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Wasatch International Micro Cap Portfolio   

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Q1 2019
Wasatch International Micro Cap Portfolios Outperformed as International Markets Rallied in the First Quarter

“We have been seeking to take advantage of the many great buying opportunities that have resulted from indiscriminate selling across global markets.”

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Overview

Wasatch International Micro Cap portfolios posted double-digit gains for the first quarter, outperforming the benchmark MSCI ACWI (All Country World Index) ex USA Small Cap Index, which rose 10.26% during the period.

The first quarter of 2019 saw a strong rebound in equity markets across the world as concerns about a potential escalation in the U.S.-China trade dispute and worries that higher interest rates would dampen global growth quickly faded with the New Year. While there is still uncertainty with regard to how trade negotiations between the U.S. and China will develop, investors seemed willing to give quick credit to any progress or even to a subsiding sense of confrontation. Expectations for U.S. Federal Reserve actions on interest rates have evolved to the point that some market watchers now expect a rate cut by the end of the year. So while there are reasons for optimism on both fronts (which the market is now reflecting), in order for the market recovery to endure, the world will need to continue its long record of economic expansion.

While there are a number of macroeconomic and political risks that could yet potentially slow global growth and increase volatility in global equity markets, keeping our focus on high-quality companies is the best way we know to mitigate those risks. With that perspective, we aim to construct a portfolio of micro-cap businesses with sustainable competitive advantages that are able to thrive, not just survive, in fluctuating and uncertain environments like we are now witnessing.

Details of the Quarter

The portfolios’ developed- and emerging-market positions once again outperformed the respective components of the Index. The countries that made the largest contributions to performance during the quarter were Japan, Australia and China, while there were no countries that subtracted a significant amount from portfolio returns. Relative to the benchmark, the United Kingdom was the largest detractor on a country basis. Additionally, most foreign currencies did not gain or lose much value versus the U.S. dollar, so the portfolios performed quite similarly in local-currency terms and U.S.-dollar terms.

Japan regained its title as the largest contributor to portfolio returns in the first quarter, despite the somewhat muted market gains relative to some other world markets. Leading the way for Japan during the first three months of the year was Digital Arts, Inc., which develops and markets email-filtering and web-security software. With sales to public-sector customers accelerating, Digital Arts also has been seeing margin expansion, leading to strong stock performance on the back of a vigorous rebound in Japan’s information-technology (IT) sector.

Similarly benefiting from strong trends in Japanese technology stocks during the first quarter was Open Door, Inc., an online travel comparison website company that our team visited again when we were in Japan during the quarter. The company continues to scale its network in Japan, which provides operating leverage as Open Door continues to improve its competitive position.

Infomart Corp. runs an online platform that allows food-service companies to replace legacy phone and fax ordering systems. Not only have recent revenue growth and margin expansion translated into potent stock returns—the stock gained over 30% for the quarter—but the company’s significant headroom for growth and steady market-share gains have allowed the stock to return over 1200% since our initial buys in 2013.

In Australia, following lackluster gross domestic product (GDP) growth and consumer spending in 2018, as well as a housing downturn last year, the equity market roared to life in the first quarter of 2019, with the health-care and IT sectors performing especially well.

Pro Medicus Ltd., the portfolios’ largest position, was up strongly during the quarter and was the top overall contributor to performance. The company provides enterprise medical imaging and radiology information system software to world-class medical groups, and has been seeing strong growth in revenues along with margin expansion.

Webjet Ltd., an online travel-booking company that we’ve mentioned many times in the past, was another strong contributor in Australia as the company continued to grab market share and was able to achieve profit-margin targets earlier than had been expected.

A more recent addition to the portfolios, Appen Ltd., is a company we visited in Australia during the fourth quarter. Appen provides data for machine learning, and the company’s asset-light service business is seeing strong growth and has been benefiting from strategic opportunities to acquire other companies.

China also made a strong contribution to portfolio performance during the quarter. Yihai International Holdings Ltd. was the portfolios’ second-best contributor. Yihai’s stock rose over 80% as the company reported strong results for the second half of its fiscal year. Yihai makes and sells hotpot soup flavorings, hotpot dipping sauces and Chinese-style compound condiments under its parent’s Haidilao brand name. Since our initial purchases less than two years ago, the stock has returned over 740%.

Vitasoy International Holdings Ltd., which produces and sells soy milk, teas, and tofu products, is another stock that has been a multi-bagger (over 600% return) since we first bought shares in 2011. Optimism over ongoing capacity expansion in order to meet robust demand from China continued to propel the stock upward during the quarter.

While we were pleased with the performance of the aforementioned companies, the performance of a few companies was disappointing. The biggest detractors from portfolio performance in the first quarter were accesso Technology Group plc, TCI Co. Ltd. and Qol Co. Ltd.

London-listed accesso develops IT solutions such as virtual queuing, ticketing, point of sales, group ticketing and guest management for entertainment and leisure venues. Following some issues in the third quarter of 2018 regarding a surprise increase in research and development spending as well as increased capitalization of product development, the company recently announced unexpected management changes while not adequately addressing questions regarding future investment plans. Investors have not digested these communications well, and we have also exited the position due to lack of confidence.

