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

Investor Class | Institutional Class
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4Q18
Finding Opportunities in the Market Downturn
by Jim Larkins

“We welcome volatility if it creates a fundamental disconnect, since stocks are often at their most compelling values at times when fear is rampant.”

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 December 31, 2018, the average annual total returns of the Wasatch Small Cap Value Fund for the one-, five- and ten-year periods were -9.45%, 6.86% and 15.29%, the returns for the Russell 2000 Value Index were -12.86%, 3.61%, and 10.40%, and the returns for the Russell 2000 Index were -11.01%, 4.41%, and 11.97%.  Expense ratio: Gross 1.20%.

 

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 nearly two years of strong performance for U.S. equities, the investment backdrop turned decidedly negative in the fourth quarter. Investors grew increasingly worried about a number of key issues, including escalating trade tensions between the United States and China, signs of a potential slowdown in economic growth, and continued interest-rate increases by the U.S. Federal Reserve. Together, these developments fueled concerns about weaker corporate earnings in 2019 and led to a sharp decrease in investors’ appetite for risk. The Russell 2000 Value Index—the Fund’s benchmark—declined -18.67% in the fourth quarter, bringing its return for the full year into negative territory at -12.86%.

As would be expected at a time in which few areas of the market were untouched by weakness, the Wasatch Small Cap Value Fund—Investor Class also posted a loss, declining -15.61% for the fourth quarter. Still, we believe we were able to mitigate some of the downside and the Fund outperformed the Index during the quarter. As the market climbed throughout the first nine months of the year, we gradually adopted a more defensive approach by shifting the Fund toward companies whose valuation discounts and higher-quality characteristics provided what we hoped would be a greater “margin of safety” in the event of a market downturn. This aspect of our strategy paid off in the form of benchmark-beating returns in the fourth quarter. The Fund continued to demonstrate positive longer-term results as well, with outperformance in the one-, three-, five- and 10-year periods. The Fund also outperformed for the period since its inception in 1997 through December 31, 2018, with an average annual gain of 11.34% for the Investor Class compared to an average annual return of 7.59% for the benchmark.

Details of the Quarter

Although individual stock selection is typically the most important driver of portfolio performance relative to the benchmark, our positions in certain sectors and industries were key contributors in the final three months of the year. Since our primary focus is on identifying great companies selling at value prices, sector weightings are largely an outcome of our bottom-up approach. With that said, we also use a “common sense” discipline around the Fund’s sector positioning. For example, our emphasis on managing downside risk led us to hold an underweight position in the more volatile energy sector. Our lack of exposure to the biotechnology industry, which finished well behind the benchmark as a whole, was a further plus.

Stock selection was primarily responsible for the Fund’s outperformance of the benchmark in the fourth quarter. Although the majority of the Fund’s holdings lost ground, as would be expected given the weakness in the broader market, we held a number of stocks that posted modest gains due to positive fundamental developments. One such company was Dorman Products, Inc. (DORM), a provider of aftermarket automotive parts that began to show signs of a turnaround in its revenue growth. We believe the company has a long runway of potential growth due to the rising average age of automobiles in the United States.

Fabrinet (FN), a long-term Fund holding that has been a strong contributor over the past three years, also delivered a positive return thanks to its cash-rich balance sheet and new growth opportunities in optical data-communication manufacturing.

Health care was an additional area of relative strength for the Fund, as our tilt toward stable, quality companies over the sector’s higher-risk stocks aided results. Ensign Group Inc. (ENSG), a skilled nursing operator that is not included in the benchmark, aided relative performance. The company focuses on elder care, a relatively stable business that was less affected by concerns about economic growth.

National Storage Affiliates Trust (NSA) also held up well in the fourth-quarter downturn. By design, we hold real estate investment trusts such as NSA as ballast against times of volatility. We see a long-run opportunity for consolidation in the self-storage industry, and we like the way the asset class has performed in other market downturns thanks to the consistent demand for self-storage across economic cycles.

On the other end of the spectrum, the Fund’s holdings in the industrials sector were particularly hard hit by the uncertainty surrounding trade policy. Given the inherent cyclicality of industrial end markets, we strive to own what we see as the highest-quality companies in the sector. Some of our key measures of quality are high cash flow generation and businesses that have a higher degree of stability due to their emphasis on replacement and consumable parts. Most of the Fund’s holdings also have strong track records of making successful acquisitions, but a few took on debt to do so. These holdings, which include Altra Industrial Motion Corp. (AIMC) and Sun Hydraulics Corp. (SNHY), underperformed amid the broader weakness in companies with elevated debt levels. While we’re pleased that our cautious approach to investing in leveraged companies mitigated some of the downside, we did not escape all of that risk.

Along this same line, energy producer Oil States International, Inc. (OIS) lagged its already-weak sector peers, largely due to debt that it took on to make what we believe was an attractive strategic acquisition. We reduced the position at higher prices earlier in the year but were not aggressive enough to avoid the fourth-quarter selloff.

Ebix, Inc. (EBIX), a provider of software and e-commerce solutions to the insurance industry, was another company with above-average debt that underperformed. Ebix has been an excellent long-run performer, but we aggressively reduced the position at the end of the third quarter on concerns about the company’s debt load and some slowing in the U.S. insurance solutions business. We wanted to maintain an investment based on the company’s long-term growth opportunities, but preferred a smaller position size as part of our efforts at risk management. (Current and future holdings are subject to risk.)

Outlook and Positioning

While rising interest rates and trade tensions led to poor market performance in recent months, we do not see economic conditions that warrant a strong negative outlook. Increased uncertainty has brought the valuations of many stocks back to more reasonable levels, indicating to us that the market may be working off the excess optimism of earlier in the year rather than discounting a recession or a sharp decline in corporate earnings.

We therefore think the downdraft has created opportunities across the small-cap market, and we are keeping an eye out for stocks that we believe have been unjustly punished in the selloff. We welcome volatility if it creates a fundamental disconnect, since stocks are often at their most compelling values at times when fear is rampant. In this environment, we remain on the lookout for what we call “Fallen Angels”—growth companies that have hit a bump in the road, but are not at the end of the road—that can add to the quality and long run return potential of the Fund. Since we like the businesses in which we are invested, some of the best chances to “buy low” may in fact already be held in the Fund. More broadly speaking, we maintain our longstanding approach of seeking to minimize downside risk by emphasizing companies that we believe are higher quality, fundamentally sound and financially strong.

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.

The Wasatch Small Cap Value Fund has been developed solely by Wasatch Advisors, Inc. The Wasatch Small Cap Value Fund is not in any way connected to or sponsored, endorsed, sold or promoted by the London Stock Exchange Group plc and its group undertakings (collectively, the “LSE Group”). FTSE Russell is a trading name of certain of the LSE Group companies.

All rights in the Russell 2000 Value Index vest in the relevant LSE Group company, which owns the Index. Russell ® is a trademark of the relevant LSE Group company and is used by any other LSE Group company under license.

The Index is calculated by or on behalf of FTSE International Limited or its affiliate, agent or partner. The LSE Group does not accept any liability whatsoever to any person arising out of (a) the use of, reliance on or any error in the Index or (b) investment in or operation of the Wasatch Small Cap Value Fund or the suitability of the Index for the purpose to which it is being put by Wasatch Advisors, Inc.

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 Russell 2000 Growth Index measures the performance of Russell 2000 Index companies with higher price-to-book ratios and higher forecasted growth values.

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.

View the Small Cap Value Fund’s most current Top 10 Holdings

Portfolio holdings are subject to change at any time. References to specific securities should not be construed as recommendations by the Funds or their Advisor.

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