Concerns about slowing global growth led to a downturn in the U.S. stock market during the third quarter, causing the small-cap Russell 2000 Value Index to finish the period down
–10.73%. While the Fund also closed the quarter in negative territory, we outperformed the Index. This comes on the heels of our outperformance in the rising markets of the prior few years—indicating that the Fund has delivered robust relative performance in both up and down markets.
This result is consistent with our goal of capturing the market’s upside potential while at the same time striving to mitigate the downside. We have placed a particular emphasis on this latter goal, as we want to protect some of the Fund’s strong absolute and relative performance of the past five years.
We believe there are three important reasons for our strong showing in the year-to-date and longer periods.
First, we have maintained our longstanding discipline of buying what we consider to be high-quality companies at value prices through our “Fallen Angels” strategy, which seeks to identify growth companies that temporarily fall into value territory due to short-term factors. This approach has helped us to capture meaningful upside in a number of stocks over time, especially since we invested at valuations†† we saw as attractively low.
Second, we have taken steps to concentrate the Fund by targeting a total number of holdings between 50 and 60 stocks. We believe this puts us in the best position to capitalize on the potential outperformance of our best ideas, as we have found that smaller positions usually have little impact on overall performance—either positively or negatively. We therefore seek to own stocks that warrant larger positions, a strategy that has held us in good stead in recent years.
Third, but not least, we have been very aggressive in selling positions when our investment thesis has proven incorrect. While we evaluate each stock on a case-by-case basis, of course, we have taken a more active approach to trimming underperforming stocks over time. We believe this has helped to support the Fund’s performance in recent years, and it may continue to do so if overall market performance remains volatile in the months ahead.
Details of the Quarter
Consistent with our bottom-up approach, stock selection was the primary driver of the Fund’s third-quarter outperformance of its benchmark. Our results were particularly strong within two traditional growth sectors—health care and consumer discretionary—which helps illustrate the potential benefits of our emphasis on faster-growing companies within the value universe.
In health care, LHC Group, Inc. (LHCG) was one of our top performers. LHC, a home health care provider that we first invested in on its initial public offering‡ in 2005, was a stock we knew from our “institutional memory.” We last invested in the company in 2010, but we decided to visit its headquarters in the autumn of 2014 as part of a routine trip to see other companies in the area. While there, we learned that LHC was just completing four years of heavy system and process implementations that had weighed on profits and growth. Believing these investments would soon pay off, we reinitiated a position soon after our visit. The profits and growth we expected have indeed come through, as home health care is taking market share by reducing costs for consumers. We have added to our position as the company’s fundamentals have improved, and LHC Group is now among the largest investments in the Fund.
In the consumer-discretionary sector, Skechers U.S.A., Inc. (SKX) delivered a substantial gain and was a leading contributor to the Fund’s overall performance for the second consecutive quarter. The company continues to gain strength globally and capitalize on the growing popularity of “athleisure” wear with their comfort-oriented GO WALK® shoes. While we trimmed the position slightly, Skechers remains a top holding based on our view that its rising stock price is justified by its growth potential. When their stocks trade down, footwear companies can be good Fallen Angel investments given the recurring nature of shoe purchases. We put this strategy to work in our recent addition of another footwear company, Deckers Outdoor Corp. (DECK). We think the combination of the company’s strong brands and good balance sheet, together with the launch of new products and the growth of its HOKA ONE ONE® running shoe brand creates a favorable trade-off of risk and return.
LGI Homes, Inc. (LGIH) also made a strong contribution to performance within the consumer discretionary sector. This relatively new public company focuses on aggressively marketing to apartment renters to turn them into first-time homebuyers. This strategy has translated to rising earnings growth,‡‡ propelling the stock to a sizable gain, despite the weakness in the broader market.
On the negative side, Select Comfort Corp. (SCSS) detracted from performance during the quarter. The stock declined due in part to investor concerns about an upcoming switch to the company’s information technology system. These transitions always come with risk, but we view the stock’s pullback as temporary, stemming from overreaction by the market. We also lost some relative performance through our position in Sigma Designs, Inc. (SIGM), a chipmaker whose shares declined in sympathy with weakness in the semiconductor group. We continue to hold the stock, as we believe the company is well-positioned for growth through its exposure to the growing “Internet of Things” space. Health-care company Mallinckrodt plc (MNK) also detracted from performance, but we feel we were able to minimize the potential losses through our due diligence. We became concerned about complex accounting issues at the company, as well as the increased public scrutiny regarding high-priced drugs. These factors prompted us to sell the position fairly aggressively, which we believe helped mitigate some of the downside.
Our decision to sell two long-held energy positions—Northern Oil and Gas, Inc. (NOG) and Ultra Petroleum Corp. (UPL)—is another example of our commitment to managing downside risk. Although both companies continue to offer some attractive attributes, they are also burdened by what we see as excess leverage. Commodity-related stocks can be challenging investments since the key variable in their earnings—the price of the commodity—is out of their control. As a result, companies with stressed balance sheets tend to have above-average downside risk. We invested some of the proceeds of these sales into Gran Tierra Energy, Inc. (GTE), which has a debt-free balance sheet and properties that have been profitable even in the current environment of low oil prices. We have followed this stock for some time, making it another example of our institutional memory at work. With a recent management change, we saw an opportunity to initiate a position at a good price in a company with a strong balance sheet. (Current and future holdings are subject to risk.)
We typically view market downturns in a positive light since they tend to give us more latitude to execute our strategy of investing in good companies at value prices. We are slightly more cautious with regard to the most recent sell-off, however, since there are some legitimate questions about the direction of global growth. We are keeping a close eye on economic developments and the potential impact they may have on our current and prospective holdings. At the same time, we are also monitoring approximately a half-dozen growth stocks, several of which are in the technology sector, that have slipped into Fallen Angel territory amid the market volatility of the past three months. We established one new position right at quarter end when its stock price traded down, and we may add others if prices become more attractive. Overall, we believe this disciplined approach, together with our emphasis on companies with solid balance sheets, recurring revenues and healthy competitive positions, has the potential to continue to translate into market-beating results even if broader market conditions remain volatile 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.
††Valuation is the process of determining the current worth of an asset or company.
‡An initial public offering (IPO) is a company’s first sale of stock to the public.
‡‡Earnings growth is a measure of growth in a company’s net income over a specific period, often one year.