Domestic small-cap value stocks returned -1.20% during the second quarter, as gauged by the benchmark Russell 2000® Value Index. After performing well for much of the period, U.S. equities lost ground late in the quarter due in part to the headlines surrounding Greece’s debt crisis. The overall environment nonetheless provided favorable conditions for the Small Cap Value Fund’s holdings, and we capitalized accordingly with a positive absolute return of 1.55% and a strong showing relative to the benchmark. Our companies performed particularly well in the information-technology, financials and consumer-discretionary sectors, enabling the Fund to build on its outperformance of the past two calendar years. Notably, the extent of our quarterly outperformance widened significantly once the market began to weaken in the second half of June, which we believe underscores the fundamental strength of the stocks we hold in the Fund.
Details of the Quarter
One of the primary challenges of value investing is identifying the difference between a true value opportunity and a “value trap.” A value trap occurs when a stock offers little more than a low price-to-earnings ratio,†† with no catalyst for the type of fundamental improvement that would lead the market to assign it a higher valuation.‡ In contrast, a value opportunity can exist when a company’s stock price doesn’t reflect the likelihood of accelerating growth. To separate opportunities from potential traps, we seek to identify companies that are out of favor but that also have clear catalysts for better results. Once a company’s growth begins to accelerate, we expect to hold the stock or add to the position as long as the improvement continues to play out.
Our investment in Skechers U.S.A., Inc. (SKX) is a prime example of this process at work. We started buying the stock four years ago, when Skechers was struggling with inventory problems after its Shape-ups product line went from boom to bust. The stock was deeply depressed at the time, but we saw the potential for the company to exit the down cycle and resume its growth with higher profit margins. This thesis has indeed come to fruition, but we have elected to hold a significant position rather than selling, as the company’s results have continued to accelerate. Further, the rest of the market has gradually begun to realize that the “new” Skechers features a broader, popular product line and a widening global footprint. These trends were reflected in the strong return of Skechers’ stock during the second quarter. Skechers closed the period as the leading contributor to the Fund’s performance.
Our position in Sigma Designs, Inc. (SIGM), another top contributor for the quarter, also helps illustrate our approach to value investing. Sigma manufactures semiconductors that address two dynamic growth markets—home automation and next-generation flat-panel televisions. Nevertheless, the stock weakened temporarily in 2014 due to product transitions in its TV business. We attended a trade show in January and noticed how popular Sigma’s home-automation chips were with developers. Further research reinforced our belief that the company was well-positioned to capitalize on this trend due to its leadership in that market. In addition, we were optimistic about Sigma’s ability to take advantage of the growing demand for next-generation televisions. We made a full investment in Sigma while its earnings were still depressed, and what we saw as the company’s growth potential has since come through in its numbers—a development that led to a significant rally in its stock price.
AVG Technologies N.V. (AVG) is another information-technology company that featured excellent profitability and cash flow, but lacked the growth to attract Wall Street’s attention. We dug deeper and found that management was purposefully pulling back on certain business lines that it believed were unlikely to deliver long-term growth and redeploying resources into faster-growing areas. We believed these investments would pay off, and we saw that AVG was positioned to generate growth within the “hot” technology themes of mobile communications and data security. We made AVG one of the Fund’s largest holdings on the basis of its potential upside, and this decision paid off as the stock staged a meaningful second-quarter rally.
Our patient, bottom-up approach extends to Fund holdings that experience short-term underperformance, but where we believe the catalysts for growth remain in place. For instance, shares of Allegiant Travel Co. (ALGT) lost ground and detracted from our second-quarter results. The stock appeared to have been hit by investor concerns about rising capacity in the airline industry, but Allegiant isn’t necessarily affected by this trend due to its strong position in smaller, underserved markets. Believing Allegiant has a long runway for future growth, we held onto the position.
The quarter also brought underperformance for a number of the Fund’s energy and transportation stocks. Energy stocks remain under broad-based pressure due to uncertainty about the direction of oil prices. This has weighed on our positions including World Fuel Services Corp. (INT) and Northern Oil and Gas, Inc. (NOG). While the overall sector is widely unpopular at present, we have maintained our positions on the belief that we have invested in fundamentally sound companies with identifiable sources of future growth. In fact, we repurchased a previously held name, Geospace Technologies Corp. (GEOS), to take advantage of depressed valuations. Transportation stocks, for their part, gave back some of last year’s gains due to investor worries about the outlook for global growth. We elected to reduce the Fund’s weighting in the transportation industry in order to manage risk and lock in some profits.
Despite the shortfall in these areas, we are pleased with our results for the second quarter. The Fund performed particularly well in the information-technology sector, which is traditionally considered more of a growth-oriented market segment. Along with Sigma Designs and AVG Technologies, two of the Fund’s other leading contributors were EPAM Systems, Inc. (EPAM) and Globant S.A. (GLOB). Both companies offer technology-outsourcing solutions that focus on revenue-generating and customer-facing programs, which are high value-added services to their customers, resulting in better pricing and “stickier” relationships. Unlike the many India-based outsourcing providers, however, EPAM and Globant have the advantage of location—EPAM in Europe, Globant in South America. Their location has provided a competitive advantage in that the companies operate in the same time zones as their customers, which puts them in a strong position to capitalize on the broader outsourcing trend. We believe these investments underscore the merits of our role as “value investors inside a growth shop,” which affords us the opportunity to search for undervalued companies with exposure to powerful secular growth themes.
The financials sector, while currently the largest weighting in the Fund on an absolute basis, has long been our largest sector underweight versus the benchmark. The primary reason for this positioning has been our view that banks would struggle to increase loans in the weak economic environment that existed in the years following the 2007–08 financial crisis. We believe many regional banks are now in a stronger position to generate growth than they were just two to three years ago, yet this isn’t fully reflected in their valuations. We therefore began boosting the Fund’s weighting in this group during the second quarter by increasing our existing positions and adding new banks.
While we have increased our weighting in financials, we have sought to take profits in areas where we see the risk/reward profile as becoming less favorable. This process led to a reduction in the Fund’s weighting in the transportation industry as we trimmed positions in stocks where we believe risks are increasing. One such position was Wesco Aircraft Holdings, Inc. (WAIR), which we sold because we believe the company has taken on too much debt due to a recent acquisition. We believe our shift into more reasonably valued companies from those with less attractive trade-offs of risk and return potential can help protect some of the gains we delivered during the first half of 2015. (Current and future holdings are subject to risk.)
With small-cap stocks having produced such strong returns in recent years, we are finding that undervalued stocks are becoming less plentiful. Fortunately, our process—which seeks to identify undiscovered, undervalued companies as well as quality companies with short-term challenges—continues to uncover a broad range of investment opportunities. In terms of managing risk, we will continue to trim positions where momentum is slowing and risk is increasing. We believe this approach will hold the Fund in good stead if the broader environment becomes more challenging in the months ahead.
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.
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.
††The price-to-earnings (P/E) ratio is the price of a stock divided by its earnings per share.
‡Valuation is the process of determining the current worth of an asset or company.