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

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4Q18
Mounting Risks Created a Difficult Quarter for Micro Caps
by Ken Korngiebel, CFA and Dan Chace, CFA

“With the Fed having spiked the punch bowl for the previous 10 years, 2018 will be remembered as the year the Fed took the punch bowl away.”

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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 December 31, 2018, the average annual total returns of the Wasatch Micro Cap Fund for the one-, five- and ten-year periods were 2.57%, 8.30%, and 15.51%, the returns for the Russell Microcap Index were -13.08%, 3.08%, and 11.71%. Total Expense Ratio: 1.65%.

 

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

U.S. equity prices fell sharply during the final three months of the year, with the benchmark Russell Microcap Index down -22.14% for the quarter. Uncertainty about global growth, international trade and U.S. monetary policy created a hostile investment environment for equities. The Wasatch Micro Cap Fund held up slightly better than its benchmark with a decline -20.52%. For the year, we’re pleased with the Fund’s gain of 2.57%, especially since the Index was down -13.08%.

Stocks were weak from the outset of the quarter as the trade dispute between the U.S. and China captured headlines and the yield on the 10-year Treasury bond surged above 3%. The selloff accelerated on October 4th after Federal Reserve Chairman Jerome Powell said in an interview that the Fed’s policy interest rate was “a long way from neutral.” Because the federal-funds rate is closely tied to rates on most forms of consumer debt, investors fretted that an extended series of Fed rate hikes might crimp household spending and slow economic growth. Worries eased somewhat in late November when Mr. Powell attempted to walk back his previous remarks, saying in a speech that interest rates “remain just below the broad range of estimates of the level that would be neutral for the economy.”

In December, however, the market headed lower on renewed uneasiness about the ability of the U.S. to come to a long-term trade agreement with China. Mixed economic data from both countries fanned concerns about weaker global growth. As key measures such as single-family housing starts and new orders for manufactured goods came in below expectations, investors feared that a misstep by the Fed might tip the U.S. economy into recession.

Micro-cap equities and stocks of other small companies fared worse than large-cap issues as investors sought to reduce risk in their portfolios. The safe-haven utilities component was the only sector of the micro-cap benchmark to post a gain during the fourth quarter.

Energy was the worst-performing sector of the Index as U.S. crude oil briefly plunged below $43 a barrel. Rising output from the U.S., Saudi Arabia and Russia weighed on oil prices, while slowing demand growth and U.S. waivers on Iranian oil sanctions also contributed to weakness in crude prices. Oil finished the quarter at $45.41 a barrel—down nearly -41% from a multi-year high of $76.90 reached on October 3rd.

The health-care sector was the Fund’s greatest source of strength against the benchmark, as our companies outperformed their Index peers. In the financials sector, two positions accounted for most of the underperformance of our stocks relative to those in the benchmark. In the information-technology sector, our holdings were down less than those in the benchmark, while our industrial holdings were down more.

International micro caps were also negative but held up better than their U.S. counterparts. The Indian economy benefited from the steep drop in energy prices, and our holdings there were up almost 9% during the quarter. As an energy importer, India’s economy benefits significantly when oil prices decline and consumers have more money to spend on staples and discretionary items. One beneficiary was V-Mart Retail Ltd., an apparel and home-goods retailer with over 150 stores and a growing online presence. Along with India’s economy, we believe V-Mart has outstanding prospects for continued growth.

Details of the Quarter

The strongest contributor to Fund performance for the quarter was Cambium Learning Group, Inc. (ABCD). The company provides educational technology solutions in the U.S. and internationally. Shares of Cambium soared on news that the company had agreed to be acquired by a private-equity investment firm. Prior to the announcement, Cambium’s stock price had more than doubled in 2018, driven by the company’s transition from legacy printed materials toward higher-margin digital products.

Fabrinet (FN) was also a significant contributor. An electronics manufacturing services company, Fabrinet assembles optical, electro-mechanical and electronic devices for other companies. Fabrinet’s stock price jumped in early November after the company reported better-than-expected quarterly financial results and raised its forward guidance. Management cited an influx of activity to Fabrinet’s plant in Thailand as Chinese manufacturers seek to circumvent tariffs placed on products imported into the U.S. We believe Fabrinet is well-positioned for future growth as the continued migration of data and computing to the cloud drive strong demand for datacom components.

