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

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4Q18
Interest-Rate Hike and Trade Dispute Played Havoc with Micro-Cap Stocks
by Brian Bythrow, CFA

“While both the trade dispute and the Fed’s interest-rate hike can be blamed for the sharp declines suffered during the fourth quarter by equities in general and micro caps in particular, the rate hike was, by far, the more concerning of the two.”

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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 -8.65%, 6.67% and 16.04%, the returns for the Russell Microcap Index were -13.08%, 3.08%, and 11.71%.  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

Concerned by the prospect of continuing interest-rate hikes, uncertainty about international trade, and faltering global growth, investors pushed U.S. equity prices sharply lower in the fourth quarter of 2018. The Wasatch Micro Cap Value Fund declined -18.19%, while the benchmark Russell Microcap Index fell -22.14%.

The quarter began on a down note, with investors increasingly worried that rising interest rates would increase the cost of consumer debt, put a damper on household spending, slow economic growth and depress the stock market. Those fears were confirmed in mid-December when the Federal Reserve (Fed) hiked the federal-funds rate for the fourth time in 2018, bringing the target range to 2.25% to 2.5%. Fed officials signaled that the December increase could be the last rate hike for a while as their projections for economic growth and inflation in 2019 removed the urgency for repeated increases. But the Fed’s slightly less-hawkish tone did little to assuage investor concerns toward the end of December.

Equity markets were roiled further by the lingering threat of a large-scale trade war with China. While the U.S. administration was able to achieve a new trade deal with Mexico and Canada—albeit one that achieved little more than a cosmetic makeover—the issues with China, which include protection of intellectual property, are more significant and will likely prove more difficult to resolve.

That said, the current tariffs on goods imported to the U.S. from China are providing an incentive for U.S. companies that manufacture goods in China to consider moving their operations to other countries not subject to the tariffs. The many attractive alternatives in Southeast Asia—including Vietnam, Thailand, Cambodia and Laos—are exerting considerable pressure on China to settle the dispute.

While both the trade dispute and the Fed’s interest-rate hike can be blamed for the sharp declines suffered during the fourth quarter by equities in general and micro caps in particular, the rate hike was, by far, the more concerning of the two. Banks are being hampered by a flattening yield curve and declining investor confidence. Rising rates will also have an adverse impact on the housing market, increasing the cost of home ownership and new construction. This was reflected in steep declines of the Fund’s holdings in the industrials and materials sectors. The overall impact from the materials sector on the Fund’s performance was mitigated by our very small position. The industrials sector was a different story. The Fund was overweight in industrials, and our holdings underperformed making the sector the largest detractor from relative performance.

Details of the Quarter

Datawatch Corp. (DWCH) was the top contributor to the Fund’s performance for the quarter. The company offers data-mining software that allows businesses to access, analyze and visualize their information. When we first invested in Datawatch, we thought the company would grow nicely on its own or would be acquired by a larger firm. In November, Datawatch announced that it agreed to be bought by Altair at a premium to the stock price just before the announcement. While the premium was significant, we would have expected it to be even larger in a better market environment. Nevertheless, we sold all of our Datawatch shares based on the announcement.

The Fund’s second-best contributor was Lovesac Co. (LOVE), a furniture manufacturer known for its Love Sac, a pillow-like chair, and the Sactional, a modular couch that has become very popular with young buyers. Apartment dwellers, for example, can buy a few units to create a small couch and then add to it when they move into a larger home. The modular units can easily be rearranged, and their covers can easily be replaced to accommodate changes in décor or damage from spills. The company is marketing it as a couch for life, geared toward a young working crowd. Further, the company guarantees that modular pieces bought today won’t be made obsolete by future changes and/or improvements. Same-store sales increased 50% in Lovesac’s most-recent quarter, demonstrating consumers’ acceptance of the company’s new products.

