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

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3Q18
Fund Outperformed Buoyed by Stock Selection and a Favorable Macroenvironment
by Brian Bythrow, CFA

“We don’t base our investment decisions on macroeconomic conditions or political events. Instead, we focus on in-depth, bottom-up research to uncover opportunities in individual companies that other investors might not yet fully appreciate.”

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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 September 30, 2018 the average annual total returns of the Wasatch Micro Cap Value Fund for the one-, five- and ten-year periods were 18.84%, 13.27% and 14.78%, the returns for the Russell Microcap Index were 13.65%, 10.51%, and 10.82%.  Expense ratio: Gross 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 4.93% during the third quarter, outperforming the benchmark Russell Microcap Index, which rose 0.83%. The benchmark’s positive but much more subdued gain was a shift from the second quarter’s strong showing for micro-cap stocks in general. During the third quarter’s somewhat flatter environment, we were pleased to see the Fund outpace the benchmark as we continued to focus on companies with the potential to do well in a wide range of economic environments.

Over the course of the third quarter, the benchmark’s performance reflected investors’ uncertainty about just what kind of economic environment may be on the horizon. Following its strong return in the second quarter, the Russell Microcap Index fell back in July, then more than regained that ground, ending August in record territory—only to slip back toward mid-summer levels over the course of September.

During both the August rally and the quarter as a whole, the Fund outpaced its benchmark despite having international holdings throughout a period in which U.S. stocks generally rose more than those in the rest of the world.

In August, the bull market for U.S. stocks—according to several measures—became the longest ever. The S&P 500® Index, which includes 500 of the United States’ largest companies from a broad variety of industries, finally pushed above its January high and crossed over the 2,900 threshold for the first time. The Nasdaq Composite, a market-capitalization-weighted index of more than 3,000 securities listed on The Nasdaq Stock Market, jumped to over 8,000 as Amazon.com’s stock pushed above the $2,000 milestone. And the Russell 2000® Index of small-company stocks moved definitively over the 1,700 level after months of flirtation.

There was plenty of good news on the economic front as well. The U.S. unemployment rate fell as the labor market continued to tighten. Job openings exceeded the number of unemployed workers for the third consecutive month. The Federal Reserve (Fed) raised its benchmark interest in September based on its latest assessment of economic conditions as “strong,” which was an improvement from its previously “solid” assessment. And the government’s Bureau of Economic Analysis upwardly revised its estimate of second quarter 2018 gross domestic product growth to 4.2% thanks to healthy consumer spending on durable goods.

Trade tensions between the United States and the rest of the world remained a top-of-mind concern. Although we seemed to receive good news regarding the renegotiation of the North American Free Trade Agreement just after the end of the quarter, during the quarter itself President Trump rejected a European Union proposal to remove auto tariffs. And the administration moved forward with new tariffs on $200 billion worth of Chinese imports into the United States.

Health care was a significant area of strength for the benchmark during the quarter. The Fund’s health-care holdings outperformed their benchmark peers, and the group contributed the most to the Fund’s return. Based on our concerns about rising valuations within the sector, however, we were underweight relative to the benchmark. In general, health-care stocks have benefited from a strong second-quarter reporting season with rising revenues and earnings growth boosted by corporate tax cuts.

Industrials and information technology (IT) were other areas of strength for the Fund. In both sectors, our selection of holdings outperformed the benchmark names. Micro-cap technology stocks also seemed to be enjoying the halo effect from intense investor interest in big-cap tech stocks.

The consumer-discretionary sector was a source of weakness against the benchmark, as our consumer-discretionary holdings underperformed their benchmark peers. On a country basis, Japan was a notable detractor from the Fund’s absolute and relative performance.

Details of the Quarter

The Fund’s top contributor for the third quarter was i3 Verticals, Inc. (IIIV), a relatively recent purchase. We regarded i3 Verticals as an “undiscovered gem,” our term for a company that has not yet attracted the attention of Wall Street analysts and is therefore likely to be undervalued. i3 Verticals offers payment-software solutions for niche areas like school lunches, high-school sporting events and speeding-ticket fines. While the company’s organic growth isn’t earth-shattering (in the mid-single digits), we believe it has a solid management team that could use acquisitions to boost earnings growth toward 20% annually. And we consider the stock to be attractively priced. The company’s initial public offering in June was valued at a discount of approximately 20% relative to its peers. i3’s performance during the quarter tells us the company is now getting the attention it deserves.

Two health-care companies, OrthoPediatrics Corp. (KIDS) and PetIQ, Inc. (PETQ), were also among the third quarter’s most-significant contributors. OrthoPediatrics continued its strong run following a second-quarter revenue announcement that topped Wall Street estimates. We believe the company’s focus on child-sized orthopedic implants gives it an attractive niche unlikely to be pressured by larger competitors.

PetIQ, Inc. (PETQ) sells pet medications and wellness products, including prescription treatments for diseases like arthritis and diabetes as well as flea and tick control. Brands include PetAction® Plus and Advecta. In August, PetIQ’s stock capped a gain of more than 100% from the post-IPO lows seen in May. The increase was fueled by the reporting on August 15th of better-than-expected quarterly results with earnings of 66 cents per share on a 96% year-over-year rise in revenues. We’re optimistic regarding growth potential as the company moves into veterinary services and widens its retail distribution network.

