Domestic small-cap value stocks rose slightly during the first quarter of 2015, as gauged by the 1.98% return of the Fund’s benchmark, the Russell 2000® Value Index. The Wasatch Small Cap Value Fund—Investor Class delivered a robust gain of 8.24% and comfortably outperformed the benchmark on the strength of our individual stock selection. Our stock picks performed particularly well in the energy, consumer-discretionary, and financials sectors, all of which outperformed the return of the benchmark. We believe our success in these areas underscores our longstanding view that the small-cap value universe offers an abundance of stock-specific opportunities, even when trends in individual sectors—or the stock market as a whole—are unfavorable.
Details of the Quarter
Among the Fund’s three underlying strategies, our Fallen Angel discipline performed well and followed through on its strong fourth quarter of 2014. This strategy includes companies that we extensively research, often for years, and then purchase when short-term developments cause their valuations†† to fall to attractive levels. Early in 2015, many of these Fallen Angels indeed reversed their temporary missteps and accelerated their internal business momentum, resulting in strong stock price gains. We believe this helps illustrate the essential role of patience in value investing.
A good example of our patient process in action is Fallen Angel Ebix, Inc. (EBIX), a supplier of software and services used by insurance companies and brokers that finished the quarter as the Fund’s top performer. We established our current position in Ebix in July 2013, when the stock collapsed after a proposed buyout offer was broken off due to a regulatory investigation. We had known the company for many years and had owned the stock previously, so we understood some of the controversies that could arise. However, our research showed Ebix to have a strong, valuable, and cash-generating business, which gave us the confidence to invest at a depressed valuation. When some of the regulatory issues cleared up and the company once again posted solid results, the stock surged and made a strong contribution to the Fund’s first-quarter performance.
Nu Skin Enterprises, Inc. (NUS), another Fallen Angel investment, rallied after showing early signs of regaining its growth trajectory following the resolution of regulatory issues in China. The Fund’s long-time holding Polypore International, Inc. (PPO), also performed well after the company received an attractive buyout offer from Asahi Kasei,‡ a Japanese industrial firm. We sold our position in the stock.
Our Quality Value strategy also added value in the quarter thanks in large part to the strength of our holdings in the energy sector. During the fourth quarter of 2014 and the early portion of this year, we focused our energy weight in companies with stronger balance sheets and healthier underlying businesses than the average energy company. In turn, we eliminated energy holdings that we expected to struggle if energy prices fell further and remained low for a considerable amount of time. For instance, we exited our investments in Comstock Resources, Inc. (CRK), DXP Enterprises, Inc. (DXPE) and seismic-equipment provider Geospace Technologies Corp. (GEOS). At the same time, we chose to add to the Fund’s position in fuel logistics company World Fuel Services Corp. (INT) following the tumble in oil prices late in 2014. The company provides improved cost certainty to its customers, which means that volatile energy prices actually benefit its results. This indeed proved to be the case, and the stock outpaced the overall energy sector by a wide margin. Two other energy companies, Northern Oil and Gas, Inc. (NOG) and Ultra Petroleum Corp. (UPL), also recovered from a weak fourth quarter to deliver returns well above that of the overall energy sector.
The Undiscovered Gem portion of the Fund, which emphasizes stocks with strong fundamentals that haven’t yet been recognized by Wall Street, also continued to deliver positive returns. Icon plc, Mallinckrodt plc, and Skechers U.S.A., Inc. (SKX) were all strong performers during 2014, and all continued to produce gains in the first quarter of 2015. Auto lender Credit Acceptance Corp. (CACC) is a more recent addition to the Fund that we purchased last year after visiting with the company’s management team. Credit Acceptance was also among the leading individual contributors to first-quarter performance.
Acacia Research Corp. (ACTG) is an owner and defender of intellectual property and patents. Acacia’s stock lost ground due to a legal setback within its patent library and was our largest detractor for the quarter. We reduced the position early in the quarter on concerns about the company’s business model, which enabled us to sidestep some of the downside in the stock. Looking forward, some upcoming court cases could increase the value of Acacia’s intellectual-property holdings. Saia, Inc. (SAIA), a shipping and logistics company that specializes in smaller truckloads, also underperformed due to concerns about its pricing power.
One area where we have had concern has been with our holdings in some investment-management companies such as Manning & Napier, Inc. (MN) and Virtus Investment Partners, Inc. (VRTS), both of which detracted from performance in the quarter. These companies are experiencing rising competitive pressure and their recent investment performance has not been sufficiently robust to attract assets, but we remain believers in their business models. Although we have low weights in these companies at present, we may consider increasing our positions if their results improve. (Current and future holdings are subject to risk.)
We continue to hold a positive outlook on the economy, but much of the hoped-for benefits of improving growth and the “tax cut” from lower energy prices have been factored into current stock prices. We therefore will not hesitate to take profits where we think it is prudent, as we are always focused on finding optimal trade-offs of risk and return potential. More broadly speaking, we are seeking to maintain the performance we have experienced early in 2015 and enhance it with new value opportunities as we cast a wide net across the small-cap space. There are many moving pieces in the economy right now, with volatile energy prices, larger-than-normal currency fluctuations, and the potential for higher interest rates all representing factors that could potentially create opportunities in the stock market. Our investment discipline is designed to take advantage of the inefficiencies, and we will look to exploit opportunities as they arise.
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**The Russell 2000 Value Index measures the performance of Russell 2000 Index companies with lower price-to-book ratios and lower forecasted growth values.
†The Russell 2000 Index is an unmanaged total return index of the smallest 2,000 companies in the Russell 3000 Index, as ranked by total market capitalization. The Russell 3000 Index is an unmanaged total return index of the largest 3,000 U.S. companies based on total market capitalization. The Russell 2000 Index is widely used in the industry to measure the performance of small company stocks.
You cannot invest directly in these or any indices.
The Wasatch Small Cap Value Fund’s investment objective is long-term growth of capital. Income is a secondary objective, but only when consistent with long-term growth of capital.
††Valuation is the process of determining the current worth of an asset or company.
‡As of March 31, 2015, the Wasatch Small Cap Value Fund was not invested in Asahi Kasei Corp.