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

Investor Class | Institutional Class
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1Q19
Stocks Show Resiliency in First Quarter
by JB Taylor, Paul Lambert and Mike Valentine

“…after all the stock-market volatility we’ve seen in the past year, analysts have generally maintained their assessment of sales performance for companies in the Index and are somewhat more enthusiastic for companies held in the Fund.”

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For the period ended  March 31, 2019, the average annual total returns of the Wasatch Core Growth Fund for the one-, five- and ten-year periods were 6.83%, 11.25% and 18.45%, the returns for the Russell 2000 Index were 2.05%, 7.05%, and 15.36%, and the returns for the Russell 2000 Growth Index were 3.85%, 8.41%, and 16.52%. Total Expense Ratio: 1.18%.

 

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

Stocks roared back in the first quarter of 2019—with the majority of global equity indexes posting positive double-digit increases. The Wasatch Core Growth Fund—Investor Class delivered a strong gain of 15.37% for the quarter, outperforming the 14.58% return of its primary benchmark, the Russell 2000 Index. The Fund slightly underperformed its secondary benchmark, the Russell 2000 Growth Index, which rose 17.14%. Overall, growth-oriented stocks outperformed their value counterparts during the quarter—as risk assets were buoyed by optimism regarding global trade negotiations and a continued dovish stance from the U.S. Federal Reserve (Fed).

The past several quarters delivered a host of geopolitical, economic and technical market events—including the U.S. government shutdown, wrangling over Britain’s exit (Brexit) from the European Union and concerns of a “hard landing” in China. Two other highly publicized macro issues also stood out to us:

1. The wild up and down swings in stock prices over the past 15 months underscored, in our view, what may be a sustained increase in market volatility. Over the last five quarters, stocks have notched about a 40% surge in market volatility as measured by the CBOE Volatility Index (VIX)—which may not abate any time soon.

2. In late March 2019, the yield curve inverted for the first time since 2007, primarily due to the release of softer U.S. economic data, very accommodative signals provided by the Fed and bond investors believing interest-rate increases are over. Of course, many market pundits have opined that every American recession over the past 60 years has been preceded by an inverted yield curve. These same pundits usually fail to mention, however, that a yield-curve inversion doesn’t predict the exact timing of a recession or the performance of stock prices.

We raise these two macro issues—a significantly higher trading level for the VIX (also known as the “fear index”) and the yield-curve inversion—not because our investment decisions rely heavily on macro conditions. Rather, we raise these issues because we think investors may have to get used to greater volatility in stock prices and because we want shareholders to be mindful that economic and market predictions aren’t as accurate as the headlines would have us believe.

No Need to Change What Isn’t Broken

One good way to describe our investment approach is that we’re “macro-aware” rather than “macro-driven.” We spend the overwhelming majority of our time kicking the tires of high-quality companies and analyzing their fundamentals. Moreover, when we remain impressed by the operating performance and valuation of our companies, we don’t buy and sell just for the sake of showing activity in the Fund. In other words, we feel no need to change what isn’t broken.

While we’re never really just standing still at Wasatch (there’s always another company to research), the first quarter of 2019 was particularly quiet from a trading perspective. This was because the companies we owned were mostly delivering the operating results we had expected. The reasons for our current optimism regarding Fund holdings are reflected in the following table, which is explained below.

Wall Street analysts continually make estimates of future sales and earnings for a large portion of publicly traded companies. One year ago (March 31, 2018), analysts made estimates for 2019 sales and earnings. Today (March 31, 2019), we have new 2019 estimates, which should be better because analysts have received additional feedback from corporate management teams and because 2019 has already started.

What we see in the table above is that for sales among Russell 2000 companies, analysts haven’t changed (0%) their overall estimates. For sales among companies in the Wasatch Core Growth Fund, analysts have actually upped their overall estimates by +4%. So after all the stock-market volatility we’ve seen in the past year, analysts have generally maintained their assessment of sales performance for companies in the Index and are somewhat more enthusiastic for companies held in the Fund.

Regarding earnings, analysts have taken down their Russell 2000 overall estimates by
-12% and by only -6% for Wasatch Core Growth Fund companies. Please note that these negative numbers don’t imply lower earnings than in the previous year—just a decline in estimates. Also note that the preceding numbers (including those in the table) were generated based on Russell 2000 and Wasatch Core Growth Fund positions as of March 31, 2018.

As of today (March 31, 2019), sales for Wasatch Core Growth Fund companies are expected to be up +14% on average in 2019 compared to the previous year. And earnings for companies in the Fund are expected to be up +10%.

So, what do these numbers tell us? First, with the panic in the markets and the negative headlines, it might have been understandable if companies and analysts had taken the opportunity to guide down their estimates for 2019. Instead, relative to a year ago, sales estimates were flat for the Index and up for the Fund. Second, earnings estimates from a year ago were down somewhat—but down less for the Fund. Moreover, while estimates were down, the forecast is still for positive growth in 2019.

