Wasatch Micro Cap Fund® (WMICX)  Invest in this Fund 

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Q3 2017
Strong Stock Selection Drove Outperformance
by Ken Korngiebel, CFA and Dan Chace, CFA

“After having surprised on the upside so far in 2017, corporate earnings entered the final three months of the year on reasonably firm footing.”

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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.

For the period ended September 30, 2017, the average annual total returns of the Wasatch Micro Cap Fund for the one-, five- and ten-year periods were 25.10%, 13.90% and 6.32%, the returns for the Russell Microcap Index were 22.33%, 13.89%, and 6.65%. Total Expense Ratio: 1.67%.

 

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

The Wasatch Micro Cap Fund added a gain of 8.86% to what so far in 2017 has been a period of strong outperformance. The Fund again surpassed its benchmark, the Russell Microcap Index, which rose 6.65% during the third quarter.

Better-than-expected corporate earnings and a modest uptick in global growth helped push U.S. equities to record highs. Subdued inflation and low interest rates contributed to the positive investment environment. Stocks received an added boost after the White House released a nine-page framework for tax reform. Because smaller firms derive more of their earnings from U.S. operations and tend to have higher effective tax rates than large multinationals, micro caps are among the companies that stand to benefit most from corporate tax relief.

Late in the quarter, the Federal Reserve (Fed) said it will soon begin winding down its quantitative-easing program—the stimulus the Fed has provided since the 2008 financial crisis. With global liquidity conditions still favorable, however, market reaction to the Fed’s announcement was muted. Ongoing quantitative easing from the European Central Bank, the Bank of Japan and the Bank of England—together with a steady flow of cash from U.S. public pension funds—have combined to suppress the yields of fixed-income securities and increase the appeal of equity investments in comparison.

Housing-related stocks were a key source of the Fund’s outperformance relative to its benchmark. Based on long-term averages dating back to the 1950s, we believe there remains a deficit in the inventory of new homes, particularly as younger Americans cease living with their parents and form new households of their own. Other factors contributing to strong third-quarter demand for building materials and other housing-related products and services included a low unemployment rate and an active hurricane season.

Stock selection in the consumer-discretionary, industrials and financials sectors was particularly strong and helped drive the Fund’s outperformance of the Index. Information technology was one of the few areas of underperformance, but the growth potential of our technology companies remains attractive. 

Details of the Quarter

One of the strongest contributors to the Fund’s performance for the quarter was ZAGG, Inc. (ZAGG). The company makes screen protectors, portable power chargers, battery cases and other accessories for mobile devices. Shares of Zagg soared on the announcement that the company partnered with Apple to develop and market a wireless charging base for the new iPhone 8, iPhone 8 Plus and iPhone X.  Apple rarely shares product information with accessory makers prior to launch, so the unique partnership gives ZAGG a strong advantage over its competitors.  In addition, the new generation of smartphones is expected to boost sales of ZAGG’s InvisibleShield screen protectors and other products.

Exa Corp. (EXA), another top contributor, develops simulation software that enables manufacturers to model aerodynamics, thermal management, fluid flow and other properties in their products. The company’s shares soared in late September after it agreed to be acquired by Dassault Systemes, a French company that is integrating Exa’s software with its own 3-D technology.

Housing-related contributors included LendingTree, Inc. (TREE), which operates an online loan marketplace for U.S. consumers. During the first six months of 2017, revenues from the company’s mortgage products grew 28% despite a 4.2% overall decline in mortgage originations. Fees from LendingTree’s non-mortgage businesses—which include credit cards, personal loans and home equity lines of credit—grew an impressive 112%.

Other strong contributors tied to housing included Trex Co., Inc. (TREX), Installed Building Products, Inc. (IBP) and LGI Homes, Inc. (LGIH). Trex manufactures wood-plastic composite products, primarily for residential and commercial decking applications. IBP installs insulation and other building materials, such as garage doors, rain gutters and closet shelving. LGI designs and builds entry-level homes in Texas, Arizona, Florida and other U.S. locations. Its innovative marketing strategy has been successful in targeting renters and younger home buyers.