The greatest detractor for the quarter was Curo Group Holdings Corp. (CURO). A diversified consumer-finance company, Curo provides financial services to a range of underbanked customers in the U.S., Canada and the United Kingdom. The company, which extends short-term loans to high-risk borrowers at high interest rates, saw its stock price tumble after a disappointing earnings report revealed deteriorating credit metrics and downward revisions to guidance for 2019. Management cited a new product introduction in Canada and higher credit lines in Virginia and Tennessee as reasons for the guidance revisions. We reduced the position to mitigate future risk to the Fund while we continue to monitor the situation.

Limelight Networks, Inc. (LLNW) was another significant detractor. The company’s content-delivery network enables businesses to deliver digital content across internet, mobile and social channels. Although Limelight reported quarterly earnings and revenues that were in line with expectations, investors reacted negatively to the company’s decision to forego low-margin business volume in order to grow in a less-price-sensitive part of the content-delivery market. The stock fell again in December after management lowered fourth-quarter guidance. Longer term, however, Limelight’s shift toward higher-margin opportunities makes strategic sense in our view. We added on the weakness to reflect what we consider the stock’s attractive valuation and potential for appreciation.

Another weak stock in the Fund was Altra Industrial Motion Corp. (AIMC). The company manufactures and supplies electromechanical power-transmission and motion-control products. Because Altra recently completed an acquisition that increased the company’s debt, the additional risks associated with integrating the acquisition and servicing the new debt made the company less attractive to investors in the risk-off investment environment present during the fourth quarter. Even so, we think the acquisition has the potential to transform Altra into a less-cyclical, more-desirable company. We continue to own the stock at an average weight in the Fund. (Current and future holdings are subject to risk.)

Outlook

With the Fed having spiked the punch bowl for the previous 10 years, 2018 will be remembered as the year the Fed took the punch bowl away. Consumers are already feeling the pinch in the form of higher interest rates on credit-card balances and other variable-rate debt. Banks, meanwhile, have been slow to pass on recent Fed rate increases to customers in the form of higher yields on savings.

Even as short-term rates have moved higher, a drop in long-term interest rates pushed bank-lending rates on mortgages and other loans lower during the fourth quarter. To the extent that the difference between the borrowing and lending rates of banks narrows further, micro-cap banks may struggle to increase profitability. A slowing economy and falling loan demand would pose additional challenges for banks.

In the micro-cap market especially, we believe it pays to be active investors rather than passively investing in an index. Indexes are often structured with disproportionate exposures to certain sectors—in contrast to investment styles such as ours that seek to invest in growing, innovative companies. For example, although banks currently represent approximately 15% of the micro-cap benchmark, the U.S. banking industry is not one that is dynamic and growing. While we do invest in banks that we believe have compelling product strategies and favorable geographic locations, we’ve never been able to find enough of them to get close to the benchmark’s weight.

Another advantage afforded to us as active investors is the opportunity to adapt to market dislocations in an attempt to use them to benefit the Fund. In the current environment, we’ve been sifting through the Fund’s beaten-down stocks in search of those we think have been unfairly punished. By examining these holdings on a case-by-case basis, our goal is to identify and increase position sizes in the ones we believe have the greatest potential for long-term appreciation. And with micro-cap stocks down significantly in general, we continue to look for new additions to the Fund.

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.

The Wasatch Micro Cap Fund has been developed solely by Wasatch Advisors, Inc. The Wasatch Micro Cap 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 Microcap 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 Micro Cap Fund or the suitability of the Index for the purpose to which it is being put by Wasatch Advisors, Inc.

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.

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.

The federal-funds rate is the interest rate at which private depository institutions (mostly banks) lend balances (federal funds) at the Federal Reserve to other depository institutions, usually overnight. It is the interest rate banks charge each other for loans.

“Risk-off” is when investors become more cautious and take money out of the market, not being willing to risk it, thus risk off.

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

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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