Fabrinet (FN), another contributor, is one of the often-overlooked companies that has benefited from the ongoing trade dispute with China. The company makes optical components for a range of industrial and communications applications. Already operating from a manufacturing plant in Thailand, the company has been able to avoid the tariffs that have put China-based manufacturers at a disadvantage. Fabrinet had been operating with excess manufacturing capacity, which is rapidly diminishing as companies seek to avoid paying tariffs on goods manufactured in China.

Our lone Chinese stock, Yihai International Holdings Ltd., benefited from the initial public offering (IPO) of its former parent and largest customer, Haidilao International Holding Ltd., one of China’s most-popular hotpot restaurant chains. Yihai manufactures and sells hotpot soup flavorings, hotpot dipping sauces and Chinese-style compound condiments under the Haidilao brand name. Yihai’s stock, despite a December decline, gained more than 145% in 2018.

Patrick Industries, Inc. is a manufacturer and distributor of building products and materials for industrial markets including recreational vehicles and manufactured housing. The company was the Fund’s largest detractor in the fourth quarter as rising interest rates and the threat of recession pushed many investors out of the industrials sector. Additionally, because the recreational-vehicle business is cyclical in nature and has likely passed its peak, investors had another reason to flee. Over the long term, however, we continue to believe that Patrick represents a substantial investment opportunity. We may add to our position if and when an attractive buying opportunity arises.

Sun Hydraulics Corp. (SNHY) was the second-largest detractor. Sun Hydraulics, which has changed its name to Helios Technologies, is a manufacturer of high-performance compact hydraulics for a broad set of industrial end markets. In addition, the company manufactures electronic controls and display and instrumentation solutions for vehicles, including marine and recreational vehicles. We like the company’s potential for strong sales growth driven by demand for its products, as indicated by a backlog of orders. We also like the company’s strategic approach to making acquisitions, including two deals that were recently closed, and its planned new-product launches. Although the shares were severely depressed as the industrials sector lost ground, we believe Sun/Helios has good pricing power—including the ability to pass on higher materials costs to customers.

Zagg, Inc. (ZAGG), a producer of accessories for mobile devices, was another detractor from performance in the fourth quarter. Zagg’s shares, along with those of other value companies that are perceived as more cyclical, were pummeled by investors concerned with the possibility that economic growth is slowing. But we believe Zagg’s fundamentals remain strong. The company has been growing and generating cash, and the stock is priced at roughly four times the company’s cash flow. (Current and future holdings are subject to risk.)

Outlook

Looking ahead, we think that much is riding on the Fed and its further action on interest rates. We’re also mindful of the Trump administration’s aggressive posturing on the trade dispute with China. Moreover, with the government partially shut down and a pending shift in control of the U.S. House of Representatives, we’ll be keeping an eye on political developments as well.

Not only is the impact of higher short-term interest rates already being felt throughout the equity markets, the effect may be greatest on micro caps. With long-term rates dropping, the yield curve is flattening, which is reducing the difference between borrowing and lending rates. This is making it especially difficult for micro-cap banks to improve profitability. Higher short-term rates also hurt lower-end homebuyers disproportionally, which puts a squeeze on the manufacturers and retailers that supply less-affluent consumers.

Looking ahead, we believe that market conditions will be largely dependent on policy decisions made by both the Fed and the Trump administration. At the same time, we like the group of companies in which the Fund has invested. And with many of our traditional value holdings having been clobbered during the fourth quarter, we’re looking for attractive opportunities to increase our positions.

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.

As of December 31, 2018, the Wasatch Micro Cap Value Fund was not invested in Haidilao International Holding Ltd.

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

The yield curve is a line on a graph that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. The most frequently reported yield curve compares three-month, two-year, five-year and 30-year U.S. Treasury securities. This yield curve is used as a benchmark for other interest rates, such as mortgage rates or bank lending rates. The curve is also used to predict changes in economic output and growth.

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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View the Micro Cap Value Fund’s most current Top 10 Holdings

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