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

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Q2 2018
Declining Tax and Regulatory Burdens Have Been a Boon for Small U.S. Companies
by Ken Korngiebel, CFA and Dan Chace, CFA

“During the second quarter, micro caps and other small U.S. companies appeared to benefit more from recent tax cuts and deregulation compared to their larger peers.”

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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 June 30, 2018, the average annual total returns of the Wasatch Micro Cap Fund for the one-, five- and ten-year periods were 38.85%, 16.16% and 11.71%, the returns for the Russell Microcap Index were 20.21%, 12.78%, and 10.63%. 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

In what was a strong second quarter of the year for U.S. micro caps, the benchmark Russell Microcap Index rose 9.97%. Outperforming the benchmark, the Wasatch Micro Cap Fund gained 13.17%. U.S. companies continued to reap the benefits of lower corporate tax rates under the Tax Cuts and Jobs Act of 2017. Also, the current administration in Washington has promoted a less-onerous regulatory climate that has boosted business sentiment and encouraged investors.

During the second quarter, micro caps and other small U.S. companies appeared to benefit more from recent tax cuts and deregulation compared to their larger peers. The domestic focus of micro caps also left them less exposed to international trade and tariff concerns. With the domestic backdrop improving and fears of a global trade war getting worse, micro-cap stocks significantly outperformed large-cap issues during the quarter.

Continued strength in growth stocks also helped the Fund. Although more deregulation would likely bring additional benefits for the economy, investors are becoming concerned that the stimulative effects of the tax cuts may prove temporary. As the unemployment rate dipped below 4%, worries grew that a shortage of labor may stall the pace of economic growth. Because growth companies are considered less sensitive to economic risks as well as economic improvement, growth stocks largely held their own against value stocks during the quarter.

Information technology was the largest source of outperformance relative to the benchmark. The Fund held most of its information-technology weight in software stocks—which posted strong returns amid a broad upward revaluation of companies using the software-as-a-service (SaaS) business model. Shares of software-security firms did especially well, as recent high-profile data breaches appear to have spurred an effort on the part of businesses to better protect customer information. Health care and consumer staples also made solid contributions to the Fund’s return—both in absolute terms and compared to the benchmark.

Energy was the top-performing sector of the Index as the price of crude oil surged above $70 a barrel. Though the energy stocks in the Fund generated a solid, double-digit return as a group, they could not keep pace with the lofty gains in the benchmark’s positions. The cyclical, capital-intensive nature of the energy business does not mesh well with our growth investment style, and so our underweight position was nothing new. The minor headwind was more than offset by our performance in other areas.

Details of the Quarter

The strongest contributor to Fund performance for the quarter was Tandem Diabetes Care, Inc. (TNDM). The company offers insulin-delivery systems for people with diabetes. Tandem’s shares extended the surge they began in February after the company’s capital raise strengthened its balance sheet and removed a major source of investor uncertainty. The stock got an additional boost in June on news that the Food and Drug Administration (FDA) had approved the latest upgrade to Tandem’s insulin pumps. The new devices use an algorithm to suspend insulin delivery when low blood glucose is predicted, then automatically resume insulin delivery once glucose levels begin to rise.

Tabula Rasa Healthcare, Inc. (TRHC), a developer of health-care software, was another strong contributor. The company’s Medication Risk Mitigation™ platform helps minimize adverse drug events, particularly for patients who take multiple medications that could counteract each other. Tabula Rasa’s stock price climbed steadily throughout the second quarter 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. Better-than-expected revenue and earnings at the company also helped lift the stock. Management cited Tabula Rasa’s recent acquisition of SinfoníaRx, as well as favorable changes in federal regulations. We trimmed the Fund’s position in Tabula Rasa to maintain the desired weight.

Another of the Fund’s top contributors was nLight, Inc. (LASR), a holding added during its initial public offering (IPO) in April. The company makes high-performance lasers for industrial, aerospace and defense applications. In its first earnings release as a public company, nLight reported a better-than-expected 40% increase in quarterly revenue. Management cited accelerating demand across all business segments, led by growth in the industrial end market. The company’s lasers are rapidly replacing older, carbon-dioxide lasers for industrial cutting and welding, particularly in the production of automobiles.