Another question is: Why have estimated earnings growth rates come down a bit when sales growth rates have held up better? We believe that’s because companies are seeing higher wages and greater input costs generally. When you think about it, rising wages and more-expensive inputs aren’t necessarily bad because they indicate that the economy has been exhibiting relatively healthy demand and consumers have money to spend on products and services.

Economy and Markets

Regarding the economy, we believe the U.S. has continued to demonstrate some resilience in the face of slowing global growth and a backdrop of political uncertainty. Nevertheless, a downward revision of fourth-quarter U.S. gross domestic product (GDP) growth and a forecast of only about 1.5% growth in the first quarter have lowered the economic bar for calendar 2019. The good news is that the U.S. economy is at least slowing from a solid position. Through February, unemployment remained low and household balance sheets are generally healthy. The key signals of slower growth are cyclical indicators such as auto sales, housing starts and factory orders—all of which have been losing steam.

During the first quarter, the sector that delivered the best returns for both the Fund and the Russell 2000 Index was information technology. This wasn’t surprising to us given that businesses are increasingly turning to technology to make their operations more efficient in an environment of slower growth, increasing competition and a tight labor market. The Fund benefited relative to the benchmark from excellent stock selection and an overweight allocation in information technology.

Our stock selection was also especially good in the consumer-discretionary sector, where the Fund was overweight relative to the Index. What paid off here were our companies that have the special abilities to thrive in brick-and-mortar locations and also online despite Amazon.com’s increasing footprint in U.S. retailing.††

Although the financial stocks in the Fund and in the Index had positive performance, financials were among the relative laggards for the first quarter. This wasn’t surprising given the state of the yield curve. Normally, the process of borrowing short-term (from depositors) and lending long-term (for mortgages, car loans, etc.) creates a good interest-rate spread for financial institutions. But as the yield curve became flatter and has now inverted, institutions have had to differentiate themselves with better customer service and credit analysis.

Details of the Quarter

The top contributor to Fund performance for the first quarter was Euronet Worldwide, Inc. (EEFT), an electronic-payments provider. Euronet operates roughly 40,000 ATMs, 293,000 traditional point-of-sale (POS) terminals, 719,000 prepaid POS terminals and 369,000 money-transfer networks. In a crowded field, Euronet continues to shine with extensive operations managed from an unassuming headquarters in a Kansas City suburb. The company released full-year 2018 earnings on February 7th and delivered a 35% increase in operating income year-over-year, and a 21% increase in adjusted earnings per share for the fourth quarter.

As is often the case with stronger-than-expected numbers, Euronet’s stock price soared post-release and finished up 39% for the quarter. Although the stock price has appreciated considerably, we still believe the company remains fairly valued. Euronet’s shares carry a reasonable forward P/E ratio of 17.5 and a rational price-to-sales ratio of 2.9. We continue to be impressed with Euronet’s operating discipline—as 2018 was the sixth consecutive year that management delivered strong double-digit growth in adjusted earnings per share.

Another significant contributor to Fund performance was auto-repair chain Monro, Inc. (MNRO), which was up 26% in the quarter. Monro started to see a turnaround in 2017, after which we visited with Brett Ponton, the company’s newly installed CEO. During this company visit, we were encouraged by Monro’s long-term growth prospects, along with Mr. Ponton’s strategic direction. Ever since, we’ve added to our position during periods of price weakness and Monro now represents one of the Fund’s largest holdings.

On January 31st, Monro reported results for the third quarter of 2018, posting record total revenue of $310.1 million and quarterly net income of $20.5 million, a 75% increase from the same period in the prior year. We remain pleased with Monro’s management team and believe the stock price has started to reflect the company’s progress. Mr. Ponton has now guided the company to its fourth consecutive quarter of same-store sales growth, a critical metric for brick-and-mortar retailers.

Paylocity Holding Corp. (PCTY) also boosted Fund performance for the first quarter of 2019. The company provides software for payroll and human-capital management using the SaaS (Software-as-a-Service) business model. Paylocity saw its stock price rise in concert with the stock of a competitor after the competitor agreed to be acquired at a premium by a private-equity firm. Incidentally, we also owned the competitor that was acquired—Ultimate Software Group, Inc. (ULTI). We think Paylocity now stands to benefit as Ultimate adjusts to the influences of its new owners. Private-equity firms excel at attracting value, but creating value is a more-challenging endeavor. For Paylocity, better-than-expected revenues, earnings and forward guidance also helped push its stock higher during the first quarter.

The largest detractor from Fund performance was Metro Bank plc, one of the so-called “challenger banks” established in the U.K. after the global financial crisis. Metro stumbled significantly in the first quarter and declined a stunning -54%. Vernon Hill, Metro’s founder and chairman, is the former CEO of Commerce Bancorp, which grew to more than 450 branches in the U.S. before being acquired by Toronto-Dominion. As a mentee of Ray Kroc, the McDonald’s franchisor, Mr. Hill brings a fast-food mindset to retail banking. Metro Bank is simply the latest incarnation of his “convenience banking” model.

