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

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Q1 2018
Growth Stocks and Micro Caps Outperformed During a Volatile Start to 2018
by Ken Korngiebel, CFA and Dan Chace, CFA

“The uncertain environment favored our bottom-up investment approach, which seeks companies with strong earnings growth, sustainable competitive advantages and experienced management teams.”

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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 March 31, 2018, the average annual total returns of the Wasatch Micro Cap Fund for the one-, five- and ten-year periods were 33.65%, 14.79% and 10.19%, the returns for the Russell Microcap Index were 13.50%, 11.79%, and 9.19%. 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 gained 5.37% in what was a volatile first quarter for U.S. equities. After having outgained the benchmark Russell Microcap Index during the preceding one-, three-, five- and 10-year periods, the Fund again surpassed the Index during the first three months of 2018. The Index finished the quarter up 0.68%, as it gave back most of its earlier gains.

Following a strong start to the year for both the economy and the stock market, inflation concerns and rising interest rates derailed the early advance in equities. Later, political uncertainty and fears of a trade war between the U.S. and China also impacted financial markets. Economic data, which had initially been coming in stronger than expected, began to weaken as the quarter continued. As of March 29th, the Federal Reserve Bank of Atlanta’s GDPNow model forecasted U.S. gross domestic product (GDP) growth for the first-quarter of 2018 of just 2.4%—down from an earlier estimate of 5.4% on February 1st.

Fading confidence in the near-term economic outlook dashed expectations of a surge in late-cycle value stocks. Instead, growth outperformed value across the market-cap spectrum. The uncertain environment favored our bottom-up investment approach, which seeks quality companies as evidenced by strong earnings growth, sustainable competitive advantages and experienced management teams.

Newly announced tariffs on aluminum and steel—as well as separate measures directed specifically at China—hung over the market as investors weighed the likely repercussions across various industries. Because smaller U.S. companies typically have less-direct exposure to international trade, small-company stocks and micro caps outperformed large-cap issues during the quarter. Additionally, smaller companies currently tend to be valued more attractively than their larger peers, and their domestic focus leaves them well-positioned to benefit from a lower corporate tax rate.

Information technology (IT), health care and consumer discretionary were our greatest sources of outperformance relative to the benchmark. Mainstays of traditional growth portfolios, these areas have been abundant sources of the types of companies in which we seek to invest. In IT and health care especially, we believe the Fund’s outperformance of its benchmark during the quarter reflected our extensive research, deep due diligence and expertise in navigating these more analytically complex sectors of the market.

While the Fund’s U.S. holdings drove first-quarter performance, Japan was a significant contributor on the international side. During the quarter, five members of our investment team spent two weeks visiting more than 80 companies throughout Japan. Japan’s entrepreneurial spirit has spawned a profusion of founder-led firms, as well as a healthy market for initial public offerings (IPOs). As in most other countries, the fastest-growing companies in Japan currently carry rich valuations that demand careful research and evaluation prior to investment.

Details of the Quarter

Top contributors to the Fund’s performance for the quarter included a number of recently added holdings. Among these were Cambium Learning Group, Inc. (ABCD), Tabula Rasa HealthCare, Inc. (TRHC) and Rapid7, Inc. (RPD). Cambium’s entry into the Fund during the first quarter of 2018 came as a result of our quantitative screening process. A little-known company with no Wall Street following, Cambium in our view is a classic Wasatch micro cap. The company provides educational products that include textbooks and digital solutions for schools. As Cambium’s online and other digital offerings perform at higher rates of profitability than its legacy print solutions, the top-line growth and mix change has evolved the company’s business model and expanded its margins and cash flow.

Tabula Rasa, a developer of health-care software, was first purchased in the Fund during the third quarter of 2017. The company’s product offerings include its Medication Risk MitigationTM platform, which directly addresses the rising epidemic of accidental opioid overdoses. Tabula Rasa’s stock price has climbed amid growing awareness of the risks associated with adverse drug events and the benefits that can be achieved through targeted, personalized and effective treatment regimens.

Rapid7, a cybersecurity firm, develops analytics software for security and IT operations. Revenues in Rapid7’s most-recent quarter came in slightly ahead of expectations, driven by the company’s shift to a subscription-based business model and increased demand for its products.