Freshpet, Inc. (FRPT) was another large contributor. The company sells fresh, refrigerated meals and treats for dogs and cats in the U.S., Canada and the United Kingdom. Shares of Freshpet rose sharply in early August after the company reported better-than-expected net sales, which jumped 23% compared the same quarter a year ago. Management raised its full-year guidance for 2018 as Freshpet’s core dog household penetration increased at its fastest rate in more than three years. To meet growing demand for the company’s products, Freshpet plans to expand its manufacturing facility in Pennsylvania. We trimmed our position in Freshpet a little in response to the company’s higher valuation, but it remains a significant holding in the Fund.

The greatest detractor from performance for the quarter was USA Technologies, Inc. (USAT). The company provides payment technology for cashless and mobile transactions at vending machines, kiosks and other unattended locations. USA Technologies saw its stock price tumble after the company announced it would not file its Annual Report on Form 10-K by the September 13 due date. Management said an investigation was underway into some of the company’s contractual arrangements and financial-reporting controls. While we continue to hold our position in USA Technologies, we’re monitoring the situation closely.

Metropolitan Bank Holding Corp. (MCB), a New York-based regional bank, was also among the Fund’s detractors. We sold out of this name during the quarter. One reason for our decision was the mild pressure on banks’ earnings being created by rising interest rates paid on deposits as the Fed gradually increases short-term rates. Rates for longer periods—those over which banks typically make loans—have remained suppressed, however, due to low levels of inflation. This reduction in the net interest margin has pressured the earnings of banks of all sizes. We also sold out of The First of Long Island Corp. (FLIC) during the quarter. Our preference in this environment of rising interest rates is to focus on banks with business strategies that can offset the margin pressure. For example, we recently increased our exposure to Capital Bancorp, Inc. (CBNK), which derives a significant portion of its income from credit-card loans that are less impacted by the differential between short- and longer-term interest rates. (Current and future holdings are subject to risk.)

Outlook

The equity markets, especially in the U.S., have been benefiting from a favorable economic environment. While the Fund has benefited as well, we don’t base our investment decisions on macroeconomic conditions or political events. Instead, we focus on in-depth, bottom-up research to uncover opportunities in individual companies that other investors might not yet fully appreciate. We seek out companies that are temporarily undervalued because they are relatively undiscovered, or because they are growth companies experiencing what we consider a short-term setback, or because their growth has stalled but we’ve identified a catalyst—such as a niche strategy—that provides strong potential for future growth.

As the current record-length bull market pushes deeper into old age, lofty valuations are testing the selling discipline of portfolio managers. We’ve seen this especially in areas like health care, IT and SaaS (Software-as-a-Service). An example from the Fund is Exact Sciences Corp. (EXAS). The company’s stock jumped up on the announcement of a co-promotion agreement with Pfizer. We sold our position in Exact Sciences to put the proceeds to work in more-attractively valued new names, including Iridex Corp. (IRIX), which makes a laser-treatment system for glaucoma. We’ve been establishing a position in Iridex at a price of less than two times sales.

Another new addition to the Fund was Magnolia Oil & Gas Corp. (MGY), a special purpose acquisition company, or SPAC. Within the energy sector, SPACs are sometimes viewed unfavorably, as they may be shell companies created to operate lower-quality assets. However, the SPAC structure can be advantageous for a high-quality operation too. In this case, we’re optimistic about Magnolia’s prospects given its experienced CEO, outstanding well results and conservative balance sheet.

We also purchased shares in Sun Hydraulics Corp. (SNHY) during the quarter. Sun Hydraulics, which recently 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 the company’s 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. We believe Sun/Helios has good pricing power, including the ability to pass on higher materials costs to customers.

Finally, we’re scouring the micro-cap universe for new opportunities in Asia. We’ve been attracted to Taiwan and Hong Kong, in particular, as recent market weakness has made

stock valuations attractive in a number of companies that have what we consider to be solid growth prospects.

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.

A bull market is defined as a prolonged period in which investment prices rise faster than their historical average. Bull markets can happen as the result of an economic recovery, an economic boom, or investor psychology.

Earnings growth is a measure of growth in a company’s net income over a specific period, often one year.

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.

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

The North American Free Trade Agreement (NAFTA) is a treaty entered into by the United States, Canada and Mexico. In accordance with the terms of the agreement, the three nations phased out numerous tariffs between January 1, 1994 and January 1, 2008. NAFTA’s purpose is to encourage economic activity between the United States, Canada and Mexico.


Launched in 1971, the NASDAQ Composite Index is a market-capitalization weighted index of the more than 3,000 securities listed on The Nasdaq Stock Market. The types of securities in the index include American depositary receipts, common stocks, limited partnership interests, ordinary shares, real estate investment trusts (REITs), shares of beneficial interest (SBIs) and tracking stocks.

The S&P 500 Index includes 500 of the United States’ largest stocks from a broad variety of industries. The Index is unmanaged and is a commonly used measure of common stock total return performance.

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.

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

Portfolio holdings are subject to change at any time. References to specific securities should not be construed as recommendations by the Funds or their Advisor.

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CFA® is a trademark owned by CFA Institute.