Despite the bank’s rapid growth, Metro’s stock plunged in January after the bank disclosed that it had applied an incorrectly low risk weighting to parts of its loan book. The stock fell again in February on news that Metro will have to raise $464 million of additional equity in order to put more capital behind the misclassified loans. The bank now faces the prospect of having to issue stock at prices that are highly dilutive to the ownership stakes of existing shareholders. These events at Metro have raised concerns about the bank’s internal controls—and management’s shifting account as to how the errors were discovered hasn’t soothed investors. Meanwhile, the bank’s ambitious growth plans have largely been shelved until the equity raise has been completed. We continue to hold the stock while we further analyze the situation.

The second-largest detractor was Cimpress N.V. (CMPR). The company reported a second consecutive quarter of disappointing earnings on January 30th, and the stock tumbled—ending the quarter with a -23% loss. Cimpress is a “mass-market customization” provider of printing, signage and packaging services under name brands such as Vistaprint and National Pen.

Regarding its most-recent financial report, Cimpress grew consolidated revenue just 8% as compared to 32% for the same quarter in the prior year, which disappointed Wall Street. Although revenue was a source of discontent and caused an abrupt selloff in the stock, operating income swung positive for the period, after turning slightly negative in the prior quarter. Moving forward, we plan to monitor Cimpress closely to see if the steep percentage decline in consolidated revenue was a one-time aberration or a more-meaningful trend. On the one hand, repeat business from already-acquired customers may support growth even if customer additions slow down. On the other hand, it may be that the company’s small-business customers can now produce for themselves the products historically purchased from Cimpress.

Healthcare Services Group, Inc. (HCSG) was also a significant detractor. HCSG provides outsourced housekeeping and nutritional services for hospitals, nursing homes and other health-care institutions. HCSG shares fell sharply in early March after the company disclosed that it would file its 2018 10-K report 15 days late. Management revealed that the company had received a letter from the Securities and Exchange Commission (SEC) in November 2017 seeking information about the way HCSG calculates and reports its earnings per share. The company also disclosed that it received a subpoena from the SEC in March 2018 concerning the matter. With little else to go on, investors assumed the worst and sold the stock. We continue to monitor the situation for further developments.

Finally, the Fund’s position in Sangamo Therapeutics, Inc. (SGMO) was down for the first quarter. A clinical-stage biopharmaceutical company, Sangamo specializes in the treatment and cure of gene disorders. Investors reacted negatively in February to interim results from an early-stage study using the company’s zinc-finger editing technology for the treatment of Hurler syndrome. However, we think it’s too early to draw conclusions until results from the study’s high-dose subjects have been released. Moreover, Sangamo has already developed a second-generation zinc-finger technology designed for greater editing efficiency, which the company expects to enter into clinical trials later this year. It’s worth noting that, just after quarter-end, Sangamo provided an unscheduled positive clinical-trial update and the stock rose significantly. (Current and future holdings are subject to risk.)

Outlook

As mentioned earlier in this commentary, we’re always aware of macro events but they don’t play major roles in our time-tested, fundamental investment approach. Our fixation is on vigorously analyzing “micro events” that occur at the company-specific level. As we’ve sifted through a multitude of sales and earnings reports over the past few months, we’ve tried to determine whether or not our long-term holdings remain on track.

For the most part, we’ve been very pleased with our companies’ progress—which has led to remarkably little turnover in the Fund. But we’ve also had a few disappointments like Metro Bank, Cimpress and Healthcare Services Group that are currently under our research microscope. Having said that, our other holdings more than compensated for our disappointments.

Going forward, we expect the relatively low portfolio turnover in the Fund to continue. We think about it this way: U.S. small-cap stocks are roughly trading at year-ago levels, but there’s been quite a lot of volatility along the way. Meanwhile, our companies have grown their sales and earnings at double-digit rates overall. So, as mentioned, we feel no need to change what isn’t broken. In fact, we think our companies may have improved their competitive positions in the past year because great companies tend to strengthen during times of slower economic growth, while lesser companies tend to weaken.

In short, we remain as confident as ever that the Wasatch Core Growth Fund currently owns a group of very high-quality companies that will grow their top and bottom lines significantly over the coming years. And that’s exactly the positioning we want to have over the long term—and also during whatever comes next.

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.

††As of March 31, 2019, the Wasatch Core Growth Fund was not invested in Amazon.com, Inc.

Brexit is an abbreviation for “British exit,” which refers to the June 23, 2016 referendum whereby British citizens voted to exit the European Union. The referendum roiled global markets, including currencies, causing the British pound to fall to its lowest level in decades.

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.

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.

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.

The price-to-sales ratio is a stock’s capitalization divided by the company’s sales over the trailing 12 months. The value is the same whether the calculation is done for the whole company or on a per-share basis.

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

VIX is the ticker symbol for the Chicago Board Options Exchange (CBOE) Volatility Index, which shows the market’s expectations of 30-day volatility. It is constructed using the implied volatilities of a wide range of S&P 500 Index options. This volatility is meant to be forward looking and is calculated from both calls and puts. The VIX is a widely used measure of market risk and is often referred to as the “investor fear gauge.”

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.

Read our Holdings Release Policy and why we have one.