Another strong stock in the Fund was Sangamo Therapeutics, Inc. (SGMO). A clinical-stage biopharmaceutical company, Sangamo specializes in the treatment and cure of single-gene disorders. Shares of Sangamo rose sharply in February after the company landed a deal with Gilead Sciences to collaborate on cancer treatments. Because Sangamo focuses on diseases affecting relatively small numbers of individuals, the company can bring its treatments to market without investing heavily in sales and marketing. We think Sangamo’s zinc-finger technology offers a safer and more-specific approach to gene editing than those of competitors.

With interest rates on the rise during the first quarter, rate-sensitive issues performed poorly. Significant detractors in the Fund included a pair of stocks tied to residential construction—Installed Building Products, Inc. (IBP) and LGI Homes, Inc. (LGIH). Worries that higher mortgage rates would make houses less affordable for potential buyers weighed on the shares of both companies. We significantly reduced the Fund’s position in IBP on concerns about the stock’s valuation. We also had taken profits in LGI, which reduced the impact on the Fund of the stock’s subsequent pullback.

Rising interest rates also hurt industrial stocks, even as softer-than-expected economic numbers reduced the appeal of cyclicals in general. Kornit Digital Ltd. (KRNT), an Israeli producer of textile-printing machinery, saw its stock price decline amid start-up delays at a new facility of its largest customer. We think those holdups have been resolved and expect the affected Kornit units to ship over the next several months. We also expect the rollout of Kornit’s new HD series to drive a pickup in sales to its customers and other textile printers, as these faster and more-efficient machines encourage screen-print operators to convert a portion of their installed base to digital printing equipment.

Another weak stock in the Fund was Freshpet, Inc. (FRPT). The company sells fresh, refrigerated meals and treats for dogs and cats in the U.S., Canada and the United Kingdom. Shares of Freshpet declined in March after earnings in the company’s most-recent quarter fell short of expectations. Investors also seemed dissatisfied with management’s guidance for 2018, which included a healthy increase in advertising spending. We think the additional advertising will accelerate top-line growth at Freshpet and continue to own the stock in the Fund. (Current and future holdings are subject to risk.)

Outlook

As the effects of the Tax Cuts and Jobs Act of 2017 began rippling through the U.S. economy, the first quarter of 2018 provided an early glimpse of what we might expect going forward. A common starting point in most a priori analyses was the assumption that lower corporate income-tax expenditures and higher repatriation rates of overseas earnings would increase the amount of cash available to large U.S. companies. The first quarter gave us reason to believe that a good chunk of those excess funds will be directed toward acquisitions of smaller competitors.

In the Fund, for example, cloud-computing company Callidus Software, Inc. (CALD) recently announced its acquisition by enterprise-software giant SAP SE. Although SAP is a German company, it still must pay U.S. corporate income tax on the profits it earns in the U.S. Moreover, the eye-popping multiple of recurring Callidus revenues that SAP was willing to pay in order to ink the deal bodes well for other micro caps with innovative products and attractive growth rates. To the extent that corporate tax windfalls find their way into the real U.S. economy, micro-cap companies also stand to gain from improved business conditions and faster growth.

Balanced against the positive aspects of tax reform is the risk that a policy mistake by the Federal Reserve may require interest rates to rise faster than expected. In that scenario, we would anticipate interest-rate-sensitive sectors such as industrials and materials to underperform.

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 March 31, 2018, the Wasatch Micro Cap Fund was not invested in Gilead Sciences, Inc. or SAP SE.

The “cloud” is the internet. Cloud-computing is a model for delivering information-technology services in which resources are retrieved from the internet through web-based tools and applications, rather than from a direct connection to a server.

Earnings growth is a measure of growth in a company’s net income over a specific period, often one year.

Gross domestic product (GDP) is a basic measure of a country’s economic performance and is the market value of all final goods and services made within the borders of a country in a year.

An initial public offering (IPO) is a company’s first sale of stock to the public.

Valuation is the process of determining the current worth of an asset or company.

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.

View the Micro Cap Fund’s most current Top 10 Holdings

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