The Wasatch Small Cap Value Fund—Investor Class had a gain of 8.20% for the fourth quarter and underperformed the 9.30% gain for the Russell 2000 Value Index. The Fund’s one-year return was 37.81%, well above the 34.52% return for the benchmark.
We are pleased by our strong showing in 2013, not just because of the extent of our outperformance, but also because we believe returns were driven by the quality of our individual stock selection. The vast majority of the stocks in the Fund finished the year with double-digit gains, and many of them delivered stronger returns than the market as a whole. Notably, we had no significant “torpedoes”—or stocks with large negative returns—within the Fund. We believe this is a function of our stock selection process, which looks for companies that we believe have high-quality business models highlighted by recurring revenues, deeply entrenched customer bases, and lack of “hyper-competition.”
We were also effective in our decision making with regard to selling underperforming positions. While it frequently pays to hold on to a weak stock if company fundamentals are intact, we also won’t hesitate to sell a stock if our investment thesis has changed. This proved to be the case with our investments in Body Central Corp. (BODY), Gordman’s Stores, Inc (GMAN) and DFC Global Corp. (DLLR), all of which we trimmed or completely sold on weakness. We are encouraged that this disciplined approach to value investing worked well in 2013.
Details of the Quarter
We generated strong performance across our three investment strategies during the quarter— Fallen Angels, Undiscovered Gems, and Quality Value.
The largest contribution came from Quality Value, which seeks to invest in stocks that feature not just traditional value characteristics, but also a specific quality—such as an exceptional business model—that sets them apart. Our investment in Ebix, Inc. (EBIX), a provider of software that allows insurance brokers and insurance carriers to communicate more effectively with each other, led this category and was a top contributor within the Fund. Ebix’s stock suffered a substantial downturn in June when a proposed buyout of the company was called off after Ebix disclosed that the U.S. Attorney for the Northern District of Georgia was investigating it. We took advantage of the downturn by establishing a position. We had owned the stock in the past and felt we understood the strength of the Ebix business model. Our belief was that the stock had limited additional downside regardless of the outcome of the investigation, yet offered upside due to the company’s potential for improved earnings and cash flow. That scenario began to play out in the quarter, and the stock was further boosted by the resolution of certain legal issues (although the U.S. Attorney’s office issue is still outstanding).
We believe this represents a prime example of a phenomenon we often see in the small-cap space—good companies declining to attractive prices due to what we call “external devaluation catalysts.” While these events often have limited impact on the ongoing earnings and cash flows of the underlying businesses, the attention-grabbing nature of the headlines can punish their stocks. Questcor Pharmaceuticals, Inc. (QCOR) and USANA Health Sciences, Inc. (USNA) were two other investments we bought following recent catalyst events, which have been successful.
Our Undiscovered Gems category, which focuses on good companies that are relatively unknown to the broader market, also added value in the quarter. DXP Enterprises, Inc. (DXPE), a stock we first invested in just over a year ago that is now gaining recognition from Wall Street, is a prime example of an Undiscovered Gem. DXP is a specialty industrial distributor, which is a business model we have seen work extremely well for many years. The company focuses on maintaining and repairing industrial items, with a heavy emphasis on the oil and gas industry. Amid the domestic energy renaissance, DXP has enjoyed a stable business environment and has been aggressively making acquisitions in an area still dominated by “mom and pop” companies. We began to take some profits as the company has become more fairly valued and its debt has risen with the acquisitions, bringing more risk to the business.
Our long-time holding CorVel Corp. (CRVL) also performed well during the quarter. The company has begun to see accelerated growth in new business ventures, as well as improving profit margins following cost reductions it made last year. CorVel has no research coverage by Wall Street banks, which highlights the “undiscovered” nature of the company. The stock has performed very well for this year, and we have been trimming the position as it has become more fully valued.
The Fallen Angel strategy also contributed positively to our fourth quarter performance, but the results were not as strong as those of our other two strategies. The share price of Life Time Fitness, Inc. (LTM) fell modestly as the company’s growth still hasn’t returned to pre-recession levels. Shares of Tilly’s, Inc. (TLYS), a surf and action-sports apparel retailer, sank after the company reported disappointing results. The magnitude of the disappointment concerned and surprised us, and we reversed our thinking on this new investment and sold our position. Apparel retailing in general has become a difficult area in which to find successful investments, even though we have achieved meaningful success in this space in the past.
On the plus side, ORBCOMM, Inc. (ORBC) was a strong performer in the Fallen Angel category. The company operates communication satellites focused on M2M—or “machine to machine”—communications, a growing theme in industrial data and telecommunications.
Our foreign holdings performed well as a group, highlighted by positions in the Taiwanese company Sporton International, Inc. and Indian commercial bank Yes Bank Ltd. MakeMyTrip (MMYT), an online travel company in India, was also a strong performer. The company has faced headwinds from declines in its domestic air market, but we see substantial upside from increased travel in India and MakeMyTrip’s dominant—and we believe underappreciated—strength in the hotel reservation business. Our holdings in India, our largest country weighting outside of the United States, received an additional boost from the strengthening of the rupee. (Current and future holdings are subject to risk.)
The past year was one of “economic thaw.” We believe this has set the stage for solid growth in 2014. The improvement in the economy was underscored by the Federal Reserve’s decision to “taper” quantitative easing.†† The global environment also seems less uncertain, and money flows into equities have been steadily rising amid instability in the bond market. We therefore hold a positive outlook for 2014, but see more modest upside for stocks due to increased valuations.‡ We expect to respond to this environment by trimming fully-valued investments and taking advantage of opportunities to buy the stocks of good companies that we feel have been unjustly oversold.
When the broader market performs so well, opportunities often arise in stocks that have experienced short-term pressure due to negative headlines. For example, we recently added a position in Acacia Research Corp. (ACTG). The company acquires, develops, licenses and enforces patents on technologies, and assists patent owners with the development of their patent portfolios. Although Acacia’s stock has suffered from potentially adverse legislative developments, we saw a chance to buy shares of a misunderstood company at what we considered to be a very attractive price. By staying on the lookout for values of this kind, we have been able to continually refresh the portfolio with new ideas.
Agriculture is one area where valuations are becoming increasingly compelling. Although agriculture-related stocks performed poorly in 2013, rising demand for protein in the emerging world forms the basis for a long-term upswing in businesses that provide products and services to agriculture. We are closely monitoring potential investments in the fertilizer, pesticide and heavy equipment businesses, but—in the interest of avoiding the proverbial falling knife—we have not yet added any positions.
Overall, we believe the Fund is well positioned for the year ahead. We believe that our two-pronged approach—which focuses on buying great companies when they stumble and undiscovered companies when they’re inexpensive—will continue to hold the Fund in good stead through 2014 and beyond.
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.
††Quantitative easing is a government monetary policy used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity.
‡Valuation is the process of determining the current worth of an asset or company.