One of the greatest detractors from the Fund’s performance for the quarter was Ellie Mae, Inc. (ELLI). The company offers innovative cloud-based software for the U.S. residential-mortgage industry. Ellie Mae saw its stock price tumble in July after management reported earnings and revenues that fell short of expectations. Citing reduced loan volumes due to slower refinancing activity and tighter housing inventories, management also lowered the company’s third-quarter and full-year guidance for 2017. We think Ellie Mae’s strong market position will enable it to weather what we consider a cyclical transition in its business. The company processes roughly one-quarter of all U.S. mortgage applications, and it continues to represent a worthwhile holding for the Fund in our view.

We sold Reis, Inc., another third-quarter detractor, due to weakening fundamentals. The company provides commercial-real-estate market information and analytical tools to real-estate professionals. With competitive dynamics uncertain and satisfaction among Reis customers showing signs of deterioration as well, we decided to move on.

Also exiting the Fund during the third quarter was MakeMyTrip Ltd. (MMYT), India’s largest online travel agent. We had expected MakeMyTrip’s merger with the ibibo Group to leave it well-positioned to benefit from increased usage of online travel in India. However, a competitor’s entry into the market earlier this year increased the likelihood that competitive pressures may persist longer than previously anticipated. (Current and future holdings are subject to risk.)

Outlook

After having surprised on the upside so far in 2017, corporate earnings entered the final three months of the year on reasonably firm footing. Aside from ever-present international, political and other risks that are difficult to anticipate and quantify, the most likely threats to U.S. companies’ continued profit growth include a tightening labor market and falling participation rates as baby boomers exit the workforce in large numbers.

While low unemployment is obviously good for people with jobs and for those seeking work, businesses need qualified workers to replace those who leave. Luring away employees from competitors with promises of higher wages and benefits drives up employment costs, but does not add any new workers to the workforce. Instead, wage increases driven by a scarcity of labor rather than by productivity growth typically squeeze profit margins and create inflationary pressures. To the extent those pressures force the Fed to raise interest rates more rapidly than expected, a sustained rise in average hourly earnings might ultimately threaten the positive environment that has underpinned recent equity performance and economic growth.

Fortunately, factors opposing such a scenario are significant. As mergers and acquisitions eliminate duplication in the workforce, laid-off workers can help fill the employment needs of other companies. In addition, low energy and commodity prices are generating deflationary forces that would likely offset potential wage increases at least partially, keeping overall inflation in check.

Against that backdrop, we continue to seek high-quality micro caps with the potential to grow into small and medium-size companies over a reasonable period of time. Examples include companies with unique opportunities to serve new markets, undiscovered growers with favorable business trends, as well as disruptive companies whose technologies make them attractive candidates for acquisition by competitors.

Thank you for the opportunity to manage your assets.

Sincerely,

Ken Korngiebel and Dan Chace

 

**The Russell Microcap Index is an unmanaged total return index of the smallest 1,000 securities in the small-cap Russell 2000 Index along with the next smallest 1,000 companies, based on a ranking of all U.S. equities by market capitalization. The Russell 2000 Index is an unmanaged total return index of the smallest 2,000 companies in the Russell 3000 Index. The Russell 2000 is widely used in the industry to measure the performance of small company stocks.

You cannot invest directly in these or any indexes.

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.

CFA® is a trademark owned by CFA Institute.

The Wasatch Micro Cap Fund’s investment objective is long-term growth of capital. Income is an objective only when consistent with long-term growth of capital.

As of September 30, 2017, the Wasatch Micro Cap Fund was not invested in Apple, Inc. or Dassault Systemes SE.

The global financial crisis, also known as the financial crisis of 2007-09 and 2008 financial crisis, is considered by many economists to have been the worst financial crisis since the Great Depression of the 1930s.

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.

The Russell Microcap Index is an unmanaged total return index of the smallest 1,000 securities in the small cap Russell 2000 Index plus the next smallest 1,000 securities. The Index commenced operations after the fund commenced operations.   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.

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