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

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Q1 2018
Firming Oil Prices May Bode Well for Energy Companies
by Brian Bythrow, CFA

“For the first time in years, energy companies appear to be gaining the upper hand in terms of pricing power. Margins are improving, and in our view brighter days for the energy sector—if they have not already arrived—may be right around the corner.”

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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 December 31, 2018 the average annual total returns of the Wasatch Micro Cap Value Fund for the one-, five- and ten-year periods were 18.92%, 13.53% and 11.33%, the returns for the Russell Microcap Index were 13.50%, 11.76%, and 9.19%.  Expense ratio: Gross 1.84% / Net 1.84%.

 

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 Micro Cap Value Fund lost -1.75% in what was a mixed first quarter of the year for micro-cap stocks. The Fund underperformed its benchmark, the Russell Microcap Index, which rose 0.68%. Underperformance of the Fund during the first three months of 2018 followed strong outperformance during the preceding one-year, three-year, five-year, 10-year and since-inception periods.

Initial expectations for a pickup in U.S. gross domestic product (GDP) gradually faded during the first quarter, as a string of softer-than-anticipated economic data forced economists to revise forecasts downward. Official advance estimates to be released in April are expected to show that real first-quarter growth in U.S. GDP fell short of the 2.9% pace observed during the fourth quarter of 2017.

The somewhat weaker economic environment confounded expectations for stocks of value companies to shine in 2018 after having lagged growth stocks during the previous year. Instead, growth stocks continued to outperform value across the full range of market capitalizations. The Fund’s value mandate did not mesh well with the strongly growth-oriented environment—especially during January, when investors displayed a remarkable appetite for risk.

Biotechnology stocks—which are considered among the riskiest of all—posted healthy gains. The strong biotechnology group helped the benchmark, which held a weight of approximately 13% in biotechnology stocks during the quarter. However, biotech companies often fail to meet our investment criteria, and the Fund’s biotechnology holdings typically have been minimal. Our underweight position in biotechnology was the primary reason the Fund underperformed its benchmark, as underexposure to this top-performing industry group was a headwind to performance.

International companies provided another modest drag on first-quarter performance in the Fund. A primarily domestic index, the benchmark was not similarly affected. Wasatch is committed to international investing, and we consider our international companies an integral part of the Fund’s portfolio. International companies tend to be more-reasonably priced than their U.S. counterparts and in our view have the potential for correspondingly greater stock-price appreciation over the long term.

Details of the Quarter

Despite lagging the Fund’s U.S. micro caps overall, the Fund’s international component nevertheless delivered the strongest contributor to performance for the quarter. Yihai International Holding Ltd. manufactures and sells hot-pot soup flavorings, hot-pot dipping sauces and Chinese-style compound condiments under the Haidilao brand name. Based in China, the company offers its products domestically and exports them to 14 countries in North America, Europe and Asia. Yihai has been benefiting from the growing popularity of hot-pot cooking and dining out. Because consumer trends can be fickle, however, we trimmed the size of this position to maintain our desired weighting in the Fund.

The second-best contributor was BofI Holding, Inc. (BOFI), the holding company for BofI Federal Bank, which operates under the name “Bank of Internet USA.” The company’s online-only business model has given it a significant cost advantage over brick-and-mortar competitors. BofI’s share price surged in late January after a major personal-finance web site listed the bank at the top of its “Best Checking Accounts in 2018” list. BofI also has gained visibility from its position as the exclusive provider of H&R Block’s no-fee, interest-free refund-anticipation loans. We think the recent publicity has served to reassure investors who previously may have been skeptical about investing in an Internet-only bank.

Another strong stock in the Fund was Everbridge, Inc. (EVBG), a software-as-a-service (SaaS) company operating in the U.S., Sweden, England and China. Everbridge offers a platform addressing tasks that school districts, states, businesses and other entities must perform in order to manage a critical event. The company’s offerings include its mass-notification application, which enables customers to send notifications to individuals or groups to keep them informed before, during and after active-shooter situations, natural disasters and other emergencies. Everbridge has seen increased demand in the wake of recent high-profile shootings, which have stimulated customers to accelerate their purchases.

