Wasatch Small Cap Value Fund® (WMCVX)  Invest in this Fund 

Investor Class | Institutional Class
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Q1 2018
A Steady Approach through a Volatile Market
by Jim Larkins

“Many of our leading contributors were long-time positions in Fallen Angel stocks that saw their healthy fundamental trends translate to market-beating performance.”

Jim
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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.
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.
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.

For the period ended March 31, 2017, the average annual total returns of the Wasatch Small Cap Value Fund for the one-, five- and ten-year periods were 14.11%, 13.47% and 9.84%, the returns for the Russell 2000 Value Index were 5.13%, 9.96%, and 8.61%, and the returns for the Russell 2000 Index were 11.79%, 11.47%, and 9.84%.  Expense ratio: Gross 1.41%.

 

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

After an extended period of robust, positive performance, small-cap value stocks lost ground in the challenging environment of the first quarter. The Russell 2000 Value Index, the Fund’s benchmark, experienced a loss of -2.64% due in part to investor concerns about rising interest rates and potentially unfavorable shifts in U.S. trade policy. Although the Wasatch Small Cap Value Fund—Investor Class lost -2.26%, it did not decline as much as the benchmark.

We are pleased that our strategy, after helping the Fund to generate a return that was comfortably ahead of the Index when the market was rising in 2017, was also able to help mitigate the downside when conditions became less supportive. Since the middle of last year, we have been gradually positioning the Fund to cushion the effects of higher market volatility. We have been seeking to achieve this by focusing the Fund on our highest conviction holdings, such as those with stronger earnings potential and/or better balance sheets, and by investing in new companies with similar quality characteristics. At the same time, we have been eliminating investments where business uncertainty has been increasing. We also have reduced the Fund’s positions in lower-conviction holdings with smaller weightings. These moves contributed to our outperformance relative to the benchmark in the first quarter, and we believe they can continue to add value if stocks remain unstable in the months ahead.

Details of the Quarter

Despite the downturn in the broader market, the Fund had a number of individual holdings that produced positive returns and contributed to performance. Many of these were Fallen Angels—growth stocks that have slid into value territory for what we think are temporary reasons. The key element of this strategy is the “Angel” aspect. Although these stocks are typically depressed when we first establish positions, our research indicates that the underlying companies have outstanding business models and robust growth prospects. Our belief is that over time these traits will be appreciated by Wall Street and the stocks will rebound to premium valuations. In many cases, we hold positions for a number of years to let the fundamental story fully play out. This approach worked to the Fund’s benefit in the first quarter, as many of our leading contributors were long-time positions in Fallen Angel stocks that saw their healthy fundamental trends translate into market-beating performance. Among these were Ensign Group, Inc. (ESNG), Copart, Inc. (CPRT) and HEICO Corp. (HEI), as well as trucking companies Old Dominion Freight Line, Inc. (ODFL) and Knight-Swift Transportation Holdings, Inc. (KNX).

The financials sector remains the largest allocation in the Fund, which provided a measure of ballast given the sector’s outperformance versus the broader market. BofI Holding, Inc. (BOFI) was the Fund’s top overall contributor. BofI is an internet-based bank with a low cost structure. We think Wall Street has largely misunderstood the company despite its favorable credit profile and healthy fundamentals. Investors heavily shorted the stock, betting against it in anticipation of a decline. However, one possible result of a large short position is a potential “squeeze” (in other words, investors being forced to close out their shorts by buying back shares at higher prices when the company performs better than they had anticipated). BofI has benefited from this phenomenon of late, aiding its performance, and we elected to reduce our position in response. While we don’t specifically look for stocks that can experience a short squeeze, we nonetheless benefit periodically since our value-oriented approach frequently leads us to stocks whose controversial nature is reflected in an above-average short interest. We see this as an illustration of how value investing often means seeking opportunities by going against the crowd.

The Fund’s largest detractor for the quarter was commercial auto insurer Atlas Financial Holdings, Inc. (AFH), which reported weaker-than-expected underwriting results. We retained the position, as we trust the management team and the company already had some changes in place to address the issues. Nevertheless, we are maintaining a smaller weighting until we are assured that the outlook for Atlas is indeed improving.

Consistent with the broader market environment, a number of stocks in the Fund declined. Our second-largest detractor was J.Jill, Inc. (JILL), an apparel retailer that had shown signs of turning around toward the end of last year. More recently, the company disappointed investors with unexpected weakness stemming from fashion misses and execution problems with a new website. In addition, the company’s long-time chief executive officer retired unexpectedly. Viewing these developments as a disappointment, we chose to limit our exposure as we monitor the company’s progress on these challenges.

The Fund’s positions in real estate investment trusts (REITs) generally lagged. As income-producing assets, REITs typically sell off when bond yields rise sharply. While we retained a total weighting of about 12.5% in REITs at the close of the period, we trimmed our position somewhat over the course of the quarter in recognition of the headwind created by rising interest rates.

Despite the effect of these individual detractors, we continue to see strong fundamentals in the Fund’s underlying companies. (Current and future holdings are subject to risk.)

Outlook and Positioning

Our ongoing effort to concentrate the Fund in our best ideas is reflected in the low number of holdings relative to historical levels. We finished March with 50 individual positions, which is consistent with our goal of having an average weighting of about 2% in each holding. Although we think this is appropriate for the current environment, we would also caution investors that having a smaller number of positions could translate into higher day-to-day volatility than the Fund has typically experienced in the past. Still, we believe this approach will help us achieve our goal of outperforming the benchmark over the long term.

Our shift toward a more focused Fund doesn’t mean we have abandoned our longstanding strategy of seeking to use market volatility to our advantage. We have long referred to the small-cap space as a “perpetual motion machine” in which good companies continually stumble and fall into value territory. In the first quarter, for instance, we saw an opportunity to purchase shares of HCI Group, Inc. (HCI), a Florida-based provider of homeowners insurance whose shares cratered following last autumn’s Gulf Coast hurricanes. We saw the market reaction as being exaggerated given HCI Group’s long-demonstrated ability to preserve capital by managing losses through the use of data-driven risk-management practices. We used the sell-off as an entry point to add to the Fund what we see as a well-managed company selling at an attractive price. Indeed, HCI Group’s shares began to stage an impressive recovery as concerns about potential losses faded.

We see reasons for optimism based on what we’ve been hearing as we talk with company management teams. Generally speaking, domestic businesses are experiencing positive momentum and improving fundamentals. For instance, trucking companies are reporting better pricing trends, and industrial firms are citing strengthening demand. What’s more, management teams are discussing the use of the proceeds from the December tax cut for increased investments in their businesses. We think these developments point to accelerated economic activity, which is supportive for the market in general, and for smaller companies in particular. We believe this favorable backdrop will help create ongoing opportunities to identify the higher-quality, fundamentally sound and financially strong companies in which we seek to invest.

Thank you for the opportunity to manage your assets.

Sincerely,

Jim Larkins

 

 

**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 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.

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.

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 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.   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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