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Report from Research: Looking for “Fallen Angels” and “Orphaned IPOs”

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Q&A With Jim Larkins on Investing in Great Growth Companies When Few See Opportunity

Special Notice:  Fee Reduction.  On November 9, 2011, the Wasatch Funds Board of Trustees and the Advisor agreed to a reduction in the advisory fee for the Wasatch Small Cap Value Fund from 1.50% to 1.00% effective January 31, 2012. Additionally, the Advisor and the Funds executed an amended and restated expense limitation agreement, wherein the Advisor contractually agreed to an expense limitation of 1.50% on the Wasatch Small Cap Value Fund effective January 31, 2012, and continuing through at least January 31, 2013.

Salt Lake City, December 9, 2011 – Jim Larkins is a value investor surrounded by growth investors.  “Most of my Wasatch colleagues try to own the highest quality small cap growth companies in the market.  Given the volatile nature of small cap companies and the significant number of companies that stumble, our research team regularly presents a tremendous opportunity set for me as a value investor.  There is a market inefficiency that exists when a growth stock becomes a value stock and we can exploit it.” 

“I try to find great companies that hit a rough patch or a bump in the road.  They become ‘fallen angels’ for one reason or another,” said Larkins who has worked on the $181 million (as of 12/6/11) Wasatch Small Cap Value Fund since its inception in 1997 and has managed it since 1999. Wasatch Small Cap Value Fund (WMCVX) invests primarily in small companies with market capitalizations of less than $2.5 billion at the time of purchase. Larkins looks for companies whose stocks he believes are undervalued but have significant potential for price appreciation.

Larkins also looks for opportunities in Initial Public Offerings (IPOs) with good stories that have fallen off investors’ radar screens after the early hype of the IPO. “We look for good companies at a time when other investors are not paying attention.  This frequently occurs within the first couple of quarters or even the first couple of years after going public.  The Street moves on to the next deal and at the first sign of trouble, some really good companies get abandoned by the crowd. ”

 

In the following Q&A, Larkins discusses a few of the “fallen angels” and “orphaned IPOs” that he is following closely. 

Q:  How do you define a fallen angel?

Our definition of a fallen angel is a company that achieved success and then faces a crisis, regulation, or event that causes a near-term disruption to their business.  We want exposure to great long-run growth names at times when no one else sees the opportunity.  We look for long-run growth opportunities that have hit a bump in the road—not the end of the road.  Ours is a contrarian approach to exploit an inefficiency that happens regularly in the markets due to short-term challenges.  Many of the best growth stories owned at Wasatch have spent time in the value fund after stumbles as they were on their road to greatness. 

 

Q:  Give us some examples?

One of our favorites is the women’s clothing retailer Chico’s (CHS).  Chico’s was a Wall Street darling until about 4 years ago.  They had a remarkable same store sales record that didn’t miss, year after year.  But then they over-expanded and struggled with inventory systems and technology that was not as good as people thought it was. The economy didn’t help either, especially for their upscale, middle-aged client who saw the value of her 401k decline.  Chico’s named a new management team, invested in new systems, and improved their stores.  Now customers have come back.  The company has other positives with a new intimate apparel store called Soma and the recent purchase of online retailer Boston Proper, all thoughtful extensions of the company’s expertise targeting upscale woman customers.

Skechers (SKX) is another example.  The company is known for affordable family shoes, but the stock is depressed because of a foray into the toner shoe fad – Sketchers invented the Shape Up Shoe – that ultimately burned out.  They were caught with too much inventory and the stock tanked.  The upside is the company was able to reposition itself as a legitimate athletic shoe provider.  For example, they’ve been able to offer an ultra-light-weight shoe at a time when demand is growing.  They moved from a $30 to $40 price point up to shoes in the $60+ range. And they are able to use their great distribution and international presence to now leverage that reputation.

One last fallen angel I’ll mention is Bridgepoint Education (BPI).  The entire for-profit education sector was under pressure due to congressional investigations and new regulations related to student loan funding.  Bridgepoint was launched by former Apollo executives to offer a lower price point for working adults seeking a college education.  They modified their recruitment methods, implemented the new regulations and are now attracting new students and growing their base.  They produce good profits and cash flow and are buying back shares.    

 

Q:  You also invest in IPOs that have taken a hit post-offering.  Why?