Other United Kingdom positions that detracted from performance included Patisserie Holdings plc and Gear4Music Holdings plc. Bakery company Patisserie was pushed into insolvency after fraudulent accounting was discovered in the fourth quarter of last year. Gear4Music, an online retailer of musical instruments, saw its stock price plummet after the company reported that capacity constraints were limiting growth. We have since sold our small position. In spite of ongoing uncertainty surrounding Brexit negotiations (but with increasing hope that a disorderly exit will be avoided), U.K. employment growth remained strong. Though U.K. economic growth was still relatively anemic in the fourth quarter, we are optimistic regarding the prospects of our remaining positions there. On a country basis, the U.K. was the largest detractor from performance relative to the Index for the first quarter and the portfolios are underweight in the U.K.

The stock of Taiwanese health-supplement maker TCI was down nearly -19% for the quarter on concerns over China’s regulatory crackdown on inaccurate advertising. Our team met with TCI management during the quarter to discuss the issue and came away feeling comfortable that the regulatory concerns are not likely to impact future growth. Furthermore, we still believe the structural opportunity in health food and beauty products remains intact.

Japan-listed dispensing pharmacy Qol was the third-largest detractor for the quarter. In addition to a regulation change in Japan that disproportionately affects dispensing pharmacies, Qol’s earnings have not met our expectations. Given the small weight in the portfolios, we decided to cut our losses during the quarter and move on to higher-conviction names.

Canadian vitamin company Jamieson Wellness, Inc. saw its stock price decline on a more challenging outlook for cross-selling in its specialty brands business.

Outlook

In general, international equity markets ended the first quarter riding a wave of optimism over less trade confrontation between the U.S. and China as well as more-dovish central-bank attitudes. Not only do investors expect the U.S. Fed to not increase interest rates in 2019, but also with the Bank of Japan (BOJ) far from hitting its two percent inflation target, we can probably expect the BOJ to keep monetary policy accommodative. Similarly, European Central Bank (ECB) officials said the ECB would not raise interest rates this year either. It remains to be seen, however, if easier monetary policy and more-stable trade policies will be enough to support the global equity markets through the rest of 2019 or whether weakness in capital investment, manufacturing and exports will slow global growth. As always, it will be important to keep an eye on China to see if the government’s announced packages of tax cuts, infrastructure investment and support for bank credit growth will be enough to adequately stimulate domestic Chinese demand.

We’ve said it in the past, but especially following our recent trip to the Land of the Rising Sun, we remain excited about the opportunities for micro-cap companies in Japan. We continue to find many gems in the Japanese market that we think have the potential to drive stock returns for years to come. In addition to Japan, the Wasatch team made research trips to the U.K., India and Taiwan during the first quarter of the year that led us to a number of new names and allowed us to invest in companies that we see as high quality and that we believe improve the portfolios’ long-run return potential.

While there is still a lot of uncertainty in global markets today, our commitment to deep due diligence gives us confidence in the ability of our portfolio companies to navigate the ambiguous paths ahead. Our ongoing travels to the four corners of the globe have given us opportunities to continue to refine the portfolios as we have met with the management teams of prospective investments and current holdings alike. As we gain confidence in the business models and strategies of our portfolio companies, our optimism for the portfolios’ long-term prospects also grows.

Thank you for the opportunity to manage your assets.


 

*The MSCI ACWI ex USA Small Cap Index is an unmanaged index and includes reinvestment of all dividends of issuers located in countries throughout the world representing developed and emerging markets, excluding securities of U.S. issuers. This index is a free float-adjusted market capitalization index designed to measure the performance of small capitalization securities.

The MSCI World ex USA Small Cap Index is a free float-adjusted market capitalization weighted index designed to measure the equity market performance of developed markets, excluding the United States.

You cannot invest in these or any indexes.

Source: MSCI. The MSCI information may only be used for your internal use, may not be reproduced or redisseminated in any form and may not be used as a basis for or a component of any financial instruments or products or indices. None of the MSCI information is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such. Historical data and analysis should not be taken as an indication or guarantee of any future performance analysis, forecast or prediction. The MSCI information is provided on an “as is” basis and the user of this information assumes the entire risk of any use made of this information. MSCI, each of its affiliates and each other person involved in or related to compiling, computing or creating any MSCI information (collectively, the “MSCI Parties”) expressly disclaims all warranties (including, without limitation, any warranties or originality, accuracy, completeness, timeliness, non-infringement, merchantability and fitness for a particular purpose) with respect to this information. Without limiting any of the foregoing, in no event shall any MSCI Party have any liability for any direct, indirect, special, incidental, punitive, consequential (including, without limitation, lost profits) or any other damages. (www.msci.com)

Brexit is an abbreviation for “British exit,” which refers to the June 23, 2016 referendum whereby British citizens voted to exit the European Union. The referendum roiled global markets, including currencies, causing the British pound to fall to its lowest level in decades.

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.

 

This commentary is intended to provide you with information about factors affecting the performance of Wasatch International Micro Cap portfolios during the quarter. References to individual companies should not be construed as recommendations to buy or sell shares in those companies. Wasatch analysts closely monitor the companies held in International Micro Cap portfolios. If a company’s underlying fundamentals or valuation measures change, Wasatch will reevaluate its position and may sell part or all of its holdings.

Past performance is not indicative of future results.