Wasatch Core Growth Fund® (WGROX)  Invest in this Fund 

Investor Class | Institutional Class
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3Q18
Identifying High-Quality Companies Is More Important Than Timing the Market
by JB Taylor, Paul Lambert and Mike Valentine

“We’re continually reminded to keep a long-term perspective—provided we remain confident in a company’s management team, competitive advantages and headroom for growth in the marketplace.”

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For the period ended  September 30, 2018, the average annual total returns of the Wasatch Core Growth Fund for the one-, five- and ten-year periods were 27.66%, 13.94% and 14.51%, the returns for the Russell 2000 Index were 15.24%, 11.07%, and 11.11%, and the returns for the Russell 2000 Growth Index were 21.06%, 12.14%, and 12.65%. Total Expense Ratio: 1.21%.

 

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 Core Growth Fund—Investor Class rose 6.77% during the third quarter of 2018, outperforming its primary benchmark, the Russell 2000 Index, which advanced 3.58%. The Fund’s secondary benchmark, the Russell 2000 Growth Index, gained 5.52%—which made for the tenth consecutive quarter of positive performance as investors continued to favor growth-oriented stocks over value-oriented names.

The Fund’s outperformance for the third quarter came largely as a result of favorable stock selection, with further boosts from our underweight allocation to real estate and our lack of exposure to energy. Both real estate and energy were among the benchmark’s weakest-performing sectors. The most-significant driver of positive performance came from a surge in the stocks of U.S. retailers and other holdings in the consumer-discretionary sector. Names in the information-technology and industrials sectors also contributed. The only sector in which we saw a negative absolute return was financials, where some bank holdings came under pressure due to rising short-term interest rates.

As a whole, the U.S. market is now at or near record highs. While large technology firms have been responsible for much of these gains, investors have also been attracted to smaller companies in a highly positive economic environment. Although this dynamic has been favorable to our investment style, it’s encouraging to see that the returns have been justified by strong underlying fundamentals. In fact, the anecdotes we’ve been hearing from company management teams suggest that the business environment is as positive as any we’ve seen since the global financial crisis, something our bottom-up analysis also supports. And that’s really saying something, given our focus on investing in what we consider to be exceptionally high-quality companies with outstanding growth prospects.

It’s also encouraging to see outstanding fundamentals translate into strong absolute and relative returns for the Fund. Just as important, we’re encouraged by the nature of these returns. In a powerful “up market,” it’s one thing to outperform by carrying a high beta—more risk—relative to the market. (For the purpose of this commentary, the market is the small-cap market as represented by the Russell 2000 Index or the Russell 2000 Growth Index.) It’s another thing entirely to outperform with a lower beta. For the five-year period ended September 30, 2018, the Core Growth Fund’s beta was 0.83 versus the Russell 2000 and 0.83 versus the Russell 2000 Growth. (By definition, the beta of an index is 1.0, and anything below 1.0 generally indicates a risk level lower than that of the index.)

Another way to gain insight into the nature of the Fund’s returns is to examine relative performance on “up days” and “down days” in the market. For the year-to-date period through September 30, 2018, the Fund outperformed, on average, both when the market was up and when it was down. In our view, the Fund’s outperformance on down days was especially encouraging because it suggested that the Fund’s high-quality nature was rewarded even at times when investors got jittery.

That leads us to a basic aspect of our investment philosophy: We believe identifying high-quality companies is much more important than timing the market just right. Consider, for example, the following stock graph of longtime holding Copart, Inc. (CPRT). For companies with long-term positive trajectories such as Copart’s, the specific entry and exit points don’t matter nearly as much as the more-basic decision to own the stock at all. While we don’t expect every holding to generate a graph like this one, it’s helpful to revisit some of our “winners” so that we’re continually reminded to keep a long-term perspective—provided we remain confident in a company’s management team, competitive advantages and headroom for growth in the marketplace.

CPRT

Having just described our long-term success with Copart, it’s important to note that the stock was one of the Fund’s largest detractors for the third quarter of 2018—which is another good illustration of the importance of having patience, as performance often accrues in rather uneven ways.

Copart is a U.S. industrial company that salvages and auctions vehicles. The company has continued to prove itself on both our growth and quality metrics. Reports from Copart management indicated that the combination of revenue growth and operating leverage was the best in a decade (after backing out unusual costs associated with handling cars affected by hurricanes Harvey and Irma). Because Copart processes vehicles deemed to be total losses by insurance companies, the company’s business picked up as an increasingly high proportion of accident claims were designated as such. Copart also benefited from strong used-car pricing. The company responded to growth opportunities by expanding its existing salvage yards and opening new facilities.

While this was all good news for most of the past year, Copart’s stock came under pressure during the third quarter as many investors became concerned that the stock may have gotten somewhat ahead of the fundamentals. For our part, we’ve learned not to bet against Copart—despite the stock’s volatility and temporary periods of underperformance. However, we do periodically buy and sell Copart shares to maintain proper portfolio weights and diversification in the Fund.

