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Q1 Chairman's Letter to Shareholders: " Even More Cautious After a Sharp Rally"

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Economy

After the fourth quarter of 2011 produced a double-digit gain for the S&P 500, I recalled the uncertainty of 2011 and suggested “a stock picker’s market” lay ahead of us in 2012. With the first quarter of 2012 again delivering a double-digit gain (S&P 500 up 12.6%), I am the first to admit that, so far, 2012 has not been a stock picker’s market. With the general market showing such exuberance over the past six months, I am reminded that a rising tide will lift even the most flimsy boats, and I continue to approach current market conditions with caution.

Stock market performance has reflected the strong underlying economic data reported during recent months. Further, troubling news regarding Greece has faded from the front pages, leaving investors more free to respond to largely favorable developments in the business climate. Central banks around the world (with the exception of China) continue to signal that they will keep the liquidity environment favorable to markets. However, this doesn’t mean the global economy is out of the woods yet. I believe Eurozone policies attempting to balance growth with austerity will be difficult to implement and will restrain the region’s growth for some time to come.

One potential fly in the ointment for the U.S. is rising rates reflective of a stronger economy and inflation fears. While the recent steeper yield curve (which means longer term interest rates have been rising) could mean the flywheel of economic progress is finally moving on its own accord, it could also mean monetary policies have been so stimulative for so long that bond investors are waking from their long slumber and perhaps starting to be concerned about future inflation.

If the economy is genuinely gaining strength, I believe having the bond market gently tap the brakes with slightly higher interest rates is not all bad. Otherwise, we are left to rely on assurance from the Federal Reserve (Fed) that it will tap on the brakes “when the time is right.” Given the Fed’s past inability to read the economy correctly, it is difficult to give too much credibility to its request to “trust us.”

The one thing we know for sure is the trends of past years (excessive spending by U.S. and Southern European consumers) will not continue as lenders are no longer willing or able to provide unbridled credit. Either, the market must expand at a more subdued pace or some new driver must emerge to propel the economy at the more rapid pace to which we’ve become accustomed.

 

Markets

So where are we now? I believe we continue to witness a slow recovery around the world. The U.S. stock market’s recent rise affirms my cautious, bullish stance. I am an even more cautious bull than last quarter solely because strong stock price performance has rendered the valuations of companies less attractive. Companies’ revenue growth has been anemic over the past three years and many companies have wrung out their earnings growth as a result of cost cutting. I don’t mean to ignore those firms that have been able to record stellar top-line growth, in many cases driven by innovation and global expansion. As overall valuations get richer, Wasatch’s style of careful stock picking will become even more important.

The macro environment continues to present a set of potential outcomes that is unusually diverse. The base case is long-term subdued growth in the U.S. as it recovers from the long work-out of the global financial crisis and its effect on banks, housing, and consumer balance sheets. But there is also a more optimistic case that the world economy, and that of the U.S., can be driven higher by favorable global demand factors. BRIC (Brazil, Russia, India and China) countries have recently added over two billion people to the global capitalist/consumer system. Emerging and frontier markets have large populations that will become part of a growing middle class of consumers over time.  The pessimistic outcome is that, like Japan over the past decade, we struggle to generate growth—a poor environment for stock market gains.

With respect to the markets, I leave you with my “leaning against the wind” advice of past letters. Just as last Fall I suggested leaning against the excessive pessimism of recent years, I also think that leaning a little against the optimism implied by the 25% short-term advance of the S&P 500 is probably a good idea. The cautious part of the bull in me says it may be wise to save a little powder for investing in pullbacks from this recent run-up.

 

Wasatch

I’ve stated our belief that emerging markets and developing economies will have higher gross domestic product (GDP) growth rates than those we’ll see in more developed countries. As urbanization accelerates in these emerging market countries, domestic demand-oriented companies could benefit from a growing middle class. This scenario presents a classic opportunity for Wasatch’s bottom-up, fundamental, company-focused style of investing.

We believe finding companies with the characteristics we like best here at Wasatch, such as strong balance sheets and/or good cash flow generation, high return on equity (ROE), and durable and predictable earnings growth, requires boots-on-the-ground research. This is exactly what our experienced international team is busy doing as they visit smaller emerging countries and frontier markets. Laura Geritz, manager of our newest Fund, the Wasatch Frontier Emerging Small Countries Fund, and senior analyst Andrey Kutuzov, just returned from a seven-country visit to South and Southeast Asia where they met with companies’ management teams in places like Bangladesh, Cambodia, Sri Lanka and Pakistan. There are thousands of uncovered, small- and mid-cap growth companies in many of these countries and we think the long-term outlook for some of them is outstanding. While there certainly is volatility and risk inherent in many of these stock markets, there is also an opportunity to find quality companies suitable for our Funds to hold.

Thanking you as always for the opportunity to manage your assets.

 

Sam Stewart

The primary investment objective of the Wasatch Frontier Emerging Small Countries Fund is long-term growth of capital.

RISKS:

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. Investing in small cap funds will be more volatile and loss of principal could be greater than investing in large cap or more diversified funds.

An investor should consider investment objectives, risks, charges, and expenses carefully before investing. To obtain a prospectus, containing this and other information, visit www.wasatchfunds.com or call 800.551.1700. Please read it carefully before investing.

 

The S&P 500 Index includes 500 of the United States’ largest stocks from a broad variety of industries. The Index is unmanaged but is a commonly used measure of common stock total return performance. You cannot invest directly in this or any index.

Someone who is “bullish” or “a bull” is optimistic with regard to the stock market’s prospects.

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

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

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.

Return on equity (ROE) measures a company’s efficiency at generating profits from shareholders’ equity.

CFA® is a trademark owned by CFA Institute.

Information in this report regarding market or economic trends or the factors influencing historical or future performance reflects the opinions of management as of the date of this report.  There is no assurance that the process discussed will consistently lead to successful investing. These statements should not be relied upon for any other purpose. Past performance is no guarantee of future results, and there is no guarantee that the market forecasts discussed will be realized.

© 2012 Wasatch Funds. All rights reserved. Wasatch Funds are distributed by ALPS Distributors, Inc. WAS002763 7/20/2012