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Wasatch Small Cap Ultra Growth Portfolio   

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Q4 2018
Small-Company Stocks Had Nowhere to Hide
by John Malooly, CFA

“Selling by investors was largely indiscriminate. Every sector of the Index except the tiny utilities component posted a loss.”

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Overview

Rising uncertainty in the U.S. and overseas sparked a sharp selloff in equities during the fourth quarter of the year. Small-cap growth stocks were hit particularly hard in volatile trading, with the benchmark Russell 2000 Growth Index finishing down -21.65% for the quarter.

Wasatch Small Cap Ultra Growth portfolios declined less than their benchmark. For 2018 as a whole, the portfolios posted solid gains, which compared favorably to the benchmark’s full-year decline of -9.31%. As of December 31st, the portfolios had significantly outpaced their benchmark over the preceding three-, five- and 10-year periods.

Worries about U.S. monetary policy dogged financial markets for most of the quarter. Economic-growth concerns moved to the forefront as seemingly contradictory messages from the Federal Reserve (Fed) stoked fears that the U.S. economy may be losing steam. The Commerce Department said real gross domestic product increased at an annual rate of 3.4% during the third quarter—revised down from the previous estimate of 3.5% and significantly weaker than the 4.2% pace logged during the second quarter of the year. As the immediate stimulus of the Tax Cuts and Jobs Act of 2017 continued to fade, investors fretted that a policy mistake by the Fed might bring on a recession in 2019.

Adding to investors’ apprehension was a lack of meaningful progress in resolving the trade dispute between the U.S. and China. Political uncertainty also weighed on sentiment from several corners. Civil unrest in France, together with the prospect of a “no-deal Brexit,” fanned anxiety about European growth even as a budget impasse forced a partial shutdown of the U.S. federal government. Softness in U.S. single-family housing starts and weaker-than-expected industrial production in China amplified concerns about a potential slowdown in the global economy.

Slowing global demand growth helped send U.S. crude oil prices tumbling as the energy component of the Index declined over -40% during the quarter. With every sector of the Index except the tiny utilities component posting a loss, there was virtually nowhere to hide. In the portfolios, industrials and consumer discretionary were the best contributors to performance relative to the benchmark, while overweights in information technology and health care hurt relative results.

Details of the Quarter

The strongest contributor to portfolio performance for the quarter was Cocrystal Pharma, Inc. (COCP). The company develops antiviral therapies for hepatitis, influenza and noroviruses. Shares of Cocrystal Pharma surged in November on positive data for its lead drug candidate in preclinical studies for the treatment of influenza. The candidate demonstrated antiviral activity against influenza A, as well as against seasonal and pandemic influenza strains.

Instructure, Inc. (INST) was the second-best contributor. A Software-as-a-Service (SaaS) company, Instructure provides applications for learning, assessment and performance management. The company’s stock price jumped in late October after quarterly earnings and revenues came in above Wall Street forecasts. Management cited a number of new contracts signed with school systems and corporate customers. Investors also reacted positively to the new CEO scheduled to begin leading the company on January 1, 2019.

A well-timed purchase of Twilio, Inc. (TWLO) provided the third-largest contribution to performance. We bought the stock on weakness during the quarter and the portfolios benefited as the stock rebounded. Twilio creates apps that businesses use for communication management. The company expects its recently introduced Flex platform to drive rapid growth over the next several years.

The greatest detractor from portfolio performance for the quarter was Selecta Biosciences, Inc. (SELB). A clinical-stage biopharmaceutical company, Selecta develops drugs for the treatment of diseases that include gout, mesothelioma and inborn metabolic disorders. Early trial results have been promising, but the company illustrates the common tug of war we see in the biotech space: great science, but a lack of financial resources to transform the science into a marketable product. Selecta failed to raise capital when its stock price was higher and now investors fear the company may not be able to do so at favorable terms. At this point, the stock represents an extremely small position in the portfolios, so we’ll continue to hold it as we expect to see new information emerge that may provide a needed boost to Selecta’s stock price in 2019. 

Selling by investors was largely indiscriminate. Paylocity Holding Corp. (PCTY) declined somewhat during the quarter with no significant change in the company’s business prospects. As the most-heavily weighted holding in the portfolios, however, Paylocity was the second-largest detractor from performance. The company provides software for payroll and human-capital management (HCM) using the Software-as-a-Service business model. Paylocity’s integration marketplace allows its customers to review more than 300 integration partners and capabilities across a number of HCM functions. We maintained our position.

Another weak stock in the portfolios was Proto Labs, Inc. (PRLB). An industrial company, Proto Labs manufactures custom parts for prototyping and short-run production. Adjusted for non-recurring items, earnings per share at Proto Labs soared 54% in the company’s most-recent quarter on 31% revenue growth. Although the results topped Wall Street forecasts, Proto Labs saw its stock price decline amid concerns of a slowdown in the industrial U.S. economy. We believe the selloff in the stock does not reflect the potential for Proto Labs to continue to deliver strong growth, so we continue to hold a meaningful position.

Outlook

Of the immediate obstacles facing global financial markets, the potential for recession in 2019 has become a significant concern. Fears of recession can become self-fulfilling as households and businesses rein in spending and banks become more conservative in their lending. While the recent plunge in oil prices should help consumers and the transportation industry, other factors—such as stock-market volatility, monetary tightening, trade wars and government shutdowns—only serve to cloud the near-term outlook and heighten uncertainty about the U.S. economy.

One widely watched, forward-looking indicator is the Treasury yield curve—a curve showing yields across U.S. Treasury securities with different times to maturity. The yield curve is upward sloping under normal conditions, while an “inverted” yield curve—in which short-term interest rates exceed long-term rates—is generally considered a harbinger of recession. The yield curve has been flattening recently, with inversion occurring at the three- to five-year tenor for the first time in more than a decade. Although opinions differ as to the yield curve’s accuracy in predicting recessions, a more-severe inversion of the yield curve would be a signal that should not be ignored in our view.

Through both up and down markets, we manage the portfolios from a long-term perspective. While we do seek to take advantage of short-term volatility to buy stocks at attractive valuations, we want to own companies that we believe can take market share and grow over a long investment horizon. We believe our disciplined approach to investing in small growth companies has the potential to generate attractive returns over time.

Thank you for the opportunity to manage your assets.


 

*The Russell 2000 Growth Index measures the performance of those Russell 2000 Index companies with higher price-to-book ratios and higher forecasted growth values. 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.

Wasatch Small Cap Ultra Growth portfolios have been developed solely by Wasatch Advisors, Inc. Wasatch Small Cap Ultra Growth portfolios are 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 2000 Growth 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 Wasatch Small Cap Ultra Growth portfolios or the suitability of the Index for the purpose to which it is being put by Wasatch Advisors, Inc.

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.

Earnings per share or EPS is the portion of a company’s profit allocated to each outstanding share of common stock. EPS growth rates help investors identify companies that are increasing or decreasing in profitability.

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.

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

The yield curve is a line on a graph that plots the interest rates, at a set point in time, of bonds having equal credit quality, but differing maturity dates. The most frequently reported yield curve compares three-month, two-year, five-year and 30-year U.S. Treasury securities. This yield curve is used as a benchmark for other interest rates, such as mortgage rates or bank lending rates. The curve is also used to predict changes in economic output and growth.

This commentary is intended to provide you with information about factors affecting the performance of Wasatch Small Cap Ultra Growth 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 Small Cap Ultra Growth 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.

CFA® is a trademark owned by CFA Institute.