In this environment of record and near-record stock prices, it’s also helpful to broaden—beyond a specific company—the point about long-term trajectories in the history of investments. Regarding the market as a whole, we can evaluate the Dow Jones Industrial Average (DJIA) because it’s been in existence much longer than many other indexes such as the Russell 2000 and the Russell 2000 Growth.

Looking back over the decades, it’s easy to identify extended periods of time—17 or 18 years, for example—that were characterized by generally rising stock prices. Sure, shorter-term bear markets were contained within these periods, but the overall movement was upward. Viewed in this way, stock-market history seems like periods of long-term rising trends interspersed with periods of sideways movements, as shown in the DJIA graph below.

DJIA

We don’t know when the next period of flat or down performance will arrive. What we do know, however, is that—based on historical stock-market data—the current rising trend may still have legs. So rather than paying too much attention to market cycles, we focus on finding high-quality growth companies that we believe will help us take advantage of favorable conditions, and hopefully help us navigate more-difficult environments too.

DETAILS OF THE QUARTER

Trex Co., Inc. (TREX), a U.S. industrial firm, was a top contributor for the third quarter. Trex has established leadership in composite decking, railing and other high-performance, low-maintenance outdoor-living products. Trex reported exceptionally strong quarterly figures for sales and earnings that far exceeded Wall Street estimates, and its share price leapt higher on the last day of July and traded at or above that level through the end of the quarter. We remain impressed by Trex’s management team and expect to see further growth as the firm takes market share from traditional suppliers of wood products.

Two of the Fund’s U.S. retailers were also among the strongest contributors to performance for the quarter. Strong sales growth in a robust consumer-spending environment played a role in driving the stocks of both companies higher. But we also believe investors have gained greater appreciation for the companies’ business models, which insulate them to some extent from the “Amazon effect” that’s been disrupting the businesses of many traditional brick-and-mortar retailers. Each company posted strong quarterly numbers and anticipates doubling or even tripling its existing store count. In both cases, we’re highly optimistic about their prospects for achieving that growth vision.

Another strong performer was Five Below, Inc. (FIVE), which has established itself among teens and young consumers as the destination store for inexpensive, fun merchandise. Low prices for the company’s products—everything in the store sells for $5 or less—make it difficult for e-commerce companies to offer such products with the free-shipping benefit that online customers have come to expect. Moreover, Five Below has so far self-funded its store expansions through organic growth, and we expect it to continue to do so.

Rounding out the top contributors was another retailer, Ollie’s Bargain Outlet Holdings, Inc. (OLLI), which acquires excess inventory of brand-name products in a wide variety of categories, and then offers those products to customers who enjoy the bargain-priced, “treasure hunt” shopping experience. We believe Ollie’s business model would be hard for online competitors to replicate, and its loyal customer base is a competitive advantage for the company. This competitive advantage is continually strengthened through its “Ollie’s Army” membership and rewards program. Going forward, we see the potential for Ollie’s to double the number of its stores to more than 500 in the coming years.

The largest detractor from Fund performance was U.S. regional bank Eagle Bancorp, Inc. (EGBN), which saw its stock price slide on concerns that, as interest rates rise, Eagle may not be able to maintain what have been highly attractive differentials between what it pays depositors and its income from lending. We think investors have overreacted because, due to its variable-rate loans, Eagle’s earnings yield also rises as interest rates increase.

Metro Bank plc of the United Kingdom was another detractor. This retail bank’s competitive advantage is a disruptive, customer-first model offering unparalleled levels of service. The bank’s branches are open early and late, seven days a week. Metro Bank is gaining significant market share in the retail/commercial banking market in the U.K. The founder, Vernon Hill, was hugely successful in the U.S. with Commerce Bank, which he grew from one bank location with nine employees to 440 branches and $50 billion in assets. We were longtime investors in Commerce Bank, and we have a long history with Mr. Hill. The cause of the pullback in Metro Bank’s stock seemed to be that some investors were displeased with the bank having raised capital via the issuance of additional equity, which diluted existing shareholders. Our perspective is that the capital raise was well-considered and consistent with management’s long-term growth plans and the opportunities available to the bank. Metro Bank’s branch network—by the nature of having physical locations—requires capital to expand. Even in the context of Brexit-related uncertainty, we see Metro Bank as a high-quality, long-term holding.

Also down during the quarter was U.S. trucking company Knight-Swift Transportation Holdings, Inc. (KNX), which is the combination of two companies. The Knight management team—which we think is among the best in the industry—is applying its approach to managing a much larger asset base, given that Swift was approximately three times the size of Knight prior to the combination. Investors seem to have become impatient with the integration and frustrated with certain metrics such as a smaller active fleet due to a shortage of qualified drivers. On the other hand, we’re willing to be patient. We think it’s a bit early in the integration process to expect the combined business to be firing on all cylinders. We remain confident in the management team and optimistic about the general backdrop for the trucking industry, which has been benefiting from tight capacity and therefore the potential for higher prices and margins.