The greatest detractor from Fund performance for the quarter was Esperion Therapeutics, Inc. (ESPR). The company develops oral therapies for people with elevated low-density lipoprotein cholesterol (LDL-C, or “bad cholesterol”). Shares of Esperion tumbled in early May after a Phase 3 readout for the company’s lead drug candidate revealed 13 deaths in the treatment group compared to two for the placebo. Although an independent safety-monitoring committee concluded the deaths were unrelated to the study, spooked investors sold the stock in what we consider an unwarranted reaction. In our analysis, the study data showed the drug is safe and effective.

Zoe’s Kitchen, Inc. (ZOES), another significant detractor, was sold on deteriorating fundamentals. The company operates fast-casual, Mediterranean-cuisine restaurants. Both top-line and bottom-line results at Zoe’s fell short of expectations in the company’s most-recent quarter. Comparable sales fell -2.3% due to a drop in foot traffic. Management cited increased competition in select markets and disruption from delivery and discounting. With the company also guiding full-year revenue lower and slowing its plans for expansion, we decided to move on.

An additional detractor in the Fund was LGI Homes, Inc. (LGIH). The company designs and builds entry-level homes in Texas, Arizona, Florida and other U.S. locations. Fears that rising mortgage rates would make homes less affordable for potential buyers weighed on LGI’s stock price. Sharing these concerns, we significantly cut back the Fund’s position in LGI prior to the start of the second quarter. However, we believe the company remains a worthwhile holding for the Fund at the current, lower weight. Tight housing supplies and favorable demographics in the markets LGI serves leave ample room for future growth in our view.

The Fund’s international holdings contributed to performance in the second quarter. Outside of the U.S., The Fund’s biggest country weightings were India and Japan, two markets with large numbers of fast growing, high quality micro-cap companies. Members of the Wasatch team recently visited both countries and returned excited about the macroeconomic environment and the sheer amount of interesting companies in the micro-cap space. Moreover, stock valuations abroad are considerably lower than in the U.S.

Indian apparel retailer V-Mart Retail Ltd. is an example of the opportunities we have been seeing abroad. The company focuses on smaller cities where consumers have fewer choices when it comes to fashion. We believe the company has the potential to produce strong revenue growth as it continues to open new stores and shift a larger portion of its merchandise to higher margin private label merchandise. We also like V-Mart’s management team, which is focused on long-term growth. For example, it is one of the few companies of its size in India to offer key employees a stock option plan, which should help it retain valuable managers as it grows. (Current and future holdings are subject to risk.)

Outlook

The concept of full employment has been the subject of much debate among economists. William Beveridge, the British economist who devoted an entire book to the topic in 1944, defined full employment as a state in which vacant jobs slightly outnumber available workers, so people who lose their jobs can immediately find new ones. Beveridge suggested a fully employed workforce was one that was 3% unemployed. More-recent formulations by other economists referred to a “natural rate” of unemployment, below which inflation rises.

However one chooses to define it, recent evidence suggests full U.S. employment may be on the horizon. Economic growth appears to be picking up, construction is booming, wages are rising, and highways have become snarled as people travel back and forth to work in greater numbers. Turnover in the workforce has increased as well, as people leave their current jobs for better-paying positions.

History indicates that wages tend to follow cycles that are very long. When average hourly earnings have bottomed and begun to rise, they have tended to keep on climbing. When those climbs have proven more rapid than expected, the risk of a policy mistake by the Federal Reserve has typically increased along with the risk of recession.

The explosion of software, robotics and other productivity-enhancing technologies has been a major investment theme in the Fund. It has allowed companies to grow their businesses with less additional hiring than in the past. With the U.S. economy approaching full employment, adept management teams applying labor-saving technologies in new and innovative ways may well hold the key to prolonging the current economic cycle.

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.

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.

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