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

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Q3 2017
Optimism for Stronger U.S. Growth Helped Micro Caps Post Solid Gains
by Brian Bythrow, CFA

“In what so far has been a sub-par economic recovery, growth in the U.S. has remained sluggish since the end of the last recession. Data released during the third quarter held out some hope that stronger growth may lie ahead.”

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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, 2017 the average annual total returns of the Wasatch Micro Cap Value Fund for the one-, five- and ten-year periods were 23.29%, 16.00% and 8.92%, the returns for the Russell Microcap Index were 22.33%, 13.89%, and 6.65%.  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

Micro-cap equities advanced during the third quarter against a favorable backdrop of steady economic growth, low interest rates and benign inflation. Surpassing the 6.65% gain in the Russell Microcap Index, the Wasatch Micro Cap Value Fund returned 7.74% for the quarter.

In what so far has been a sub-par economic recovery, growth in the U.S. has remained sluggish since the end of the last recession. Data released during the third quarter held out some hope that stronger growth may lie ahead. The Commerce Department reported that gross domestic product (GDP) expanded at a seasonally adjusted annual rate of 3.1% during the second quarter—up from 1.2% in the first quarter and the strongest reading since the first quarter of 2015. Unemployment held steady at around 4.4%, before ticking down to 4.2% in September according to a report released shortly after the third quarter ended. Meanwhile, the Consumer Price Index increased just 1.9% during the 12 months through August as inflation remained in check.

With the economy seemingly on firm footing, the Federal Reserve (Fed) said it will begin winding down its massive balance sheet in October. The move will essentially reverse quantitative easing—the monetary stimulus the Fed has provided since the global financial crisis. Financial markets showed little reaction to the announcement, which was largely expected. For the most part, investors appeared to view the news as signaling a healthy U.S. economy no longer in need of extraordinary support from the Fed.

Advantageous stock selection in financials was the primary reason the Fund outpaced its benchmark during the quarter. While the financials in the benchmark underperformed the benchmark as a whole, the Fund’s financials posted a healthy double-digit gain. Improved prospects on the interest-rate, regulatory and housing fronts appeared to help some of the Fund’s bank and mortgage-related holdings. By favoring reasonably valued banks in growing metropolitan statistical areas, we find that the Fund’s small banks tend to make attractive targets for acquisition by larger competitors.

The Fund’s international companies lagged its U.S. holdings, primarily as the result of company-specific factors. One of the third-quarter bright spots for the Fund was Japan, where we added new positions after returning from a research trip this past spring. According to data released in August, Japan’s GDP grew at an annualized rate of 4% during the second quarter. The better-than-expected GDP print marked the sixth-straight quarter of expansion for the world’s third-largest economy.

Details of the Quarter

The strongest contributor to Fund performance for the quarter was ZAGG, Inc. (ZAGG). The company makes screen protectors, portable power chargers, battery cases and other accessories for mobile devices. Shares of Zagg soared on optimism surrounding its recently introduced mophie® wireless charging base for the iPhone 8, iPhone 8 Plus and iPhone X. The universal wireless charging pad will leave the customer's device fully functional while charging, so users can continue to use the display and connect to Bluetooth accessories. In addition, the new generation of smartphones is expected to boost sales of ZAGG’s InvisibleShield screen protectors and other products.

Second-best contributor PetIQ, Inc. (PETQ) offers over-the-counter and prescription pet medications, as well as health-and-wellness products for dogs and cats in the U.S., Canada and Europe. After completing its initial public offering in late July, PetIQ saw its stock price rise in August after management reported healthy net-income growth and a 42.3% increase in net sales during the company’s most-recent quarter. Management said the expansion of 6.6 percentage points in the company’s operating margin demonstrated the significant leverage of its business model. We think PetIQ’s first-mover advantage gives it a clear runway for the next couple of years before competitors can begin to gain a foothold in this new area of pet health care.

Independent semiconductor foundry Tower Semiconductor Ltd. (TSEM) was the Fund’s third-largest contributor. Headquartered in Israel, this rapidly growing company manufactures semiconductor devices in the U.S., Asia and Europe. Investor concerns about looming capacity constraints at Tower were dispelled in August when management announced an agreement with a Hong Kong-based company for the establishment of a new semiconductor-fabrication facility in Nanjing, China. In addition to the $18 million initial payment Tower has already received, it stands to collect future milestone payments in exchange for providing technological expertise and consulting services. Tower also will be entitled to up to half of the facility’s fabrication capacity, which the company may use at its discretion.