As mentioned above, Copart, Inc. was also a significant detractor for the quarter—despite being one of Wasatch’s best long-term holdings. (Current and future holdings are subject to risk.)

OUTLOOK

As we’ve spoken with corporate management teams in the U.S., we’ve heard again and again that they’re seeking ways to grow their businesses and make their companies operate more efficiently. Both of these endeavors are aimed at helping the companies benefit even more from an expanding economy. We believe one reason the information-technology sector has continued to thrive is that by investing in technology, executives can address their desire to achieve both growth and efficiency. Technology can facilitate growth by creating ways to reach more customers in more ways. Technology can improve efficiency through initiatives such as shifting applications to the cloud and, in a tight labor market, finding more ways to automate processes.

Although we’re always watchful for deterioration in fundamentals, we don’t see any broad-based challenges to the strong growth prospects we believe are represented by the companies held in the Fund. In certain industries, such as autos and homebuilding, market action seems to suggest a tug-of-war between continuing economic optimism on the one hand and concern that we’ve reached “peak earnings” on the other hand. But broadly speaking, we see little standing in the way of further growth in the U.S. economy.

Having said that, a robust economy and strong company-specific fundamentals don’t always translate into gains in stock prices. It’s possible for a company to experience growth without being rewarded by a higher stock price—a phenomenon we observed for some of our names in 2015 and 2016 prior to the elections. That’s one reason we focus our time and resources on researching companies we consider to be high-quality. We believe such companies are more likely to perform solidly in narrower markets, or during times when investors prefer value over growth. As we wrote last quarter, we see the companies held in the Fund as top-notch operators that we’d want to own during any type of market environment.

Of course, we do make adjustments to the Fund over time, for reasons usually relating to company-specific fundamentals—but sometimes for reasons relating to broader market dynamics. At present, the SaaS (Software-as-a-Service) industry provides a good example of the latter. Although the momentum of corporate investment could carry SaaS names even higher—especially given tax reform—we’ve trimmed some holdings in this area not because company fundamentals have deteriorated, but rather because we think valuations have reached levels at which even strong growth over several years is unlikely to translate into attractive share-price gains. As we took profits in some SaaS holdings, we reinvested the proceeds in what we see as more-reasonably valued names.

Finally, given continuing global trade tensions, we’d like to echo something we wrote previously. The short-term impacts of tariffs are difficult to predict. Over the long term, however, it’s hard to deny the benefits of globalization. Whether it takes three months or three years, trade issues are likely to be resolved. In the meantime, small-cap companies—with their greater focus on domestic markets—may provide some insulation from trade-war fallout.

Thank you for the opportunity to manage your assets.

Sincerely,

JB Taylor, Paul Lambert and Mike Valentine

 

 

**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.

The Russell 2000 Growth Index measures the performance of Russell 2000 Index companies with higher price-to-book ratios and higher forecasted growth values.

You cannot invest directly in these or any indexes.

The Wasatch Core Growth Fund has been developed solely by Wasatch Advisors, Inc. The Wasatch Core Growth 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 2000 and Russell 2000 Growth indexes vest in the relevant LSE Group company, which owns these indexes. Russell ® is a trademark of the relevant LSE Group company and is used by any other LSE Group company under license.

These indexes are 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 these indexes or (b) investment in or operation of the Wasatch Core Growth Fund or the suitability of these indexes for the purpose to which they are being put by Wasatch Advisors, Inc.

The Wasatch Core Growth Fund’s primary investment objective is long-term growth of capital. Income is a secondary objective, but only when consistent with long-term growth of capital.

A bear market is generally defined as a drop of 20% or more in stock prices over at least a two-month period.

Beta is a measurement of a fund’s trailing return in relation to the overall market (or appropriate market index).  A beta of 1 indicates the share price will typically move with the market. A beta of more than 1 indicates the share price will typically be more volatile than the market. A beta of less than 1 indicates the share price will typically be less volatile than the market.

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.

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 Dow Jones Industrial Average (DJIA) is a price-weighted average of 30 significant stocks traded on the New York Stock Exchange (NYSE) and the NASDAQ. Charles Dow invented the DJIA in 1896.

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

Earnings per share or EPS is the portion of a company’s profit allocated to each outstanding share of common stock. EPS growth rates help investors identify companies that are increasing or decreasing in profitability.

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.

Valuation is the process of determining the current worth of an asset or company.

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 2000 Index measures the performance of the 2,000 smallest companies in the Russell 3000® Index, which represents approximately 8% of the total market capitalization of the Russell 3000 Index.   The Russell 2000 Growth Index measures the performance of the Russell 2000 companies with higher price-to-book ratios and higher forecasted growth values.   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 Core Growth 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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