We actively screen for IPOs that have cracked.  These are stocks that come public and then trade below their offering price.  One of the advantages of being a “value guy in a growth shop” is that we take a look at and know most of the good companies that are coming public.  These young companies can be fragile in the way they are traded by Wall Street.  Analysts and investors are still getting to know the company and understand the business model.  When some companies face their first public bout of adversity, investors will frequently sell and step to the sideline.  I have the advantage of having longer-range institutional knowledge about the company from our growth research which allows me to identify some of the companies whose long-term prospects are still attractive but whose stock declines may represent real small cap value.  

 

Q:  Name a few examples of “orphaned IPOs.”

Body Central (BODY), a fast fashion retailer with lots of stores in the Southeast, saw its valuation fall on general concerns about the economy and retailers.  The company came public at $13 and is now trading at $21.43 (@12/7/11).  The company briefly broke the deal price shortly after going public which gave us the opportunity we wanted to start a position at an attractive price.  We saw an opportunity for the company to grow at an attractive pace from 200 to potentially 500 or more stores.  Their stores appeal to teens and young adults and, with low price points, and we think the demand will be stable even in tough economic times. 

Another abandoned stock we like is Westco (WAIR).  They distribute fasteners for the aerospace industry.  They came public at $15, but are now trading in the $13.00 range (@ 12/7/11) as investors worried about defense industry cuts and the Boeing 787 production schedule. Yet Westco has good management, a 10-year track record of growth, and a really nice niche.   The Boeing 787 now has a backlog and is flying and Westco has excellent exposure to this 787 production.  We think they will perform well in the coming years at the aerospace cycle heats up.

 

Q:  What’s it like being a value manager in a growth shop?

In the long run, we are all trying to find great investments for our shareholders.  By managing a value fund in a growth shop I see subset of value names that I believe is unique compared to other value managers.  The potential return of buying names that are fundamentally long-run growth stories at value prices is very attractive.  You capture not only the effect of a correction in valuation but the compounding impact of long-run earnings growth.  Sometimes it takes some thick skin to buy the “scratch-n-dents” of the growth world.  But I buy many of the same companies other Wasatch Funds have purchased in the past.  I believe they’re good long-run investments that have just hit a rough patch.

Past performance does not guarantee future results.

About Jim Larkins

Jim Larkins is a cum laude graduate in Economics from Brigham Young University. Before receiving an M.B.A, also from Brigham Young, he worked in the technology sector as a systems consultant for Accenture and for Pinnacle Microa, a start-up technology firm where he gained valuable insight into smaller companies. At Wasatch Funds, he puts this knowledge to use researching small cap and micro cap companies.

About Wasatch Advisors®

Wasatch Advisors is the investment manager to Wasatch Funds®, a family of no-load mutual funds, as well as separately managed institutional and individual portfolios.  Wasatch Advisors pursues a disciplined approach to investing, focused on bottom-up, fundamental analysis to develop a deep understanding of the investment potential of individual companies.  The portfolio managers employ a uniquely collaborative process to leverage the knowledge and skill of the entire Wasatch Advisors research team in making investment decisions.  Wasatch Advisors is an employee-owned investment adviser founded in 1975 and headquartered in Salt Lake City, Utah.

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Investing in small and 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 entails special risks, such as currency fluctuations and political uncertainties, which are described in more detail in the prospectus.  Investments in emerging markets are subject to the same risks as other foreign securities and may be subject to greater risks than investments in foreign countries with more established economies and securities markets. 

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.

Small Cap Value Fund Top 10 Holdings as of Sept. 30, 2011

Security Name

Net Assets

Copart, Inc.

4.32%

CorVel Corp.

3.61%

DFC Global Corp.

2.60%

Huron Consulting Group, Inc.

2.52%

HEICO Corp., Class A

2.44%

Allegiant Travel Co.

2.09%

Body Central Corp.

2.02%

Old Dominion Freight Line, Inc.

2.00%

Skechers U.S.A., Inc., Class A

1.98%

Corporate Executive Board Co. (The)

1.96%

Total

25.40%

 Portfolio holdings are subject to risk and may change at any time. References to specific securities should not be construed as recommendations by the Fund or its Advisor.

©2011 Wasatch Funds, All rights reserved. Wasatch Funds are distributed by ALPS Distributors, Inc. (ADI).  ADI is not affiliated with Wasatch Advisors. Gene Podsiadlo is a registered principal of ADI.