The greatest detractor from Fund performance for the quarter was Best Pacific International Holdings Ltd. A Chinese company with manufacturing facilities in a number of other countries as well, Best Pacific makes elastic fabrics, elastic webbing, lace and other products used in lingerie, sports bras, sportswear and casual apparel. The company’s share price fell after a decline in order volume from a major customer depressed sales in Best Pacific’s most-recent quarter. We’re currently evaluating our position in Best Pacific, as we’re concerned that smaller upstarts may continue to take market share from the company’s customers.

Flotek Industries, Inc. (FTK) was the second-largest detractor. The company supplies drilling and production products and services to the energy industry. Shares of Flotek have languished in recent quarters as low energy prices impacted exploration and production of oil and natural gas. In addition, citrus-greening disease has increased the costs of the citrus oils the company uses in the manufacture of its products. Flotek’s stock price fell further in September after Hurricanes Harvey and Irma damaged Florida citrus crops and created shortages of other raw materials for Flotek and its clients. Despite the challenges facing the company, we think its depressed valuation and upside potential justify continuing to own it at a low weight in the Fund.

Another weak stock in the Fund was Fabrinet (FN), a contract provider of electronics-manufacturing services. The company assembles optical, electro-mechanical and electronic devices for other companies. Although earnings and revenue topped expectations in Fabrinet’s most-recent quarter, the company’s stock price declined on guidance that fell short of Wall Street forecasts. We think investors are overreacting to what we view as normal volatility in end-user demand. From a longer-term perspective, we believe Fabrinet is well-positioned to benefit from a continued shift toward cloud-based data storage, and our growth outlook for the company remains favorable. (Current and future holdings are subject to risk.)

Outlook

Recent gains in U.S. equity prices have outstripped the earnings growth of the underlying companies, pushing price/earnings multiples higher. In the Fund as well, valuations have increased. The Fund, however, has significant exposure to small, growing companies yet to be discovered by mainstream investors. These undiscovered growers have seen more-modest increases in their stock prices and offer valuations that are still very attractive in our view.

Higher market valuations for equities bring increased risk for investors. One risk starting to garner attention is the low unemployment rate—or, more specifically, tightness in the labor market. During research visits to companies, management teams have commented to us recently on the difficulties they encounter finding qualified employees to help them grow their businesses.

According to economic principles, a scarce resource (in this case labor) must command a higher price in the face of unwavering demand. When labor costs rise, companies must either pass them along to customers in the form of higher prices, or see their profit margins shrink. While neither inflation nor a downturn in corporate profits would be good for investors, a modest uptick in wages would not be entirely bad. By boosting the purchasing power of U.S. households, a shift toward wages in the division of national income between wages and profits would benefit consumer-related businesses directly—and other companies indirectly through an overall increase in economic activity.

Small banks in particular have faced headwinds in recent years, as sluggish wage growth crimped demand for housing, auto and consumer loans. As a result, the banking industry remains one of more-attractively valued areas of the micro-cap equity market. With Japan just recently having emerged from its decades-long recession, reasonably priced growth opportunities can still be found in Japanese stocks as well. We’ve added several Japanese companies to the Fund this year, and we’re looking to increase the Fund’s holdings in Japan going forward.

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.

The “cloud” is the internet. Cloud-computing is a model for delivering information-technology services in which resources are retrieved from the internet through web-based tools and applications, rather than from a direct connection to a server.

The Consumer Price Index (CPI), also called the cost-of-living index, is an inflationary indicator that measures the change in the cost of a fixed basket of products and services, including housing, electricity, food, and transportation. The CPI is published monthly. The headline CPI includes volatile food and energy prices, while the core CPI excludes food and energy.

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

The global financial crisis, also known as the financial crisis of 2007-09 and 2008 financial crisis, is considered by many economists to have been the worst financial crisis since the Great Depression of the 1930s.

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 price/earnings (P/E) ratio, also known as the P/E multiple, is the price of a stock divided by its earnings per share.

Quantitative easing is a government monetary policy used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity.

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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