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

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Q2 2018
Trade Worries Shaped Investment Returns During a Strong Quarter for Micro Caps
by Brian Bythrow, CFA

“Because small companies are typically more domestically focused than larger companies, small-capitalization stocks outperformed large-cap issues during the second quarter as investors sought refuge from multinationals and other companies with significant exposure to global trade.”

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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 June 30, 2018 the average annual total returns of the Wasatch Micro Cap Value Fund for the one-, five- and ten-year periods were 22.02%, 14.53% and 12.27%, the returns for the Russell Microcap Index were 20.21%, 12.78%, and 10.63%.  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 gained 8.31% in what was a strong second quarter for U.S. micro caps. The Fund lagged its benchmark, the Russell Microcap Index, which rose 9.97%.

The U.S. economy appeared to pick up steam during the second quarter after expanding at a lackluster 2.0% pace during the first three months of the year on an inflation-adjusted basis. With economic data coming in stronger than anticipated, the Federal Reserve raised its overnight lending rate and guided expectations higher with respect to future interest-rate policy. Conditions in the labor market remained tight, and the civilian unemployment rate dipped below 4% for the first time since December 2000.

Worries grew that a trade war between the U.S. and China may impact corporate profits and derail economic growth. The escalating conflict over trade—which threatened to engulf regions including the European Union, Mexico and Canada—largely shaped investment returns across market capitalizations and sectors. Because small companies are typically more domestically focused than larger companies, small-capitalization stocks outperformed large-cap issues during the second quarter as investors sought refuge from multinationals and other companies with significant exposure to global trade. Areas of strength in the U.S. micro-cap space included health-care companies, software companies selling to U.S. businesses and consumer-staples companies focused on the domestic market.

Energy was the top-performing sector of the Index as the price of crude oil surged above $70 a barrel. The cyclical, capital-intensive nature of the energy business does not fit well with our focus on high-quality companies, however, and our underweight exposure to energy was a headwind for the Fund. Also, the Fund’s energy stocks generated a negative return as a group, which hurt performance in view of the outsized gains in the benchmark’s energy positions.

Even with energy included, the Fund’s U.S. holdings outperformed the benchmark. But, as the U.S. dollar climbed 5.0% against a basket of major rivals during the quarter, the surging greenback sapped investor enthusiasm for assets denominated in other currencies. Consequently, international stocks—which accounted for around 30% of the Fund’s assets and only about 1% of the benchmark—were the greatest source of second-quarter underperformance.

Health care was the largest source of strength against the benchmark. The Fund’s health-care stocks significantly outgained the health-care positions in the Index, boosting Fund performance in absolute terms and compared to the benchmark. Underweight exposure to biotechnology stocks also benefited the Fund, as biotechs lagged both the health-care sector and the Index as a whole.

Details of the Quarter

Financials were another area of strength in the Fund. Top gainers in the sector included Goosehead Insurance, Inc. (GSGD), the strongest overall contributor to Fund performance for the quarter.

Through its network of franchisees and corporate agents, Goosehead acts as the broker for insurance products from over 80 carriers. The company’s innovative business model leverages technology to handle a variety of customer-service and back-office functions, allowing its brokers to focus primarily on sales. Net income in Goosehead’s most-recently reported quarter jumped 66% versus the year-ago period on a 47% increase in revenues. We initiated the Fund’s position in Goosehead during the company’s initial public offering (IPO), which was completed on May 1st.

OrthoPediatrics Corp. (KIDS) was the second-best contributor. The company develops orthopedic implants to treat injuries and deformities in children. Because child-sized orthopedic implants represent a relatively small and unattractive business segment for larger competitors, we believe OrthoPediatrics is uniquely positioned to serve an underdeveloped and underpenetrated area of the implant market. Revenue grew nearly 24% in the company’s most-recent quarter, topping Wall Street estimates.

The third-largest contributor to performance was USA Technologies, Inc. (USAT). The company provides payment technology for cashless and mobile transactions at vending machines, kiosks and other unattended locations. Shares of USA Technologies rose sharply in May after the company reported financial results for its most-recent quarter. Management’s upbeat assessment cited the successful recent integration of a major competitor the company had acquired, improved operational efficiencies and revenue and margin expansion across the company’s business.

The greatest detractor from performance for the quarter was Hudson Technologies, Inc. (HDSN). The company sells reclaimed and virgin refrigerants, and industrial gases. Hudson’s stock price fell in May after earnings and revenues missed expectations in the company’s most-recent quarter. Management cited a weak pricing environment and lower sales volumes, which it attributed to cooler-than-normal weather and reduced preseason stocking activity compared to previous years. The pricing headwinds forced Hudson to lower its revenue and earnings guidance for full-year 2018.

We think this is a temporary setback for the company and continue to own the stock in the Fund. Hudson is the largest U.S. recycler and processor of the refrigerant chlorodifluoromethane (more commonly known as HCFC-22 or R-22). With virgin production of R-22 already being phased out and scheduled to end completely in 2019, we expect dwindling supplies of R-22 to push selling prices higher.

Other significant detractors included John Bean Technologies Corp. (JBT). The company sells food-processing equipment and offers services for the air-transportation industry. Although revenue in John Bean’s most-recently reported quarter came in ahead of Wall Street forecasts, earnings fell slightly short of expectations. Investors punished the stock severely in what we view as something of an overreaction. Longer term, we think John Bean stands to benefit as the growing popularity of frozen and packaged foods drives increased demand for the company’s products.

Another weak stock in the Fund was LGI Homes, Inc. (LGIH). The company designs and builds entry-level homes in Texas, Arizona, Florida and other U.S. locations. Fears that rising mortgage interest rates would make homes less affordable for potential buyers weighed on LGI’s stock price. Sharing these concerns, we significantly cut back the Fund’s position in LGI prior to the start of the second quarter. However, we believe the company’s shares remain a worthwhile holding at their current, lower weight. Tight housing supplies and favorable demographics in the markets LGI serves leave ample room for future growth in our view. (Current and future holdings are subject to risk.)

Outlook

Although our international companies were a drag on performance during the second quarter, we remain committed to international investing and consider our international companies an integral part of the Fund’s portfolio. International companies tend to be more-reasonably priced than their U.S. competitors and in our view have the potential for correspondingly greater appreciation over time.

Extended outperformance of growth stocks in recent years has driven their valuations to very high multiples. Valuations became stretched even further during the second quarter as concerns about global trade drove outperformance in health care, software and other domestic growth areas of the market. While we cannot predict if or when the valuations of growth stocks will normalize in relation to value stocks, reversion toward the mean has been a historical tendency of valuation metrics. Should value stocks again enjoy their day in the sun, we think the Fund is well-positioned to benefit and has the potential to outperform.

We were pleased to observe a substantial pickup in the pace of initial public offerings (IPOs) during the second quarter. We have a very deliberate screening process for IPOs that we believe helps us identify attractive offerings for the Fund. Even when we decide not to participate in an IPO, we consider our screening process a valuable tool for understanding the company. We believe the insights gained during the IPO-screening process prepare us to revisit the stock in the secondary market if the company’s valuation or fundamentals should improve down the road.

From a long-term perspective, we think a healthy IPO market is important for a couple of reasons. First, IPOs are needed to replace companies that graduate out of the micro-cap asset class. Second, we believe a healthy micro-cap IPO calendar helps to sustain investor interest and create a deeper, more-liquid market for micro-cap equities.

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.

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 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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