The Wasatch Small Cap Value Fund generated solid outperformance amid the volatile environment of the first quarter. Small-cap stocks began the year with a downturn in January, rallied sharply in February, and then closed the quarter with a spate of renewed volatility. While the economy continues to show signs of strength, stocks were pressured by concerns about turmoil in the emerging markets and questions about future Federal Reserve policy.
The Fund’s Investor Class returned 4.87% and significantly outpaced the 1.78% gain of the Russell 2000 Value Index. Stock selection in the health-care and energy sectors, where the majority of our holdings delivered double-digit gains, was the most important factor in lifting the Fund’s performance above that of the Index.
Details of the Quarter
The Fund’s performance continued to be driven by our Undiscovered Gems and Quality Value strategies. Our Undiscovered Gems strategy focuses on good companies that are relatively unknown to the broader market, while with Quality Value we seek to invest in companies that feature not just traditional value characteristics, but also a specific attribute—such as an exceptional business model—that sets them apart. Our third major strategy, Fallen Angels, didn’t make a significant contribution to performance during the quarter. The companies in this category typically have short-term fundamental challenges that we believe are fully factored into their stock prices, which creates upside potential once investors look past the near-term headwinds. While the Fallen Angel strategy has added substantially to the Fund’s performance over time, investors generally favored “cleaner” value stories during the first three months of the year.
Quality Value was our top-performing strategy in the quarter, as some of our larger weightings in the strategy delivered solid performance. Ebix, Inc. (EBIX), an insurance software company, continues to demonstrate solid underlying fundamentals even as it navigates some legal issues. Comstock Resources, Inc. (CRK), another top-weighted holding, is a drilling company that gained ground on the strength of the rising price of natural gas. We believe investors are beginning to discover the company, as its new oil-focused investments have begun to play out. On the negative side, consumer-finance company Regional Management Corp. (RM) underperformed in the first quarter. Increased regulatory scrutiny in the consumer lending industry has cast a shadow over its business. We also saw some negative trends in the company’s loan delinquencies, and we have since reduced the Fund’s weighting in the stock.
In the Undiscovered Gem category, Flotek Industries, Inc. (FTK) finished the quarter as one of our top-performing stocks. Flotek’s “green” chemicals are gaining traction as oil companies respond to concerns about toxic fluids that are employed in the process of drilling, “fracking” and completing wells. We elected to sell this investment, after holding it for about 18 months, based on our view that the “green” aspect of its business had caused the stock to move beyond what we viewed as its fair value. Tristate Capital Holdings, Inc. (TSC), a bank in which we invested at its initial public offering (IPO)†† last spring, also performed well after acquiring an asset manager at what we believe is an attractive price. A notable detractor within Undiscovered Gems was Chico’s FAS, Inc. (CHS), a retailer that Wasatch has followed and owned off and on in various funds for over a decade. We reduced our position in the autumn of 2013 due to concerns about fashion trends, a well-timed move given that the overly competitive apparel-retailing environment during the holidays hurt Chico’s results. We continue to think the company’s multi-brand approach and robust systems and management platform provide a firm foundation for performance, but rising competition—within malls as well as from online vendors—prompted us to reevaluate this position.
While the Fallen Angel strategy was flat overall, our performance in this area gained a significant boost from MakeMyTrip Ltd. (MMYT), an online travel company focused on India. Our colleagues on the growth side of Wasatch owned the company and encouraged us to take a look at MakeMyTrip last year after the stock came under pressure from broader issues regarding the domestic Indian airline industry. Since these issues were outside of the company’s control, we viewed the downturn as an opportunity to buy a leader with a business model that has proven to be successful in other countries. The company’s key attribute is its ability to book the small “mom and pop” hotels that are common in India—something the market may have overlooked when the stock sold off. This is a prime example of our willingness to take advantage of opportunities when growth stocks briefly move into value territory for reasons that are unrelated to long-run company fundamentals. (Current and future holdings are subject to risk.)
Given that small-cap valuations‡ have become more expensive, our outlook is more cautious now than it was throughout 2013. We believe that small-cap stocks still have the potential to deliver positive returns this year, but we urge investors to maintain realistic expectations. However, for active managers like us, the improving economy provides a continual opportunity to buy shares of good companies when their stocks experience short-term disruptions.
In terms of portfolio activity, we continue to follow our long-standing approach of trimming stocks that have become fully valued and rotating into stocks that offer a more compelling risk-return profile. We believe this allows us to maintain a reasonably valued overall portfolio, and helps us navigate a market in which the small-cap asset class has become more richly valued. It’s important to note that we are being very selective in our search for values at this stage of the cycle, since many stocks that appear to be attractively priced are in fact inexpensive for a reason. We therefore believe it’s essential to employ a cautious approach rather than reaching for low-priced stocks with questionable long-run fundamentals.
Patience is also critical given the extent of the rally in small-caps in the past year. As part of our value strategy, we monitor out-of-favor industries for interesting opportunities. We have been watching the agricultural industry in recent months, conducting due diligence on fertilizer and agricultural chemical companies. Seismic monitoring companies—key players in oil and gas discovery—have been out of favor, and they also have been on our radar for some time. While we see longer-term opportunities in agriculture and seismic monitoring, we also think we may be rewarded for patience as we look to raise our weighting in these areas given that small caps have delivered such strong returns in the past 12 months.
Overall, we believe our selective, value-driven and patient approach will provide the Fund with the potential to participate in additional market upside.
Thank you for the opportunity to manage your assets.
**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.
††An initial public offering (IPO) is a company’s first sale of stock to the public.
‡Valuation is the process of determining the current worth of an asset or company.