascular diseases. What appeared to hold back Ra Medical’s product success, and hurt revenues in the fourth quarter of 2018, was the need to hire qualified sales personnel and improve training for the company’s entire sales team to ensure that doctors are comfortable using Ra Medical’s innovative devices. From our perspective, we’ve seen that it’s common for small med-tech companies to experience such hiccups. Ra Medical’s management believes that the newly hired chief commercial officer will alleviate the sales-force hiring and training issues.

Sangamo Therapeutics, Inc. (SGMO) was another detractor. A clinical-stage biopharmaceutical company, Sangamo specializes in the treatment and cure of single-gene disorders. Investors reacted negatively in February to interim results from an early-stage study using the company’s zinc-finger gene-editing technology in vivo for the treatment of Hurler syndrome. However, we think it’s too early to draw conclusions until results from the study’s high-dose subjects have been released. Moreover, Sangamo has already developed a second-generation zinc-finger technology designed for greater editing efficiency. The company expects to begin clinical trials for the newer version later this year.

In addition to in-vivo gene editing, Sangamo’s development pipeline includes gene therapy and ex-vivo genome medicine. The company’s ex-vivo genome-editing programs build on its foundational studies in HIV, which were the first trials to use ex-vivo genome-edited cells as a treatment approach. The company expects data from five different clinical trials this year, including its gene-therapy program for hemophilia A and its ex-vivo gene-edited cell therapy for beta-thalassemia. It’s worth noting that, just after quarter end, Sangamo provided an unscheduled positive clinical trial update and its stock rose almost 30%.

During the first quarter, we added a few stocks to the Fund, including Selecta Biosciences, Inc. (SELB) and Digi International, Inc. (DGII). We believe Selecta has an innovative platform of biologic therapies addressing unwanted autoimmune responses, including a promising treatment for gout. Despite exciting potential for its pipeline of products, Selecta’s stock suffered a setback that has become commonplace among micro-cap biotechnology stocks. When these small biotech companies release positive clinical results, their stock price often drops as investors anticipate a capital raise to develop, market and distribute the potential therapy. Our biotech analyst had anticipated positive results from Selecta, and we participated in the company’s secondary offering at a depressed price that served as an attractive entry point into the position.

We also saw a good opportunity to add Digi International to the Fund. We think the company is participating in several promising secular growth trends, including the proliferation of sensors in many products and machine-to-machine learning. In particular, we like Digi International’s products that focus on “cold monitoring.” These products constantly measure temperatures within storage areas that must be kept cold, alerting personnel if the temperature starts to rise. We see a large addressable market for cold-monitoring applications—from drug stores to grocery chains, among other end markets.

Fiesta Restaurant Group, Inc. (FRGI) and Tower Semiconductor Ltd. (TSEM) were two names we sold during the quarter. We eliminated our position in Fiesta due to what we view as hyper competition in the company’s niche. Regarding Tower, given what we foresee as a tough environment due to a glut of capacity in the semiconductor-fabrication space, we chose to sell the remainder of our position. (Current and future holdings are subject to risk.)

Outlook

International stocks have lagged those in the U.S. over the last several years and now appear quite undervalued. While the Fund’s international holdings have also lagged, the businesses themselves have performed quite well. We believe this situation makes it likely that the Fund’s international stocks will eventually play catch-up to their U.S. counterparts. In both international and domestic holdings, we continue to manage down the Fund’s exposure to international industrial activity, which is slowing.

With the Fed softening its policy stance and with the release of strong corporate earnings reports, the U.S. equity market has swung from extreme pessimism in the fourth quarter of 2018 to seemingly boundless optimism so far in 2019. This upward spike in sentiment appears to have generated considerable changes in appetite for investment risk and increased valuations. Given historical patterns following strong market rallies, we wouldn’t be surprised to see stocks pause over the next several months.

For the rally to continue throughout 2019, we believe we’ll need to see a more complete resolution of the U.S.-China trade disagreement. And we think it’s in the best economic interest of both countries to resolve their differences.

As always, we’ll continue doing what we believe we do best and that is using our bottom-up research process to find outstanding micro-cap companies with the potential to contribute to the Fund’s long-term performance.

Thank you for the opportunity to manage your assets.

Sincerely,

Brian Bythrow

 

 

**The Russell Microcap Index is an unmanaged total return index of the smallest 1,000 securities in the small cap Russell 2000 Index plus the next smallest 1,000 securities, based on a ranking of all U.S. equities by market capitalization. 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 Micro Cap Value Fund has been developed solely by Wasatch Advisors, Inc. The Wasatch Micro Cap Value 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 Microcap 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 Micro Cap Value 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 Micro Cap Value Fund’s investment objective is 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.

Program trading is defined by the New York Stock Exchange as the purchase or sale of a group of 15 or more stocks that have a total market value of $1 million or more and are part of a coordinated trading strategy. Program trading uses computer algorithms to buy and/or sell a basket of securities. Orders are placed directly into the market and executed according to predetermined instructions.

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.

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

The Russell Microcap Index is an unmanaged total return index of the smallest 1,000 securities in the small cap Russell 2000 Index plus the next smallest 1,000 securities. The Index commenced operations after the fund commenced operations.   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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