The greatest detractor from performance for the quarter was Atlas Financial Holdings, Inc. (AFH). The company underwrites insurance policies for commercial automobiles in the U.S. Shares of Atlas tumbled in March after the company announced it had been forced to take an accounting charge because reserves had been inadequate to cover remaining claims from 2015 and prior years. In particular, management attributed the shortfall to higher-than-expected claims in Michigan and at one of the company’s subsidiaries.

Though disappointing, these developments at Atlas represent a temporary setback in our view. Management said the company had revamped its claims models and indicated that results for more-recent years were coming in as expected. We think the stock is likely to recover and continue to hold it in the Fund.

ZAGG, Inc. (ZAGG) was the second-largest detractor. The company makes screen protectors, portable power chargers, battery cases and other accessories for mobile devices. ZAGG saw its stock price decline sharply after earnings fell short of expectations in the company’s most-recently reported quarter. Management cited adverse impacts from tax reform, which required ZAGG to record a $12.4 million non-cash charge stemming from the remeasurement of deferred tax assets and the tax on mandatory deemed repatriation of foreign earnings. The surprise retirement of the company’s CEO also appeared to weigh on the stock. We believe the fundamentals of ZAGG’s business remain positive and increased the Fund’s position.

Another weak stock in the Fund was Installed Building Products, Inc. (IBP). The company installs insulation and other building materials, such as garage doors, rain gutters and closet shelving. Although the new-construction segment of IBP’s business continued to grow at a healthy clip, higher labor costs pressured the company’s margins. The decline of approximately 21% in IBP’s stock price during the first quarter is not unusual for micro-cap stocks, which in our experience can be quite volatile. Here again, we remain patient. (Current and future holdings are subject to risk.)

Outlook

Home to over 5,000 energy-related companies generating about 40% of U.S. petrochemical capacity, Houston, Texas is known as the “Energy Capital of the World.” We traveled there recently to get a firsthand look at how business was doing. What we found is that the energy business is doing pretty well.

Strong global growth and rising demand have kept oil prices on firm footing so far in 2018. After plummeting below $30 per barrel in 2016 and having languishing below $60 since 2015, crude oil prices have held above the key $60 level for most of the first quarter. According to recent estimates from the International Energy Agency, global demand for crude in 2018 is expected to rise by 1.5 million barrels per day.

Investors haven’t seemed to notice. Energy was one of the worst-performing sectors of the Russell Microcap Index during the first quarter, posting a decline of about -8.3%. On our metrics, stock valuations for energy companies have currently fallen to what we consider attractive levels. In short, sentiment toward the energy sector has been so poor for so long that investor expectations seem to have become anchored around a permanently gloomy outlook.

Our research indicates that continued negativity may be unwarranted. For the first time in years, energy companies appear to be gaining the upper hand in terms of pricing power. Margins are improving, and in our view brighter days for the energy sector—if they have not already arrived—may be right around the corner. In terms of downside risk, we think most of the companies we visited in Houston can remain profitable with oil as low as $50 per barrel.

As far as equities as a whole are concerned, we count possible inflationary surprises and the potential for a full-blown trade war among the greatest risks to the market. Historically, either of these developments has posed a significant headwind for even the best-managed, highest-quality companies.

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.

Frank Russell Company is the source and owner of the Russell Index data contained or reflected in this material and all trademarks and copyrights related thereto. This is a presentation of Wasatch Advisors, Inc. The presentation may contain confidential information and unauthorized use, disclosure, copying, dissemination or redistribution is strictly prohibited. Frank Russell Company is not responsible for the formatting or configuration of this material or for any inaccuracy in Wasatch Advisors, Inc.’s presentation thereof.

CFA® is a trademark owned by CFA Institute.

The Wasatch Micro Cap Value Fund’s investment objective is long-term growth of capital.

Gross domestic product (GDP) is a basic measure of a country’s economic performance and is the market value of all final goods and services made within the borders of a country in a year.

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. 

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