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

Investor Class | Institutional Class
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Q2 2018
Maintaining Our Focus on Growth Companies with Sustainable Competitive Advantages
by JB Taylor, Paul Lambert and Mike Valentine

“We are, indeed, zeroing in on companies with earnings potential that goes well beyond the shorter-term, macro-level tax-reform effects enjoyed by companies generally.”

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For the period ended  June 30, 2018, the average annual total returns of the Wasatch Core Growth Fund for the one-, five- and ten-year periods were 26.34%, 14.15% and 12.70%, the returns for the Russell 2000 Index were 17.57%, 12.46%, and 10.60%, and the returns for the Russell 2000 Growth Index were 17.57%, 12.46%, and 10.60%. 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

During the second quarter, the Wasatch Core Growth Fund—Investor Class logged a strong return of 6.65%. The Fund’s primary benchmark, the Russell 2000 Index, advanced 7.75%. And the secondary benchmark, the Russell 2000 Growth Index, gained 7.23%.

After outperforming our benchmarks in recent quarters, we were pleased that the Fund roughly kept pace during the quarter ended June 30, 2018, which was a period of strong gains for the small-cap stocks in the Russell indexes. Our approach often shines the most in volatile, down market environments—we think as a result of our commitment to invest based on metrics signifying high quality. While some investors might be tempted to trade down in quality to increase participation in a more-speculative market environment, we’ve continued to focus first and foremost on what we consider high-quality companies.

We see the companies held in the Fund as top-notch operators that we’d want to own during any type of market environment. They’re companies with excellent business models, significant pricing power, experienced management teams, differentiating features in the marketplace, plenty of room to expand revenues, and attractive returns on equity. These characteristics give our companies the potential for strong and sustainable earnings growth.

Now is an interesting time to look at the earnings growth rates of the Fund’s holdings versus those of the benchmarks’ positions. While the Trump tax reforms have boosted earnings growth for a broad swath of U.S. companies, we’re actually more interested in other factors that have contributed to earnings growth. In other words, we want to identify company-specific factors that should, over time, separate businesses with sustainable competitive advantages from businesses that are just riding the tax-reform wave.

The following chart presents the pre-tax and after-tax earnings growth rates for the companies in the Wasatch Core Growth Fund versus the companies in the Fund’s primary and secondary benchmarks. The purpose of this chart is to look at the growth in after-tax earnings compared to what we believe is the more important growth in pre-tax earnings—which shows the true, underlying earnings power of companies because the one-time effects related to taxes aren’t included.

As the chart indicates, the Fund’s holdings achieved higher earnings growth than the benchmarks’ holdings on both a pre-tax basis and an after-tax basis. Please note that the differences in the Fund’s bar heights compared to the benchmarks’ bar heights are more pronounced for pre-tax earnings growth—suggesting that we are, indeed, zeroing in on companies with earnings potential that goes well beyond the shorter-term, macro-level tax-reform effects enjoyed by companies generally.

1q18

During the second quarter, we continued to see impressive reports regarding earnings growth among the companies held by the Fund. Regarding the Fund’s total return, which exhibits some randomness from quarter to quarter, the Fund lagged the benchmarks slightly. The main reasons for this were our overweight position in industrials and uninspiring stock performance in that sector, as well as our lack of exposure to the energy sector. Energy was the top-performing sector in the Russell 2000 Index as the price of crude oil surged above $70 a barrel. Despite this short-term performance advantage of energy stocks, the cyclical, capital-intensive nature of energy businesses generally doesn’t mesh well with our bottom up, high-quality, growth-oriented investment style. We invest the Fund’s assets based on company fundamentals and make no attempt to try to match the sector weights of the indexes, despite the potential for periodic underperformance relative to the benchmark.

On the other hand, our stock selection was positive overall—with particularly strong performance coming from our holdings in the consumer-discretionary sector. Other than industrials, the only sector with a meaningful shortfall in stock selection was real estate (which represented less than 3% of the Fund’s assets).

Below we discuss the quarterly performance of several holdings, but one holding in particular warrants mentioning here because it illustrates our investment approach. Shares in Cantel Medical Corp. (CMD), a U.S. health-care company focused on the prevention of infections, fell sharply at the end of May when Cantel released quarterly earnings information. Our take is that investors have overemphasized short-term results and have missed the larger point as we see it: we believe Cantel is led by an outstanding management team with a solid five-year plan.

We visited Cantel’s management team on-site at its New Jersey headquarters during a research trip in June. We came away feeling confident that Cantel is now past the short-term hindrances that spooked investors in May. Given that the stock price had nearly doubled in the prior year, we think the recent pullback is best seen as the stock just taking a breather. We’ve found that patience with short-term issues—in the context of intensive research that confirms a strong growth picture—has led in many cases to long-term holdings becoming incredible investment successes over time.

DETAILS OF THE QUARTER

The Fund’s leading contributor during the second quarter was U.S. health-care company Ensign Group, Inc. (ENSG). The company’s share price has been inexpensive relative to peers given investors’ concerns about some recent stumbles with facilities Ensign has acquired. As we expected, the management team has been largely able to solve these problems. We see more upside to Ensign because our research indicates that some of its operations are still under-earning their potential, that the regulatory landscape is shifting in favorable ways and that industry consolidation will shake out weaker competitors.

We recently visited Ensign’s management team and came away, once again, impressed with the company’s culture. Ensign is a decentralized business with a high degree of authority given to local managers. These local managers—and many throughout the company—are invested in Ensign’s long-term success. We learned, for example, that a striking number of Ensign employees hold over a million dollars of company stock. It may be that these employees see the business as a very special one, just as we do.

The Fund’s next three major contributors during the second quarter were U.S. retailers, each of which we see as insulated to some extent from the “Amazon effect” that’s threatening so many of their peers. One of these contributors, Ollie’s Bargain Outlet Holdings, Inc. (OLLI), benefits from bargain stores’ continuing appeal as brick-and-mortar destinations. Another contributor, Five Below, Inc. (FIVE), focuses on low-cost items that are difficult for online retailers to provide with the now nearly requisite free shipping. Finally, online home goods and furnishings seller Wayfair, Inc. (W) has been successfully pursuing a business model that differentiates it from Amazon’s approach. We believe Wayfair stands to benefit from overseas expansion and expertise in large-parcel logistics, which enable the company to deliver damage-free furniture increasingly quickly. In addition, the company has been spending heavily to acquire new customers, and we see plenty of reasons for optimism considering that existing customers are likely to become increasingly profitable.

The Fund’s largest detractor during the second quarter was real-estate brokerage and professional-services provider HFF, Inc. (HF), which issued poorer-than-expected quarterly numbers and saw its stock price fall sharply. We view the selloff as overdone based on the fundamentals of both the company and its industry. The brokerage industry as a whole tends to see lumpy earnings, which can make any particular quarter look worse (or better) than it should when taking a longer-term perspective. Over time, we expect HFF to continue taking market share from its competitors.

Other detractors included Cantel Medical Corp., as described above, and a pair of U.S. industrial firms. The first of these industrials, Knight-Swift Transportation Holdings, Inc. (KNX), saw its stock price decline despite attractive growth—which has even accelerated in the context of higher utilization and favorable pricing. The fall in its share price after reporting strong quarterly results suggests that macro-level concerns more than business-specific factors were responsible. Our view of Knight-Swift remains firmly positive. Capacity in the trucking industry is tight, supporting prices. And just as importantly, we consider Knight-Swift’s management team to be exceptional. The team comes mainly from the Knight side of the business, which was much smaller than Swift prior to the firm’s combination. In our opinion, a high level of management talent for expanding operating margins, when applied to a larger asset base, is a recipe for success.

The other industrial laggard during the quarter was budget airline Allegiant Travel Co. (ALGT), whose stock price fell sharply in April as a result of negative publicity in the form of a critical 60 Minutes segment that, in our view, failed to make a distinction between two-year-old operational issues—which were known and acknowledged by Allegiant—and the current state of affairs, which is that a large-scale fleet transition should be mostly complete by the end of this year. Given our continuing confidence in the company, we recently sold our position in another airline, Spirit Airlines, Inc. (SAVE), and instead purchased more shares in Allegiant. Because Spirit’s approach is to compete head-on with big-name airlines, Spirit became vulnerable to intense competition as fuel prices dropped, giving bigger airlines more margin with which to pressure Spirit. Allegiant, on the other hand, operates routes that insulate it more from such hyper-competitive tactics. (Current and future holdings are subject to risk.)

OUTLOOK

While we remain conscious of elevated stock valuations and while we emphasize high quality in our selections for the Fund, we expect favorable macro conditions to continue in the U.S.—consistent with U.S. Federal Reserve Chairman Jerome Powell’s stated expectations for U.S. growth robust enough to support the central bank’s continued normalization of monetary policy.

Somewhat higher volatility in U.S. equities suggests a tug of war between two basic perspectives. On the one hand, we’re seeing strong economic data as well as solid corporate earnings growth. On the other hand, fears are increasing that many companies may have reached “peak earnings.”

On this question, our view is solidly in the first camp. Fundamental research, including direct engagement with the management teams of our companies, suggests plenty of room for continued growth. During the past several years, strength in growth-oriented stocks has been driven largely by innovative companies using new technologies to disrupt their industries and take market share from competitors. We don’t see anything as likely to bring this trend to an untimely end.

Of course, it’s possible that a monetary-policy error could usher in an economic slowdown. But we expect the Fed’s cautious approach to continue. Global trade conflict is another current risk factor, though in this case smaller companies are somewhat insulated given their relatively less significant direct exposure to international markets compared to larger companies.

An additional risk factor relates to the employment picture. With a U.S. unemployment rate below 4%, what economists consider “full employment” may be on the horizon. Economic growth appears to be picking up, construction is booming, wages are rising, and highways have become snarled as people travel back and forth to work in greater numbers. Turnover in the workforce has increased too, as people leave their current jobs for better-paying positions elsewhere.

Although a labor shortage has the potential to stall the pace of economic growth, that concern needs to be considered in relation to the explosion of software, robotics and other productivity-enhancing technologies in recent years. These have allowed companies to grow their businesses with less additional hiring than in the past. With the U.S. economy close to firing on all cylinders, adept management teams applying labor-saving technologies in new and innovative ways may well hold the key to prolonging the current economic cycle.

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.

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.

Return on equity (ROE) measures a company’s efficiency at generating profits from shareholders’ equity.

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

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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